
What’s  Cheap,  What’s  Dear?
123
FIGURE  5.10
PROFITABILITY,  1990  SHORT-TERM  ADD-ON  TRADES.  Despiteamazing  daily  swings,  any  of  the  stop  strategies  kept  you  in  the  gameand  reaping  profits  from  market  actions.
WINNERS  AND  LOSERS,  1991  ADD-ON  TRADES  FROM  SHORTMOVING AVERAGE. 1991 profitability. MAE fails to perform miracles inthe  wild  ride  of  1991.  Add-on  trades  suffer  their  only  losing  year  in  thevolatility 
the  Gulf  War.
surrounding 
EQUITY  LINES  FOR  VARIOUS  STOPS,  1990  SHORT-TERM  ADD-ONTRADES.
PROFITABILITY,  1991  SHORT-TERM  ADD-ON  TRADES.
124
Piling  On:  Expbiting   the  Trend
What’s   Cheap,  What’s  Dear?
125
FIGURE  5.10  (Continued)
FIGURE  5.11  (Continued)
PROFITABILITY,  1992  SHORT-TERM  ADD-ON  TRADES.
EQUITY  LINES  FOR  VARIOUS  STOPS,  1991  SHORT-TERM  ADD-ONT R A D E S .
FIGURE 5.11
I:::::;
‘INNERS   AND  LOSEROVING   AVERAGE.  T t,hter  than  .3  would  hacursion  for  winners  c;
992  ADD.rear  is one)een   more8s  this  resu
,DES  FROM Sw  to date whc!_  The  very  lo\
EQUITY  LINES  FOR  VARIOUS  STOPS,  1992  SHORT-TERM  ADD-ONTRADES.
128
Piling  On:  Exploiting  the  Trend
FIGURE  5.13  (Continued)
What’s  Cheap,  What’s  Dear?
129
Inspection  of  Figures  5.4  through  5.13  should  give  you  an  ideaof the variety of experience you’ll face in the market once you viewit through the lens of your trading rules. The 198441994 charts cer-tainly  show  profitability  and  they  show  the  impact  of  using  theMAE  technique  to  manage  losses,  The  trading  rules  here  are  farfrom  the  most  complicated  that  could  be  devised,  and  the  yearshave  a  wide  variety  of  trading  experiences,  yet  each  year  showshow,  given  these  trading  rules,  losses  can  be  minimized  and  equitygrown  with  a  straightforward  technique.
As you can see. there is plenty of variety in the results, so somesummation  would  be  nice.  Figure  5.14  is  the  summary  table  oftrades  with  various  MAEs  for  Crude  using  the  trading  of  thenearby active months for  198461994.
To  summarize  eleven  years’  experience  day-trading  the  short-term  moving  average.  this  approach  has  a  higher  win-loss  ratiothan  the  underlying  trend  trade,  and  trades  more  frequently  forsmaller gains but greater total profitability (see Figure 5.15).
From  the  standpoint  of  the  campaigner,  this  low-margin  activity(positions  aren’t  held  overnight)  can  significantly  exploit  a  trend
-P?PE48%EBi8%zfa%:?:zg~%csaxE
__________ 
llilnllNRl
EQUITY  LINES  FOR  VARIOUS  STOPS,  1994  SHORT-TERM  ADD-ONTRADES.
FIGURE  5.14 MAE  FOR  ADD-ON  TRADES.  WINNERS  AND  LOSERS,SHORT  AVERAGE  ADD-ON  TRADES,  1984-1994.  The  high  percentageof  winners  is  the  most   comforting  feature  of  add-on  day-trades.  Nextbest a  good  choice  in  a  stop.
in  the  two  distributions,  which  should  allow
is  the  sharp  distinction 
130
Piling  On:  Exploiting  the  Trend
What’s  Cheao.
  What’s  Dear!
1 3 1
closed  at  the  end  of  the  underlying  trade.3   Trades  were  enteredwhen the low or high exceeded the average’s value by two or morepoints.4
To spare you all the charts from each year, Figures 5.16 and 5.17
summarizes  the  1984-1994
  position-building  trades.
It’s  tough  to  make  too  much  of  these  results  because  there  arevery few trades during the ten-year period. Some years there wereno  trades  at  all-the  market  just  ran  away  from  the  long-termtrend  line.  Some  years  there  was  only  one.  Analytically,  therearen’t  enough  trades  even  to  have  confidence  that  the  distribu-tions  are  exemplary,  even  though  they  look  familiar:  the  losingdistribution  with  a  long  tail  and  the  winners  clustered  around  theY axis.
FIGURE  5.16 MAE  FOR  POSITION  ADD-ONS.  WINNERS  ANDLOSERS VS. MAE, 1984-1994.  There aren’t many chances to add ontrades  to  your  underlying  position  using  the  logic  in  this  system,  buteven  with  distinct  trading  rules,  the  winners’  adverse  movement  is  muchless  than  losers’.  This  makes  possible  some  artful  stop  placement.
) Later we’ll look rn~re  closely at the issue of exiting. For now, OUT  exit is definedby the rules of the trend trade.4  Because the  extreme prices  of  the  day  have  only  a  trade  or   tw, it’s  mire   realisticto try to enter a couple ticks  awa.y  from the extreme recorded in the price data.
PROFITABILITY  OF  SHORT  AVERAGE  ADD-ON
FIGURE  5.15TRADES, 1984-1994. Risk gets its reward in the ten-year compilation.As  you  cut  losses  by  using  stops,  profits  drop.  As  stops  are  relaxed,profits 
rise.
with manageable losses. Just looking at the results with no stops in-dicates that, in this peculiar case, this type of add-on trade is a sen-sible strategy with solid profitability. While it doesn’t build a biggerunderlying  position,  it  does  build  the  campaigner’s  strength  for  themain  push.  Now  the  campaign  has  two  things  going  for  it:  thetrend trade and intraday add-on trades.
Position-Building  Trades
Because  the  longer  average  turns  upward  last  (usually,  though  notnecessarily),  its  direction  is  really  the  defining  feature  of  trendingas it’s defined in this book. Now we want to see what the results areof adding on trades when prices hit the longer average.
The  trading  rule  used  in  this  test  was  that  (1)  an  underlyingtrend trade was under way, (2) a buy or sell stop was placed at theday’s  projected  value2   for  the  longer  average,  and  (3)  each  trade  was
?  Any  imaginative  analyst  can  look  at  a  series  of~moving-average   values  and  comeup  with  a  good  estimate  of  the  next  value.  I  usually  extend  the  five-day  trend  ofchanges to the change from today to  calcul~ate   tomorrow’s  value.
132
Piling  On:  Exploiting  the  Trend
Summary Profitability 133
SUMMARY  PROFITABILITY
We’ve now tested three ways of trading, and our campaign is onlyin the trend mode so far, Table 5.1 shows how the three combine inimpact.
From  a  campaigner’s  standpoint,  we’ve  developed  three  meth-ods, each more or less successful, to exploit trending behavior. Thecumulative  profitability  of  the  campaign  is  beginning  to  build  andtherefore our trading strength. This is the effect we seek in the cam-paign: a gradual accretion of strength and power.
I  don’t  claim  that  these  particular  rules  are  the  best  but  I  willvouch  for  the  process  of  testing  to  limit  losses  and  estimate  profitlevels. That the MAE process is unusual shouldn’t be a deterrent. Itaddresses  the  core  problems  of  any  trading  operation  and,  so  far,has  been  successful  for  three  different  sets  of  trading  rules.  Thattesting could be applied to any other set of rules you could imagine.For example, how about trading against the trend? When or how
could that make sense? Ideas about the channel of a trend are com-mon so, if you’d defined a channel, prices would be rich at the up-per  side  of  an  uptrend’s  channel  and  cheap  at  the  lower  side  of  adowntrend’s  channel.  You’d  sell  at  the  extremes,  as  illustrated  inFigure  5.18.
As far as the campaigner is concerned, the question is, no matterhow  perilous  the  idea,  how  would  it  test  out?  That  is,  how  muchadverse price movement would be expected for a winning trade andhow much for a losing trade? Just from Figure 5.18 we can see we’dmiss  some  trades  and  suffer  adverse  prices  on  others.  Rather  than
TABLE  5.1 CAMPAIGN  TRADING  PROFITABILITYNEW  YORK  LIGHT  CRUDE,  1984-1994.
Rllle
StOD   kV‘?t
Profit/Loss
Two  moving averages
Add-on  day Add-on  position 
trades
trades
.31.31.31
36002500640
Mode
TrendTrendTrend
PROFIT  FROM  POSITION  ADD-ON%   PROFITABILITY
FIGURE  5.17VS. MAE, 1984-1994.  Here’s a unique case where wider stops, oncomparatively few trades, show lower profitability even as more risk isaccepted. Only if the stop is \,irtually  ineffective does higher rewardmatch  the  higher  risk.
This  is  “real  world.”  You  don’t  get  textbook  clarity  in  the  dataand  you  have  to  make  decisions  on  indications  and  insufficientdata.  Personally,  I’d  be  comfortable  trading  from  this  because  I’mcomfortable  that  these  distributions  crop  up  wherever  consistentrules apply. You might say. “Forget it! I’m not going to make  add-on trades to the longer trend. The data just aren’t there.” These aredecisions traders make in an uncertain world.
The  profitability  distribution  shown  in  Figure  5.17  demonstratesthat  using  stops  reduces  overall  profitability.  Lower  potential  forloss  means  lower  profit.  It  is  unusual,  though,  that  as  the  stop  iswidened  from  .16   to  1.06,  profits  decline  slowly.  Given  the  lownumber  of  trades  we’re  working  with  here.  I  don’t  attribute  muchsignificance to this. I’d be comfortable putting my stop anywhere inthe range  from ,16  to  .61  (the 2% or $600 limit on position losses).Again,  purely  from  the  convenience  of~using   two  contracts  insteadof one, a stop at .31  would work as well as prevent any catastrophiclosses.
134
Piling  On:  Exploiting  the  Trend
Summary 135
SUMMARY
Exploit a trend with additional entries to take advantage of the un-derlying  movement  of  the  tradable.  The  goal  is  to  build  yourstrength  and  the  basic  trend  position.  The  rules  you  select  don’tmake  a  lot  of  difference  as  long  as  the  losses  are  controlled  ade-quately with MAE stops. For example, we tested three simple rulesand  found  all,  adequately  stopped,  contributed  to  profitability.Many other ideas and rules could be tested.
Time
FIGURE  5.18 COUNTERTRADING.  Here’s  an  idea:  countertradingagainst the trend. Not something many are comfortable doing, it’s still atechnique that can be tested with the MAE process to see if it makessense.
just stick with the trend trade, or just stick with the add-on trades,we  can  evaluate  countertrading  too,  with  the  same  loss-limitingtechnique.  If  it  makes  money  under  our  loss  limitations,  we  tack  itinto our campaign’s list  of tactics.
What wouldn’t make sense? It wouldn’t make sense to use coun-tertrading  if  there  were  no  difference  between  the  distributions  ofMAE  for  winning  and  losing  trades.  That  would  mean  the  ruleswe’d selected just could not distinguish between winning trades andlosing  trades.  Although  the  distributions  can  be  distinguished  instatistical terms of median, skew, and  kurtosis’  traders will skip allthat  and  eyeball  the  situation.  Because  there’s  no  need  to  push  it(there  being  lots  of  trading  situations  and  trading  rules),  an  am-biguous  distinction  from  one  set  of  trading  rules  should  simply  berejected. Move on to another set of rules.
j Skew is the amount of lean to one side or another that a distribution has.  Kurto-sis is the “peakedness” of a distribution.
6Reversing  Bad  Trades
The  campaigning  trader  has  taken  three  looks  at  the  market  al-ready  but  doesn’t  stop  there.  Are  there  other  aspects  of  trendingthat  can  be  exploited?  What  about  nontrending  periods?  Is  theresome  other  market  mode  that  can  be  defined  and  exploited?  Inother  words  the  trader  is  always  looking  for  another  avenue  totrade, to build equity. Here’s another,
Our  logic  on  trending  trades  was  that,  if  we’re  right,  the  tradewon’t go very far against us. As we’ve seen, this isn’t perfect, but inthe aggregate, it works out. Also, as the biggest benefit, this cuts offsome  trades  that  would  otherwise  go  way  in  the  hole.  What  if  in-stead of just cutting off some of those losers we turned around androde them?
In this chapter, we’ll explore this idea conceptually before testingit.  The  idea  of  reversing  is  generally  worth  keeping  in  mind.  Later,when  we’re  working  on  channel  breakouts,  the  breakout  will  bedefined by a reversal. The manner in which the reversal or breakoutis defined will be the same as defined in this chapter.
This  idea  may  seem  a  little  off  the  wall  to  some.  After  all,  thetrend  indicators  are  by  definition  headed  in  one  direction,  andwe’re  talking  about  taking  trades  in  the  other  direction.  However,this  is  simply  “getting  right  with  the  market,”  “admitting  you’rewrong,”  or  “turning  on  a  dime.”  This  chapter  discusses  a  rationalway for the campaigner to do this difficult chore.
137
138 Reversing Bad Trades
THE  IDEA
It  won’t  take  much  inspection  of  the  charts  in  Chapter  4  to  findseveral years with large adverse excursions, price movements in the“wrong”  direction  that  were  cut  off  with  MAE  stops.  Nearly  al-ways,  these  were  eventually  losing  trades  under  the  trending  rules.If  they  were  going  to  be  losers  (and  going  past  our  MAE  stopmade  that  probability  about  90%),   why  not  turn  them  into  win-ners? After all, what’s the risk? The risk would be if they eventuallyturned  into  winners  for  the  original  trade-which  we  estimate  is  a10% probability.’ In 10% of the cases, we’ll cut off an eventual win-ner  by  reversing,  but  in  90%  of  the  cases,  the  amount  that  can  belost is  our   original  MAE  stop  mnount.2   That  amount  is  well  withinour  capital  constraint  guideline,  and  if  that’s  the  case,  this  is  anidea worth exploring.
When you think about it, there are really only three outcomes toa  trade  entry:  favorable,  unfavorable,  or  no  action.  (You  could  cutthat  to  two  if  you  wanted  analytical  rigor.)  These  results  are  de-picted in Figure 6.1.
Profitable  Trade  (Line  A)
Looking  at  Figure  6.1,  first  focus  on  line  A.  This  is  the  hoped-forresult,  and  it  measures  how  much  profit  the  position  holds  mea-sured  from  the  point  of  entry.  It’s  all  in  the  black  here  and  endswhen  there  is  a  sharp  reversal  in  the  market,  causing  a  drop  inprofit  and  an  end  to  the  trade  according  to  our  trading  rules.  Inthis  book,  it  would  be  the  reversal  of  one  of  the  two  averages;probably the short-term average.
This  reversal  establishes  the  trade  horizon,  the  period  of  timeduring  which  our  logic  will  hold.  It’s  the  period  of  time  defined  byour  underlying  trend-trading  rules.  In  this  book’s  example,  it’s
’ You can adjust these ratios by your place of the stop on the original MAE trade.To  go  from  90%  to  95%   for  example,  you’d  widen  the  stop  at  the  cost   of  largerlosses from stops and the benefit of fewer winners being stopped  out.z Why? Because otherwise it would have ended up a winner in the first place.
The  Idea  139
N Trade horizon
I
I
Time*
_  Stop  Level
PROFITABILITY  SINCE  INCEPTION.  Trades  go  favorably,
FIGURE  6.1unfav&ably,  or nowhere in this depiction of the profit or loss measuredfrom  entry.  Trades  that  hit  the  stop  are  candidates  for  reversal  becausethere is a low probability they will return to profitability.
when both averages are headed up or down. It’s during this periodthat  we  have  some  information  about  what  a  good  trade  will  doand what a bad trade will do, particularly the latter. (That informa-tion was the trend trading in Chapter 4.)
Goes  Nowhere  (Line  B)
Another  possibility  for  traders  is  that  the  trade  will  essentially  gonowhere. Where movement was expected, none occurs. This is line
140  Reversing  Bad  Trades
Results  141
B,  here  carried  out  to  the  trade  horizon’s  boundary  for  consis-tency’s  sake.  Here,  we’re  probably  in  a  trading  range,  thoughwhether it’s tradable is a subject for a later chapter.
A Loser That Comes Back (Line C)
Third, a trade could go bad. It would wander down to the stop andhit it. Or it could be one of those few winners we chose to cut offby  our  selection  of  the  MAE  stop.  If,  for  some  irrational  reason,we  didn’t  stop  out  at  the  MAE  stop,  it  would  rebound.  Line  C  isthe line of hope wherein losses turn into profits or are at least mini-mized.
Fat  chance!Depending  on  the  distribution  of  adverse  price  movement  forthe  losers,  it  may  have  a  sharply  higher  chance  or  only  a  slightlyhigher  chance,  but  one  thing  is  nearly  certain:  once  it  hits  the  stop,the chances that it would have been a winning trade are as minimalas we’ve chosen to make it by our stop placement for the originaltrend trade. We’ve chosen a stop that is specifically designed to dis-tinguish between winners and losers. If this trade were to be a win-ner,  it’s  unlikely  given  our  measured  experience  that  it  would  havehit the stop in the first place. No, this trade is likely a loser and thequestion is: how much of a loser?
According  to  Figure  6.2,  if  we  set  the.stop  at  .31   the  estimatedprobability  of  still  being  a  winner  on  the  original  trade  is  12001   orabout  12%.  In  other  words,  from  .31   south  there  are  12  winnerswe’ve cut off (in ten years) and 89 losers. Note that some of those89 losers went kvay  into the hole. We want to get some of that pricemovement  into  our  equity  account.
A  Reversal  Trade  (Line  D)
If  the  underlying  trade  has  a  low  probability  of  profitability  (12%)having  hit  the  .31   stop,  it  also  has  an  apparently  high  probability(88%)  of  going  further  bad  (line  D)?  Turning  things  around  now,  ifwe reverse the original trade we would have  an  upside  potential  offrom  .31   to  over  2.10  and  a  downside  of  .31,   keeping  in  mind  that
FIGURE  6.2 MAE  USING  MONTHLY  CONTRACTS.  Winners  andlosen  versus   MAE,  1984-l  994.
12  underlying  winning  trades,  if  reversed,  will  become  losers.  Thisis  potentially  favorable  and  so  merits  some  investigation.
TRADING  RULES
If long or short, place a reversing stop (sell or  buy two contracts orblocks of stock) at  .31   trading  points.  For  the  initial  analysis  of  thereversal strategy, place no protective stop. Exit on the end-of-tradedate for the underlying trade.
Did  you  forget  about  the  trade  horizon?  Because  all  our  infor-mation  about  trade  behavior  takes  place  within  the  trading  horizonestablished  by  the  underlying  trade’s  rules,  we  must  continue  totrack its status. If we’re long, we have until one or the other of theaverages goes down. If we’re short, one or the other of the averageswill  break  upward,  indicating  the  period  of  the  underlying  trade  isover.  At  this  point,  we’ll  exit  the  reversal  trade  just  as  we  wouldhave exited the underlying trade.
RESULTS
Following  these  trading  rules,  Figure  6.3  shows  the  results  usingthe eleven years of Crude data, rolling every month to the most ac-tive contract.
142  Reversing  Bad  Trades
Inspection  143
thing by seeing what happens trade by trade. As you see each tradeprogress day by day, Crude shows several typical market behaviorsat  the  times  when  reversals  are  triggered,  behaviors  that  I’velumped  into  descriptive  categories.  I’ve  done  this  to  show  that  re-versal  trading  is  not  always  “getting  right  with  the  trend.”  Thathappens, but it’s more complex than it seems and takes two steps:(1)  reversal  out  of  the  original  mistake  and  (2)  initiation  of  a  trendtrade.  Figure  6.4  shows  the  types  of  trades  I  encountered  whilewatching Crude reversal trades.
Mistaken  Reversals
Days  in  underlying  trend  trade  before  reversing:  one  or  two.  Daysin reversal trade: seven or more.
In  these  trades,  the  reversal  catches  the  underlying  trend  trade’sstop and triggers by just two or three ticks. This is the thing tradershate  the  most,  especially  in  the  11  cases  (11%)  here  where  the  rever-sal trades went on to become losers, sometimes serious losers. Notonly  do  you  convert  winning  trend  trades  to  losers,  but  you  makethe loss bigger by reversing
FIGURE  6.3 REVERSAL MAE. Winners and losers versus MAE,1984-l 994. Compared to the underlying trend system, reversal tradeshave a very high success rate even with simple exit rules. Limitations ofthe data exaggerate the size of the MAEs  for winners.
The  most  striking  thing  shown  by  Figure  6.3  is  the  heavy  domi-nance  of  the  winning  category.  Winners  occurred  68  times  to  31losers,  even  with  a  naive  exit  scheme.  There  aren’t  many  tradingschemes  that  offer  a  70%  success  rate  but  there  are  still  soberingthoughts  regarding  this:
1. Keep in mind you had to eat a loss of 31 ticks on the underly-
ing  trend  trade  to  get  to  the  winner.  That  amount  is  tallied  inyour  profit/loss  statement  for  the  trend  trading,  though,which was profitable despite it.
2.  The  distributions  are  much  more  similar  than  they  were  forthe  underlying  trade.  Both  winning  and  losing  distributionshave long tails. What could that mean?
3. There are some huge  MAEs for winning trades Why?4. What is the overall profitability if stops are used?
INSPECTION
Stepping  through  the  experience  of  the  actual  trades  is  extremelyvaluable.  Although  the  process  can  be  automated,  you  learn  some-
FIGURE  6.4 CATEGORIES  OF  REVERSAL  TRADES.  About  half  thereversals done in Crude from 1984-l 994 were of false trend signals.These usually happened quickly: in and out in two  or three days.
144  Reversing  Bad  Trades
lnsoection   1 4 5
In these data, trades are typified by entry soon after the start ofthe underlying trade (1 or 2 days) and then a long run (7 to 35 days)going  the  wrong  direction.  These  trades  are  the  source  of  the  longtails  in  Figure  6.3.  Thankfully,  this  is  a  rare  experience,  though  liv-ing through it is not fun. It should be rare because we selected thetrend trade’s MAE stop to make it rare. Having selected the stop,though, we should keep in mind that it’s not perfect. We’re playingexperience, and experience is not a perfect guide to the future.
Ceffing  Right  with   the  Market
Especially if the stop has been picked by just a few points, we mayneed to reverse again to get right with the market. The problem an-alytically  is  that  there  aren’t  enough  of  these  situations  to  definerules for MAE stops. Frankly, we are thrown back on judgment,
In  Figure  6.5,  the  logic  of  our  original  reversal  idea  is  that  if  areversal trade were to back up  .31,  the trade might be one of thosetrend  winners  we  cut  out  with  an  MAE  stop  (line  A).  This  isn’tfoolproof because all we know from experience is that at the  end ofthe trade horizon, 12% of the winning trades will have experiencedan MAE greater than  .31  and come back into the black. If a trendtrade  goes  back  to  zero  (which  would  be  an  adverse  excursion  of.31   from  the  reversal  trade’s  entry),  it  could  happen  at  an):   timeduring  the  trend  trade’s  horizon,
The  other  alternative  shown  in  Figure  6.5  is  line  B,  a  trade  thattouches  the  adverse  excursion  stop  and  then  retreats  back  to  zerobefore  ending  as  a  loss.  Without  intraday  data  and  enough  tradesto  do  an  analysis,  we  can’t  develop  trading  rules  supported  byquantitative  observation.  This  is  a  limitation  of  MAE  analysis