If you have ever taken the time to attempt to develop a trading system, chances are that you have noticed a sort of “evolution” during the process.
Typically an individual will start out with a very simple idea. Typically that idea will involve some sort of trend-following or counter-trend trading technique. In any event, the plan is to generate trading signals using the simplest set of rules possible. And if the concept is good then the whole thing may go pretty well. At least for a while.
Eventually, if the system is like virtually 99.999% of all other trading systems, the performance will “lag”, however one might wish to define that term. And soon “doubt” will creep into the mind of the trader using the system. And he will start to wonder if maybe – just maybe – he can “tweak” things a bit and come up with a “better” system. And so the tweaking process begins.
This process usually starts out slow and then builds momentum as it goes. And if the individual in question is like a lot of other individuals who have ever developed a trading system, eventually the “system” ends up resembling a plate of spaghetti noodles, with “rules” twisting and turning in all manner of directions in order to make sure that the “everything is covered”.
Ultimately the developer becomes so weary of coming up with new rules all the time to cover every twist and turn – not to mention the inevitable disappointing results – that the system is either abandoned or stripped back down to its simplest elements. And the process begins again. (Please trust your humble author on this one – he knows of what he speaks).
Two Simple Concepts
So what is the key to successful trading system development? Books can and have been written in an effort to answer that question. But for our purposes, let’s boil it down to two simple concepts:
1) A simple set of rules (triggered by a logical catalyst).
2) An idea of the type of trading we intend to do.
The first concept is what I mentioned earlier. Finding a reasonable catalyst to trigger trading signals and a relatively simple set of rules to identify when the trigger is activated.
The second concept involves having an idea of how long you might hold a trade and also involves an honest assessment as to whether or not you have the wherewithal to follow the rules as they are written. To illustrate with a simple example, if a trader knows for sure that he or she will not be able to hold a position for more than a few days without feeling the urge to “do something”, then there really is no point in utilizing a long-term trend following system, for the odds are low that the trader will be able to hold onto positions long enough for them to pan out in a meaningful way.
One other key point to acknowledge is that it is impossible to “buy the bottom” and to “sell the top” with any consistency, so in almost all cases, attempting to do so is actually counterproductive. Given this reality, we are essentially left with attempting to take as much of what “the market gives us” as possible.
So understanding what to expect from your system and honestly assessing whether you have the wherewithal to actually follow it is key. This is neatly summed up I dare say in:
Jay’s Trading Maxim #5: Trading success requires, a) a method that has a realistic expectation of profitability, and, b) the financial and emotional wherewithal to follow the method.
“a” without “b” won’t work. Likewise “b” without “a” won’t work either. So with all of this in mind, let’s look at one “taking what the market gives us” approach.
Deciding How to Enter a Position
Markets have a way of lurching from bullish to bearish and back again in very unexpected fashion. This leaves traders with three entry method “possibilities”.
1) Attempt to anticipate the reversal
2) Buy (or sell short) as soon as a new trend is established
3) Wait for a new trend to be established then buy (or sell short) on the first pullback
Method #1 can theoretically generate the largest profits because it may enter into a new trend far earlier than either Method #2 or Method #3. However, it is also susceptible to the “Catch a Falling Safe” Syndrome, which let’s face it, can hurt.
Method #3 is a very reasonable approach, however it can require a great deal of patience – something that many traders do not seem to possess in abundance – and may also result in missing some very large moves if a security just “takes off and goes” on a long run before experiencing any kind of a meaningful pullback.
So for now we will focus on entry Method #2. This is also a good approach for option traders as we can enter a limited risk position (which is very useful for reducing dollar risk on those occasions when a new trend does not pan out but instead the security in question “whipsaws”) and we can also look at ways to “adjust the original position if the market in question does move in our favor.
Introducing Jay's First Thrust Method
Moving averages are probably the most basic of all market indicators, so since we are seeking a “simple” approach, it makes a lot of sense to start here. We will combine two basic moving average “concepts” into one method.
First, it is quite common for traders to deem the “long-term” trend for a given security to be “up” if the price is above its 200-day moving average, and vice-versa. On a shorter-term basis, Optionetics co-founder, the late George Fontanills often taught a simple 10-30 moving average crossover method. In other words, the current trend is considered to be “up” if the 10-day moving average is above the 30-day moving average, and vice versa.
So we will establish two simple “entry” rules:
A bullish trend is said to be established for a given security when:
a) The close is greater than the 200-day moving average, and;
b) The 10-day moving average is above the 30-day moving average.
A bearish trend is said to be established for a given security when:
a) The close is less than the 200-day moving average, and;
b) The 10-day moving average is below the 30-day moving average.
A Few Operating Notes:
-When a new “bullish” or “bearish” trend is established we will consider this a “first thrust” in that direction and will look to enter a position in that direction.
-Following an initial buy signal, if the 10-day average drops below the 30-day average and then reverses back above it, this is only considered to be a new signal if somewhere along the way, both the closing price and the 10-day moving average dopped below the 200-day moving average, otherwise this IS NOT a new buy signal.
-Our goal is to establish a “long” or “short” position (by buying a call or put option, respectively) just as soon as a new trend begins to emerge.
-If the security moves in our favor our objective is to “adjust” the original call or put position as soon as it is possible to do so and “lock in” a profit and to let the remaining position ride.
-If a position reverses before the original trend plays out, one must establish some exit criteria for cutting a loss (although again the purpose of trading an option is so that initial risk is limited to a predefined amount to begin with).
Figure 1 displays a bar chart for Spot Gold with the 10-30-200 day moving averages added. You see two signals display, one bearish in red and the other bullish in green.
Figure 1 – “First Thrust” Signals for Gold
Let’s look at the green “bullish” signal generated on 8/22/12. For trading purposes we will consider buying a call option on ticker GLD, which is an exchange-traded fund that tracks the price of gold.
We will look for a call option that:
a) Has at least 45 days left until expiration and
b) Has the highest Gamma value of the near-the-money options for that expiration month
In Figure 2 we see a position that involves buying the 8 of the October 2012 GLD 160 strike price calls at a cost of $3,560.
This position has 56 days left until expiration and a Gamma of 3.95, which is the highest among the October call options.
Figure 2 – Long Oct 2012 GLD calls
As you can see back in Figure 1, after this “bullish” signal, gold embarked almost immediately on a sharp advance. On 9/7/12, GLD closed above the Upper Bollinger Band and at this point the trade showed an open profit of $3,920, or +110%. At this point the trader has a choice to make:
a) Sell and take a profit
b) Let it ride
c) Adjust the position to try to lock in a profit with the potential for more.
As I mentioned, one of the advantages of trading options is that they afford you the opportunity to adjust an existing position. So let’s take a look at one of many ways that this position can be adjusted to lock in a profit, while still maintaining additional profit potential.
Adjusting a Long Call into an Out-of-the-Money Butterfly (with upside)
OK, let's be honest, there’s a title you don’t see very day. Anyway, let’s consider this an “advanced” lesson in adjusting a long call position. Here is the adjustment:
Original Position: Long 8 GLD October 2012 160 calls
-Sell 6 GLD October 2012 160 calls (locking in a profit on 75% of our original position)
-Sell 3 GLD October 2012 173 calls
-Buy 2 GLD October 2012 186 calls
This changes the position to that which appears in Figures 3 and 4
Figure 3 – Adjusted GLD Position
Figure 4 – Risk curves for adjusted GLD position
As you can see, this adjustment locks in a worst case profit of $2,647 while still retaining additional unlimited upside potential.
Figure 5, 6 and 7 display “First Thrust” opportunities in crude oil, Japanese yen and t-bonds. A serious Optionetics student might consider taking the time to use Platinum software to “walk through” some hypothetical trades using these “signals” – with the key decisions being:
-How much to commit to a new position
-What position to enter
-What type of stop-loss criteria to use
-When to “adjust” the position if possible
-What type of adjustment to make
Figure 5 - First Thrust signals for crude oil
Figure 6 - First Thrust signals for japanese yen
Figure 7 - First Thrust signals for t-bonds
Whether or not you ever use this particular method to enter actual trades, working through the process above can be one of the best ways to teach yourself to be a better trader.
Certainly not every “First Thrust” signal will result in a meaningful new trend. Sometimes a market may move little bit in the right direction before stalling, and in other cases, the signal will be just plain wrong and the market will reverse. Hence the reason that stop-loss and a reasonably early trade adjustment trigger must be planned out in advance.
The method I’ve described here may apply greatly to some traders and not at all to others. That’s just the nature of trading. The key overarching point however, is the concept of planning out a method in advance to attempt to take as much as possible of “what the market gives you” – as simply and efficiently as possible.
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site