Sunday, February 07, 2016

Looking backwards to go forwards

The last few weeks have been a total washout for me. The volatility in the market (and in individual stocks) meant that I was getting hardly any setups to consider, let alone take - in either direction. As someone who follows price trends, this was a concern. The majority of stocks, as well as the general market averages have been trending downwards, so why was this?

Well, the lack of activity coincided with me updating my own scan code, which I use to identify potential opportunities. I've talked in the past about continually trying to refine and improve both my processes and performance. Over time, the use of scans has proven to be an important element of that.

Now, being fully in cash the last few weeks may well have outperformed a lot of traders and investors. And I've been able to look on, free of stress, and watch all the intra-day craziness.

However, while this period of inactivity has helped me preserve capital, you are in this business to make money. And if you are stuck in cash, then you can't generate any profits.

So is this a 'glass half-full' or glass half-empty' situation?

Well to a degree that depends on your own trading concepts and beliefs.

While I want to maximise my profits, my primary goal as a trader is always to preserve capital.

To help me achieve this, I try and look for good quality setups, with a consolidation in price and volatility, prior to there being a potential breakout which may signal the start of a new trend.

Focusing on these aspects also help me get into trades where the risk:potential reward is skewed in my favour - price has to move less in my favour to generate each profit multiple of R.

Given the gyrations in the market so far in 2016, and how I have been trying to identify those opportunities, these conditions simply haven't been met.

As I've said to a number of traders recently:

"The good news is that the volatility has kept me out of the market. However, the bad news is that the volatility has kept me out of the market".

Now, this may go against a 'pure' trend following approach. If you get a signal (long or short) when a certain price level is hit, you take the trade, right?

Possibly. If you trade a small basket of instruments, then yes - it was a critical element of the Turtle Traders' success, for example. But if you have a potential universe of thousands of worldwide stocks that you could trade, you need some additional criteria or 'filtering' to go through. This is where the scan code I use comes in.

Not only does this help filter out a lot of setups that wouldn't interest me, it also helps leverage my time.

The problem with creating scans is that you are potentially placing absolute values on different criteria or conditions which must be met before a setup is considered to be valid. And, if that criteria is too restrictive, then you will get nothing to look at.

A change in the general market 'state' may impact on this - for example, criteria which works in a quiet market environment may not work when the underlying level of volatility spikes.

This recent lack of trading activity has led me to think deeply about my own trading, particularly when compared back to 2008, which was a very profitable year. This you will recall is when there was a market downtrend combined with a general increase in volatility.

While my basic approach has not changed since 2008 (in terms of basic entry and exit parameters), how I go about identifying those potential setups has changed, with some extra levels of complexity being added over time. One such specific element relating to measuring volatility has been the reason why I have had almost no opportunities to look at.

In other words, my criteria had become TOO restrictive. How I was looking and interpreting volatility (I used two metrics, which are shown on my standard chart setup) was over-complicated.

Now, traders need to be patient and disciplined, and ensure they follow their rules (whatever they may be). Indeed, I preach this to myself and others. But what if those rules keep you out of the market for a prolonged period of time? What if you got no signals for say 3 months? 6 months? Or even a year? When do you say 'enough is enough'? Has something in your process changed? Have the underlying market conditions fundamentally changed? Or has something changed in you? (More on that one in a minute).

The difference in my trading activity between 2008 and now was showing that something had clearly changed. So I needed to identify what this was, and make any remedial changes needed. And it all came back to how I was identifying potential stocks to trade.

The clincher (as if one was needed) was seeing the latest report from Jez Liberty who tracks various basic trend following systems, and seeing the returns generated in January. This was a valuable reminder that simplicity, particularly when markets get frothy, works.

So, this morning I changed my latest version of the scan code to reflect this small change. It is only a minor difference, yet the results churned out were massively different. Now all of a sudden I have gone from having almost nothing to look at, to having lots of potential setups to go through.

These still look for the same characteristics in terms of price structure as before (including a contraction of price and volatility). The change now is the 2ATR volatility measurement is simply to be used for initial stop placement and position size purposes, whereas previously I was also using it as part of interpreting the quality of a setup.

It should be noted that, in a quiet market state, extra levels of complexity can work. But, had I used the similar criteria back in 2008, what was a great year would almost certainly turned out differently, in that I would have been stuck a lot more in cash, denying me the opportunity to make money.

One other interesting and important point came out of this - seeing this lack of activity, a trader I have known for quite a while asked me "Has something changed in you which has meant you are more risk averse now compared to eight years ago?".

It's a valid question. Had I had been receiving the signals and not acting on them for some reason, then the answer would unquestionably be yes. However, because I was following my rules and setup criteria, and they were not giving me that opportunity, then the answer would have to be no.

Even if I was a 100% systematic trader, instead of using a 'rules-based discretionary' method, I still would have been in cash - my scans weren't identifying any setups. The warning signs that something has changed within me will be if I fail to act on any new signals given.

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