Wednesday, January 26, 2011

Applying A Directional Market Edge To Your Own Individual Trades

This post is the 6th in the series "Using Quantifiable Edges to your Advantage". In the last two posts I've discussed 1) combining historical edges to develop a market bias, and 2) factoring in overbought/oversold measures to improve risk/reward. So now let's assume you've done those things, and the situation setting up is suggesting a strong directional edge. You've either got an upside bias and a market that is not "too overbought", or a downside bias and a market that is not "too oversold". How do you translate that information into profits?

The most obvious way to try and take advantage of this kind of setup is to take on an index position. This is something that I do a lot of, but index trading isn't for everyone and there are many ways to take advantage of a directional market edge without trading indices.

Another way to apply a directional market edge is to favor trades in the direction of that edge. Let's use the example of a systems trader that focuses on either individual stocks or ETFs. Rather than simply take entries that may occur at any time, that trader may elect to use directional market edges as a filter. In other words, if there appears to be a strong upside market edge and one of his short systems triggers, he could opt to ignore the signal or view it as invalid. But if the market edge is to the downside and a short system trade triggers, he could jump on it.

In the 10/6/10 blog I showed how I did this for my own systems. I used the Aggregator as a proxy for my market bias. I've discussed the Aggregator on numerous occasions, but if you are unfamiliar or would like a review the embedded link is a good place to start. For my tests I broke out the system performance by times the Aggregator was suggesting a market directional edge in the same direction as the system versus times it wasn't. I found that for almost all of my systems, statistics were substantially better when you were trading with a directional market edge. Times where the Aggregator signal was not confirming the individual system signal, the system simply did not fare as well.

But while I've been talking about this using a mechanical systems approach, the concept is applicable to discretionary traders as well. If you are able to identify a directional market edge then you can consistently apply that information in your decision-making. During periods where you expect the market to flourish, you should trade the long side more aggressively and the short side more conservatively. Those times when you determine there is a downside market edge you should take the opposite tack. Trade more aggressively with your short positions and more conservatively with your long ones.

At Quantifiable Edges I do my best to try and identify directional market edges for my subscribers. While some subscribers trade indices and perhaps utilize some of the index trade ideas I publish, many of the more astute subscribers simply use the information to enhance the application of their own strategies. A few public examples of this include David Varadi of CSS Analytics and Ray Barros of

In his 11/18/10 blog post entitled "3/10 Offset HV as a Mean-Reversion Filter" David had this to say. “I am always looking for new and interesting ideas to improve the edges of conventional systems or indicators. One valuable source of ideas is a subscription to Quantifiable Edges, where I get the opportunity each night to review how Rob Hanna classifies the most relevant situations in today’s market.”

On the other end of the trading spectrum from David is Ray. In his December 22nd post, “2010 Adieu” Ray wrote the following, “2010! You taught me many new things. If I had to choose, the Oscar would go to Rob Hanna of Quantifiable Edges. He and I are poles apart when it comes to trading style and timeframes. But through his excellent site and newsletter, he showed me his way of viewing quant studies. I have adapted and integrated his ideas into my own trading with success. Thanks Rob”.

But your trading skills don't need to be at the level of these two traders in order to take advantage of quantifiable edges. And you don't need to overhaul your trading strategies either. A simple approach like tweaking your aggressiveness based on your market outlook can go a long way in improving returns.

Index traders have long understood how to take advantage of directional market edges. But for those that trade individual stocks and ETFs, my research suggests it makes great sense to take a top-down approach. First determine a directional market edge and then look for those stocks or sectors that are set up best to take advantage of the anticipated market move. By doing this you'll have the market wind at your back and your risk/reward and total profits should benefit accordingly.

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