The way to find an edge… a mix of math and philosophy

This post will not be technical at all, only food for the mind!

There are many brilliant brains throughout history and also many people who have had more luck than anyone else. Think of our dear Warren Buffet or even Bill Gates. If they had not been in the right place at the right time, they could have had totally different destinies! So was it luck or was it intelligence or both? Imagine one second that our computers could run OS/2 version 2020 operating system…

Finding an edge is key for trading, as your trading system needs to have a positive expectation if you want to be profitable over the long term. I have uncovered many edges in this blog that have been there for long, and will stay for long as it is unlikely that finance will change their model for a long time.

Now look at recent history: a small tiny virus has pushed many companies over the edge, pun intended! Finance is everywhere in each company, be it business case, cost tracking, profitability analysis, … and what? Companies are so weak, that a virus throws them off board?

The truth is more simple. The bosses are all trained in same business schools, applying same models without thinking about their validity. Role of chance is totally underestimated in their career, they think they manage successfully and will write books about it. Nothing is further from truth.

Finding a robust edge is key to your trading career. Most of those published on this blog can land you in positive territory but this is just the start. You need to work on your own edge, by finding new ones or improving those shared here. You do not need mathematics or philosophy to start with. Use these approaches only to confirm your theory. Honesty is also key: do not look for confirmations that your system is working, look at the cases where it does not work and find the reasons. Exactly what business schools are denying to do, because, should they do it, they would have to close their doors!

My latest trading strategy, which I can’t share of course, has found recently the mathematical confirmation I was looking for: Laplace first law of errors, created in 18th century! The second law of Laplace, also called Laplace-Gauss is the one used by finance in spite of its non applicability. The performance of the system is beyond all expectations… Laplace was a genius! Henri Poincaré is an other one of my favorites. Do you know them? H. Poincaré had identified the relativity before Einstein, who was only better at marketing it!

Henri Poincaré

S&P500 Market analysis June 23rd 2020

Some say that markets are not allowed to go down any more. Many PMI figures will be published today, as well as new houses selling numbers. As usual, there will be plenty of comments about how markets have gone up or down by a tiny 0.x% because investors like or disliked the numbers. Which is absolutely ridiculous, it is just noise commenting! You should always look at wider charts and understand the underlying movements!

S&P kagi line is still yang so it is no surprise we are still in up market.

There is a divergence between Williams A&D and its momentum just below, but it is just a warning, no action needed for now. Your stop should be around 2960 and you would better go out and enjoy the sunshine!

Would you mind buying yourself a Ferrari?

Even if you are not interested in car business, there is a good chance that you have seen at least once a Ferrari drive by, and because of its specific engine noise and design, you wished to be able to drive it even for a few minutes. I had the chance to drive one for 20 minutes once, it was an incredible experience!

Anyway, let’s go to today’s topic, and see if there is any Ferrari like tool for trading, and to add for the fun, we will look at Ferrari graph! Think about their business: when you order a Ferrari, you will not be delivered before end of 2021 and you need to pay … now! Those interested in fundamentals should be looking on this stock! And so should you… and get a little piece of Ferrari!

Before we continue, remember that a Ferrari works fine in nice long roads, but it will be a painful drive if the road is bumpy with dangerous bends every quarter of mile!

DEMA – Double Exponential Moving Average – is for those traders interested in taking the fast lane. I colored it green when going northward, and red when going southward. As you can see, we have a good indication of the trend!

For those interested, the formula of DEMA is as follows. It is in short an EMA that is corrected for delay. So you can and MUST use long averages, don’t use 10-days DEMA, it doesn’t make sense!

DEMA = 2 x EMA – EMA(EMA)

Using DEMA as a stop is not best idea you may have since prices may jump above and below the hood, so you need to add a bumper, sorry a stop! Here you go:

Last but not least, you do not want to enter too far away from DEMA. Remember my random walk path? DEMA is not the same of course, but let’s check if price are not going too far away from this path! For those who know, it is a Keltner channel with DEMA as central average!

Wonderful! Prices are not going more than 8 ATR’s away from DEMA! I colored the zone between 6 and 8 ATR’s away from DEMA (don’t enter in red zone!) now the landscape is plain visible, provides a good idea of the direction, the stop prevents you from falling in ditches.

As previously said, do not use this Ferrari on small country roads, your portfolio will end up in a ravine sooner or later!

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

Have you been fooled by the bell curve?

I know you like some food for the mind for the week-end, this post is sure to make you think even it is simple mathematics! Of course, it will be fun to read too!

I have talked previously about how not use the Bollinger bands and I am going to kick even more on this concept.

As soon as you start talking about standard deviation (or sigma), you are assuming a bell curve, that is 62% of measurements (price) should be within one standard deviation of the average price. Let’s check that immediately, let’s display a Bollinger band with 1 sigma on Apple graph:

Apple Daily

Now look in each blue blox. There is almost ZERO price inside the band! The guy who sold the Gaussian curve to finance was the best salesman EVER!

Though attributed to Gauss, the bell curve was created by Abraham de Moivre in 18th century and then promoted furiously by an Adolphe Quételet in 19th century. Johann Carl Friedrich Gauss, one of best ever mathematician, published a book about normal distribution for astronomical data, and since then, we are talking the Gaussian or bell-shaped curve.

Gauss never studied the stock market random data! And standard deviation is only a ‘trick’ to locate 62% of the data around the average.

As shown on Apple graph, stock data is not consistent with normal distribution. Now what? When you have spotted a problem in trading, you got an edge!

You may remember from your years in high school the basic average deviation, sometimes called mean absolute deviation (MAD). In other words, it is the raw deviation measurement. Quoting Wikipedia:

MAD has been proposed to be used in place of standard deviation since it corresponds better to real life.[3] Because the MAD is a simpler measure of variability than the standard deviation, it can be useful in school teaching.[4][5]

School teaching? Hmmm… Most important part is first sentence: it corresponds better to real life! More on the difference between MAD and Gaussian distribution by fabulous Nassim Taleb here.

Stock price is not an industrial process measurement, it reflects the opinion of all people about the studied stock. If you are a car manufacturer and making 4.50m long cars, your production should make cars, say between 4.49 and 4.52, because otherwise the doors will not close properly is car is 4.78m long and you will need re-manufacturing with all associated costs! That is not the case for stock price, you are allowed to be excessively bullish or bearish!

Let’s give this theory a try. I am removing the Bollinger bands and adding a simple moving average, 34-days for the example, but you may change it.

Steven Nison, in his book introduced the Disparity indicator, created by Japanese traders, which is defined by:

Disparity = close – average over n days of close

It is very close to what we are looking for! We only need to add an average to get the Moving Averaged Disparity (MAD also just to add confusion!)

Apple Daily

The blue line is disparity and the MAD line is shown green when pointing up, red when pointing down.

As you can see, trading is almost straightforward. Buy when prices are over the 34-day average and disparity crosses over MAD (or when price cross over average and disparity is above MAD). Then get out when prices drop below average! Easy, isn’t it? You also get some nice divergence at the top, disparity has crossed below MAD end of January, far before the correction started!

From this introduction, there are plenty of ways you can improve this very basic but nonetheless very efficient indicator!

Here is a non commented graph of Nasdaq for you to play with:

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

S&P500 market analysis June 15th 2020

S&P500 seems to continue sliding along reaction line but, as you can see, the 3 moving averages are still up, more or less for the red one.Markets may decide to move up again, we will see. A bit too early to to say markets are resuming the down trend. Objective 2680 unchanged but unlikely for now!

What is happening? It is all about COVID-19 again. The epidemic is more or less, rather less than more, under control. There are still hundreds of new cases in most countries every day, even those who have completely stopped the containment measures. If people wear a mask, of course, odds are in their favor they will not catch it. But what about all these demonstration throughout the world? Nothing is really under control, safe vaccine is long way before being available. It is likely markets are going to jump up and down a few times along pandemic making trends or moving sideways!

Don’t get unduly stopped out by the markets

Here we go for another technical post. Let me start first by answering a question: no, I will not post videos because text and pictures make you think, you can even print them if you wish. Though video can be a very good tool to show something, if you can not write it down with simple words, then you just have no clear idea of what you are talking about. So read, read again, think, confirm and write down your ideas, progress! This is the way this blogs intends to help you, dear readers!

I am going to discuss today trader’s least understood tool: the trailing stops. Because it gives a false sense of security, trading apprentices may loose lots of money, and even go broke if not careful.

There are a few conditions to use a trailing stop:

  • A trend should already exist
  • The stock or selected security should have the capability to trend (refer to history)
  • you know what you are doing!

Let’s look first at the performance of a trailing stop used as standalone tool:

As you can see, the performance over 20 years for Apple is absolutely ridiculous, especially when compared to 3-SMA and volatility system!

Why is that? When the stock is not trending, prices hover over and sink below the stop very fast, causing losses each time. Even a good up move will have hard time to catch up for losses. Even if your stop is carefully engineered, the behavior will be quite bad in flat markets.

Fair enough, how am I supposed to use stops now? You need the WWW stop technology! Don’t worry, you can use this one even on Yahoo finance:

For the example, I used the Moderna stock which became known to public right at the top of the graph!

Now add not one but three ATR trailing stops!

  • The Red one: the Wake-up call (2 ATR’s below price here). As name implies, its goal is to wake you up from time to time and make you think! You have to decide whether you stay and do nothing, stay and increase your line (pyramiding), or take a partial gain or get out. It is YOUR DECISION!
  • The Blue one: the Warning stop! (4 ATR’s below price here) When prices go under this one, you should definitely consider stepping out before it hurts too much!
  • The Green one: the Waouh stop (6 ATR’s below price here). This one has 3 objectives:
    • it tells you about the trend: see how Moderna was above of the stop for most part of the graph
    • you are sizing your line based on this stop
    • It is your hard stop: exit! But your loss might be greater than expected! Enter it in the trading system if you can not monitor the market for some time.

You should always have an exit strategy and the exit is based on a sole parameter: the max pain level you can stand!

Say for instance that your pain threshold is 100$. Just buy a number of stock so that, if the green stop fails, you will loose 100$ (you might need to get a round number of stock). Simple mathematics: say stop is 20$, close is at 25$, so a risk of 5$ per stock, so invest no more than 100/5=20 stocks!

If prices close below the blue stop, you may get a loss but it won’t hurt (too much!) because you will loose less than 100$

Of course, as trend starts picking up, all stops will go up, which will void your risk and you can decide to increase line size, always carefully checking that you can’t loose more than you pain threshold!

Note that you replace the Waouh stop by anything you like, could be the low Bollinger band, the low band of a Keltner channel, … whatever makes you safe and will follow the trend at good enough distance so you are not missing major market moves!

Remember the rules for trailing stops:

  • Size the line according to bearable pain
  • Use stops only when a trend does exist
  • Make sure you get warnings from the market before the stop is hit

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

Volatility lovers: Crypto, what else?

Investing in crypto currencies might be something for geeks, many of you probably think, but for the pleasure of trading small amounts and and making big gains in percentage, this is worth a detour.

It is not because you hate some companies that you should not invest in them. Trading is about making profits, full stop. Yes, crypto may not environment friendly, and will be worth zero should a huge wordly power outage occurs but that is a risk you have to manage. Also crypto are showing the path to the future, nobody in maybe 10 years from now will pay with banknotes and coins. This is why you should be bullish on this technologies and why not trade of few them!

There is now a big number of cryptocurrencies to invest in, but please stick to major ones, as most of them are scams and will be worth zero far before our gigantic power outage! I do not wander beyond the big ones like Bitcoin, Etherum, Litecoin and a few others. Trading those is actually quite straightforward because of huge volatility, and remember volatility means also likeliness of emergence of trends. Use a Kagi graph to enter is easiest strategy, then use a candlestick graph to place stop!

Here we go with Bitcoin!

Bitcoin bottomed out by March 22nd, Kagi lines made a 2-level break, MACD is up. One day later, the double window bottom was also confirmed. I entered below 6000!

If the accumulation/distribution also showed a buy signal about the same time, it was not so obvious we should go! Skeptic bull, uh? As the trend lines then started going up beginning of April and price starting to hover the random walk path, it was second possible entry!

Where is Bitcoin headed now? As you can see on Kagi, the Bollinger bands are pointing upwards. A correction may or may not come, next objectives are 10700 and 12000. Out if closing below 8800 (as of today!). Just wait and see!

Note: major crypto currencies will not disappear tomorrow, unless this enormous power outage again! Using a stop based on volatility is fine. But price may zoom through the stop line, so be careful and make the line size much smaller than on a stock and you will be safe!

S&P500 market analysis June 12th 2020

I wrote a warning on Monday morning (see previous post) that passing a reaction line is a sometime precarious event and markets usually make tops or bottoms on this occasion. Please remember that tops are mirrors of bottoms from the past. The accuracy is not perfect but if you ‘add’ the gaps, then you fall back on your feet!

Similar to previous market action shown in ellipse, S&P500 has moved above the reaction line and then fell down back on it yesterday. In theory, our drunkard can walk down to 2800 and 2685 afterwards. The uptrend is still there, so you should not worry too much and it will open some buying opportunities on many stocks already in up-trend.

A quick note about comments

While I see genuine comments, I guess many are also an opportunity to post links to your own business. While I do not mind which business you are in, I do think that relying on chance of someone clicking on your name in the comments section is not the best way to get opportunities for you. I do understand that even one click out of ten thousands can make your business profitable but it clearly does not help the blog writer to have comments from ‘b.tt pl.g’ or ‘huge cl.t’. Sorry you should not read this if you are under 18. I am not after huge audience, only people authentically interested by the subject. From now on, please consider a cool name like ‘Warren B.’ or ‘Barrack O.’ and you can still link to your site if you wish. I will be more cautious from now on when validating comments!

TTYL

S&P500 market analysis June 8th 2020

Warning signals conjunction are always important to watch!

The kagi line is closing to Bollinger upper band. From there, it can go through or reverse. In any case, it is worth securing partial profits or revise stops upwards.

On candlestick chart, price is also closing to reaction line shown last week. If it goes through, there is virtually no resistance until next one. Pretty much like a plane taking off, speed is important for air support under the wings. The opposite scenario is a sliding down the reaction line but we have yet to get a confirmation before looking deeper this assumption.

Two synchronous warnings should wake up your skeptical bull mindset!

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

The skeptic bull mindset … or how to look at stock tips

I will attempt in this post to make the bridge between statistics and probabilities in the lightest possible way! This will position us with the right mindset when trading!

All what I have written so seems to be fine with you, and therefore if you want to convince me to follow you on a trade idea on ‘Thin Air Company’ (TAC), you need to give me the following information:

  • When to enter? At which price?
  • What is price objective?
  • What is the exit strategy?
  • What is the probability of success?

Last question might seem very puzzling to you because of one of the following reasons:

  • you don’t have statistics about your trading methodology because you can not program back testing, and no clue how to derive probabilities from statistics on past data (very good point, it is indeed too complicated to explain in a blog post!)
  • You are very bullish on TAC because you got advice from Sure Winner Top Notch Wall Street Analyst (SWTNWSA)
  • You got a tip from that Famous Marabout Who Can Also Repair PC Hardware Failures Remotely (FMWCAPHFR)
  • You are using Extra Sensory Perception To Forecast Market Movements (ESPTFMM), it usually fails miserably but this time it looks like perfect setup
  • You Won’t Tell Me!

Do not worry, we are going to play a little game with little bit of money to spice it up. The rules are pretty simple:

  1. If your trade idea is profitable, I give you 10$
  1. If your trade idea is a looser, you give me any amount. Let your brain decide the amount! Since you are so bullish, and for this example, I assume you will play 500$

If you think I am too impressive to play against, imagine you are playing with Warren Buffet!

Now we are all set up for a probability calculation from your perspective! You need to solve the little equation system below:

Probability(Winning)/Probability(Loosing) = 500 / 10 = 50

Probability(Winning) + Probability(Loosing) = 1

Easy? So you (your brain) estimate the probability to win to be about 98%!

Let me be honest! Even with this huge asymmetrical setup, I will take the bet!

Why?

Let’s look at the expected value from my perspective, which takes into account what I know!

Best stock pickers score 85% winning trades and even with this value and this particular set up (500$ vs 10$), I have a positive expected value! I might not win this time, but if we play together a few times, I am almost sure to get those 500$ notes fly into my pocket!

Now think about it the other way around: if I have positive expected value, you have not! One way to overcome that is to significantly reduce the bet size, which in turn will also give you a better idea of the probability of success!

In summary, it is perfectly right to be bullish (in the sense of opinionated whatever market direction) and we need the bull force to enter trades. At the same time, you need to be skeptical about what your are being told and evaluate correctly the probabilities of winning, even with simple methodology as above!

And remember the following conclusions:

Sure winners ideas are sure to make you a looser over time!

Loosing risk consciousness makes you a sure winner over time!

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

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