Issue 7

How To Select a Trading System - Ashif Jumma

The selection of a winning Trading System is a process a lot of technical traders go through. Some seem to have no problem, while others get tied in knots even after spending a small fortune.

Some of the checks I would use to select a winning system are:

1. I would look at two or more independent reviews. I would not rely on back-tested computer-simulated performance results. Only forward tested performance results without the benefit of hindsight would come close to real-time.

2. Note the number of parameters of the system, the less the better.

3. Check to see how often does the developer optimizes the system. An over optimized system is unlikely to work in the future.

4. Commission and slippage. A profitable S&P 500 day-trading system trading aggressively using a $50 commission and slippage might in real-time turn out to be a loser.

5. I would prefer a 'white box' system.

6. Paying more money does not necessarily mean you will get a better system.

7. A trade-by-trade performance report will give a better picture of drawdown than the monthly or yearly performance.

8. The system has to be time-tested. I would like to see a system be around for 2-years to consider it.

9. The developer himself should be trading the system. There preferably should be a real-time account with account statements available and/or references.

10. The system should be based on sound market principles.

11. If a vendor is turning out different one commodity systems periodically, like one for Coffee, another for Pork Bellies, third for T-Bonds. I would be very careful of curve filling. I would prefer a system that trades different markets.

12. Finally, I would compute the drawdown to see if I can handle it, the money required to trade the system, time required to trade system and the objectivity of the system. I would also paper trade for at least 3-months before risking my money on it.


Risk of Ruin and Dealing with Probabilities ... The Importance of Doing What's Right - Mike James

Thank you Robert Edwards for your frank dissection of your orange juice trade, which appeared in the October issue of CTCN.

It reminds me that it doesn't matter how much time and effort we put into analyzing the market, the market will choose to do what 'It' wants to do.

Obviously, the market doesn't set out to cause any particular trader to loose (although it may seem like that to you sometimes!) when you put on a position. It's the trader himself that decides the potential loss, by use of a stop.

You may say that this is not true, due to such events as limit moves and gaps. However when initiating a position, if you ALWAYS define where the market has to go to (your stop position), to prove your current market position to be incorrect, BEFORE you put the trade on AND then either:

1. Enter the stop when you put the entry order in or;

2. Watch the market and IMMEDIATELY this price is hit Phone in the Exit order - either a market order or a 2 or 3 tick stop - and let nothing deter you from this action even for a split second.

Your risk is defined rather than being unlimited i.e., the stop order will get executed as soon as the market allows it (probably immediately), rather than when you decide it's time to get out.

If your anything like me, I prefer option 1. It helps me to sleep better and makes it more difficult for me to sabotage myself.

I've tried option 2, and besides raising my stress level, I didn't ALWAYS end up doing the right thing i.e., in this case exiting at my pre-defined Stop point.

As Robert Edwards says, right at the beginning of his letter "If you are around to trade tomorrow, you are in a position to hit a home run." To do this you must use stops, and I would suggest be reluctant to risk more than 1-2% of your account equity on any one market position. That isn't much, so smaller accounts may have to look at using mini-contracts or a system that uses very tight stops.

If you think that's too small, take a look at risk of ruin calculations. Whereas your expected return increases proportionately to the leverage, your risk of ruin increases exponentially. So one of the worst things you can do is overtrade.

Any trading system lives with the possibility that independent of market conditions, it will self destruct. Computer Analysis of the Futures Market by LeBeau & Lucas covers this and other points well.

For example, a $25,000 account has a 9% chance of bombing out, if your system has 40% winners and a 2:1 profit/loss ratio. (A reasonable system?)

However,if the same account with a 2:1 profit/loss ratio only has 35% winners your risk of ruin increases to 35%! I'd guess that sort of figure is unacceptable to most people.

The other point I'd like to offer, is that you need to be very careful that you don't 'own' the trade - (Stops entered in the market help here!).

I'll repeat that it does not matter how much time and effort we put into analyzing the market, the market will choose to do what 'it' wants to do.

After all, when we put a trade on, aren't we just dealing with probabilities? Even if our system gives us 60% winners, a rare gem indeed, what we're saying is that the system will loose 40% of the time.

So wouldn't the biggest mistake we could make, be to take a market view that's fixed, when we already know that we're going to be wrong A LOT?

I've already offered the quote below in an earlier issue, so Dave may choose not to repeat it.

In Jim Sloman's book 'The Adam theory of Markets' he says, "To succeed in the markets we must surrender. Never ever let any opinion about the market get in the way of trading." -- "Analysis is great, but when analysis and reality diverge, we must always go with reality." -- "Knowledge is great, but when knowledge and reality diverge, we must always go with reality." -- "We must allow ourselves to mirror the market, follow it surrender to it.

We must be willing to let go of what we think we know about it, so that we can see it directly." -- "Price is reality. Price reflects everything. Price is all we want to look at because price is what the market is doing."

Everyone would like tomorrow's issue of the Wall Street Journal, just once. But in the meantime, when we trade we must realize that we are only dealing in probabilities, not certainties. So in a nutshell, surrender and go with reality!


Why Shorting Options Makes the Most (Sense) Cents, 90% Wins Are Possible - Robert Edwards

I recently read that 90% of options expire worthless and about that same percentage of option buyers lose money. This coincidentally corresponds to the roughly 90% of commodities traders who also lose money. I feel that the easiest way for the average trader to join the ranks of the winners is to sell options, to short puts and calls.

If 90% of options end up worthless, one would expect that if options are sold, and the short option positions are held until near expiration, one would collect virtually the entire premium on about 90% of the trades. Well, those are phenomenal statistics. But based on my personal experience, it is now rare that I ever take a loss on out-of-the money options I sell.

There are never any "sure things" but utilizing a carefully planned strategy which accounts for virtually any contingency, I think there is a way to come up with an option selling plan, that if properly implemented, will bring results much better than 90% winning trades. I am working hard to try and refine my trading methods to try and accomplish this.

Let me reveal some background information and then describe what I see as a golden opportunity now unfolding. The background information is very important as there are many pitfalls that must be avoided in order to be successful.

I keep adding to my knowledge every time I put on a trade. I am writing so like-minded traders can contact me and we can learn together.

A few years ago, I only had to look at my own trading account to conclude that trying to make a profit from buying commodity options was a rough road to travel. I was consistently losing. It was then that I reasoned that I should do "naked" call and put selling. I decided to try a new approach.

Now, every time I felt I should buy a call because I thought the market was going to go up, instead I would sell a put. Instead of buying a put when I felt the market was going down, I would sell a call. My results instantly and quite dramatically improved.

I had a lot to learn though, and continued to lose money because I combined futures contracts to do covered writing when the market would go against me. Whenever I covered a call by going long the underlying futures contract, often the market would immediately turn lower and the loss on the futures contract exceeded the gain from the decay of option premium.

I was an overall winner on the options I sold, but lost a great deal of money on the futures contracts I purchased as a defensive measure to protect the options which seldom needed protecting.

Today I only combine futures contracts with my option writing, in very limited, special circumstances, and I near totally balance the number of contracts to become what they call 'delta neutral'.

One of the secrets I have found is to sell options that are "less rich" meaning further out of the money. Well, I went to the library a few years back and started doing research, manually back-testing several strategies. I immediately recognized that there was definitely something there. But doing the testing by hand became so tedious and hypothetical I gave it up and went back to day-trading.

A year ago I began intensively studying the markets to try and find a winning strategy. My study revealed that selling options had several advantages. I just love getting paid up front with an immediate profit the day I sell an option, and then my task is to try and keep as much of the money as possible.

Also, option selling allows one to do more long-range planning and does not require near as much scrutiny and close attention as buying and selling futures positions. And option trading is much more forgiving. I have done the most stupid mistakes when employing my option strategies and somehow was able to make a net profit.

Believe me, if I can't make money selling options with the time decay working in my favor, the guy trying to buy options and fight the time decay is in real trouble. The option seller is like the gambling house. One has to be well capitalized and willing to make small, slow profits. But those gains add up.

In search of a perfect strategy, I started from a premise that I wanted a market that spent a lot of time going sideways. I like trading Live Cattle options because when the market sells off, it usually springs back.

There is good underlying support from traders to always go long cattle, taking advantage of the backwardation that is often present in this market and the generally upward bias of cattle prices. Up moves are seldom straight up with ample backing and filling of prices.

There are rhythms and cycles present and the support and resistance levels are clearly defined.

There are few false break-outs as there is usually follow-through when a support or resistance level is breached.

Most of what follows relates to Live Cattle options but the information is generally applicable to other markets as well:

Let me begin by setting up the conditions of my personal method for option trading. You might be able to learn something from this that will make you a better trader. I would love to hear some suggestions which might help me improve my methods, heaven knows there is plenty of room for improvement.

When I originally sold uncovered calls and puts, I began by selling a call and a put at the same strike price, known as a short straddle position. I was taking the opposite side of the trades of persons who were buying a put and a call, waiting for a violent reaction. I was hoping the market went to sleep. To help expedite this, I decided to sell sleeping markets that were going nowhere.

What I didn't realize was that with a dead market, the volatility was low and thus the premiums I got from selling were at reduced prices. When the market finally erupted, the values of both the puts and calls increased.

That increase in volatility killed me when I was shorting volatility at the bottom when there was no room to diminish further. Therefore, to do well selling options which always involves shorting volatility, it is important to sell right after a strong move has occurred.

After the market advances a few days, the call premiums expand and that is an excellent time to sell. I like to sell right into that strength. When the markets decline I like to sell puts, selling right into that strength of increasing put premium, as well.

Suppose December Live Cattle is in a trading range from $72.00 to $78.00. Then suppose that the market is in the middle, say at $75.00. If the market rallies to the top end of the trading range and then one sells out-of-the-money calls, and then the market retreats to the bottom of the range and one sells out-of-the-money puts, if the market returns to the middle, one can have an extremely wide range of prices where a profit is assured.

I like to sell calls first because I find selling puts more tricky. This is due to the fact that markets drop much faster than they go up, about 3 times faster I think.

By waiting for a rally before I sell calls, I get the benefit of the fact there are more buyers of calls when the market is rising than when it is falling. Selling into strength allows one to sell to traders rather than local market makers, who virtually control the pits when liquidity is low.

You also want to sell into strength because when the market turns at a top, the premium diminishes very fast, because the call buyers are trying to quickly take profits the same time you are trying to initiate your short trade. There is an order imbalance and only a market order is filled and that can be several minutes later at a very unfavorable price. It is better to sell a little early rather than late.

The same holds true with puts, you want to sell into price weakness when the put premiums are the highest. This goes back to being short volatility. You want to be a lion tamer, putting your hands around the jaws of a wild, ferocious lion, selling options when you can still hear the roar. When things are quiet premiums disappear.

I call these options 'sleeping bears'. Let sleeping bears sleep. If you should awaken them they will rip you apart from both ends as the puts and calls both gain premium. When a market is limit up (down) is the best time to sell calls (puts), as the premium of the option continues to rise.

The next day the option premium shrinks down, virtually guaranteeing a profit. Often the panic buying of options causes a high during the day of the locked limit move and if you time it right, you are making a nice profit even that first day with the market still locked limit.

I have found that selling an option in the last hour of the day works out best for me. Option traders, the next day wait around trying to figure out which way the market is going and often don't trade for several minutes after the market opens. Price fills are usually very poor.

They also often lag the market which gives them an excuse to either fill you at a lower price than you theoretically deserve or not at all. On the other hand, during the close I believe that someone is there to try and keep the markets orderly so there is more credibility in option fills by the locals at the end of the day because prices are going to be printed in the newspapers and the trading prices have to roughly correspond to the estimated values of the options.

The fills have to be in the ball park at the end of the day, whereas during the day the options market is free to trade about anywhere. That is just my theory.

I like selling options 7 to 8 weeks before expiration to maximize the time decay of premium and try to get out about 1 to 2 weeks before expiration.

Because the options expiration of the meat and livestock options often correspond to a meat report date, I never like to be in at the end when someone gets to find out the results of the report and then decide at the end of the day whether or not to exercise the option if it is in or very near the money.

Near expiration, volatility can actually increase rather than decrease. When I have recouped about 2/3rds of the option premium I look for a place to take profits. Many times this has made the difference between a winning and losing trade.

Numerous times the market rallies and the puts are almost worthless. I take my profits and then the market tumbles a couple limits down and those puts are now worth as much or more than I paid for them. But I don't need to worry, as I already took profits.

I have predicted the wrong trend direction many times but because I was able to take profits or a small loss during a correction, I am able to get out of the losing positions in good shape and the winning options more than make up for the losses.

As I described briefly above, I like to sell calls and puts at different strike prices. This is called a 'short strangle'. I leg the position on by doing one side or the other, depending on market conditions, my bias of where I think the market is headed, and several other factors I consider.

I already mentioned how I usually like selling the calls after a counter-trending rally and then later selling the puts. If on the other hand you think cattle is going to trend up shortly and you don't mind getting long the market, you can sell puts and effectively get a lower price than you would have gotten equal to the premium amount received.

That would occur if the market trended strongly lower and the put was exercised. If however the market reversed and went up, the put will lose value and although you did not get exercised, you make money that way and that is all that matters.

This time of year (Fall) is a good time to sell April puts on any weakness as I wouldn't mind getting long the April contract if the market trends lower and the option is exercised. On the other hand, the downside is limited on the April contract due to the fact seasonally April cattle has in recent years rallied to $80.00 or more during the January through March or April rally. You win either way.

Today as I write this (10/15/93), December Live Cattle options have 7 weeks to expiration. Cattle has just rallied from lows and a very oversold condition. Today, December cattle closed at 74.70, very near the last swing high just around 75.20. The contract should begin to run into some resistance.

With the couple dollar premium that December is trading over October, when October goes off the board next week and December takes over, it is already a couple extra dollars higher than cash. Either cash has to rally to the futures or the futures will need to come down. I believe the futures will come down.

Feeder Cattle has a lot of problems in the cash market which should also negatively impact on cattle prices. I am looking for sideways to possibly higher prices near-term with a final break into December when cattle has to compete with turkey for Thanksgiving and Christmas.

This slackness in demand comes at one of the worst times, when seasonal slaughter numbers are up. Although I will be selling calls lightly at this time to initiate the position. If we bottom early, I will be a very aggressive seller of December and later February puts should the market retest the bottom soon as I expect it to. I want to be effectively long the market by January 1, 1994 so I can take advantage of the first quarter rally.

I am experimenting with some different strategies right now, so I am not strictly following my basic scenario. But for the readers I will go through a dry run of what I anticipate will happen in the coming weeks. I will keep the numbers in single units, but a person with sufficient capital can double or triple these numbers while more conservative traders could cut these positions in half.

Since Dec Cattle broke above the resistance today at 74.20, the next resistance is around 75.20 and it is likely we will see that price on Monday. However, there is a down-trending line which could contain the contract right at today's closing price of 74.70.

So what I would do is to sell a set of two 76.00 Dec. Live Cattle calls into today's close, placing a limit order during the last hour of trading with a cancel replace at the market if I am not sure I got filled, about 15 minutes before today's strong close.

One should have been able to do this at a premium of about 75 cents or more today. As long as Dec Cattle does not go off the boards above 76.75, I will be in a profit situation, less the commission of course.

However, this would require that December makes a new high which is of course possible, but it is unlikely that it will happen immediately with a move straight up with no correction.

Upper resistance will begin to mount above 75.00. If the market can close at 75.20 or higher, I would sell an additional set of 2 Dec. 76 calls at a premium of $1.00 or more. If the market never reaches 76.00 I pay absolutely no attention to the premium I may be losing on paper, as my account is well margined.

I do not get concerned until the options begin going into the money as I intend to keep these options close to the time of their expiration. When the market reaches 76.00 which I doubt will happen, but if it did, I could double my original position. Since I have already sold 4 options with a 76.00 strike price, I would now sell 4 77.00 calls and 4 78 calls.

If the market appears that it is going to close at a price of 76.00, I am concerned only about the 4 original 76 strike calls as they are the only ones going into the money. To balance out 4 calls one would roughly buy 2 futures contracts based on a delta of about .50, meaning the option premium of the calls rise 50 cents when the futures price rises a dollar. However, I have gotten burned so many times buying 2 futures contracts to balance this and gotten stung, that I will only buy one now, leaving myself only half balanced. I have somewhat cured this problem by buying earlier on a stop, say at 75.25 or 75.30 stop. Then by the time the market reaches 76.00 I can stop myself out of the 75.30 futures contract if the market takes a dive.

I don't want too many futures contracts going long, as I want to be able to still improve my position if the market retreats. What I would do if the market started rallying past 76.90, the approximate break-even for the two 76 calls sold for 75 cents, and the two 76 calls sold for over a dollar. That is not an easy question to answer. I guess I would have to hang tough and maybe say a little prayer.

If sufficient time passes, before we hit these prices, I will have the time to remove some options at little or no loss, reducing my exposure and allowing me to sell ever higher priced calls.

If we reach these levels very near expiration, the time premiums are greatly reduced and the 77 calls will be making money and the 76 calls sold for over a dollar will be making money so I will still net a profit even when I was selling calls and the market kept going up.

A move into new market highs in the December Cattle contract would just be a tough break. I would call it a worse case scenario. I believe the market will find resistance at today's close, or somewhere above 75.20 and it will quickly begin dropping, putting me in great shape. Then as the market tests the lows, I would sell puts.

If the market goes sideways, and the chances of the 76 or 77 calls getting into the money, becomes very remote, I would sell more 76 or 77 calls, making sure I get at least 50 cents premium, and hopefully 70 cents or more premium for any options sold.

If the market drops, I would more aggressively sell puts as I want to be long the market going into the new year. I want to be long cattle going into February so in late November or early December, I will begin selling February puts on any weakness.

It may ultimately turn out that I will have to move up a strike price, and be further out of the money as I may be selling options that are too close to the money. Some readers may not be aware that in the nearby option month, the odd priced cents options trade so there is an option strike every dollar rather than $2.

I believe the Wall Street Journal still prints only the even numbered strikes, causing many traders to ignore the odd numbered strikes and greatly reducing the volume, open interest and liquidity in these odd numbered strike options.

How it will come out, only time will tell. As I'm still trying to figure this out, I would gladly accept any suggestions readers may have about this trading strategy as well as hearing about an options selling method that someone else has found successful.


Trading Paradoxs - Dr. Satish

This is what I have discovered and you should know about if you want to trade commodities:

1. They will never fill you long, if prices come down and touch your entry price and then go up.

2. They will always fill you short, if prices come down and touch your entry price and then go up.

3. They will never fill you short, if prices come back up and touch your entry price and then go down.

4. They will always fill your long, if prices come back up and touch your entry price and then go down.

5. In T-Bonds, in the first 10 minutes after the release of any report at 8:30 am New York time, even if prices go through your entry point, they will deny you a fill if there is profit after that fill.

6. However, they will always fill you if there was a loss after that fill!

Where is the F.B.I. - Brokers don't prevent this rape, all they do is come after the rape has taken place and harass you to go over the whole thing again and again, and torture your agony.


Viewpoint of a Commodity Trade - Roy W. Longstreet

The Right Stuff - Contrary to popular opinion, the most important factor in trading profitably is not "knowing" where the market is going. Nobody knows for sure exactly what a given market will do next! The most important thing is to have a plan of attack that will allow you to successfully cope with the uncertainty that is an inherent part of trading or investing in anything.

It is a well-documented fact that the world's most consistently successful investors and traders (in any market, including stocks, bonds, commodities, etc.) do not have any inside information and do not know what will happen next.

What they do know is that they have an excellent chance for success in the long run if they can develop the discipline to stick to their plan. Their "secret weapon" is that they have survived their mistakes long enough to develop a good clear common-sense trading plan. Any they survived long enough to learn that even though their plan isn't perfect, it is more profitable to exercise the discipline to stick to the plan through thick and thin, than to deviate from it after some losses.

So you see, this discipline to follow a plan even when the chips are down, so crucial to success, comes from the confidence that comes from experience. If you do not have the time and/or inclination to develop your own trading plan, develop supreme confidence in that trading plan and the discipline to stick to that trading plan, then the odds will be stacked against you. That is, unless you can join forces with someone who does have the time, inclination, plan, experience and discipline to trade successfully.

"There are those who sit and wait for the world to change for them. Some few guess correctly that they are the ones who must change. In commodity trading, one usually gains by yielding, by admitting that he needs help, that here is a better way."


Surprising Differences in Data - Randy Stucky

The bar charts that follow on next page contain data that I have obtained from 3 different data sources, Peter Aan's data, Trend Index Trading Co data, and Genesis Data Service. They are all CSI continuous contract data files. All 3 have the same price patterns but different absolute levels. Note: Peter Aan says his is initially high to avoid zero prices - says it works OK, except if a system uses a "% of price" formula. See Chart on next page.

Editor Comment: As long as you maintain the same data, the actual old price level is normally not important when analyzing back data, as long as its done consistently and current prices are correct. Chart in Print Copy


EDITOR COMMENTS

In the last issue of CTCN, Dr. Arora said that in his opinion, 14 well known participants in the commodity business have nothing of value to offer. Of course, he is entitled to his opinion, but I must strongly disagree with him. Many of the parties he referred to have things of great value they offer to traders.

For example, Name Withheld has written many books dealing with psychology of trading and trading methodology, including great research on seasonals. I have read some of Jake's books and found them extremely informative and of excellent value.

Larry Williams has also contributed much to traders' knowledge, especially with his many educational trading seminars.

Welles Wilder is one of the pioneers of commodity technical analysis and wrote one of the first books about various technical indicators that can be used to trade commodities.

Futures Truth Ltd has done extremely useful work involving the highly complex and difficult day-to-day tracking of hundreds of trading systems. John Hill, John Fischer and George Pruitt are extremely knowledgeable and of the highest integrity. They have done a superb job reporting on all those trading systems, with a small staff and limited budget.

The ideas on how to select a trading system submitted by Ashif Jumma has some excellent suggestions. In particular, I believe you should only buy a trading system providing it is in fact a fully disclosed 'white box' system. That is because discipline is a major problem. If you are going to trade a system correctly you need to have confidence in it by being aware of the principals behind the system and the actual algorithm. An undisclosed system makes the discipline problem we all seem to have, much more severe than is involved with a disclosed trading system.

I also strongly agree with him on his point #6 that paying more money does NOT mean the system is better. In the past, I have received calls from traders who told me they bought System X over system Y because X was $3000.00 and Y was $1000.00, so therefore X must be 3 times better than Y! That premise is completely incorrect. The cost of the trading system seems to have little or no bearing on its actual value.

Lastly, I would like to comment on Ashif's point #11. The fact most systems are only designed for a specific market or market group gets me very concerned. A system based on sound principles and NOT heavily curve-fitted, should as a general rule work in all markets, not just specific markets.

At times a system will work much better in certain markets, but that is because that market happens to be performing in a way that benefits the system, such as trending well or volatility that happens to conform to the system's algorithm. Also, at certain times the same or other markets will perform poorly due to the contrary happening, i.e.: non-trending or very low volatility, etc.

Generally speaking, a trading methodology should 'work' in ALL markets, as all the markets have basically the same or very similar price behavior, except at times different trends or volatility.

I challenge anyone to look at a series of old daily bar charts, with the price scale not shown, and identify which market belongs to which chart. It is impossible to do, unless just by luck you happen to remember a certain price pattern evident on a chart, based on 20-20 hindsight.

Mike James has written a very informative discussion about preserving your capital and risk of ruin, and how the market will do what it wants, regardless of how good our analysis is.

It was also very nice of Mike to compliment Robert Edwards submission in the October issue, in which Bob admitted his very thorough and extremely good research on Orange Juice price direction turned out to be incorrect.

Robert Edwards latest submission on trading commodity options will be extremely valuable to option traders. Bob's point that about 90% of options expire worthless, I believe is correct based on what I have heard in the past. Therefore, it only makes sense that 90% of the puts and calls that are written make money. If in fact that premise is correct, there is a potential gold mine involved here!

Dr. Satish's criticism and paradox examples involving trade executions are I believe exaggerated, but it is in fact true that the fills or lack thereof, will go against your more often than not.


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