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Stocks & Commodities V. 28:9 (8-9, 67): Letters To S&C by Technical Analysis, Inc.

The editors of S&C invite readers to submit their opinions and information on subjects also at the Traders Resource database
relating to technical analysis and this magazine. This column is our means of communica- at our website, www.Traders.com, under
tion with our readers. Is there something you would like to know more (or less) about? the Consultantscategory).Editor
Tell us about it. Without a source of new ideas and subjects coming from our readers, this
magazine would not exist. ARTICLES ONLINE?
Address your correspondence to: Editor, Stocks & Commodities, 4757 California Ave. Editor,
SW, Seattle, WA 98116-4499, or email to Editor@Traders.com. All letters become the Is it possible to retrieve articles from
property of Technical Analysis, Inc. Letter-writers must include their full name and address past issues of S&C via the web?
for verification. Letters may be edited for length or clarity. The opinions expressed in this John Dueweke
column do not necessarily represent those of the magazine.Editor
Yes. You can purchase individual past
articles from the Online Store at our
CALENDAR SPREADS will shift the risk curves higher (that website at http://store.traders.com/.
Editor, is, farther in a positive direction), while You can use the search feature there to
Perhaps in a a decline in implied volatility will push help locate articles.
sequel to The the risk curves farther into negative
Double Cal- territory.
endar Spread In sum, if implied volatility is extremely
(Stocks & Commodities, July 2010), high, favor the iron condor. Under
author Jay Kaeppel might compare the any other circumstance (and as long
double calendar to the iron condor. as you have some reason to think the
Ive had limited success predicting the implied volatility will not fall sharply),
outcome of calendar spreads, primarily a double calendar is a strategy worth
because their risk curves do not accu- considering.
rately reflect the spreads value as the Hope this helps.
near-term option approaches expiration.
With their sag in the middle, the risk VWAP code for Real Tick? You can also access some of our
curves for the double calendar seem to Editor, regular features and departments from
be far more uncertain than the plateau- As an avid reader past issues for free at our website. Visit
like risk curves of the iron condor, of your maga- our back-issue archive (http://www.
whose risk/reward is comparable to the zine, I particu- traders.com/Documentation/FEEDbk_
double calendar. larly enjoyed the docs/backissues.html) to browse past
Incidentally, Kaeppels book, The article by Andrew Coles in the July tables of contents.
Option Traders Guide To Probability, 2010 issue, An Anchored Vwap For Another alternative is to purchase
Volatility, And Timing, has an excellent Congested Markets. In the Traders our S&C On DVD if you have a need
chapter on calendar spreads. Tip section of that issue, you give the for many of our past articles, since one
Chris Pflum code for various trading platforms, but price gives you access to 27 yearsworth
Las Vegas, NV unfortunately, not the one that I use for of articles.
my stock trading. Thank you for writing.
Jay Kaeppel replies: Do you or does someone else there
The primary difference between a have the code equivalent for us Real- The Forex Gambit
double calendar and an iron condor is Tick users? Editor,
the circumstance in which they should Ray Thank you to author Walter
be utilized. Toronto, Canada Downs for an excellent
In a high-volatility environment, the article in the June 2010 is-
iron condor is generally preferable Unfortunately, we are not able to provide sue (The Forex Gambit).
because: a) it allows the trader to take the code. You might try the RealTick tech- When I saw that he had an
in the most premium, and b) a double nical support forum or user forum, or try advanced education in esoteric math-
calendar spread is susceptible to a requesting the code equivalent directly ematics I was afraid I would be lost within
volatility crush if volatility falls after from RealTick technical support. two sentences. On the contrary, his article
the trade is entered. When entering a Alternatively, you could try posting is one of the most clearly written and
double calendar, the trader ideally wants your request for RealTick code at a gener- understandable articles about any kind
implied volatility to either rise or at least al forum for traders or technical analysts, of technical analysis I have read in the
remain relatively unchanged. or use a private programming service for past 15 months of daily study.
For any calendar spread double or your particular needs (some are listed Leroy Cook
otherwise a rise in implied volatility in our magazines classifieds section and Ann Arbor, MI
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 28:9 (8-9, 67): Letters To S&C by Technical Analysis, Inc.
QUESTIONS ON THE Forex Gambit
Editor,
I really enjoyed reading the article The
Forex Gambit by Walter T. Downs in
the June 2010 S&C. However, I have
some queries.
1. Is this a two-bar strategy (that is, two
consecutive lower lows and a close
above the midpoint of the second bar
and above the simple moving average)?
If there are two bars of lower lows,
and a third one is an inside bar, having
closed above the midpoint of the bar
and above the simple moving average,
can this setup still be valid?
2. Can I use this strategy to trade stock
index futures, where the leverage is
approximately 1 to 10? If yes, do I
need to change the bet/position size
formula?
Vinod Nadoda
Ahmedabad, India
Walter Downs replies:
In response to your first point, it is
important for the bar that completes
the pattern to have reversed from its
lows and closed above the midpoint of
the bar and also formed a lower low.
I would not consider your suggested
setup a strong enough indication that
the trend was resuming. Of course, this
is my preference. One of the tenets of
highly systematic discretion (Hsd)
analysis and trading is that you utilize
your own knowledge of the market in
your decisions.
In response to your second point, the
leverage afforded isnt nearly as attrac-
tive as in the forex market, and also,
with a market that is closed overnight,
a sudden price shock and resultant large
gap could be dangerous to your account.
Personally, I would feel that the gambit
is too aggressive for these markets,
given the greatly reduced leverage and
overnight exposure.
MORE ON The Forex Gambit
Editor,
I found Walter Downs article in the June
2010 issue, The Forex Gambit, infor-
mative and well presented. I do believe,
however, there are a few errors in concept
that do not destroy his message, but do
raise some questions of mathematical
correctness.
Downs presents a standard deviation
(std) formula that I believe is flawed.
The formula is:
Std=[((pct.*(Win*Win)) +
((1-pct)*(Loss*Loss))]^0.5.
By inspection, this formula doesnt
seem correct, since if one expands pct
to 1.0, std approaches win (all $39s)
when, of course, such a condition
actually leads to std=0. I believe the
correct equation is:
Std= (1+R)*Loss*((W*(1-W))^.5
(where Loss=Bet, and W=pct) that these Mdds are of no consequence
which is an equation I derived in my S&C
article, Trading Tradeoffs With Risk Vs.
Reward (S&C Bonus Issue 2010). It is
quadratic in form, going to zero at both
W=1 and W=0 as I believe the std should.
The difference is not trivial, since they
produce different results for std.
Since Downs uses std to then calculate
his Por (risk of ruin percentage), that
throws into doubt the resulting Por
calculations. He mentions only one Por
value, 0.000055. The generally accepted
values for risk of ruin were presented
by Nauzer J. Balsara in his December
1992 S&C article, Appreciating The
Risk of Ruin. In this case, the Balsara
Ror is 0.
I was able to replicate Por in Excel, du-
plicating the authors results, and found
that for Bet(loss)=50%, R=3, W=.65,
Por=8.6%, and Ror=1.6% a rather
large difference. More disconcerting is
the fact that if R is set to 1.0, Por=8.4%,
a value less than 8.6%, in contradiction
of the fact that Por (and Ror) always
decrease as R is increased (for fixed W).
Still more important is that this is the
only Por value the author gives, and it
could imply that his trade results have
such a low Por when, in fact, they have
rather high values of Por (data presented
below).
In Figure 3, the author presents rather
extraordinary trading results. In the first
trade, $100 becomes $11.4 million in
only 30 trades (six of which are neutral).
Copyright (c) Technical Analysis Inc.
This represents a startlingly high 62.5%
gain per trade. What I think the author
neglected to point out is that the equity
drawdown (Mdd) and the concurrent
Por associated with each trade are all
rather large. I calculated the following
values for the three trades:
Trade1: Mdd = -60%, Por = 16.2%
Trade2: Mdd = -74%, Por = 27.6%
Trade3: Mdd = -82% (wow!), Por =
19.4%
The generally accepted pain level
for Mdd is 30% (some would argue
for higher values). Balsara suggests
Por=10% as a maximum reasonable
Ror. I also believe it is fallacious to argue
as it is house money. As for myself, I
could tolerate a 100% loss of the initial
$100 (or $300) before I could stomach
a -82% equity drop. Then there is the
generally unfavorably high Por values
to contend with. These trade gain results
are extraordinary but they also entail
high risk not unsurprising, since the
author is trading forex with 100-to-1
leverage and betting at close to the Kelly
optimum (a reference from page 27 of
Downs article). Perhaps it comes down
to ones definition of risk?
Finally, I believe there are a couple
of errors (or perhaps lack of clarity)
in Figure 3, when converting from the
pip linear trade data to the exponential
trade data. In trade 1, row 7, the -150 loss
should be bet at a 60% loss level, whereas
the actual reduction is only 30%. This
lowers his final equity from $11.4 mil-
lion to $6.5 million, a huge decrease, but
still an excellent return. One explanation
for this lower bet level (30% in lieu of
60%) would be if the program knew
ahead of time that it is a high-loss bet
and thus could cut back the number of
lots traded before the trade occurred. But
this is clairvoyant, and I dont see how
it could be achieved. In fact, if it could
be achieved, the author should bet the
following up bet (+200) at double the
lots (or higher) to maximize that (and
subsequent) returns. Obviously, there is
no margin call when equity is so much
greater than the margin to trigger such
a reduction.
Stocks & Commodities V. 28:9 (8-9, 67): Letters To S&C by Technical Analysis, Inc.
The same problem exists for trade 3.
Starting at row 10, three consecutive
losing bets (-200, -250, -200) drop the
equity by 82%. Here, it might be possible
to minimize the -250 bet (which should
decrease equity by itself to zero!) as the
two preceding drops signal the danger,
but it doesnt explain why the first bet
(-200) has a loss of equity of 40% when
the pip value indicates it should have a
loss of 80%. Either the conversion from
pips to equity is wrong (in these four
trades), or the authors program is power-
ful enough to anticipate big decreases,
and lower the lots bet to mitigate such
losses (but not upswings).
Norm Brown
Walter Downs replies:
The formula used in the article was cre-
ated by Teresa Lo and a Cfa. I am not
familiar with the work of the Cfa, but
Teresa Lo is a well-known and respected
market analyst with an advanced degree
in engineering. You should probably
direct your concerns about her formula
to her.
I noted several of the shortcomings you
mentioned during my own use of the for-
mula and took these into consideration
during the analysis process.
Some comments on your analysis:
Pardon me, but at the higher std that
you claim for the formula versus the qua-
dratic approach, it seems to me that my
results would represent a more pessimis-
tic view of system outcome rather than
a more optimistic view of the outcome.
First, you claim the formula overstates
values of Ror, then you claim it under-
states values of Ror a flip-flop that is
bound to drive any logician crazy.
That aside, if you apply the formula
exactly to the figures in the article, you
will produce exactly the same results
I did. When comparing the results of
Balsaras formula, and the formula I
used exactly as I used it, I deemed the
differences between the two formulas
as trivial since the differences were
both considerably less than 1% and
amounted to differences of fractions of
a percentile.
It seems to me that your differences
in results stems from your attempts to
monkey with the values used in the
production of those results.
In further analysis of the formula, in
response to your concerns, I derived an
even lower expected Ror of 0.000022.
If I compare this to your results, the
lowest of which you claim is 16.2%, if
we divide 0.162 by 0.000022, we get
a difference of 7,363 times the risk!
This cannot be accounted for by either
Balsaras formula or the formula I use,
and suggests a serious error in logic
on your part in the calculation of your
Por/Rors. From the appearance of
your results, I suggest that you are not
accurately calculating the fractional
betting portion of the system as a figure
that represents the probability not of
Ror, but a probability that the account
will ever return to the reserve level.
As such, this probability is multiplied
by the reserve betting probability to
derive the final Ror of the system, and
is not considered as an Ror factor in
future calculations in and of itself.
In other words, if the reserve Ror is
0.01, and the fractional bet Ror (risk
of returning to reserve level) is 21%,
to average the two results, producing
an Ror of 11% would be incorrect.
Instead, you multiply 0.01 by 0.21 and
derive the correct Ror of 0.0021.
All mathematics aside, if you just
consider the possible Rors of a system
that wins 67% of the time, and has a win-
to-loss ratio of 3 to 1, and has trading
characteristics as specified in the article,
Copyright (c) Technical Analysis Inc.
you can ascertain that, logically, even
without further calculation, this system
would have very low Por/Rors.
As to the actual risk entailed in the
trading of this system, you and I would
probably go round and round on that
point. I maintain that since you are
essentially playing with profit and not
your initial risk capital, this represents
as close to risk-free investing as you
can get.
In the adjustments made in the data
runs, I made some allowances for
trades that carried a higher initial
risk than the average risk of about 100
pips. In these cases, in actual trading,
I would have reduced my exposure to
2030% instead of the full 40% risk.
In these cases, I would not have been
foretelling the future, as the risk
on the trade would have been known
beforehand to the trader before the
trade was executed based on his entry
price and stop-loss price, and without
which, in fact, he would not have been
able to properly size his bet.
Editor replies:
Readers are also encouraged to explore
alternative formulas for calculating the
Ror. Here are several references that
may touch on formulas for Ror, including
Norm Browns article:
Brown, Norman [2010]. Trading Tradeoffs
With Risk Vs. Reward, Technical
Analysis of Stocks & Commodities,
Volume 28: Bonus Issue.
Kaufman, P.J. [1998]. Trading Systems
And Methods, 3d edition, John Wiley &
Sons.
Kaufman, Perry J. [2003]. A Short Course
In Technical Trading, John Wiley &
Sons.
_____ [1994]. On Profit-Taking, Techni-
cal Analysis of Stocks & Commodi-
ties, Volume 12: April.
S&C
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