The markets stumbled into a bottom signal. The sentiment indicator entered the warning signal on Jul 2. It was a waiting games for a volatility pop. The pop was very disappointing. On Jul 9 the vol indicator hit the upper band. From that point, we wait for a trailing stop violation. That occurred on Jul 16 at 1236. The chart shows the signals.

It’s time for an update on my long SP500 put position. The SP500 closed at 1262.80. I’m long the Sep 1275 puts. The delta is up to 0.55. That means it’s 55% of a full short position. The sentiment indicator hit the lower band with today’s close. Small cap stocks in the Russell are taking it hard in the last week. This is the first signal of a potential bottom coming. Thursday is the June unemployment report.

The Gameplan

1. A rally. I will cover my puts if the market trades above 1293. That is the high for the week. A move above there could be the start of a meaningful bounce.
2. Unchanged .I’m hoping for a big jump in the unemployment rate. Last month, the market had a big selloff on the unemployment report after a lackluster open. If the market trades in the unchanged area I will let it develop and use a trailing stop of the previous day’s high.
3. Big gap lower. If the market opens on a good gap lower I will sell 50% of my puts in the first 30 minutes.

The market will not stay in this area for long. I anticipate a big move that will spike the volatility range indicator in the next few days. It could be a rally or a selloff so I want to give it some room to move lower but I will be aggressive if it moves higher.

Our short signal was activated this morning on the open in the SP500 at 1395.75. We had a low Daily Average True Range and a High Russell SP500 spread. The signal was activated when today’s open was below Friday’ low. The chart below shows the indicators.

I put on a risk reversal in the Sep SP500 on May 20, 2008 with futures at 1421.00. I bought the Sep 1275 puts for 23.00 and sold the Sep 1545 calls for 13.00. My indicator for the short is a combination of two factors. I use a proxy for option volatility. It is a 10 day average of the average true range. It is highly correlated to implied volatility levels. I like to see this at a low level. The other factor is the Emini SP500- Russell Spread. The spread widens during bullish runs. I like to see it at a high level. The trigger is the combination at the same time. The last two signals were on Dec 25, 2007 and Mar 27,2008. When the setup is fired then I wait for a violation of a daily low. The delta on the position is 40. It equals the percentage of a full contract position. If you bought 10 risk reversals then you are synthetically short 4 SP futures contracts. I bought in one futures short already. The next goal would be to buy in the short calls around $1.00. The exit of the entire position would be the reversal of the entry signal. in other words a high implied volatility spike with a low SP500-Russell spread.

Today’s article roundup

A Tale of Two Housing States Real Clear Markets

Writedown Bug For Lehman Fortune

Trichet Says Shocks Aren’t Over for Europe’s Economy, WSJ Says Bloomberg

Buffett sees “long, deep” U.S. recession CNBC

Long Term Investor Screen Investors Business Daily

Maximum Adverse Excursion(MAE) is the maximum loss of a trade during its complete time period. It can be a valuable tool for stop placement. If your winners have low maximum adverse excursion then moving your contracting your stops can dramatically increase your results.

Example

I have an intraday daytrading breakout system in a Sector index. It is profitable system that has these statistics below with a current stop of 1.00.

• Profit Factor 1.52
• Win % 52
• Average Win 91.26
• Average Loss 65.65

Here is a screenshot of the Maximum Adverse Excursion graph from Tradestation.

The red triangles are losing trades. The green triangles are winning trades. The X-axis is Drawdown and the Y axis is Profit.

A large cluster of green trades to the left is a great sign. This indicates that the winning trades don’t go against you from your entry point. The trick is to find the dividing line that separates the majority of the winning trades to the left of your line. I selected 33 cents. I then reran the strategy and these are the updated numbers

• • Profit Factor 2.59
  • Win % 46
  • Average Win 94.81
  • Average Loss 31

Here is the new Maximum Adverse Excursion Graph

The profit factor jumped because I was able to raise the average win and dramatically lower the average loss while lowering the win percentage modestly. That is the goal. If you have any questions drop me a line.

How can volatility expansion help the daytrader?

It sounds like a simple concept. I have a little homework for you. Click on this Amazon link . It is a book by Toby Crabel. I’m sure that you have never heard of him. But he is a legend in the managed futures industry and manages 5 Billion dollars. He wrote a book before he started his fund and now the book is out of print. It originally sold for $35. It now goes for $700. Do you want to know the technique that is in that book? Volatility Expansion.

A Simple breakout technique

Use implied volatility to sort daytrading candidates. Stocks or futures that have had a contraction in implied volatility are prime candidates for breakout trades. Check the list daily for candidates. Conversely, isolate the high implied volatility markets for choppy trades and fade breakouts.

I will be expanding on all these concepts and more in the future.

After designing a breakout strategy, it’s time to improve the results. There are many methods but I will describe my two favorites. Filtering before the trade is one technique and recognizing a trend day is another method.

Filtering the days

Look for trends in the daily pl of your trading. Identifying a trend in pl that is either up or down is the goal. It’s always easiest to start with the losing streaks. Try and find correlating factors. Volatility is the most correlated for my system. After sustained upward volatility my overall pl and individual sectors level off at best or head into a drawdown. A simple 10 day moving average of daily range is the most basic filter. After a prolonged winning streak that shows a rise in the 10 day range, I will cut size and shift to more profit target trading. It’s time to be defensive. After range falls to a lower level I will return size to normal and be aggressive in my entry and let my profits run. The graph shows a 10 day mva on a daily chart

Trend Days

True trend days occur on 15% of the trading days. they have a basic pattern.

1. Price moves quickly away from the open.
2. Initial breakout trades will have little adverse movement.
3. Price will level off and then retest the breakout move to a higher level or lower level if the move is down.
4. Intraday breakouts will be with the trend or counter moves will be quick in time and price.
5. The time and price duration of consolidations will be shallow and consistent.
6. The finish will be strong in the direction of the trend.
7. The open and close will be on the opposite ends of the price bar and the overall daily range will be in the upper 15% of recent ranges.

As the trading day progresses use this as a checklist. The earlier you recognize trend days the better your results.

Great poker players calculate the odds before every move. They determine the expected value based on their cards and their estimates of their opponents cards. If the number shows a positive expected value to call or raise then they follow the numbers. Great traders follow the same philosophy.

Expected Value Calculation

The essential calculation is the expected value. The probability calculation for expected value is below.

expected value=(prob of event1)(payoff of event 1)+ (prob of event2)(payoff of event 2)

The probability is the winning percentage of our trading

Event 1 in our equation is a profitable trade

Event 2 in our equation is an unprofitable trade

For example, If you average 50% winners and the winning trade is $1.0 and the losing trade is .50 then the expected value is below

.25=(.5)(1)+(.5)(-.5)

Goals

In order to maximize our expected value then we have three options

1. Raise our winning percentage
2. Raise our average win
3. Lower our average loss

Those are the goals. If you improve on any of those parameters then your results will improve.

Market prices seem to move randomly. One parameter that does have some predictive power is volatility. A good measure of volatility is implied volatility. Implied volatility can be a good parameter of the assessment of risk in the marketplace. The problem is that volatility tends to reflect an interpretation of past movement and less of an assessment of risk at its current level. Volatility contracts and expands with price movement. Option players will bid option prices up as price moves to compensate for their rise in risk. This is reflected in a rise in implied volatility.

Using Volatility

Volatility can be a valuable tool in the trader’s arsenal. First, it can be a risk parameter for stops. As volatility expands the noise of price movement increases. The calculation of stops should have a volatility component. As volatility increases the stops should expand thus reducing your contract size. For instance, if volatility spikes in the crude oil consider moving your stop out from 50 cents to a higher level to reflect the added risk. This will lessen the impact of noise volatility on your results. Conversely, a lower implied volatility market allows for a contraction in stop levels. This can be a powerful tool. Since volatility cycles between expansion and contraction, you will be increasing your chances of catching a multiple risk move from the cycle transfer with a higher contract size. When implied volatility is low , go for breakout trades and but option premium.