Presenting my brand spanking new "Daikoku" trading system

I've been quietly working on this trading system for a few weeks now. My first-round backtesting was finished today and the system is looking very profitable.

 

It's a low volatility breakout system, based on the weekly timeframe.

 

My backtest details:

 

Years tested: 2001 to mid 2012

Pairs tested: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCAD, USDCHF, EURJPY, NZDUSD, GBPJPY, AUDJPY, NZDJPY

Timeframe: 1W

 

Sample trades collected: 403

Profit factor: 2.49

 

There are no indicators involved. I initially backtested using ATR to measure volatility, but didn't find it useful in this timeframe. I then merely measured changes in volatility by comparing the current week's range with the previous week. If it's less than 50%, we have an entry signal.

 

We look for entry signals over the weekend after the trading week is over. We then place pending orders that will last for all of next week.

 

Entry signal: At the close of the week, the week's range must be less than 50% of last week's range. On Monday morning when the markets open, we place a pending long at the high of the week + 1 pip, and a pending short on the low of the week - 1 pip. The orders should be set to expire at the end of next week.

 

Stop loss: If going long, the low of the week - 1 pip. If going short, the high of the week + 1 pip.

 

Take profit: 25% of your stop loss

 

Some people may raise their eye brows at the level of the take-profit. At this level, our reward-to-risk is 0.25:1, which is a little unconventional. But I cannot deny my backtest results. This is one of the best R:R ratios to use. All R:R ratios are profitable, but 0.25:1 R:R almost maximises my profit factor, up to 2.49, which I think is very good for a mechanical system with little optimisation.

 

Here's a graphical example of a trade:

 

 

Everything about this system is preliminary at the moment. I would like to further optimise but even at this stage, the system is tradable. My main concern is the relatively small sample size of 400 trades, although it has been tested 10+ years across all the majors and Yen crosses. The high profit factor makes this alluring.

How the filthy rich handle drawdown

I'm halfway through reading Theo Paphitis' (BBC Dragons' Den) autobiography and noticed that the self-made ultra-rich have something in common. Almost all of them came perilously close to bankruptcy at some stage, usually early in their "career".

 

In trader parlance, you can say that their drawdown came close to 100%. In fact, many of these millionaires / billionaires took on astronomical levels of debt at the lowest point of their careers, so you can say that drawdown exceeded 100%.

 

Can traders learn something from this? Trading is just like any other business. You have suppliers and customers (both from the market), you buy low and you sell high, you use other people's money (OPM) via leveraging and you have overheads that you want to minimise (spread and overnight swap rates).

 

Quite often these self-made entrepreneurs would fully invest themselves in a single enterprise. That would be the equivalent of putting in 100% equity into a single trade. A big no-no.

 

So are entrepreneurs like Theo Paphitis and Richard Branson stupid? Did they fail to manage their risk? Or perhaps the risk they took fits their psychological profile?

 

I'm not saying I have the answers. But drawing a parallel between entrepreneurship and trading is interesting and I think valuable lessons can be gleaned from this.

 

To be fair, these entrepreneurs began to manage their risk better as their wealth accumulated. These days Richard Branson segregates each of his businesses into autonomous units so if one blows up, it doesn't affect his business empire. That's like risking 1% equity per trade. It's a very managable level of risk. Reading their biographies, you realise that many of these entrepeneurs were somewhat naive when first starting out and I guess got "lucky" when their 100% equity trade won. We don't read the biographies of those who lose everything.

 

The journey to wealth usually goes like this:

 

1) Risk big early on

2) Hit a home run or lose everything

3) Once you're rich enough, slow down and manage your risk

 

"Losing everything" isn't the end-all, be-all. I guess these entrepreneurs accepted such a possibility. As long as you have two hands and a brain, you can always regather some skin to get back into the game.

 

But no-one ever got filthy rich by being conservative. If you do play it safe, you may end up as a single-digit millionaire by retirement. It's not a bad position. But to get into the hundreds of millions and above as a self-made man, I don't think there's any way around taking large risks.

The future: managing my own money, or other people's money?

I spent the last week having a good think about my future's direction. As a professional trader, I have two options:

 

1) Manage my own money

 

2) Manage other people's money

 

I've been reading CASHFLOW Quadrant from the Rich Dad Poor Dad series, and according to Robert Kiyosaki, most wealthy people obtain their wealth by utilising other people's money (OPM) and time (OTM).

 

If you're a professional trader / investor with a solid track record of profitability and low drawdown, investors will throw money at you. If you do decide to manage other people's money, your main source of income will come from fees. An advantage of managing OPM is scalability. There's not much difference in effort when investing $1m or $100m. Your investment or trading system(s) should be very similar in both cases. However, in the latter case, your income increases a hundred fold. Not bad at all. If you're a profitable trader using your own money, why not charge investors a fee to piggy-back on your success?

 

On the surface, this looks like an attractive proposition. But here are my reservations:

 

1) It becomes almost like a job. You're no longer answerable to yourself, but also to your investors. You'll be required to meet all sorts of regulations, expectations and KPIs. Most traders become so because of the freedom, and this sets you back in the corporate world, albeit you are your own boss.

 

2) Your psychological profile may mismatch with investors. Now, this can be partly remedied by being selective about those who invest with you. Most passive investors seek steady and reliable returns. In contrast, most traders want to strike it rich and retire as early as possible. Different goals. Many investors will balk at the prospect of losing 10-20% equity in a short-term drawdown, but traders know that such drawdowns are expected during long-term wealth creation.

 

There's prestige in finding your own hedge fund. Pyschologically, though, I don't think it's for me.

Entry signal on XAUUSD

A low volatility candle has appeared on XAUUSD (gold) at Friday's close.

Win on NZDUSD, equity update

My trade on the NZDUSD resulted in a win. I used a 1.25:1 reward:risk ratio when trading with the trend.

Equity Update

Since going live at the start of September, my equity has grown by 5%. If annually-adjusted, that should mean a performance of 17% p.a.

I've used various levels of risk, from 1% to 5% per trade. I found 5% risk to be quite high, particularly for mechanical trading. I've reduced my last few trades to 1% risk or less and found it much more comfortable - in fact I forget I have trades open at this level. The key to winning mechanically = low risk * high frequency. It's the high frequency part I need to focus on.

Entry signal on NZDUSD, full-bodied candles

A low volatility candle appeared on the NZDUSD over the weekend. The NZDUSD is running into some resistance, so it will be interesting to see how this plays out.

Full-bodied candles

 

I'm currently backtesting a new system based on full-bodied candles. Essentially, the open and close of a full-bodied candle should occur within the top and bottom quarters of the candle. I'm building a database on the USDCHF which will also contain RSI(14), ATR(14) and ADX(14) values to see if there is any relationship between these variables and profitability.

 

I have noticed that full-bodied candles can be profitable when their range is between 100% and 150% of ATR(14), trading with the trend. The sample size was 100, from the USDCHF between 2001 and 2006. Our entry would be the break of the candle's high or low, and our stop loss would be the opposite end of the candle. With a 1.5-to-1 reward-to-risk, profit factor was 1.36, which is okay. The profit factor for all R:R ratios above 1 are also positive, so thus far this is looking promising. 

Optimisation and simultaneous entry signals

One thing I noticed in my optimisation is the occurence of simultaneous entry signals.

 

Depending on your system, trading simultaneous entry signals may improve or detract the profitability of your system. If it does improve profitability, it can be problematic if you don't adjust your % risk per trade.

 

For example, suppose the current day ends and you see five juicy entry signals on different pairs eg. EURUSD, USDJPY, AUDUSD, NZDUSD, XAUUSD. Your backtest shows that it is favourable to trade every entry signal on the market. If we risk 2% of our equity per trade, we will end up risking 10% altogether if we take all five entry signals. Because we can expect some moderate correlation between all pairs, trading simultaneous signals usually ends up as an "either or" affair. We usually either win or lose all trades.

 

10% risk is high. Is there a way of being to trade all entry signals without excessive risk?

 

Here are our options...

 

Option 1 - Continue with the status quo and stack on the risk

 

We typically risk 2% equity per trade. If we see five entry signals, we trade all five and risk a total of 10% equity. If we see ten entry signals, we risk a total of 20% equity etc.

 

Option 2 - Split the risk among the trades

 

If we typically risk 2% per trade and see five entry signals, we may split that 2% among the five trades. In this case, we will risk 0.4% equity per trade.

 

Option 3 - Reduce our risk in general, stack on the risk when multiple entry signals appear

 

This is much more system-specific. If your backtest shows significant improvement in profitability when trading multiple simultaneous signals, wouldn't it make more sense to reduce your risk when you have a solitary entry signal? That way, should multiple signals appear, we can stack on the risk without it being too excessive.

 

Suppose we reduce our risk per trade to 1% when trading a solitary entry signal. Should five entry signals appear simultaneously, we can stack on this reduced level of risk. In this case, we will risk a total of 5% equity for these trades. While 5% risk is high, it isn't insanely high.

 

Option 4 - only trade the pair with the highest expectancy

 

Of the five pairs signalling an entry (EURUSD, USDJPY, AUDUSD, NZDUSD, XAUUSD), your backtest shows that the EURUSD has the highest expectancy. We may decide to trade the EURUSD only and ignore the rest.

 

My thoughts

 

There is obviously no "right" answer, although there are wrong answers. Blindly stacking on risk is a sure-fire way of busting your account when the stars align and the gods conspire against you in the perfect nightmare trade.

 

However, if there is a significant improvement in profitability from simultaneous entry signals, we want to make the most of this. Another way of looking at it is that we may see a decrease in profitability with solitary signals, hence we should risk smaller during these situations. When multiple signals appear, we ramp up the risk, but not too much. Some variant of Option 3 may be ideal, with perhaps a total risk limit of 5% or some other value.

 

Option 4 is straightforward. We trade as normal, but when multiple signals appear, we cherry-pick the best pair to trade from our backtest results. The danger stems from curve-fitting, although if our system is robust, this shouldn't be a real problem and we'll approach a result similar to our backtest.

 

Optimisation of Hermes

My optimisation of my "Hermes" low-volatility breakout system is proving to be very messy.

 

The trouble with optimisation is that you can take it in any direction. At the moment I added an RSI filter to check how the sytem performs when going with and against the trend.

 

There is a noticable improvement in profit factor when trading with the trend. I have also noticed that the system performs best against the trend if I use a Reward:Risk ratio greater than 2, while trading with the trend performs best with a Reward:risk ratio of less than 2.

 

I suppose this makes sense. If you are trading with the trend, the likelihood of running into the end of the trend is relatively high. On the otherhand, if you trade against the trend and the trend-reversal is strong, it can turn into a new trend and you succeeded in catching the beginning of this trend. This would explain the bigger pay-off if trading with a larger reward:risk ratio.

 

With that in mind, I have also noticed other behaviour that can be used to "optimise" my system further. For example, I have noticed that trades perform better when you have a multitude of entry signals on the same day. I guess the entry signals on different pairs reinforce each other. Trading only on days with multiple signals may improve my profit factor, but at what point does it end being an exercise in optimisation, and the start of curve-fitting?

 

To be safe, I may stick with one level of filtering only. I also feel that I'm getting sidetracked. Mechanical systems are not intended to be perfect. They should be "rough but ready", and ideally deployed as part of a portfolio of independent trading systems. To win mechanically, you should trade with a low risk per trade, and let high frequency and exponential growth do the heavy lifting. To do this, though, you'll need more systems to trade with. I'll return my attention to system development.

Recommended resources (Dec 2012)

Over the last year I've gathered a few sites / resources that I've found to be very useful. Some of my recommendations:

 

BabyPips

 

For anyone new to trading, I recommend BabyPip's "School of Pipsology". It's a FREE online course on basic trading. I've read a few introductory forex / trading books from bookshops, and found the School of Pipsology superior. The online community at BabyPips are also generally helpful.

 

Mercenary Trader

 

Mercenary Trader covers trading in general, not just forex. It's main emphasis, in my opinion, is on trader psychology. Mercenary Trader routinely releases newsletters that I've found inspirational and insightful. I tend to ignore the market commentary, although that is available as well.

 

Mechanical Forex

 

The owner of this blog / website, Daniel Fernandez, is a pure mechanical and automated trader. I'm a mechanical trader myself, and would like to become automated in the future. The site provides a free e-book which I can currently perusing. There's a noticable absence of quality information regarding automated mechanical trading. This site is one of those rare gems of expert knowledge that you'll find once in awhile.

 

Trading Heroes

 

I enjoy this website because I find the webmaster, Hugh Kimura, refreshingly honest and down-to-earth. I also believe that we're both at a similar level of development. The site doesn't contain much, strategy-wise, but it's most useful resources are the podcasts and interviews with professional traders. Getting an insight into the world of other traders is fascinating.

 

Pepperstone

 

My forex broker. I used to be with GoMarkets but found the spreads on Pepperstone to be much better. Many Australian traders seem to prefer Pepperstone. I've been with them for half a year and haven't encountered any critical problems so far.