Sunday, March 25, 2012

Negative excursion volatility based stops

Over the past few months I have begun to employ more and more traditional price based stops. The beginning of this year found meantrades reaching into drawdowns which I was not that comfortable trading with. Taking hard stops and walking away for the day is tough in any system but when applying it to a mean reversion system it means you are inevitably getting stopped out just before the market turns.

Since employing supertrend volatility metrics I realized that there is a remarkably consistent pattern occuring between price action and the ATR based indicator popularly known as supertrend. When the market reverses and the signal is created in the meantrades system very often if the market does not take off in the expected direction it will pasue for a while and then resume the expected direction. However if it doesn't it will accelerate resuming the trend creating a negative excursion for meantrades. This is ok, I have always dealt with this and will continue to do so. But the beauty of supertrend is that it allows you a chance to observe price action and its commitment for continuation or mean reversion.

So I'm adjusting my stop method slightly again. Instead of taking the swing high or low I will employ the  supertrend crossover on its second negative excursion.

You can see in the screenshot below that a signal was generated at 11:24 and then the market resumed its uptrend. Once more the market began to revert to its mean however it could not reverse as anticipated so a stop was taken on the second supertrend crossover to the upside. Notice that the stop taken is actually lower than the swing high--where we have been taking stops for the past few months.

This stop method does have an unpleasant downside. You cannot know exactly where you will stop out before you enter the trade. However taking the observations of legendary traders who have come before me as dogma, it has been said time and time again, markets revert to their mean, even on a fractal level and thus for every larger stop painfully absorbed, there will be many smaller stops which create more meantrades alpha in a longer data set. Markets will always seek the most viscous point to move towards in order to damn the largest amount of traders in the market. By employing a volatility based stop which assumes markets will revert on every level of price action, stops should see a positive reduction in end of day balance draw-downs. However this means intraday account balances will almost certainly increase.

Employing this stop revision, results from the 3rd week in March have been encouraging.

EUR 3/19-3/23: +160
GBP 3/19-3/23: +47
XAU 3/19-3/23: +184 (this includes the stop posted above on Friday's trade)