Tuesday, January 15, 2008

Reversal Bar Study Trade Management & Expected Value Concept Discussion

The market put in a nice rally today as all three major indices rose between 1% and 1.6%, but volume was lower eliminating any chance of an IBD Follow Through Day. I’ll get back to my series on IBD Follow Through Days shortly, but tonight I think it’s more important to follow up on my reversal bar study .

One very important element of trading quantifiable edges is trade management. Just because your risk/reward is good going in to a trade doesn’t mean you can just “set it and forget it”. It’s not a Ronco. By continually monitoring trades and following up on studies you can make sure the edges remain with you.

Since the reversal day on Wednesday the 9th the S&P 500 has pulled back and closed below its reversal day close, and then rebounded higher. This is typical of the type of action we observed in our sample set. All of the 16 winning trades discussed with a 14-day holding period pulled back at least 0.5% below the reversal day close before launching higher. So now that we know we are on the right track, it is important to consider what might derail us.

One observation I can make about the winning trades is that it was very rare to see the low of the 1st pullback violated. In fact the only “winning” trade to close below the low of its first pullback was the August 6, 2007 reversal bar. The first pullback off of that reversal was violated on August 14th and the market dropped an additional 4% over the next day and a half before hammering out a panic bottom. While that one was labeled a winner, it would not have been easy to sit through. The only other times the low of the 1st pullback were violated were on an intraday basis. On 12/11/91 the S&P dipped 0.17% below the pullback low before finishing higher. On 11/13/97 there was a 0.34% intraday dip that reversed and also closed higher.

In looking at the 8 losing trades with 14-day holding periods they all saw their 1st pullback eventually fail. More interesting is how they failed. Six of eight of them saw their rebound off the pullback last 2 days or less. In other words – failures happened fast.

This data indicates to me that the low of the 1st pullback can act as an important level. Traders could consider that level to be a reasonable area to place a stop. The winning trades have typically made higher lows from the outset and the losers have failed their 1st pullbacks quickly. Should the S&P 500 close below 1395 or drop much below it on an intraday basis, the setup will cease to be providing a quantifiable edge. When you no longer have a quantifiable edge you no longer have a reason to be in the trade.

The ability to manage and continually re-evaluate the trade as it unfolds is what ensures quantifiable edges remain quantifiable edges. It’s what allows traders to receive better odds than gamblers. The original expected value (gamblers odds) based on the reversal bar study was about a 2.1% return for the 14-bar holding period. (4% * 16/24) + (-1.7% * 8/24) = 2.1%. Even if moving the stop up to around the 1395 level costs us one of the 16 winners, the expected value is still increased to (4% * 15/24) + (-1% * 9/24) = 2.3%. Traders that took the trade on the pullback as suggested should have a substantially better expected value than this since their entry point would be below the 1409 close on 1/9/08. Throw in the fact that the worst-case-scenario for the trade is now only a 1% loss and the trade now looks incredibly favorable. Conservative traders could also take partial profits at this point to ensure they break even / make a small amount / lose only a small amount, on the trade even if they do get stopped out. I’ll talk more about expected value and trade management in future posts since I feel they’re important concepts that traders should make themselves familiar with.

Good trading,


lonelytrader said...

I was trying to calculate expected value for the last 100 trades I've taken...and it is very clear to me that I need to go back to school. It's been too long since I've really dug into the math. I've concentrated on exursion studies for so long that I've neglected some very important quantitative tools. Thank god I found your blog.

Nice work man.

Anonymous said...

Excellent post. Love your blog so far and eager for more. Tharp's, "Trade Your Way..." is one of my all-time favorites so you caught my attention very easy with the (proper) mention of expectancy. Best of luck with the blog.