Bulkowskis Position Sizing

December 3, 2012 5:00 am1 commentViews: 1282

Position Sizing Background

For most of my investing career, I used a fixed dollar amount for money management
when buying stocks. At the beginning, it was $2,000. That bought me 100 shares of a
$20 stock. I thought thats the method that everyone used. As I learned about the stock
market, I knew that there were better ways to position sizing (money management)
but I didnt know what they were.
In the August 2007 issue of Active Trader magazine, Volker Knapp (see Trading
system lab: Percent volatility money management) tested a system that used
volatility to determine the position size. I already use volatility to determine stop
placement (see Stop Placement), so this was a welcome addition. The article was
based on Van K. Tharps book Trade Your Way to Financial Freedom.

Percent Risk Position Sizing

The first method, percent risk position sizing, is well known and its based on risk to
determine the position size. For example, if you are looking to buy a stock with a
price of $20 and a stop loss of $19, with a maximum loss of $2,000, you should buy
2,000 shares.
The formula for this approach is:
DollarRiskSize/(BuyPrice StopPrice)
In this example, the DollarRiskSize is $2,000, the BuyPrice is $20 and the StopPrice
is 19 giving a result of $2,000/($20 $19) or 2,000 shares.

Percent Volatility Position Sizing

The percent volatility position sizing method adjusts the risk according to the stocks
volatility. Tests described in the article say it performs much better than the percent
risk method.
Heres the formula.
PositionSize = (CE * %PE) / SV
Where CE is the current account equity (size of portfolio)

%PE is the percentage of portfolio equity to risk per trade.

SV is the stocks volatility (10-day EMA of the true range).
For example, if the current account equity (CE) is $100,000, the percent of portfolio
equity we want to risk (%PE) is 2%, and the stocks volatility is $1.25, then the result
is: ($100,000 * 2%) / $1.25 or 1,600 shares.
Instead of calculating the 10-day exponential moving average of the true range, I just
calculate the volatility using Patternz, which provides it at the click of a button.
The downfall of these two methods is that if your portfolio is $100,000, then the trade
just described would chew up 1,600 shares x $20 buy price or $32,000. Thus, you can
buy just over 3 stocks, giving you a concentrated portfolio. The percent-risk method
would be even worse with $40,000 used for just one stock. (Of course this assumes
that the stocks share the same buy price, volatility, and so on).
One way to avoid the concentrated portfolio problem is to divide the $100,000 into
$10,000 allotments (or whatever size you feel comfortable with that would lead to a
diversified portfolio), one for each stock. Use the same formula to determine the share
size. In the percent volatility example, the computation would be: ($10,000 x 2%) /
1.25 or 160 shares.
I dont know what this does to the profitability of the method because the articles
author didnt discuss this. In any case, this page is about position sizing and not
portfolio theory.

Position Sizing Excel Spreadsheet Template

I have an Excel spreadsheet template which does the math for both techniques. To use
the spreadsheet, first download it and then fill in the yellow cells with the appropriate
information. The position size appears in the blue cells. The following shows what the
template looks like. Click the image to make it larger.

Bear Market Position Sizing

When a bear market begins, I cut my position size to limit losses. Recently, I decided
to derive a mechanism to achieve that. The following table shows the rules for this
new method to limit losses in a bear market.

By definition, a bear market begins when an index (I use the S&P 500) drops 20%
below a peak. When that occurs, cut the amount allocated to each trade by half. If my
position size is $20,000, I will cut it to $10,000.
If the market drops another ten-percentage points, then cut the position size in half
again from $10,000 to $5,000 in my case. Continue cutting the position size by
half until it reaches $2,500 (or whatever value you choose).
The advantage of this position-sizing algorithm is obvious. As the bear market begins
and worsens, your have the potential to lose less and less of your trading capital.
However, this method does keep you in the market, so you can shop for bargains
among a variety of stocks. That promotes diversity, which is also a good thing.

If there is a drawback, its that at a bear market bottom, you are investing few dollars
in the market. When the bull market resumes, thats when you want to pile back in. Of
course, its often difficult to determine when a bear market ends and a bull market
begins, so prematurely ramping up the position size can lead to larger losses.
dom.

Portfolio Position Sizing

How do you size the positions in your portfolio, assuming you wish to make multiple
buys per stock (or just once)?
To get the position size (shown in the above table as $20,000 then $10,000), take the
value of the trading account and divide it by the number of positions you want to
hold. The number of positions you choose is up to you. Many will say to hold no
more than 10 to 12 with at least 7 to 8 positions to give adequate diversity. As I write
this, I own 22 positions with an eye to 30. Think of this as my own private mutual
fund. Im a skilled investor/trader with 30+ years of experience, so owning this many
is not a problembut thats just me.
For example, say you have a portfolio currently valued at $300,000, and want to hold
30 positions, then each position would be $10,000. Within 20% of a bull market peak,
youd start with 10k per position. When the bear market begins, youd cut that in half,
to 5k and then 2.5k as the bear market worsens.
That gives you the amount to invest in each stock. Now, lets adjust the position for
volatility. The more volatile the stock the fewer shares you should own.
dom.

Shares Per Trade

I saw one algorithm that compared the current stocks volatility with its historical
range. The current period used a 10-day high-low calculation but they didnt specify
what was meant by historical. In their example, they said a few years ago
(whatever that means).
That bothered me. A company could have had a drug failure, dropping the stock by
70% in one session (huge historical volatility) and then sold the division. You might
not know that unless you read the press releases or discovered it some other way.
I have a better idea. Why not compare the stocks volatility to the markets? Heres the
formula.
Shares = (PositionSize * (MarketVolatility / StockVolatility)) / StockPrice
PositionSize comes from the above table, so its adjusted for the market conditions.

MarketVolatility is the daily change of the market over the last month, averaged,
expressed as a percentage.
StockVolatility is the daily change of the stock over the last month, averaged,
expressed as a percentage.
For the two volatility calculations, I calculate the high-low difference of the stock or
market index (I use the S&P 500 index) each day for 22 trading days (about a month),
average it, and divide it by the most recent close. This is nearly the same calculation
that I use for a volatility stop, so check that link for an example. You can use the ATR,
but its not as effective.
This will give you the number of shares to invest per position. You can have multiple
positions per stock.
In short, take the ratio of the two volatilities to further adjust the bucks you spend and
divide that by the current share price to get the number of shares.
dom.

Volatility Stop
We adjusted the amount spent per trade for the market conditions, and then we
adjusted the number of shares for the stocks volatility. The third leg of the algorithm
is to use a volatility stop. That calculates a stop loss order based on a stocks volatility
in a manner similar to the above volatility calculation.
Thus, you have three pieces: Adjusting the position size for the market conditions,
adjusting it for the stocks volatility versus the markets, and using a volatility stop to
limit losses.
dom.

Position Sizing Example

Lets assume we want to buy Gap (GPS) stock. It closed Friday, December 17, at
21.19. Our portfolio has a current value of $100,000 and we want to hold 10 stocks in
the portfolio.
The S&P index is down less than 20% from its high a few days ago (its down less
than 1% from the high). Thus, wed spend the full $10,000 for this trade (thats
$100,000 / 10 stocks = $10,000). To find the number of shares, the market volatility is
0.009 (0.9%) and the stocks volatility is 0.0213 (2.1%) I have a program that
calculates the two volatilities automatically. Plugging this into the formula, we get,
Shares = ($10,000 * (0.009 / 0.0213)) / 21.19 or 200 shares (I round up to the nearest
100 shares). They would be worth 200 * 21.19 or $4,238.

The volatility stop would be placed at 20.15, or 5% below the current close.
That gives us plenty of dollars to spend on the stock sometime in the future, to
increase the position. The volatility and portfolio value will have changed by then, so
youd run another calculation to get the next investment amount.
Tom Bulkowski

Measuring Success: Key Performance

Metrics
November 26, 2012 5:00 am8 commentsViews: 2480
When you see the performance of a trading system, how do you know its good? How
do you know its the right system for you? Many people simply look at the net profit
assuming the system with the more profit must be the better system. This is often far
from a good idea. When comparing trading systems during the development process
or when comparing systems before making a purchase, it is nice to have a
few metrics on hand that will allow you to compare the system either to
a hypothetical benchmark or against another system. There is no one single score you
can use that will work for everyone since we all have unique
risk tolerances and definitions on what we consider tradable. Likewise, not all scoring
systems are equal or perform under all circumstances. However, in this article Im
going to talk about my favorite methods used to score and rank trading systems.
These are my key system performance metrics that I use during the system
development process.

Number of Trades
Any trading system should have a significant number of trades. What is significant?
Well that varies. For a swing system that takes no more than 10 trades a year, having
100 trades is good. This represents about 10 years of historical testing. As a given
trading system starts to produce more trades per year, I would expect to see more
trades utilized during backtesting.

Profit Factor
While net profit can be a factor in your decision about a particular trading system,
profit factor is often even more important in my opinion. Profit factor measures
the efficiency of your trading system. Profit factor is calculated by dividing the
generated profit by the generated losses. A profit factor of 1.5 indicates for every two
dollars lost, three dollars are gained ($3 win / $2 lost = 1.5). Obviously a number
above 1.0 means you are making money. I like to see a profit factor of 1.5 or higher.

Average Profit Per Trade

Like profit factor, the average profit per trade tells me if a system is making enough
money on each trade. When designing a trading system I like to see an average
profitable trade above $50 before commissions and slippage are deducted at
an absolute minimum. If the average net profit is above $50 with commissions and
slippage deducted, thats even better. The higher the average profit per trade the better.

Percent Winning Trades

I dont follow this too much. I make note of it but its not all that important to me. The
percent winning trades is simply the number of trades that generated a positive net
profit divided by all trades taken. This factor can be important if you dont like to
have a large string of losers. For example, often longer term trend following systems
can be very profitable, but only have a win rate of 40% or less. Can you handle many
losing trades? Maybe you are only comfortable with systems that tend
to produce more winning trades than losing trades. If so, then a system with a win rate
of 60% or higher would be better for you. Percent winning trades is a
psychological tolerance indicator that will vary between people.

Compounded Annual Growth Rate (CAGR)

This describes the growth as if it were a steady, fixed rate of return. Obviously this
does not happen when trading as your trading system produces a jagged equity curve
over time. Yet, this is a way to smooth your return over the same trading period. Lets
say your trading system produces a 5% CAGR over a 10 year period. Over that same
period you have a bank CD that also yields a 5% return over the same time frame.
Does this make the CD a better investment? Maybe. One thing to keep in mind is this:
the CAGR calculation does not take into account the time your money is at risk. For
example, while the trading system may be retuning 5% CAGR over 10 years, your
money is only actively in the market for a fraction of the time. Most of the time its
sitting idle in your brokerage or futures account waiting for the next trading signal.
CAGR does not take into account the time your money is at risk. Remember, a 5%
return in the CD is realized only if your money is locked away 100% of the time. With
our example trading system our cash is also freed up to be put to use in other
instruments.

Risk Adjusted Return (RAR)

This calculation takes into account the time your money is at risk in the market. This
is done by taking the CAGR and dividing it by exposure. Exposure is the percentage
of time (over the test period) that your money was actively in the market. I like to see
a value of 50% or better.

Maximum Intraday Drawdown and The Equity Curve

How big are those drawdowns? Can I mentally handle such a drawdown? Along
these lines I also look at the shape of the equity curve. Does it climb with shallow
pullbacks or does it have steep pullbacks? Are there long extended periods with no

new equity highs? Ideally, the equity curve should rise as time goes by, creating new
equity highs with shallow pullbacks.

t-Test
This is one you dont see much of. The t-Test is a statistical test used
to gage how likely your trading systems results occurred by chance alone. You would
like to see a value greater than 1.6 which indicates the trading results are more likely
to not be based on chance. Any other value below indicates the trading results might
be based upon chance. The t-Test value should be calculated with no less than 30
trades. Below is the t-Test calculation.
t = square root ( number of trades ) * (average profit per trade trade / standard
deviation of trades)

Expectancy
Expectancy is a concept that was described in Van Tharps book Trade Your Way To
Financial Freedom. Expectancy tells you on average how much you expect to make
per dollar at risk. Expectancy might also be a value that you optimize when testing
different strategy input combinations. While computing the true expectancy of a
trading system is beyond this article, it can be estimated with the following simple
formula.
Expectancy = Average Net Profit Per Trade / | Average losing trade in dollars |
For those no too familiar with mathematics, the vertical lines around the Average
losing trade in dollars indicates the absolute value should be used. This simply
means if the number is a negative value, we drop the negative sign thus making the
value positive.

Expectancy Score
This value is an annualized expectancy value which produces an objective number
that can be used in comparing various trading systems. In essence the Expectancy
Score factors in opportunity into the value by taking into account how frequently
the given trading system produces trades. Thus, this score allows you to compare very
different trading systems. The higher the expectancy the more profitable the system.
Expectancy Score = Expectancy * Number of Trades * 365 / Number of strategy
trading days

Conclusion
With the above values we can get a decent picture on how the system will perform.
There are, of course, other values you could evaluate and even more you can do such
as passing the historical trades through a Monte Carlo simulator. But these values
discussed in this article are the important values I utilize when designing a system or
when evaluating a third party trading system.

Building A Better Trend Filter

November 12, 2012 5:00 am8 commentsViews: 3189

In this article I will create a trend filter (also known as market mode filter or regime
filter) that is adaptable to volatility and utilizes some of the basic principles of
hysteresis to reduce false signals (whipsaws). As you may know, I often will use the
200-period simple moving average (200-SMA) to determine when a market is within
a bull or bear mode on a daily chart. When price closes above our 200-SMA we are in
a bull market. Likewise, when price is below our 200-SMA we are in a bear market.
Naturally, such rules will create some false signals. By the end of this article you will
have a market mode filter that can be used in your system development that may
produce better results than a standard 200-SMA filter. To build our better market trend
filter we will use the following concepts:

Hysteresis

Price proxy

Hysteresis Basics

When building trading systems many of the decisions have a binary outcome. For
example, the market is bearish or bullish. You take the trade or you dont. Introducing
a gray area is not always considered. In this article Im going to introduce a concept
called Hysteresis and how it can be applied to our trading. Hysteresis was used in a
previous article on reducing whipsaws within a moving average crossover trading
system. While the word Hysteresis was not used specifically in that article, it was a
good example.
The common analogy to help understand the concept of hysteresis is to imagine how a
thermostat works. Lets say we are living in a cool weather climate and we are using a
thermostat to keep the temperature of a room at 70 degrees F (critical threshold).
When the temperature falls below our critical threshold the heaters turn on and begin
blowing warm air into the room. Taking this literally as soon as the temperature
moves to 69.9 our heater kicks on and begins blowing warm air into the room driving
the temperature up. Once the temperature reaches 70.0 our heaters turn off. In a short
time the room begins to cool and our heaters must turn on again. What we have is a
system that is constantly turning off and on to keep the temperature at 70 degrees.
This is inefficient as it produces a lot of wear on the mechanical components and
wastes fuel. As you might have guessed, hysteresis is a way to correct this issue. More
in just a moment.
The purpose of this article is to improve our market mode filter. Below is the result of
buying the S&P cash index when price closes above the 200-SMA and selling when
price closes below the 200-SMA. This is similar to our thermostat example. Instead of
turning on the furnace to heat a room we are going to open a new position when a

critical threshold (200-SMA) is crossed. In order to keep things simple, there is no

shorting. For all the examples in this article, we are starting with a $100,000 account
and risking $1,000 for each trade. The number of shares is scaled based upon a 20-day
ATR calculation. To account for slippage and commissions $30 is deducted for each
round trip.
SMA_Line = Average( Close, 200 );
If ( Close > SMA_Line ) then Buy next bar at market;
If ( Close < SMA_Line ) then Sell next bar at market;

In the above image we can see we entered into the market six times before the trade
moves significantly in our favor. The first five attempts were closed at a loss as price
moved from bull territory back to bear territory. Thats five consecutive losing trades!
Trading Bands

Going back to our thermostat example, how do we fix the problem of the furnace
turning on and tuning off so many times? How do we reduce the number of signals?
Lets create a zone around our ideal temperature of 70 degrees. This zone will turn on
the heaters when the temperature reaches 69 degrees and turn off when the
temperature reaches 71 degrees. Our ideal temperature is in the middle of a band with
the upper band at 71 and the lower band at 69. The lower band is when we turn on the
furnace and the upper band is when we turn off the furnace. The zone in the middle is
our hysteresis.
In our thermostat example we are reducing whipsaws or false signals, by providing
hysteresis around our ideal temperature of 70 degrees. Lets use the concept of
hysteresis to attempt to remove some of these false signals. But like our ideal
temperature we want an upper band and a lower band to designate our lines in the
sand where we take action. There are many ways to create these bands. For
simplicity lets create the bands from the price extremes for each bar. That is, for our
upper band we will use the 200-SMA of the daily highs and for the lower band we
will use the 200-SMA of the daily lows. This band floats around our ideal point which
is the 200-SMA. Both the upper and lower bands vary based upon the recent past. In
short, our system has memory and adjusts to expanding or contracting volatility. The
EasyLanguage code for our new system look something like this:
SMA_Line = Average( Close, 200 );
UpperBand = Average( High, 200 );
LowerBand = Average( Low, 200 );
If ( Close crosses over UpperBand ) then Buy next bar at market;
If ( Close crosses under LowerBand ) then Sell next bar at market;
Below is a screen shot showing the effect of opening a new trade after the daily bar
closes above the upper band. We have reduced our five consecutive losing trades
down to two trades.

Here are the results with using our new bands as trigger points.

Looking at the performance table above we can see an improvement in nearly all
aspects of the systems key performance. Most notably, increased Net Profit, Profit
Factor, Percent Winners and Average Trade net Profit. We also reduced the number of
trades and the number of consecutive losing trades. In the end we really end up with
about the same amount of net profit but we accomplish this task with fewer, more
profitable trades.

Its interesting to note that our Expectancy Score falls even as we increase the
Expectancy value from 1.55 to 1.71. This is due to the reduced number of
trading opportunities.
Price Proxy

A price proxy is nothing more than using the result of a price-based indicator instead
of price directly. This is often done to smooth price. There are many ways to smooth
price. I wont get into them here. Such a topic is great for another article. For now, we
can smooth our daily price by using a fast period exponential moving average (EMA).
Lets pick a 5-day EMA (5-EMA). Each day we compute the 5-EMA and its this
value that must be above or below our trigger thresholds. By using the EMA as a
proxy for our price we are attempting to remove some of the noise of the daily
price fluctuations.
Below is what the EasyLanguage code may look like.
SMA_Line = Average( Close, 200 );
UpperBand = Average( High, 200 );
LowerBand = Average( Low, 200 );
PriceProxy = XAverage( Close, 5 );
If ( PriceProxy crosses over UpperBand ) then Buy next bar at market;
If ( PriceProxy crosses under LowerBand ) then Sell next bar at market;
Below is an example of a trade entry. Notice the trade is opened when our price proxy
(yellow line) crosses over the upper band. We have also reduced our losing trades to
one.

Lets see how this affects our performance.

Looking at the strategy performance table above we are making slightly less money.
However, we are once again being more efficient with our trades by eliminating
unprofitable trades. We have reduced the number of consecutive losing trades,
increased consecutive winning trades and increase our percent winners to 50%. So,
which strategy is better? It all depends on what you want or what you are comfortable

with. Some people will wish to simply take as much money as possible. Others will
wish to reduce the number of consecutive losing trades.
The above examples are designed to demonstrate the effect a better trend filter can
have on a simple trading strategy. If we want to use this in a trading system it would
be ideal to create a function from this code that would pass back if we are in a bear or
bull trend. However, the programming aspect of such a task is really beyond the scope
of this article. Nonetheless, below is a quick example of setting two boolean variables
(in EasyLanguage) that could be used as trend flags:
BullMarket = PriceProxy > UpperBand;
BearMarket = PriceProxy <= LowerBand;
In this article we have created a dynamic trend filter that smooths price, adapts to
market volatility and utilizes hysteresis principles. With just a few lines of code we
can significantly reduced the number of false signals commonly associated with this
style of trading strategy . This type of filter can be effective in building the trading
systems for ETFs, futures and Forex.
Download

TradeStation Strategy Code (ELD file)

TradeStation WorkSpace (TWS file)
Strategy Code (text file)

Jeff Swanson

Jeff is the founder of System Trader Success an inBox magazine dedicated to

sharing great ideas and concepts from the world of automated trading systems. Read
More Google
System Optimization With Expectancy
October 1, 2012 5:00 am4 commentsViews: 563

In a recent article called Rank Your Trading System With Expectancy Score I
discussed the concept of expectancy and expectancy score and how they can be used
to help evaluate and compare the profitability of trading systems. In this article Im
going to provide some EasyLanguage code that will help you compute these values
for a trading system and how to optimize a trading system based on expectancy. This
article will be heavily geared towards TradeSations EasyLanguage, however the
concepts can be applied to any programming language.
Expectancy Function

In the previous article I showed you how to compute both expectancy and
the expectancy score. Here I want to provide you an EasyLanguage
function that will do it for you. This code can be used when building your
own systems or when evaluating trading systems where you have access
to the code. Basically, if you have access to the code you can use this
function. The function is called _CE_Expectancy and it uses the formula
discussed in the previous article to calculate an expectancy. This function
provides a quick way to calculate both expectancy values easily.
Place this function at the very bottom of the strategy code and execute
your strategy. The function with then perform two things. First, it will
populate two variables (oExpectancy and oExpectancySctore) with the
expectancy value and expectancy score value. Second, if the Display
boolean is set to true, the two expectancy values will be displayed within
the TradeStation output window. If you dont have Display set to true, the
two expectancy values are not displayed but are accessible within the two
output variables, oExpectancy and oExpectancySctore.
Below are the function input parameters as they appear in the code:

float oExpectancy(NumericRef), // Output: Expectancy

float oExpectancyScore(NumericRef), // Output: Expectancy Score
bool Display(Truefalsesimple); // Display results or not
Below is an example of using the function within a strategy. The first two input
parameters will be the expectancy values. You can use these variables to display the
values or send them to a file. The last parameter tells the function not to display the
expectancy values in the TradeStation print log:
RetrunVal = _CE_Expectancy( vExpectancy, vExpectancyScore, false );
Below is a video where I give a demonstration on using the expectancy function.

Expectancy Optimizer
In the previous article I hinted that you could use expectancy score as the
key value to optimize a trading system against. Many people will use net
profit or average profit per trade, but expectancy score might be useful as
well. The expectancy score includes trading opportunity (as defined by
the frequency of trading) its calculation. However, there is a problem.
TradeStation provides no way to optimize over expectancy score. It must
be done manually. To aid in this process I created a simple function
called _CE_Expectancy_Optimizer.
This function can be added to the bottom of any trading code and is
designed to help you optimize a single parameter. For example, lets say
you wish to optimize the RSI look-back period for a particular strategy.
After adding the function and configuring the required parameters, you
perform your TradeStation optimization as you normally would. After
each iteration of the TradeStation optimizer a line is written to an Excel
file which contains the current RSI look-back period, expectancy and
expectancy score. You can then use Excels sort feature to sort the
different optimization iterations based upon the expectancy score.
There is nothing fancy about the Excel document generated. In fact, if you
open up this file you will find no headers or description. This is due to this
function being called each time an optimization run is performed. I found
no quick way to add headers only once.
Below are the function input parameters:
iWriteFlag( TrueFalseSeries ), // Should we write to a file or not?
iFileName(string), // File name
iSystemName( string ), // Name of system to test
iSystemVersionNumber( string ), // System's version number
iOptimize(NumericSimple); // The strategy input value you are
optimizing

Here is an example of using the function within a strategy:

vRetValue = _CE_Expectancy_Optimizer( iWriteToFile, vFileName,
RegimeLookback );

Below is a video demonstration of the _CE_Expectancy_Optimizer function.

Conclusion

With these two functions you will have two tools needed to calculate both the
expectancy and expectancy score for the trading systems you are developing.
Downloads

The following download link contains both expectancy functions.

Expectancy Functions (TradeStation ELD)
Expectancy Function (Text file)
Expectancy Optimizer (Text file)

Rank Your Trading System With Expectancy Score

September 24, 2012 5:00 am10 commentsViews: 2803

In a previous article called System Performance and Confidence Interval, I showed

how a statistical method could be used to analyze historical trading results to give us
an idea if the system would likely fail in the future. In this article I would like to
introduce a mathematical formula which can be applied to any trading system and
used as an objective score to compare and rank different trading systems.
When it comes to trading systems, no two are alike. There is a vast number of
different trading styles that cover the range from simple tick scalping to multi year
investment models. Of course, there is a huge number of different instruments and
markets to trade. How would one determine if two different trading systems that trade
different markets with different trading styles make an informed choice on which
system was more profitable? How do you compare two trading systems
performances? If two trading systems are both profitable and both seem like good

systems, is there a single metric that can be used to compare the profitability between
each?
Expectancy

Expectancy is a concept that was described in Van Tharps book Trade Your Way To
Financial Freedom. Expectancy tells you on average how much you expect to make
per dollar at risk. For example, if you have a trading system that has a .50 Expectancy
that means for every dollar you risk the trading system returns $.50.
There are two ways to compute Expectancy. Both methods are simple but one requires
a little more explanation but does give a more conservative answer. The second
method is a bit more straightforward to explain but only give an approximation of
Expectancy. However, this approximation is good enough for what we are attempting
to accomplish here.
Often you will find expectancy is computed with the following formula:
Expectancy = (AW * PW + AL * PL ) / | AL |
Where:
AW = Average winning trade in dollars
PW = Probability of winning trades
| AL | = Absolute value of the average losing trade in dollars
PL= Probability of losing trades

But if you look carefully at the calculation within the parenthesis you will see the
value is nothing more than the trading systems average net profit per trade.
Substituting this value gives us the simplified formula of:
Expectancy = Average Net Profit Per Trade / | AL |

The two values you plug into the Expectancy formula can be found on most (if not
all) strategy performance reports generated by backtesting. This is certainly true for
TradeStations strategy reports.
Now that we have our trading systems Expectancy value are we ready to use this
value to compare to other trading systems? Not yet. There is another step we must
first take. Our Expectancy value simply tells us our historical profit per dollar risked
for each trade. But we are missing something. Lets imagine we have two trading
systems that have two different Expectancy values:
Trading System #1 has an Expectancy of .25
Trading System #2 has an Expectancy of .50
Based on what we know it appears Trading System #2 produces more profit per dollar
risked on each trade. In fact, it produces twice as much profit per dollar risked. Thus,
if we risked $500 on each trade, Trading System 1 would generate $125 dollars while
Trading System #2 would generate $250. But this not the complete picture. We are
missing the frequency at which each trading system operates. For example, maybe
Trading System #1 trades once per day while Trading System #2 trades once per
week. We need to take into account the number of times the trading system trades

over the number of days the system was tested. In Van Tharps book he described that
as Expectancy multiplied by opportunity. Opportunity is nothing more than how often
does a given trading system trade. Opportunity times Expectancy leads us to our final
calculation for Expectancy Score.
Expectancy Score

This value is an annualized Expectancy value which produces an objective number

that can be used in comparing various trading systems. In essence the Expectancy
Score factors in a trading systems trade frequency. The higher the Expectancy Score
the more profitable the system. This final score allows you to compare very different
trading systems.
Expectancy Score = Expectancy * Number of Trades * 365 / Days in
historical test

The Number of strategy trading days is nothing more than the number of days your
backtesting was performed.
Conclusion

With the Expectancy Score in hand we have a metric to aid us in comparing different
trading systems. Other uses for Expectancy Score might also include using this value
as a target for optimization. Often optimization is performed on net profit, profit
factor, Sharpe ratio or other metrics. Using Expectancy may also be something worth
pursuing. But how would you do that using TradeStation? Unfortunately, there is no
easy way to do it with TradeStation. However, Im working on some EasyLanguage
code that will help with a manual process. More on that in a future issue.

Step One In Building An Intraday

Trading System
August 6, 2012 5:00 am5 commentsViews: 2017
If you have been reading System Trader Success for a few months youre probably
familiar with how I develop trading systems. The very first step is to come up with a
simple idea to act as the seed or core of your trading system. I call this your key
concept. This key concept is a simple observation of market behavior. This
observation does not need to be complex at all. In fact, they are often very simple. For
example, here is a key concept: most opening gaps on the S&P market close if the
gaps are less than 4 points. This key concept is very simple, and testable. From this
key concept there is an entire process of building a trading system which I described
in the free ebook, How To Develop Profitable Trading Systems.

Testing An Intraday Key Concept

Today I want to show you a tool I use to help test key ideas on an intraday chart.
Building trading systems on intraday charts (day-trading systems) are some of the
more difficult systems to develop when compared to daily charts. First, you must deal

with more market noise but even more dangerous is slippage and commissions. Why?
Your potential profit per trade is small on a day trading system thus, both
commissions and slippage take a bigger bite out of your profits (as a percentage of
your P&L) and produce more drag on the performance of your system. The hill youre
climbing is a lot steeper when creating a day trading system.

They Key Concept

For this example lets create a simple trend following strategy for the Euro currency
futures (EC) market on a 5-minute chart. Well use the extreme readings on the RSI
indicator as our signal. Because we are using RSI as a trend indicator that means we
are looking to enter the market when RSI gives us an extreme reading. That is, golong at the oversold region (RSI value above 80) and go-short at the lower region
(RSI value below 20). This is a bit unconventional, but when it comes to the markets,
unconventional can be beneficial. As for the extreme values, those are unoptimized
numbers. I just picked them off the top of my head in hopes of looking for a strong
swing in ether direction.
Below is the EasyLanguage code for the key concept.
MyRSI = RSI( Close, RSILookBack );
If ( MyRSI < ShortZone ) Then
begin
GoShort = true;
GoLong = false;
End
Else If ( MyRSI > BuyZone ) Then
Begin
GoShort = false;
GoLong = true;
End;
If ( MP = 0 ) Then Begin
If ( GoShort and BullTrend ) Then Sellshort (RSI Short) next bar market
Else If ( GoLong and BearTrend ) Then Buy(RSI Buy) next bar at market;
End;
If you code this basic concept up and test it from 0830 to 1500 (central) on the EC
market what do you think youll get? Thats right, a losing concept with an ugly
equity curve.

Take Every RSI Signal

Clearly, we dont want to trade our system at any time during the U.S. day session.
We want to focus when EC is most likely to show strong trending characteristics. If
the price of EC is strong enough to push the RSI value above 80 we want price to
continue climbing. So, what market session is best suited for this RSI trend system?
Or are all market sessions hopeless for this simple trading concept? Lets find out.

Session Testing
When designing a day trading system one of the first steps I want to perform is to test
which market session will likely produce the best results. We are all aware that
different sessions exist for any market. For example, when dealing with the emini
S&P we have a pre-market session, the morning session, lunch time session and an
afternoon session. Often you can see distinct characteristics within each session. So,
when Im developing a trading system for day trading I dont want to blindly trade
during every session. I want to be more targeted in my approach. There will most
likely be a particular session or two where my key concept will do better than other
sessions. In order test our key idea over different sessions I needed to create an
EasyLanguage strategy that can isolate these sessions and execute the key concept
individually over those session only.
This is where my Session Testing code comes into play. Session Testing is an
EasyLanguge Strategy that I wrote to help me in this task of testing various intraday
sessions. Using TradeStations optimizer I can test my idea across different
combinations of sessions and discover how the key concept holds up across each
session. Here are the basic sessions:

1. Pre-Market Between 530 and 830

2. Open Between 830 and 1030
3. Morning
4. Lunch Between 1030 and 1230
5. Afternoon Between 1230 and 1500
6. Close Between 1430 and 1515
7. Post-Market Between 1500 and 1800
8. Night Between 1800 and 530
From this list of basic session I created several more sessions based upon
combinations of the above.
1. Pre-Market + Open
2. Pre-Market + Open + Morning
3. Open + Morning
4. Open + Morning + Lunch
5. Lunch + Afternoon
6. Lunch + Afternoon + Close
7. Daily Session
8. Night + Pre-Market
9. Morning + Afternoon
The 17 different sessions I came up with may not please everyone. Perhaps you have
a different idea on how to break the different sessions up and with the code provided
you can simply change them to your liking. For example, if you are interested in the
European markets and trade those times, you can create your own sessions based
around the European markets.
Within the code youll find a location to put your key trading idea. This is where I
placed the RSI rules. I picked a value of nine for the RSI look-back period because I
wanted it to be more sensitive than the default 14 that is often used. (The value of nine
really has no significance. It was not optimized and I could have very well picked
seven or ten. I just simply picked it.) Also, notice I have no stops or targets within my
test code. Instead the strategy simply enters a trade if the the proper condition is met
and the trade is exited only at the close of the session. Thats it. Remember, Im not

testing a trading strategy. Im testing a key concept vs. different market sessions. Our
goal is to locate the best possible market sessions for my key concept. In this case,
which session holds the strongest trending characteristic? Once a session(s) has been
identified only then will I continue to develop a complete strategy (containing stops,
targets and other rules) tailored to the top session(s).
Next lets see what happens when I run TradeStations optimizer over each of the
sessions. In doing so TradeStation will systematically execute my key concept
strategy over each market session and record the trading results. After all the sessions
have been analyzed I can generate a bar graph representing the P&L for each session.
Below is the Net Profit graph which depicts the total net profit from our testing. By
the way, we were testing this strategy from January 1, 2003 to December 31, 2011.
This timespan covers both bull and bear markets. Its important to test your key
concept over a wide range of market conditions. Slippage and commissions are not
factor into these results.

Net Profit vs Market Session

In this case we can see session input value number 12 produces the best net profit.
This input value is actually a combination of Open, Morning and Lucnh sessions. Its
during these times EC market apparently demonstrates strong trending characteristics
that we might be able to take advantage of with our key concept.
Lets now isolate the session input value to 12 and execute our key concept on this
specific time. For this test I will deduct $18.50 per round trip for slippage and
commissions. Below is the equity graph of our key concept along with some
performance numbers.

EC RSI Trend Key Idea Equity Curve

There is no optimization here. The code simply trades based off un-optimized RSI
signals and the results look promising. Below is the Trade Summary Report.

Strategy Performance Report

There you have it. This type of RSI trend following concept should be developed for
the Open, Morning and Lunch sessions. This makes sense. The big volume and big

trends often appear during the U.S. day session. This is also corroborated from a
previous Best Times To Day Trade where I explored the hourly range of the Euro
Currency market. In that study we can see the hours between 0800 and 1100 (Central)
have the highest price movement of the EC market.
I would like to point out again, this is not a trading system. What we did in this article
is validate our key concept. The code presented in this article does not have stops, a
regime filter, volatility filters, profit targets or any number of other checks and
balances we might see in a true trading system. In fact, take a look at the average
profit per trade. Its $24 after slippage and commissions which is too low in my
opinion. I would like to see this closer to $50 per trade or higher.
Whats next? First I would begin the testing process as described in the free ebook,
How To Develop Profitable Trading Systems. This would include testing testing
regime filters, entry methods, trailing stops, profit targets, volatility filters and
whatever else you feel might make a better system.

Summary

This simple trend following concept appears to have potential if executed on

the correct market session.

This is not a trading system but a proof-of-concept. Further research and

development is needed for a final system.

When developing a day trading system, take a look at the different market
sessions and see if your key concept performs better in certain sessions.

Many people will try to develop an intraday system without taking into account the
different market sessions. However, if you test your key trading idea across all market
sessions and narrow it down to the most productive sessions, I think this will help
jump start your development of a profitable system. The Session Test strategy code is
available below.

Download
Session Test ELD (TradeStation)
SessionTest Workspace (TradeStation)
Session Test Strategy (text file)
Session Test Function (text file)

Jeff Swanson