Big Bamboo Update

More pain for the Big Bamboo. DXD closed out on today’s open, after the RSI2 for the diETF closed Friday above 70. The trade may have closed with a small loss, or a small gain (hard to know for sure) if the indices would not have gapped on the news of our government signing a 30+ year adustable rate sub-prime mortgage on our future.

All politics aside, SDS closed out on Wednesday last week after the stop was hit.

I am disappointed in the performance of the system. The win/loss ratio is atrocious, compared to what we expected through backtesting. Although this is difficult psychologically, the system is still showing a profit, since inception. Since it is all about making money, I’m trying not to overweight the win/loss ratio and instead focus on the fact that the exit criteria and position-sizing seem to be holding up well.

In the interest of fairness and transparency, the Bamboo selected ROM for entry today, but because I did not run the update over the weekend, I did not catch the trade, or alert everybody prior to entry. The trade would have netted a gain of 6.8% today, and would have been closed on tomorrow’s open.

The Bamboo is now set to get long the bullish levered ETFs (as it did with ROM), as soon as there is a pullback.

Discretionary alpha is a term I’m rather enamored with right now. It is a derivative of “incremental alpha attributable to discretion,” which is described here by Henry Carstens, who attributes the phrase to Dr. Brett Steenbarger.

Due to discretionary alpha, short positions in my personal account are just a smidge in the green as of Friday’s close. The audited system account will not have this benefit as discretion is forbidden, and as a result, it will likely record a loss on its first trade. Ahhh…the beauty of incremental alpha attributable to discretion.

Truly, this week was difficult for me as I was focused on working through the painful feelings associated with a developing drawdown. I was reminded of Chart Addict’s post Trader’s Mindset and Common Psychological Issues as I knew that if this latest trade ever turned in my favor that the good feeling would not be stronger than the pain of having it go hard against me. As the trade is now in my favor, I polled the voices in my head, and they assure me the pain was worse than the relief. I think that pain will always be stronger than relief, and that the trade would have to go in my favor from the beginning and earn 2-3x the expected profit to feel joy equally as strong. Even then, it may not be as powerful of an emotional response as the pain of a deepening drawdown.

To understand that the pain of losing will always be stronger than the joy brought from winning is very very important. The realization of this forces into focus that the most important reason for trading is not to feel intense joy or pain but to make money. It is easy to get addicted to the rush of winning and losing, but since winning is never as powerful as losing, one is much more likely to intervene and over-ride during a losing trade. This intervention by the trader will likely occur at the worst possible time.

I don’t know what it was about this week that made it so hard to stay short. Maybe it was the cheerleading by CNBC, or the constant jawboning by Obama and the Feds. Everywhere I looked, listened, and read, it was as if the markets would never pull back, ever again. As crazy as everyone was, it was difficult not to jump on the bandwagon filled with crazies and ride off into the sunset.

But I resisted, stuck with my models, and will have a smaller loss to show for it. And that is what I’m focusing on…not the emotional highs and lows, but instead on the satisfaction of following the system, and by default, gaining a degree of control over emotional responses to trading. This is not a game, or gambling. It feels more like how I imagine a Restaurateur may feel after a slow week….

There are obviously better ways to demonstrate how a mean-reversion strategy works during bull and bear markets. It’s probable that a blogger somewhere has covered this issue a lot more scientifically than I’m about to right now. If I had to bet who it was, I’d say Michael Stokes over at MarketSci. Poke around over there and see what you can find.

From what I can tell about mean-reversion strategies, they love volatility. Love it, love it. They thrive on it.

It makes sense then, at least to me, that MR strategies would outperform in bear markets.

My research seems to confirm this.

Below are equity curves from two different mean-reversion systems.

Exhibit A:

Exhibit B:

Each strategy risked 10K every trade without compounding gains or using leverage. Exhibit A used $50.00 on each side of the trade to account for commissions and slippage, and Exhibit B used .01/share for commissions with no allowance for slippage. Not ideal for the sake of comparison, but this was never really intended to be overly scientific in the first place.

Some time ago I wrote a post where I repented for the sins I committed as a system trader. This prompted Gio to title the post “Confession of a System Trader.” I liked the sound of it and so here is the first installment of Confessions of a System Trader.

3/17/09

The last three weeks have been very difficult. The market is stretching itself first to the downside and now to the upside in a way that makes it challenging to profit from being a contrarian. Independent auditing began on the primary system last week with the first tracked trade being on the short side. The system has a 60% success rate with short trades, over the past 15 years. That’s not a colossal winning percentage but I was hoping to be on the right side of it for the first real-time tracked trade.

The past 5 days of the market have made me really miss my early days of discretionary trading, when I would trade breakouts and chase momentum. Oh, to just place a bunch of trades, never keeping good records, just looking only at the profit/loss column. Not having studied much about market history, it was easy to throw money into trades, with nary a thought of an exit strategy, with outsized positions. I made money. It was fun. If something didn’t seem to be working, I just didn’t do it anymore. I did more of what worked. With system trading, even if something does not seem to be working, I have to keep doing it. Over, and over, and over.

Bloody hell it is so hard to just sit here and do nothing while everyone gets drunk and buys stocks. I feel like one man alone on a deserted and windy patch of earth, who can hear faint sounds of glasses clinking, laughter, and celebration. He wants to find the celebration, seek fellowship, and join the fold, but never sets out to find it as he knows that he will arrive too late to enjoy the festivities. Instead, he sits alone, listening to the sounds, thinking, “all this time has passed. Had I left earlier, I would probably already be there, celebrating.”

What are the chances, after working with a partner for many months on a system, that as soon as we feel it is ready and we are ready for it, it just quits working? I mean, traders are forever buying at highs and selling at lows. What if it is no different with system trading? What if my primary system peaked two trades before I began trading it by the book?

Just like Tuesday of last week (March 10th), when the Citibank news shocked the markets out of an awfully persistent 3-week downtrend, there is surely some news out there that will reverse this current rally, at least for a pullback, right? Right?

One thing I have learned about trading systems is that when the trade finally moves from a rather large loss to a small loss, or from a loss to a profit, it seems almost like magic, even though I may have spent half-a-year studying the system inside and out.

Maybe it will be a good thing to hit a good 10-20% drawdown right away, in the same way that chemotherapy can eliminate the cancer while simultaneously sickening the patient. What doesn’t kill me will make me stronger.

QID gapped below the stop this morning, costing the system .30% more than planned. It hate it when trades hover near their stops for extended periods of time. The psychological ramifications notwithstanding, they will often gap beyond the stop on the open, as QID did.

SDS and DXD closed in the good.

The Bamboo really has to make something happen here. Two more losers, making another five in a row, would really hurt.

Behind the scenes tonight there is work happening on a better Big Bamboo. Eventually, all the issues listed here will be addressed. When the system emerges, it will hopefully be lean, mean, and green. And, the signals may become available as a premium service, IF it turns out to be as good as I think it might.

Stay Tuned…

Today’s almost perfect gravestone doji signals a reversal may be underway. Making matters worse was the increase in volume.

The SPX tested an intraday high near 1:45 this afternoon and formed a double-top. As the SPX failed to make a new high, sellers appeared and did not relent as bids were hit all the way to the close.

Looking at the charts, I find it hard to believe the bulls will press their luck tomorrow, with overbought conditions still existing and resistance looming near. Of course I’m short and talking my book, but it appears we will get the pullback I was looking for.

I have two different systems, using two different entry methods, that are both signaling that there should be some weakness ahead over the next several days.

Granted the Bamboo is one of the systems, and over the last 23 trades has only been right 47% of the time. However, over the past 90 trades, since November 15, 2007, it has been right 78% of the time.

The other system, which trades less frequently than the Bamboo, is also calling for a reversal. Since November 15, 2007 it has closed 44 trades and has been right 84% of the time. Over the last 20 closed trades, the system has been right 80% of the time.

The methodolgy behind these systems has been tested on other indexes and maintains the general win/loss percentage across longer time frames. Because the two systems referenced in this post trade the leveraged ETFs, some of which are new, testing over longer time frames is difficult.

Two other systems, the VIX Stretch and the CCI System are close to signaling short entries. Another up day on Monday will likely trigger the VIX stretch short entry. A down day on Monday will likely trigger a CCI short entry.

Yet another system, tested back to 1994 on the SPY, is already short. It has a 60% win rate on short trades.

Truly, last week was very bullish. Many traders have noted that the two 90% up volume days in one week suggest real strength. I will stick to the probabilities. I feel very confident that a reversal is imminent and am positioned for it. My confidence should probably be faded… We’ll see what happens this week.