FXStrategies Web-site

FXStrategies is a great little web-site that I’ve just recently come across through my association with the trader behind it, Frank Walbaum. Originally from Germany, Frank now lives and trades from his adopted home in Singapore. I got to know Frank at a recent FX conference where we were both speakers and we’ve kept in touch ever since. Frank is a professional trader who started off working in a family office for three years before moving to managing other people’s funds in 2014. He has a refreshingly simple “naked trading” approach with no indicators or bells or whistles: instead it’s about candle patterns and support and resistance lines for him. Each morning (9 a.m. UK time) Frank runs a “morning call” where he goes through his trades and discusses what he’s presently looking at in the markets. It’s also a chance to ask him questions and learn about his approach to trading.

For subscribers who pay his modest monthly fee, his web-site has loads of content including numerous webinar recordings (include some by myself on trading psychology), tutorials, podcasts, Metatrader code and all sorts of other stuff. You also get access to his trade call updates many times a week via Twitter. As a subscriber you can also ask Frank questions directly via Skype or e-mail. He is happy for others to learn how to trade his style and this offers a great opportunity to have direct access to a top professional trader.

So all in all it’s a great little site and well worth looking into.

Just some of the tutorial content that’s available on the site for subscribers

Naked Forex Now

The Naked Forex Now forum is a great forum that has been set up by Walter Peters, author of the book “Naked Forex – High Probability Techniques for Trading Without Indicators”. His background is in psychology but he got bitten by the forex bug and has spent many years researching and developing his trading approach. His main idea is to throw away all those indicators and just to rely on price action itself, hence the “naked forex” in the title. What is so refreshing about his site is that he doesn’t preach trading in any one style, rather the idea is that one should come to ones own method of trading that suits one’s own personality and his site is all about going through that process. Firstly, I should mention that this is a private forum for which you pay a fee to access it. Whilst many wannabe traders may balk at this prospect I suggest that you at least read through until the end before dismissing it out of hand.

 

The site is set up in different sections. To start with there are the “house experts”, currently Mr. Peters himself, Darren Littlewood and Jorge Espinosa who each have a different trading style. They each post their trades and answer questions on their trading approach and are generally very accessible. Walter uses support and resistance lines on daily and weekly charts for his set-ups, Jorge uses the “4E” strategy, a short term swing approach whereas Darren trades using his “Flow Method”, an unusual form of stop and reverse trading which has a refreshingly unique philosophy behind it. Each expert posts regular video updates (Walter often doing two updates a day) on their trades. They are also very willing to answer any questions that you may have and will go out of their way to help.

 

As well as this there is also a whole host of teaching material from Walter. He’s developed a vast number of courses over the years and all these are on offer as part of the membership of the site. These include the trading set-ups that Walter uses as well as a great psychology course that is a must-do for any trader (I can testify to this!). There are hundreds of hours of video material all available for members to view.

 

But what makes the Naked Forex Now forum stand out from others is the community feel. There is a supportive and encouraging atmosphere from the various members like nothing I’ve found anywhere else on the web. What’s more these other members post some great content of their own. There are a number of trading journals from people, some of whom are really expert traders. “Rupin9999”, a very successful trader who trades for a living, did a webinar for the forum a while back which blew people away and she now has a thread on the forum dedicated to followers of her methodology. “Martin” has taken some of Darren’s ideas and made them his own with some very profitable tweaks that you can follow within his journal. “James” is a professional fund manager who has joined the forum and who kindly shares some of his many techniques within another thread. There are many others who have taken some of the basic ideas and have made them their own and then are only too happy to share their ideas with members.

 

This does illustrate the core idea behind the forum, namely that of finding something that suits your personality and then making it your own. The basic process is that you take a look at the many approaches that are on offer, have a go at trading them using ForexTester which is a great bit of software that allows you to back-test bar by bar, making your trading decisions and then seeing how they play out. Gradually you should start to adapt these approaches to suit your own psychology and to make them your own before trading a demo account, then a small live account and finally a full-sized live account. There is a lot of emphasis on the psychology side of things all the time, with constant mention of how important it is to find something that suits your personality otherwise at the first sign of trouble you’re going to dump it.

 

One point I should mention is time-frames: most of the traders on here tend to be trading off at least 4 hour charts if not longer. Walter often has daily or weekly set-ups and whilst Darren has traded off 1 hour charts he’s presently doing 4 hour as well. For short term traders or scalpers you might find relevant content rather thin on the ground. There has recently been a webinar on a short-term scalping approach and people have been doing journals on high frequency EA trading but the general focus does tend to be on slightly longer term stuff. This also applies to automated trading as well – there isn’t a great deal of content on this though there are one or two people who are posting regularly about this.

 

To add to the mix, on the forum there are regular webinars, sometimes from the house experts but often from either guest speakers or from members of the community themselves who want to share a trading approach. Walter also does a regular Non-Farm Payrolls trading webinar where he uses a simple trading approach off 5 minute charts to trade this news release. As an aside, if you want to learn more about what Walter and Darren think about trading then they post weekly podcasts under the title “The Two Traders”, well worth a listen!

 

In conclusion, this is a fantastic site for supporting traders on their quest to becoming profitable and successful and I personally have been a member since April 2015. By way of full disclosure I should mention that I’ve been posting so regularly that Walter has promoted me to one of the regular “house posters” for which I get modest compensation and free membership. Having said that, I can definitely say that I would willingly pay for membership – it’s one of the best investments a trader can make to help them on their way to becoming successful.

Some Thoughts on the UK EU Referendum Outcome

I thought that I’d just take the time to post some thoughts on the whole EU referendum situation as it’s really a huge deal here in the UK. Half the country is mortified at what we’ve voted to do and it feels like a very divided nation at present. Personally I think that there are several factors at play here in how we got to this point:

 

1. In my opinion this outcome all stems back to the 2008 financial crisis and the subsequent austerity that has been imposed on the country. The conservative party have been preaching a “sound national finances” line and have imposed round after round of cuts in the public sector. Remarkably, the country seemed to take all this very quietly with no protests or riots or anything. However, this kind of austerity hurts the poorest the most and away from the affluent south of the country these poorer regions voter overwhelming to “Leave”. In that respect it’s very much a protest vote – if we’d been in the midst of a huge economic boom at the time then the outcome would surely have been different.

 

2. One of the most controversial aspects of the EU is the free movement of people within it. What it has effectively meant is that people from eastern europe have come over to the UK where they are more than happy to work for the minimum wage which to them is a pretty good amount. Now, here in the UK people probably wouldn’t be prepared to work for this little but the migrants are effectively undercutting them and keeping wages down. That’s how free competition in the job market works but it can be brutal when you introduce this migration factor. Incidentally, the even Conservative government realised that the working people were suffering when the raised the minimum wage quite a bit – most uncharacteristically generous for the Conservatives! Anyway, so when the down-trodden workers get a chance to vote down this whole free movement thing naturally they seize on it with both hands. Of course, whether they’ll actually get rid of this economic migration as a result very much remains to be seen.

 

3. David Cameron, the British prime minister, has a lot to answer for. The Conservative party has been suffering for years from political in-fighting with the euro-sceptic right of the group and with Mr. Cameron only having a slim majority he decided for once at for all to lance this boil with a referendum, to have it out once and for all so that he could get on with governing the country. However, there were several areas where he went wrong:

 

i) His timing was very poor (for the reasons that I’ve stated in points 1 and 2)

 

ii) He meant to use the threat of the referendum to get a better deal from Europe which would give everyone an incentive to vote Remain. However Europe didn’t take the Leave vote that seriously and called his bluff so he came away with next to nothing

 

iii) The campaigns on both sides were terribly negative with all sort of ridiculous claims which were complete speculation (or even down-right lies). I quickly switched off completely from listening to either of them. One of the worst things to see was George Osborne (the UK chancellor) threatening a “punishment budget” of tax rises and more austerity should we all not do as we were told. That man seems to have a real political blind spot about some of his actions and basically with this blunder (and the Leave outcome) he finished his political career.

 

The bottom line is that David Cameron bet the entire country on a gamble to sort out his party’s in-fighting and he lost. He will go down in history as the man who drove the UK out of Europe and possibly even lead to the break-up of the United Kingdom with Scotland now almost certain to hold another independence referendum and this time they’ll probably win (though quite how they’ll balance their books now that oil is half the price it was at the last referendum is beyond me). Northern Island too is deeply unhappy about suddenly having an international border to police on its frontier and Wales will surely not stay united when everyone else has left. He might even become the man who breaks up the whole EU (see point 5).

 

4. Ed Milliband too has a lot to answer for though he can’t really accept as much blame as Cameron. Had he not stood against his brother David, the Labour party might have been a more credible opposition. Who knows what the outcome of the election might have been with David not Ed at the helm. If we’d had another coalition government (as had been predicted) then this referendum never would have taken place.

 

5. Europe too must shoulder some of the blame. The truth is that the EU is very far from perfect. It’s bureaucratic and unaccountable and doesn’t seem to care at all what the people of Europe want but just keeps ploughing on with its grand vision of a united states of Europe. Now, don’t get me wrong, I still think that on balance Europe is a good idea: the Single Market and the peace aspect are all real boons and in these troubled times it pays to stand together in larger multi-nation groups and for this reason I voted Remain. However, it is in desperate need of reform but because of it’s lack of accountability, doesn’t seem to see the need to do so. Any national government this unresponsive to its people would have long ago been kicked out but it doesn’t seem possible to do that to the Eurocrats so nothing changes. Over the years there have been various national treaty votes and occasionally the people of one country have stood up and said actually enough is enough and we don’t really share this united states of Europe vision. What do the Eurocrats do? Why they sidestep the vote, make the treaty change by the back door etc. This typifies their attitude. And as for the Euro, whilst it’s great to have a single currency to conduct trade with, the whole point about a free-floating currency is that it can adjust to take up the slack in the rise and fall of the fortunes of a nation’s economy. However with the one-size-fits-all Euro, Germany prospers whilst other countries go bust. There is of course no easy answer to this problem and for some reason the single currency seems to be inextricably tied up with the whole european identity but eventually something has to give and it will be messy when it does. Through this lack of reform, Europe has now lost one of its strongest economies and now that the genie is out of the bottle other countries are starting to talk about their Brexit as well. It’s not impossible that the whole thing might unravel. One point of light in all this darkness is that one of the EU ministers said yesterday in the EU summit something along the lines of “perhaps we should actually start paying attention to what the people of europe want from now on”. Let’s hope it’s not too late.

 

So that’s my analysis of how we got to this point. What is going to happen next it anyone’s guess and it’s still not certain that Brexit will happen for sure. I might write some more on what might happen next in due course but it’s been good to get all this stuff out on paper which has been rattling around in my head for days now.

Choosing a Broker – Safety of Funds

There’s one aspect to choosing a broker that often gets overlooked which is safety of funds. Sadly, when you place your money with a broker your money is at risk from the broker going bust. Now, you may think that this a very remote possibility and of course it is but during the 20 odd years that I’ve been trading (very much on and off) I’ve had two brokerage accounts go bust on me so it does happen. You only have to look at the “Francageddon” incident to see what can happen in extreme circumstances and quite a few brokers went bust when the Swiss Central Bank suddenly pulled the plug on their EURCHF line-in-the-sand that they’d been supporting for quite some time. The thing that you have to remember is that a broker takes on the liabilities of its clients so if a few clients get into serious trouble and go bust then the broker is suddenly dumped with those losses. Sometimes it’s a rogue trader who racks up huge losses and keeps doubling down to try and make it back (à là Nick Leeson). If this person happens to be trading with your broker and they don’t spot it then again the broker can go under. Now of course you’d expect that all brokers would have proper risk management in place to spot all this but sadly it does still happen. All scary stuff!

How safe is your money with your broker?

Fortunately, here in the UK we have the Financial Conduct Authority (FCA) who oversee financial institutions. They have minimum capital adequacy regulations (basically each broker much have sufficient funds to cover such contingencies) and there is a compensation scheme which means that you’ll get back the first £75k or so of your money should they go bust. This is a very re-assuring thing for UK investors and which leads me on to my general rule when choosing a broker that you should choose someone in a good jurisdiction where there’s proper regulation and a reasonable chance of getting your money back should they go bust. I wouldn’t personally invest in some small off-shore brokerage company in a country that I’ve not even heard of and quite frankly you’re asking for trouble if you do this.

There’s one more thing to consider, namely that some brokers are down-right dishonest. I’ve heard of one case of an off-shore broker that, when clients try to withdraw their money, they suddenly decide retrospectively to adjust all their fills, slipping each trade by a few pips on every trade they’ve done so that suddenly all the profit that was sitting in their account has vanished. All completely illegal of course but whether you can do anything about it depends on whether they’re regulated at all. Again, it’s worth looking at the broker’s business model: if they’re an ECN then they’re not going to do something like this as they don’t care about the trading as long as they get their commission. A bucket-shop type of market maker on the other hand is going to have more of an interest in you doing poorly. Of course such blatant dishonesty isn’t a viable long-term business model and word does get around but you should be wary of reviews in public forums as they can be posted by the brokers themselves. A good sign of this is a broker review from a new member who’s only done one post – very dodgy! 
So, in conclusion, the safety of your funds in the worst case scenario is an important part of choosing your broker.

FX Broker Review: LMAX

LMAX are a UK-based ECN broker that I have used and at the time of writing still do use. I first came across them via some promotional material and was blown away by how tight their spreads seemed to be. Up until now most of the retails brokers that I’d come across were Market-maker type of brokers but LMAX were an ECN operation with a very low cost of entry (see the post here for the important difference between Market-maker and ECN brokers). I did further research and decided that I liked them and opened an account. 

It turns out that LMAX are actually primarily (or at least originally) a platform developer and they have some super-fast technology for matching orders etc. so in a sense they are offering their own exchange. They also offer a brokerage service and their web-platform gives you access to their exchange with all the usual functionality that you’d expect. They offer all the major and minor FX pairs that you might expect with quotes from a number of different liquidity providers as well as some CFD offerings on the major indices and commodities etc. All well and good and I had no complaints about their service. After a while I switched over to their Mt4 offering which too all worked fine.

The LMAX web platform – click to enlarge
So how are LMAX compared to other brokers? Well, firstly they’re an ECN broker which is important to me. Their pricing is pretty tight (though I’ve since come across tighter) which is what you expect and hope for from an ECN offering. During news releases the spread quickly reverts back to reasonable levels and there aren’t any horrible “air pockets” of liquidity when you’re trading. Commissions are reasonable and on the couple of occasions when I’ve had to ring them up they’ve been competent and dealt with my queries quickly and accurately.

So, is everything wonderful with LMAX? Well, sadly not. Firstly, their CFD offering are market maker driven and are therefore prone to the usual price manipulation. In fact the example of price manipulation in the Crude Oil CFD contract that I wrote about was on the LMAX platform (see original article here). Fair enough – the CFD’s aren’t on their ECN and one knows what to expect from a market-maker broker. 

Secondly, and this for me is the killer, LMAX overnight swap rates are outrageous – they’re by far the worst ones that I’ve come across and for me they’re a total deal-breaker when it comes to holding positions overnight. Now, I know that swap rates aren’t the first thing that people think about when choosing a broker and that’s precisely why brokers can be rather devious with these charges (see the article on swap rates here). I did query them with LMAX, kind of expecting that they’d reduce them for me since I’d actually pointed out how expensive they were – but they didn’t seem to care.

So, in conclusion, they’re a decent enough broker but only if you don’t use their CFD’s and you don’t hold positions overnight.

The Gambler’s Fallacy

I thought that I’d write about something known as the “Gambler’s Fallacy” as it’s something that crops up in trading (particularly FX trading) from time to time. The basic idea is that you can make money by betting cleverly and that somehow through doing this you can turn something that has no inherent edge into something that does. The clue as to whether this works is in the second half of the name – of course you can’t do this but it can be packaged up in a very alluring way that can trick the unwary.

 

Here’s how it works. Take any game of chance with a 50-50 win rate such as betting on black or red on roulette. Make a 1 unit bet on either and if you win then you simply collect your winnings and start again. If you lose then your P&L is currently -1 so this time you bet 2 units, one to cover your loss and one is the profit that you’re looking for. Again, if you win you’ve ended up +1 so far on the session but if you lose then you’re now -3 on the session. Once again if you lose you now bet 4 units to try and make back the 3 that you’re down and 1 for your net profit. I’m sure that you can see that pattern here, you keep doubling your bet each time you lose, hoping to make back your losses and your 1 unit profit. Eventually of course you will win and then you pocket your net +1 unit profit and start the whole process again.

 

It sounds fool proof and the appealing thing about it is that most of the time it works. In fact my daughter used this method at a college ball on a play money casino to break the bank, cleaning them out entirely! However, before you start reaching for your wallet and heading to the nearest casino, the downside to the method is that eventually you’ll hit a losing streak so big that you’ll hit either the house limit (the maximum bet size that a casino will accept) or you’ll run out of money. It’s unlikely but of course eventually it will happen just as eventually it will come up ten blacks in a row on roulette.

 

You also have to be aware of how quickly the bet stake grows. Say you come to the table with 100 units.

After 1 loss    you’re left with 99 and betting 2
After 2 losses you’re left with 97 and betting 4
After 3 losses you’re left with 93 and betting 8
After 4 losses you’re left with 85 and betting 16
After 5 losses you’re left with 69 and betting 32
After 6 losses you’re left with 37 and betting 64

… except that you can’t because you don’t have enough money left! So with 100 unit table stake, 6 losses in a row will leave you with only 37 units left and unable to recoup your losses. What’s more, this event will happen 1 in every 64 rolls so it’s more likely than you think!

The Trading Equivalent

So what has all this to do with trading? Well, the other day I came across a “foolproof” way of trading which was basically this concept though package up in a rather elaborate way. You can download the pdf here if you want. It basically involves setting up a breakout strategy. If it wins then you’re done for the day, if it loses you take a trade in the opposite direction and (you’ve guessed it) you double your size. Keep doing this until you’ve made your money for the day or you’ve wiped out your account.

Grid Trading

There is one other area where this sort of concept comes up which is grid trading. This basically involves buying and selling at fixed intervals on a chart usually in a mean reversion way and hoping that the market reverses after trading. Usually these strategies are offered as an EA (Metatrader Expert Advisor) of some kind which promises untold riches. There are all sorts of elaborate variations on this theme, which generally involves doubling your stake size or at least taking on increasingly large positions in order to try and make back your previous losses and a little bit extra for your profit. They all suffer from the same Achille’s Heel that the Gambler’s Fallacy does, namely that eventually the market will keep going against you and will wipe you out.
A client of mine spent quite a lot of time testing out various versions of these, trying to find a combination of parameters that would somehow avoid the inevitable. I kept telling him that no variation on this theme was going to work but that wasn’t what he wanted to hear. I don’t know whether he saw the light in the end, I hope that if he did it wasn’t at the expense of his entire account!

 

How Good is Your System?

How good is a trading system? How can you compare the performance of two different systems and make a judgement as to which you would rather trade? Originally published in “Traders Magazine”, in this article I explore the various different ways of assessing the merit of a trading strategy.

Strategy Development Process

There are many different software platforms available which offer the ability to develop and test trading strategies on historic data and many traders are out there working away trying to develop a winning system that will make them rich. Whilst the software functionality makes the process of testing a strategy relatively straight-forward many have found to their cost it is not as easy as it looks to translate these virtual test results into actual hard cash. Many a trader has come unstuck when his system, which performs wonderfully on historic data, falls flat on its face when trading with real-money. This leads to an important question: how do you measure how good your system actually is?

 

Typically when developing a system there is an iterative process which involves coding up an idea and seeing how it performs and then assessing that performance according to some figure of merit. The system is then adjusted or often parameters are optimised to achieve the best figure of merit for the test data. When system developers work on systems they often assume that the only figure of merit worth looking at is the net profits that are generated by a system and when optimising over a range of parameters they will often use this figure alone to select the optimal parameter set. However this can be a far from ideal approach to system development and can often be misleading. For example the system could have one huge winning trade and the rest are losers but still come out as the best profit figure. Whilst this system might have generated the highest total return over the test period it is relying on the one huge trade to make up for everything else and the circumstances which lead to that trade may have been unusual. This means that the test results won’t be very reliable. It is therefore important to look at a number of the strategy performance figures when assessing how good a system is.

Percentage Profit

There is an equation for the average profit per trade of any trading strategy which (before costs) is:

Avg Profit Per Trade = Pwin x Wavg – Plose x Lavg

where
Pwin =  percentage winners
Wavg = average win size
Plose =  percentage loses
Lavg =  average lose size

At break-even this average profit per trade is zero, so re-arranging this and using the fact that Plose=1-Pwin gives us:

Wavg/Lavg = (1-Pwin)/Pwin                    (Equation 1)

This represents the relationship between the respective average trade sizes and the percentage winners for a break-even system before costs. It is always amazing that system vendors (usually the less reputable ones) advertise systems as 90% winners in S&P’s etc. From the above equation it can be seen that just because a system has 90% winners there is no guarantee that it is profitable. For example a naked out of the money option writing strategy might have a 90% win rate but the losses when they occur will be many times the average premium collected and the strategy could still be a net loser. Without knowing the relative sizes of the wins and losses as well it is not possible to assess whether the system is net profitable or not on the basis of percentage profitability.

 

Whilst a high percentage win isn’t necessarily a pre-requisite to a profitable system, it does give an indication of how frequently you might expect profits to come along. It’s no good if you develop a long-term trend-following system if you are a short-term scalper at heart so this figure is important in giving you an idea of what your system is like. It helps to think of what sort of system you are developing: a long-term trend following system might for example only be profitable 20% of the time but the average winning trade is much larger than the average losing trade. Using our equation above we can see that for the system to break-even you need Wavg/Lavg to be 4, that is the average winner needs to be 4 times the average loser for the system to break even with this win percentage.

Case Study 1

Recently a client asked me to look at a set of parameters for a system that he was developing. He had chosen the parameter values based on optimisation of the total profit. When I looked at the performance figures the percentage profitability was only 7%! The optimisation process had resulted in the stops being incredibly tight which meant that the position sizing algorithm selected very large sizes to trade. This meant that most of the time he was being stopped out and in fact there were only three winning trades in the whole test but they had made very large profits compared to the numerous losses. Whilst this might still be a viable system it is important to think what it’s going to be like to trade this method. Day after day of losses waiting for that occasional big win – and what happens if you happen not to take that trade? That one trade makes up for all the losses and without it you have a losing strategy. This means that the system will psychologically be difficult to trade and also the test results are not very reliable because of the small number of winning trades.

The Number of Trades

This figure is not important in it’s own right except that too few trades means that the performance metrics of the system are less reliable. It also gives you an idea of what it will feel like to trade the system: will you be waiting for long periods for a trade to be generated or will you be constantly in and out of the market?

Case Study 2

A client had done an optimisation and wanted to know why the optimal parameters that he was getting were different from the ones that I suggested. I looked at his optimisation results from which he had simply picked the best Net Profit and noticed that his parameter set had only traded once during the entire test period and had held the position open for many months on what was supposed to be a short-term swing trading model. It is always a good idea to check that the trade results are sensible and what you expect from your model.

Average Profit Per Trade

This is always an important figure to look at because of trading costs. Equation 1 above did not include trading costs but these are an important part of the reality of being a trader. When testing you should always include realistic estimates of total trading costs including commissions and slippage. The average profit per trade after costs tells you how much profit there is left after you have paid all the costs. If this is rather small then it is important that you make sure that your trading cost estimate are correct. For example if you estimate that the total costs are 1.5 ticks for your system and your average profit per trade before costs is only 2.0 ticks per trade then you have better hope that your 1.5 tick estimate is correct because if the real costs are 2.0 ticks per trade then you won’t be making any money. This also tells you that your costs are 75% of your gross profits which is very high. For a high frequency trading strategy this could still be viable but you might want to work on reducing your costs in order to increase profitability.

Maximum Drawdown

Drawdowns are always an important figure to look at when assessing a system. They are a somewhat tricky figure to assess as they depend on a run of consecutive losing trades in order to create the drawdown which means that the order in which the trades occur makes a difference to the size of the drawdown. Now a run of losing trades can occur by pure chance just as when tossing a coin it is possible for it to come down as head eight times in a row, say. Alternatively a drawdown can occur because the prevailing market conditions at the time of the drawdown were not suited to the method. It is always useful to have a look at your system to try to work out whether a drawdown was generated by chance or because of the prevailing market conditions.

 

It is often useful to look at the ratio between the drawdown and the annualised profit return. For example the annualised return might be 20% and the maximum drawdown might be 15%. This is a ratio of 1.33 which is a reasonably healthy one. Anything over 2 is good, over 1 is ok, below 1 and your annual profits are starting to look a little small compared to the drawdown figure.

 

Drawdowns also have an impact on the initial account size: if you experience the maximum drawdown when you start trading a system you are obviously going to need at least the maximum drawdown plus margins to trade the system. However due to the uncertain nature of drawdowns there is always the possibility that the next drawdown will be even larger than the maximum one that occurred during your back-testing. You want to consider how large a drawdown you or your investing clients could stand before pulling the plug on the system. It is an unfortunate fact that investors tend to bail out of a system during a drawdown just before it turns round and tend to invest after a good run up just before it starts to draw down. It is therefore a good idea to keep the drawdowns to a manageable size even though this will mean trading smaller size and therefore reducing the profit potential. A professional fund manager for example might scale his trading size for a system down so that the maximum drawdown is only 5% if that is all he feels that his clients could stand.

 

It is also worth looking at the duration of a drawdown: a drawdown that lasts a year is pretty tough psychologically as well as meaning no income (from performance fees or from trading profits) for a whole year. How well could you handle such as situation? It’s one thing to look at an equity curve over 15 years with a good general up trend and to see a six month drawdown half way through this period in this context. It’s another thing actually to be in the middle of it wondering when or even if it will ever end. It’s at times like these that you can start to doubt your system. Therefore it is always worth studying your system’s drawdowns carefully.

Annualised Return

This is an often-overlooked performance figure but one which is very important as it tells you how much money you are going to make each year using it. If you are looking to make a living from a system you need to know whether it is going to make sufficient profits for you to live off. Professional money managers for example would are happy with a return of 20% with a maximum drawdown figure of 5% but if you have only 10,000 Euros or Pounds to trade then, unless your living standards are pretty modest, you are probably not going to be able to live off the profits that such a system would generate. Individual traders tend to tolerate larger drawdowns in order to gain increased profits but you still need to do this calculation and to check that you cal tolerate the larger drawdowns that go with larger profit potential.

Trade Distribution

When looking at the trade distribution you are looking for this to be fairly even. You don’t in general want all the profits to come from one or two huge trades though of course for some long-term trend following methods this may in fact be the way that that the system works. The more widely distributed the trades are the more volatile the equity curve is going to be. In fact when we come to look at the Sharpe ratio we’ll see that in general the lower the standard deviation of the trade results the better the system is.

 

The trade distribution will tend to vary according to the nature of the system anyway: a short term scalper will tend to have lots of trades all the same size whereas a long term trend follower is looking for a few huge winners to offset the numerous relatively small losses.

Sharpe Ratio

This is a measure that is particularly used by fund managers. It is a measure of the amount of profit that is being generated relative to the risk that is being taken.

Sharpe Ratio =     Rann / SDann

where
Rann   = Adjusted Annualised Return
SDann = Annualised Standard Deviation of returns

The Adjusted Annualised Return is meant to be the annual return over and above the risk-free rate of return, the idea being that you would otherwise have your capital in the bank earning risk-free interest. Whether you need to subtract off the risk-free interest rate from your rate of return depends on what instrument you are trading: for highly leveraged ones such as futures you are only tying up a small amount of your capital to the trade so you can still be earning interest on the bulk of your account whereas for an unleveraged stock position you are losing the interest that you would otherwise earn and so have to subtract it off from the return. In general to keep it simple and since I tend to work mostly with leveraged instruments I leave off the risk-free interest rate subtraction.

 

The annualised SD of returns is the standard deviation of the return figures multiplied by a scaling factor to annualise it. The scaling factor will be explained below.

 

The calculation of the Sharpe Ratio is best explained by way of a simple example. Consider the monthly returns of a hypothetical trading system over two years below:

Month  Year 1   Year 2
Jan    2.45%   -0.91%
Feb    0.84%    1.23%
Mar    1.20%   -0.24%
Apr   -1.34%    0.89%
May    0.67%   -0.28%
Jun    0.80%    0.44%
Jul   -0.20%   -0.61%
Aug    3.20%    1.16%
Sep   -0.59%    1.74%
Oct    0.65%   -0.41%
Nov    1.18%   -0.68%
Dec    1.35%    3.10%

Using standard spreadsheet functionality one can determine that the average monthly return is 0.65% and the standard deviation of the returns is 1.21%. To annualised the return you simply multiply the average monthly return by 12. To annualise the standard deviation of the monthly returns you multiply it by the square root of 12. This gives annualised figures of 7.81% and 4.18% respectively. Thus the Sharpe Ratio comes out to be 7.81 / 4.18 = 1.87 in this case which is a pretty reasonable figure.

 

You can probably see that in calculating the Sharpe Ratio the numerator has the scaling factor (12 in this case) and the denominator has the square root of the scaling factor which means that the formula can be written as:

SR = squareroot( Scaling Factor ) * Ravg  / SDret

Where
Ravg  = average of returns
SDret = standard deviation of returns.

For monthly returns the scaling factor is 12, for weekly it is 52 and for daily it is around 260. You will get slightly different answers for your Sharpe Ratio calculations according to your sampling interval. The standard that is usually used amongst fund managers is the monthly returns.

 

The point of the Sharpe Ratio is that it measures performance relative to risk. If you take the system results in the table above and leverage them all up by 10:1 then the annualised return goes up to 78.1% but the annualised standard deviation will go up by the same factor of 10 so the Sharpe Ratio will come out the same. This makes it an extremely useful figure for assessing relative performance figures when different leverage is being used.

 

A very good Sharpe Ratio is anything over 2 but anything over 1 is worth looking at and 1.5 is a reasonable figure. This is a very useful figure of merit and one which is well worth calculation. Performing optimisations using the Sharpe Ratio can often give better parameter selection than other methods.

K Ratio

This ratio was developed by Lars Kestner. It is based on the simple idea that the best equity curve is one which goes up as a straight-line with as steep a slope as possible. Therefore the best measure of a trading system is how closely it follows the ideal. A straight line fit is first made to the equity curve and the slope of this line is measured. Next the deviation of the equity curve from the straight-line fit is evaluated: usually the standard error of the straight-line fit is used. The ratio is then given by:

K-Ratio = Seqc / ( Eslp * Square Root (Np) )

Seqc = Slope of Equity Curve
Eslp  =  standard error in slope from straight-line fit
Np    = number of point in equity curve.

Again this is best illustrated by way of an example. We will take the same returns as in the previous table and use them to construct an equity curve starting with 100,000 in whatever currency you choose:

Month  Year1         Year2
Jan    102,450.00    109,595.18
Feb    103,306.46    110,942.01
Mar    104,548.96    110,671.60
Apr    103,149.93    111,656.57
May    103,842.94    111,344.48
Jun    104,669.91    111,834.40
Jul    104,456.87    111,148.68
Aug    107,799.49    112,438.00
Sep    107,159.13    114,394.42
Oct    107,859.80    113,929.28
Nov    109,130.45    113,154.18
Dec    110,599.76    116,661.96

Next because the equity curve is compounded (each 1% gain is applied to the previous equity value not just the original 100,000) we need to take the log of the equity value. Otherwise the ideal equity curve is going to resemble an exponentially increasing curve rather than a straight line. Note however that if the equity curve is uncompounded then there is no need to take logs first. Next we fit a straight-line to this log equity curve. In Excel this is easily done using the LINEST function. This will give you the slope of the curve which is 0.002221 and the error in this slope value which is 0.000118. The K-Ratio is then given by:

K-Ratio = 0.002221 / ( 0.000118 x sqrt(24) ) = 3.84

which is a very good value. From the plot below you can see that the curve looks good and the straight-line fit closely matches it which is why the K-Ratio value is so good.

This is another indicator which is a good general performance figure and again which can be used for optimisations.

Visual Inspection

We’ve looked a variety of different ways of assessing a system’s performance including some more sophisticated methods such as the Sharpe and K- Ratios. However, one of the best ways of assessing a system quickly is simply to look at the shape of the equity curve. A quick glance at this tells you a lot about the system and what it is like. Does the curve slope smoothly upwards or are there prolonged periods of drawdown? Are there a few large spikes upwards indicating that a few huge winners are making up the bulk of the profits? Are there periods of prolonged sideways movement and if so to what period in the market do they correspond? This can often tell you something about the nature of the system and what its weaknesses are. It is for this reason that the equity curve plot is the first thing that I look at for any system.

Spreadsheet and Equity Curve Model

To help you get an understanding of some of these metrics there is a spreadsheet available for download here. Here you can see the details of the calculations of the Sharpe Ratio and the K-Ratio.

 

In addition to the above calculations, in the spreadsheet there is a formula for generating hypothetical equity curves using the model:

Current Return = Previous Return * ( 1 +  Trend + Noise * (0.5-RAND))

where Trend and Noise and user-input parameters for the equity curve model and RAND is a random number between 0 and 1 so 0.5-RAND is a random number between +0.5 and –0.5. You can vary the Trend and Noise parameters and see what sort of equity curves are generated (they are plotted in a chart) and look at the Sharpe and K Ratio values and other performance metrics. From this you can see that the larger the noise factor compared to the trend factor the more variable the performance is and the lower the performance metrics. Nevertheless it is surprising that even with a low trend factor for some of these essentially random equity curves they look good and have good figures. This is always worth bearing in mind least we look back at a good period of trading and conclude that we must indeed be expert traders – it could all be random!

Conclusions

Unfortunately there is not single measure of system performance that can be used to give an indication of how good a system is. Instead the developer needs to go through a variety of different measures in order to get a feel for the strengths and weaknesses of a system. We have seen how the Sharpe Ratio gives a good measure of the returns for a given amount of risk and how the K-Ratio gives a good assessment of the overall equity curve shape. It is important to take time when assessing a system, to understand why it is behaving in the way that it is so that one can incorporate this information into improving it still further. With this insight you can develop better trading systems.

Web Resources: Forex Live

There are plenty of forex news portals around besides Forex Live but this is the one that I use to keep in touch with what’s going on in the forex world. It’s a pretty straight-forward site with one central page where all the latest news and comments come up in real-time without the need to refresh anything. If you want to drill down into a particular article to see more and to look at the comments then you just click on the headline. There are sub-headings across the top which filter the posts by sub-category but I generally just keep on the front page. There is a team of several reporters who maintain rolling 24/5 coverage across all time zones. Posts include previews of impending news releases, actual numbers when they’re released (and they’re usually pretty quick about getting this out), general breaking news that might affect the markets, key orders levels (obtained by phoning around the big banks), option expiry news and some light technical analysis. Many of the team trade their own accounts and occasional give their trading opinions.

All in all it’s just what you’d expect and need from a forex news portal and it’s an integral part of my daily trading routine.

click to enlarge

Blatant Price Manpulation by Market Makers

A short while ago I wrote about the differences between the two main forex broker types, namely ECN brokers and Market Maker or Single Counterparty Brokers (see here). At the time I said that the problem with a Market Maker broker is that they’re taking the other side of your trade and hence there’s a huge conflict of interest and a great temptation for them to tweak their prices in their favour. There was a classic example of this yesterday during the Crude Oil Inventories release. I was following the Crude Oil CFD offering on an unnamed brokerage platform. Now whilst this broker’s forex quotes are a proper ECN (which is why I’ll trade with them), their CFD isn’t though I don’t know who is providing the quotes on their platform. Anyway, take a look at what happened as the market approached the post-release lows.

 

Crude Oil CFD

 

See that huge spike on the lows? I was watching the price there and the spread, which was a fairly tight 2 or 3 ticks suddenly went 20 wide as the quote provider fished for stop orders below the low. It did this two times in quick succession and then it was back to 2 or 3 ticks wide again. Compare this with the Crude Oil futures chart:

 

Crude Oil futures chart
FYI the two other broker CFD’s offering that I had accounts with (OandA and AxiTrader) were both fine with no spikes. I’ve said it before and I’ll say it again: don’t trade with a single-counter party/market maker broker on small time frames as the temptation may well be too great for them. I should just qualify this slightly: it does depend on the broker, some market maker outfits offer fixed price spreads and in general they won’t try this sort of thing on. Some of the better brokers will value their reputation too much to try it on as well so you may find that your broker is OK. You have been warned though!
For my part, I only trade CFD’s occasionally and fortunately I wasn’t in a position at the time. I’ll never trade Crude Oil CFD’s with this broker’s platform again though.

 

Is Trading Like Poker?

Is trading like poker? A strange question you might think but actually there are a number of similarities and making the comparison can help improve ones trading strategy. Adam Hartley explores the similarities and differences between the two and finds that learning about poker can improve trading performance.

There has recently been a great upsurge in interest in the game of poker, not least because of the recent TV coverage of the World Poker Tour where you can see the hands that the players have and watch their decisions as they make bets for huge sums of money. Traders are of course making similar decision with large amounts of money on a daily basis and like professional poker players, looking to make a living from this process. Can studying the habits of winning poker players help traders improve their performance?

Firstly, for those who are not familiar with the basics of the game need to be outlined. All variations of poker (and there are quite a few of them) come down to the relative rankings of 5 cards in each players hand. Players bet on their hand according to how good they think it is and at the end the player with the best hand takes all the money in the pot. The hands are ranked according to how likely they are to occur with the rarer hands beating the more common hands. The rankings are as follows:

High Card:             if all else fails the highest card wins
One Pair:                having a pair, i.e. two cards of the same rank
Two Pairs:              having two different pairs
Three of a Kind:     three cards of the same rank
Straight:                  a sequence of five cards in ascending order of any suit
Flush:                      five cards of any rank but of the same suit
Full House:              three of one rank and two of another rank
Four of a Kind:        four cards of the same rank
Straight-Flush:         a straight but all cards also the same suit

Some variations of poker give you more than five cards and the best five cards are selected to make the final hand. Most variations involve several rounds of betting on the cards as they are dealt out before the final showdown. Some have communal cards that everyone uses whereas other variations keep the cards separate to each player.

Having dealt with the basics of how the game is played the next question is how do professional poker players play the game and what can traders learn from this?

Great Expectations

The first and most important point is that poker, like trading, is all about expectations. This does not mean looking forward to making all that money, rather the expected value of a bet is the amount that you earn on average from it. If a bet of $1 will win the pot of $10 25% of the time and the rest of the time results in the loss of that $1 then the expected return from the bet is:

0.25 x $10 + 0.75 x -$1 = $1.75

That is to say, on average you will make $1.75 every time you find yourself in this situation and you make the bet. This is clearly a good bet to take as it makes you money on average. On an individual basis each bet could go either way but over a period of time it will average out to a clear profit. On the other hand if the bet will only win 5% of the time then the expectation is

0.05 x $10 +0.95 x -$1 = $-0.45

This is clearly not a good bet and over time will lose you money. That’s not to say that you cannot win this bet and some times you will be lucky but over a period of time you will be a net loser.

In the famous Market Wizards books Ed Seykota said  that there are good trades and bad trades, and winning trades and losing trades and that these are not the same things. A good trade is one with a positive net expectation and a bad trade is one with a negative expectation and these are not the same as winning and losing trades. The job of a trader or poker player is to take good traders or bets and not bad ones and to let the winning and losing take care of itself. This is often something that people have problems with: they get hung up on the winning and losing rather than whether what they are doing has a positive expectation. If the expectation is positive then the numbers will work out in the end. One way to think about it is to think that when you are making a trade or bet you are buying a piece of expectation and that if it is a good quality piece of expectation then over time this will crystallise into actual money but that your job is to seek out and purchase the best pieces of expectation that you can buy. If you make a good trade or bet then irrespective of the actual outcome you need to tell yourself that you’ve done the right thing and to keep on doing it. The worst thing that you can do if you get a run of losing bets or trades is to start deviating from a positive expectation strategy.
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Having an Edge

In order to have a positive expectation you need to have an edge. If there is no edge then you cannot get a positive expectation. There is a good reason why there are no professional roulette players: you cannot get a positive net expectation from any plays because of the house edge.

In poker they talk about how “tight” a player is. That is how disciplined and selective he is about what cards he chooses to play. One of the basic mistakes that rookie poker players make is in playing too many starting hands (the cards that you are initially dealt) that don’t have a positive expectation. In other words they are far too “loose”. A professional player knows that only the best starting hands are going to make money over the long run and so they spend most of their time folding their hands, waiting patiently for the best quality ones to come along. A poor player on the other hand will bet money on mediocre hands far too much. And what happens to this money? It ends up in the pockets of the good players who have had the discipline to wait for those big hands and to rake in big winning pots as a consequence.

A professional poker player can almost guarantee to make money over the long run in a loose game being played by relative amateurs. His edge in this case is in playing only the best quality cards and waiting patiently until they come along. You can try this for yourself with on-line poker games where you can even play with pretend money. Because there is no real money for stake people tend to bet on anything. If you play a disciplined and tight game then you will always come out ahead in the long run.

 

What’s Your Edge?

So how does what we’ve said so far relate to trading? As with poker, trading is all about expectations, making good bets and not bad bets, buying good pieces of expectation and letting the winning and losing trades come and go. Its about having an edge. Ask yourself with your trading what your edge is. Why is it that you expect to make money from what you do. A market maker has an edge which is the spread in the market that he is trading. Because he gets the right side of the bid and offer he has a positive expectation on his trades. Sure there will be times when the whole market turns bid and he’s the one selling to all those buyers but he still has an edge which will always win out. For the rest of us this spread is part of the costs that we have to bear when trading and these costs are significant. Our net expectation on each trade must be greater than all our costs per trade for trading to be worth doing at all.

Using this analogy of tight poker playing when thinking about trading can help you become a better more disciplined trader. When contemplating a trade, ask yourself are these the best trading conditions and do I have a genuine edge here or should I wait until better “cards” come along? Unlike in poker when you are forced to bet at least twice each time the dealership passes round the table (the small and big blind bets are forced bets that players have to make before they even see their cards) in trading there is no cost in not trading so sitting there waiting patiently for the right conditions to come doesn’t cost anything. It’s well worth remembering that you don’t have to trade and there is no point in doing so unless the conditions or trade set-up give you an edge. Over-trading is the trading equivalent of playing too loosely with the same devastating financial consequences.

 

The Only Game in Town

One of the most striking differences between poker and trading is the level at which the game is played. In poker you can get games with the stakes as low as a couple of cents for each bet all the way up to no limit games where tens of thousands of dollars are at stake. As you can imagine the higher the stakes the better the quality of the players. Fortunately the rookie player can start off at the bottom where the amounts risked are manageable and the opposition relatively inexperienced.

With trading on the other hand whilst you can still make small sized trades when starting out the opposition that you are playing against includes the best on the planet! There is only one game in town for any given market so if you want to trade that market then you are in effect doing the trading equivalent of sitting down to play at the poker table with seasoned professionals. Clearly someone starting out in poker would balk at having to do this but they are quite happy to start trading with little experience at all. It is no surprise that the vast majority of traders lose money when it is viewed from this perspective as they are playing in a zero-sum game with the best players who have learned how to win at this game. If you want to think of it in Darwinian terms then survival of the fittest certainly applies to trading: the losers drop out of the game leaving only those who win and new players who have just joined the game.

The moral of this observation is to be cautious with trading. I have often seen people who have been successful in other areas of business and who’ve made some money who come along thinking that trading is going to be easy. For the reasons pointed out above it is not easy as you are up against the best players in a zero-sum game. That’s not to say that trading can’t be successful but that it requires discipline and patience to succeed.

 

On Tilt

No doubt you’ll not be surprised to learn that there is an important psychological aspect to poker just as there is in trading. There is of course the element of reading opponents and bluffing but in addition to this there is the issue of managing your own emotional state. There is an expression in poker for when a player starts playing emotionally and irrationally, it’s called going “on tilt”. This very often happens after someone has taken a big loss, they try to make it back by playing hands that they shouldn’t and making bets that they shouldn’t. Other players love it when a player goes on tilt because it means that they will make more money from his bad decisions.

This is of course a common failing also with trading; monitoring and managing ones emotional state is an important part of the trading process. As traders we’ve all experience this but it is vital to learn to monitor ones emotional state before placing trades. If you go “on tilt” then stop trading. Remind yourself that you need to be looking to buy good expectations and the money will take care of itself.

 

State of Mind

Top professional poker players need to keep a clear head. Contrary to what you might think, the vast majority don’t drink alcohol at the table as they need to be able to do the calculations and make the assessments with full concentration for hours at a time. In trading one’s state of mind is often overlooked, trading when not feeling 100% can lead to mistakes and making trades which don’t have good expectations. Remember, unlike in poker, it costs you nothing not to trade.

 

Conclusions

So what have we learnt from this comparison between poker and trading? Firstly that without an edge of some kind there is no point in making a trade. Waiting with discipline for the right “cards” or trading conditions to come along is the basic edge and once you deviate from this then your edge is gone. Monitor your emotional state. Are you “on tilt” – should you walk away from the table. Remember there’s only one game in town and you are playing against professionals so unless you trade in a professional manner they’ll end up taking all your money! Stick with your strategy, buy “good expectations”, trust that the numbers will work themselves out and you will succeed.