Three-Line-Break or the integrated trend-volatility tool

I have been a fan of Three-Line-Break (TLB) trading for long time because it is a KISS (Keep it Simple Stupid) methodology and takes no time to make decisions, which is mandatory when you have an other full time job! As long as I did not have any backtesting tool and was working only small caps which are trending usually for longer period of time, then the feeling was there was a positive expectancy. However, from time to time, I experienced losses more than I liked, and felt like missing trend departures.

Once again I assume you are already knowledgeable about the basic topic. For more details on TLB, please refer to here

Backtesting becomes possible when you can actually display the TLB back on daily chart. On the following chart, you can see on the right the TLB chart, with red and green lines; these appear on the left candlestick chart as red and green boxes.

There are signals from TLB that you would obviously not take after adding our usual 3 single Moving Averages for instance.

When we backtest over long period of time the TLB strategy on standalone only, we surely are disappointed.

Let’s look at Apple. First with TLB, taking buy and short signals, 300%

Taking our 3-moving averages on the long side only, we fare far better!

So if you hate candlestick charts, then you need to put those 2 technologies together. First add the 9 and 18 averages on on your TLB chart.

The size of each TLB line represents also the volatility, though you don’t know how long it took to have this volatility increment. Fair enough, the daily volatility is filtered out to show the trend volatility. The ROC indicator should be very talkative. I am displaying the ROC 9 days on this chart:

Any time, ROC crosses 0, or just touch down 0 and goes back up are good entry points. When ROC is positive, just filter out the short signals. An other confirmation is SMA9 is above the SMA18. And there are also divergences to help anticipate trend change!

You may also look at the volatility of 3LB, this time using Bollinger bands, because TLB lines stick to 2 standard deviations!

I tried to move back these good-looking curves to candlestick charts for back-testing but to no avail. So I can not show you the backtesting result.

As a conclusion, if you are not after option trading where time does matter, these TLB chart are a very good tool. Overall trend is given by a single moving average, which allows easy filtering of false signals.

That’s it. Until next time, trade safely!

Random comments, some answers, and other random thoughts…

Thank you all of you for writing supportive comments. This blog is, as far I know, absolutely unique, I have no competition! Maybe I should charge a few hundred bucks just for viewing,… just kidding!

I am going to answer here in bulk manner to the comments.

The blog platform

The blog is powered by WordPress but is an offshoot provided by https://vivaldi.net/ Vivaldi is an awesome browser, but they also offer a free web-mail, a very good alternative more privacy focused that Gmail and similar, plus a free blog. You can have your blog up and running in less than 10 minutes. Should you start your own blog on a related subject, let me know and I will reference here. You are also welcome as guest writer on this blog.

The blog is surely working with latest navigators such as Firefox or Vivaldi, but you may experience problems with old Internet Explorer.

Starting a new blog

I am no guru about blogging, I am sure you can find good material on the web. I started out with same idea as the posts I write: Keep It Simple Stupid (KISS). After a few months of writing, I see audience is increasing through number of real comments (not spam), so great!

Pretty much you can revive your old desktop with a new wallpaper, you need a good picture so that your blog looks good. I recommend your browsing Deviant Art, they have plenty of original pictures and web art.

About comments

I don’t know how WordPress behaves when you leave a comment and if you get many annoying emails. If you come back often here, use a disposable email for entering public comments, e.g. this service or that one

Captcha for plug-ins: I do not know.

If you want more in-depth exchange, you are welcome to email me: dragon trader at vivaldi.net. Or @ randomerrance on Twitter.

RSS

I understand you can use this link: https://dragontrader.vivaldi.net/feed/

About statistics and probability

There is a big difference between these two notions and you must understand it. As finance often says “past performance is not indicative of future performance”. We may hate to say it, but they are right. You can calculate statistics of past performance, e.g the number of winning trades over last 10 years, the average performance, … and thus the overall expectation of the strategy. If the expectation was negative over the last 10 years, why do you believe it will work in the future?

Also as discussed in some posts, the probability of winning does not tell you anything else than, on average, you should win x% of the time and so you can experience long loosing streaks based on that probability. Also having a good probability of winning (say 51%) does not mean a positive expectation, you need to control the losses and make sure the gains fare much better than losses, at least 2x. Stock picking comes into play here: small volatility also means low risk of course but low gains, most often not good enough to have positive expectation. Trading is playing with stocks or securities that have the capability to land you big gains! Do not look too far: Apple is such one, as well as Microsoft or even Visa. Of course, many Nasdaq stocks such as Tesla are far better choices to push your expectations skywards!

Investment publications often boast about their past wonderful performances, they even sometime annualize the figures (e.g 1400% based on 1 trade that made 20% in 10 days!) but they never report publicly about their failed trades, their overall performance and expectation. Some may be quite good a stock picking, but you should always wonder whether the writer is not somehow the market maker, especially with small caps, so he needs many subscribers not only to have a very profitable newsletter but also moving the market in author’s intended direction! The folks are Sock Gumshoe do a wonderful work deciphering the teasing of such newsletters, so a good source to find trade-able stocks!

That’s it! until next time, trade safely!

Risk / Reward Ratio: my relative take on it!

We have previously discussed the win/loss ratio and the impact on occurrences of winning and losing streaks. You may fix it somehow, especially if you are lucky, but if, like for normal humans, it is not always the case, then it is not enough to be profitable.

Imagine the following:

  • Winning percentage: 40% Loosing percentage: 60%
  • Average performance of winning trades: 20%
  • Average loss of losing trades: 15%

Then your gain expectation over 100 trade is .4*20-.6*15 = -1%

Your expectation is negative, you will not win over the long term! Remember it is an average expectation, the actual can be far lower.

Whatever your win/loss ratio, the risk/reward ratio is here to help counterbalance the effect of luck. Say you bet 1€, you may lose it or gain it back. Is it worth playing it?   NO! You are better off keeping your 1€ in your pocket.

It is the same for trading. If you bet 100€, you wish to get at least 150€ or much more. This is sometimes called asymmetric position. The risk/reward is calculated opposite:

%RR = (potential reward) / (risk taken)

In our case: %RR= 150/100 = 1.5

To be honest, I never take trade with %RR less than 2.

You will see in many books or websites that you should never risk more than 1% of your trading capital on a single trade. It tends to be confusing for many because this 1% tends to become bigger as capital grows and since you still want to sleep at night, it is better think in a different manner.

The question to ask yourself is this: if you lose 100€, does it hurt? No? what about 200€? 300€? Oups it hurts too much! So be it, you are just above the pain threshold.

Take note of this value, this is the (absolute) risk, the divisor in the calculation above.

I have discussed previously how-to guesstimate a potential objective (with drunkard’s walk for instance).

So, we are ready to trade!

Let’s take an example. A signal (green arrow) indicates you have trading opportunity. We assume you will buy tomorrow just above today’s high at 3.56€. The stop is at 3.18€ and possible objective is 4.31€

%RR = (4.31 – 3.56) / (3.56 – 3.18) = 1.97

Not too bad, uh?

Now we need to ensure you are not crossing the pain threshold! Let’s assume for a moment that it is 100€. Small but why not.

Now you can size your position accordingly.

The risk for each stock you buy is 3.56 – 3.18 = 0.38€

Therefore, the number of stocks you can buy = 100€ / 0.38€ = 263 (rounded)

So you will invest: 263 * 3.56 = 936€.

Just be sure to sell if the stop is reach so that your pain does not exceed too much 100€.

Should the objective be reached, you will have gained: 263*(4.31 – 3.56) = 197€. In line with our win/loss ratio 🙂

If all goes well, after a few days, the calculated stop will start hiking up, so your risk will be void.  After objective is reached, feel free to take back some profit and let your profits run.

How did it go for this trade? It went far beyond my expectations!

In summary, you may be a stoical kind and only look at the risk in percentage or relative view. For most of us, it makes more sense to look at the risk in absolute value and sleep well at night because we are not risking more than we can afford money-wise and psychology-wise.

How far will the market go?

When you want to know where price is going to go, there are many ways to guess. Among others:

1. Return to average. If price go too far away from average, then they are likely to go back to average

2. Fibonacci retracements and extensions

3. Check analysts price objective

The weakness is the same for all: when? in one swing or after many up and down swings?

With volatility trading, we can answer thoroughly two different ways

1. The drunkard’s walk

The concept  of ‘drunkard’s walk’ was introduced by  William Feller by the following math problem:
If a drunk guy leaves the lamp post he is leaning against, how far would he have gone, on average, after n steps?”

The answer is he would have gone the square root of n multiplied by the average length of his stride:

√n * Average length of stride

Here is how to translate for price objective setting: start from a major price bottom, the first objective that should be reached within n days is the average price change (or Average True Range)

Example: if we look at an ATR over 25 periods (days, weeks), the first objective that can be reached in 25 days is lowest low (the lamp position) plus 5 x ATR25.

Easy, right? If objectif is not reached, then just give up.

When we say first objective, it is because we are considering a random walk, but if a trend is given birth (or the street has a slope for our drunkard), then prices may go much further away and you need to re-estimate the new objectives with each swing low.

2. Action-reaction

The usual way to use action-reaction is enclose price action into channels, so as to get high probability entry points. Also the distance between lines gives the potential objectives in straight lines.

I am removing previous lines for clarity but I am now drawing an other set of lines. Distance between the lines also indicates potential

By having two sets of AR lines on the chart, crossing of lines indicate precisely where prices are going to go. There may be several possible objectives, but many can be discarded (too sloppy change required, or objective in the past)

See here yellow highlighted target reached almost on time (depending on accuracy of lines drawing)

That’s it! Because we are analyzing price and time together (aka volatility), we are reaching high quality trading

Volatility trading? Hmmm…

All the content on this website will be original. No lessons about Bollinger bands or how Average True Range is calculated.  This first post will reposition volatility trading with respect to other kinds of trading.

For this purpose, let’s travel east to reach China. They have theories like Yin and Yang but the one that interests us more here is the 5 elements theory. According to it, plants, humans, animals are all driven by a cycle including 5 elements: wood, fire, earth, metal and water. There are 2 cycles actually, one for creation and one for destruction. The market being driven by humans, and robots are programmed by humans so are no exceptions, this cycle to market themselves!

A stock has been issued by a company, this is the wood. Then wood generates fire, price is matter of hot arguments we need lots of computer to finalize. The way prices go and up and down each is volatility, it is earth, it is linked to muscles, so the market is shaping up. Then from the volatility appear trends, which is kind of illusion that prices are going in one direction. Once trend appear, volumes change; volumes are like water of the river, they make the market. When price goes up in a trend, then volumes go down as nobody wants to sell before the trend is over. Volumes in turn change the company; if lots of money flows in, then they have capability to invest and this in turn will change the price of the company. Cycle is over!

From a trading perspective, you can position yourself wherever you want:

  •  At stock level, traders carry out fundamental analysis. Their strategy is usually buy & hold and they want to catch dividends for the money you invest in. They don’t usually care too much about the actual price, saying it doesn’t matter. They come up with funny price  objectives by comparing with other companies in same sector and when the stock plummets, they say they keep it for long term!
  • At price level, traders are usually day traders, order book traders, robots… They draw lines which they call support or resistance. They of course totally disagree with one another, given they are not looking at the same chart with same time frame.
  • At volatility level, there is … almost nobody. Nobody is pure volatility trader. People hate volatility (subject of another future article). Bollinger himself agreed his bands are far from perfect. Keltner also paved some way. This area is still not much explored. The point is you need to ‘see’ things in all this random data that is the market. It gets lots of convoluted mathematics to play here. But the rewards are great
  • At trend trading level, one will meet sour guys. Why? Because they are blamed any time the market plummets, as they openly say they play both upside and downsides of the markets. They may have low success rate but when they win, they win big,  and so an overall positive expectancy
  • At volume level, traders have lots of money to manage. So they can call the company’s CEO and advise on the strategy or the volumes might just die, right?

That’s it. There are times when you need to trade price level (sideways markets), other times when trend is a better choice , or dividend playing at some other time. We need to get an edge to enter the market and to exit.

Until next time, trade safely from the right perspective.