Trading Strategy Risk Management

The Zignals Trading System Builder is unique as a strategy builder in that positions are entered using technical signals but exited using a risk managment system designed around fixed percentile target/stops or trailing target/stops. The type of risk management employed will in large part be dictated by the volatility (beta) of the component stocks/ETFs/FX pairs in the trading system.

In my first article I looked at how to build a Trading Strategy using default risk management settings. In this article I will look to adjust the risk management options, while trying not to 'best fit' for the outputs.

As a recap, the strategy employed the Active Trader list of components. The associated Beta values of those stocks are given below:


With an average Beta of 1.36 our list of stocks is slightly more volatile than the underlying market, with a range of 0.2 up to 3.05.

The values we will be adjusting are the Stop Conditions; Money Management is unchanged from the original.


How do the Stop Conditions work?

The Target Percentage sets the conditions at which the Trail Target/Stop kicks in. The Stop Percentage is the opening risk for the trade, assuming the Trail fails to kick in. Once the Target Percentage is hit the Trail Target and Stop becomes the new exit rules. As each Trailing Target is hit the Trailing Stop is updated. If at any point the Trailing Stop is hit then the position is exited. The Trailing Target continues until the Profit Target is hit - then the position is exited once and for all.

Our back test period is from 24th Nov 2007 to 23rd Nov 2009.

The default a 15% Target Percentage, 10% Stop, 10% Trail with a 5% Stop, and a Profit Target of 25%. This gave the following returns:

No. of Trades: 142
Profitable Trades: 47%
Net Profit: 17%

As we adjusted the Stop Price we got a drop in the win percentage but booked more profit.


Because of the close-to-market Beta of our component stocks there was still a relatively strong return with a tight stop of 4%.

If we focus on the 6% stop and adjusted the Target (the price at which the Trailing prices kicked in) then there was a radical improvement in the percentage of profitable trades. Simply dropping the Target price from 15% to 10% brought a substantial increase in the percentage of profitable trades and percentage profit.


Next was adjusting the Trailing Target and Stop. However, there was little to be gained adjusting either


Leaving the Trailing Target and Stop unchanged and increasing the Profit Target made modest improvements up to a ceiling imposed by the back test period.


At this point it was a matter of going back to the start and looking at our opening Stop Percentage. As we had used an optimised value of 6%, how would the strategy have performed if we used stop values of either 5% or 10%?


Dropping the stop another percentage point didn't lose any of the 31% return for the past 2 years (long only). Increasing the Stop to 10% gave the strategy a little more breathing room which increased the percentage of profitable trades (on fewer trades) - although there was a slight drop in net profit.

From the point of strategy development; the 10% Stop, 10% Target, 10% Trail Target, 5% Trail Stop and 25% (or 50%?) Profit Target is perhaps a good starting point to build around. In terms of net return, the largest impacts came from adjustments in the initial Target and Stop values versus changes in the Trailing Stop and Target.

But the best way to find out is to start building your own trading systems. Don't forget to publish your winning trading strategy into our MarketPlace for a chance to earn real money.

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Dr. Declan Fallon, Senior Market Technician, Zignals.com. November 2009 has seen a significant upgrade to the site on the course to becoming the eBay of finance with our new Beta MarketPlace and a new rich internet application for finance, the Zignals Dashboard. Zignals now has new fundamental stock alerts, stock charts for Indian, Australian, Frankfurt and soon Canadian stocks, tabbed stock list watchlists, multi-currency portfolio manager, active fundamental system stock screener and trading system builder. New Forex and Index data.

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Creating a Trading Strategy in Zignals

We have just launched with a brand new Trading System builder which will allow you to create your own trading strategies and follow the trade signals generated via email. You will eventually have the opportunity to earn money selling it in the Zignals MarketPlace. If you would like to read more about our Trading System builder you can do so here.

But first things first; FREE registration with Zignals followed by a prompt to download Microsoft's Silverlight will give access to the trading strategy builder. For this article I am working through the Zignals Dashboard which gives full access to all of our services (stock alerts, stock charts, stock screener and portfolio manager) within a single application. The key advantage of using this over the individual applications is the seamless switching between applications.

We shall start with a simple strategy - a price cross above a 20-day Simple Moving Average (SMA). This will be a long only strategy.

On loading the Trading System interface you will be greeted with a grid-interface; along the top is a set of menu options and on the right a series of steps, numbered 1 to 5, required to create a strategy. For the first step, select My Strategies.

This will open a window which defines the risk management and exit strategies. The first version of our trading strategy builder offers exits based on percentile steps; this is an excellent way of letting trades run as you can be as tight or as loose with the trailing stop/target as you want to be.

Default trading strategies start with $100,000 capital and an allocation of $10,000 per position. Checking the autocalculate option will preset the amount per trade based on the pool of stocks to draw from (so as to ensure you don't overinvest in situations triggers are given for all constituents). In this example we will be using 17 stocks which gives an allocation of $5,888 per trade; I have rounded this to $6,000 per position. The comission is set at $10 and have left the slippage percentage unchanged. The Delay Between Trades is used to control whipsaw and we have set this to 10.

The Stop Conditions offer more flexibility. There is the option to use or not use a trailing stop. To maximise profits we will use a trail; the trail kicks in once the initial Target Percentage is set - a position will be exited if prices fall by the Stop Percentage (in a long strategy). When the Target Percentage is hit then a rolling target and stop defined by the Trail Percentages is activated with an end point Profit Target which closes the position once reached.


Next it is time to assign your stocks. I have created a list using the same stocks of Active Trader: Apple (AAPL), Boeing (BA), Citigroup (C), Caterpillar (CAT), Cisco (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International Business Machine (IBM), Intel (INTC), International Paper (IP), J.P. Morgan (JPM), Coca Cola (KO), Microsoft (MSFT), Starbucks (SBUX), AT&T (T), and Wal-mart (WMT).

The most important step is to assign your rules. As this is a simple price crossing a moving average we will create a new Technical Rule. In the left-hand-dropdown we select Price and in the right-hand-dropdown we select Trend/Simple Moving Average with a period length of 20.


After a rule is created we need to Add to Strategy. This places the rule into a rule list on the right; from there it's a matter of dragging it into the workspace.


The first rule dragged-in will automatically connect to the starting point. Other rules you drag-in can either be connected to existing rules or, by dragging the top box down to the new rule, connect to the dragged-in rule (see below).


The final step is to connect your rule(s) to the end-point to complete the flow.


Once you are happy with your strategy it should then be saved.

From there we move to step 4 and define our back-test period. The default is the past 2-years but you test for any period back as far as 2001 (for US stocks). During a backtest an historical portfolio is created; if you wish to give this portfolio a name it can be done here. The option to view the portfolio is offered after the run is complete. This is recommended so you can see the performance of your strategy.

In the price cross of 20-day SMA with our trailing target/stop set at 10%/10% and profit target of 25% returned 17.2% over the past 2 years. Max drawdown was -23.4% but the srategy enjoyed a 44% win percentage. However, it did endure a maximum losing sequence of 13 trades which would hurt anyones confidence! The current portfolio holds 13 stocks.


At this point two options are available:

[1] The strategy can be edited further and new portfolios created OR
[2] The strategy can be Published so that the trading signals can be received by email.

To do this it is necessary to switch from the Portfolio Manager back to the Trading System. In the Trading System open your saved Strategy.

There is a full range of edits available including changing the risk management options - the stocks, Forex pairs, or commodities used - or the rules themselves.

When you are satisfied the last step, step 5, allows you to Publish the trading strategy to our MarketPlace. Publishing brings up a summary of your strategy and the conditions attached. A brief commentary can be attached and the subscription cost you would like to charge for when the MarketPlace comes out of Beta.


Publishing activates the mailing of signals. As the publisher of a strategy you will automatically be subscribed and will get trade signals delivered to your email box as they occur. Published strategies also appear in your Published Trading Strategies window.

If you would like to subscribe to this strategy - called Developing a Strategy - then you can do by searching for my user id ('fallond'), or any of the aforementioned stocks comprising the strategy, in the MarketPlace. Should the strategy perform well, then it will appear in the Top 20 Trading Strategies widget in the Dashboard.

If you have any issues or concerns, don't hesitate to contact me (declan-at-zignals.com); your queries could be the basis of my next blog post!

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Dr. Declan Fallon, Senior Market Technician, Zignals.com. November 2009 has seen a significant upgrade to the site on the course to becoming the eBay of finance with our new Beta MarketPlace and a new rich internet application for finance, the Zignals Dashboard. Zignals now has new fundamental stock alerts, stock charts for Indian, Australian, Frankfurt and soon Canadian stocks, tabbed stock list watchlists, multi-currency portfolio manager, active fundamental system stock screener and trading system builder. New Forex and Index data.

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Lessons Learned

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.

Arthur Schopenhauer (1788 - 1860)

Perhaps the least surprising thing the market crash of 2008/2009 was, was that no one saw it coming.

The establishment experts were all asleep at the wheel. Research analysts in Wall Street or the City of London were overwhelmingly bullish about just about everything. Buy Recommendations exceeded Sells by nearly 8 to 1. [This is not as big a deal as you might think -- the “official” experts are always bullish, but this was extreme]! Those few brave souls who sounded a negative tone were derided and then silenced. Now of course the ridiculous excessive of the years from 2003 to 2007 are obvious and the man on the street knows how we were taken for a ride.

The relevant question now for the trader or investor is what have we learned. To fail to learn from history is to be condemned to repeat it. I contend there are three lessons [ 3 blog posts?:]

1: Alleged market experts don’t know much. By the time their generic investing advice gets to the average client its worthless.
2: This worthless advice is extremely costly (typically some percentage of the assets under management, and/or commissions on trades and/or performance incentives and/or bid-offer spreads). Given that it has no worth any price is too much to pay. As Warren Buffet pointed out once these guys have their hands on your checkbook under-performance is guaranteed.
3: For decades apparently expert advisors were simply lucky. Their “ Buy and Hold” strategies succeeded by virtue of an underlying economic success which has (with hiccups) lasted since the ‘50s. A long-only random walk monkey would have done as well and cost less.

There is an alternative and we’ll be discussing it in my next post.

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Pat Brazel, CEO of Zignals.com. November 2009 has seen a significant upgrade with our new Beta MarketPlace and new rich internet application for finance, the Zignals Dashboard. Zignals now has new fundamental stock alerts, stock charts for Indian, Australian, Frankfurt and soon Canadian stocks, tabbed stock list watchlists, multi-currency portfolio manager, active fundamental system stock screener and trading system builder. New Forex and Index data.

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FTSE 250 ETF : Breakdown of 20-day moving average

For the second time in the space of a month the FTSE 250 has cracked below its 20-day moving average. The last time this occurred was early summer; then the index went on to spend a few weeks below this moving average, making a new lower low, before resuming the trend higher.


A similar event here should see a test of the 902.50 low -which was both an August reaction high and the early October reaction low - with the potential to drift down to 867 if a more protracted decline kicked in. Intermediate trends in the market tend to run between 3 weeks and 3 months with the current end-of-year a handy time scale for a flat/downward phase.

A more serious decline (one lasting months) would require confirmation of a top with a test of October's highs. This test could only emerge after a break of the prior March-October trend, with a sideways market shifting the focus from one of accumulation to one of distribution an important precursor to this test.

Market tops rarely shape the sharp reactions of market bottoms because people tend to be more reluctant to sell (even when holding a loss) than buy.

So setting a Zignals Stock Alert for XMCX at 902.50 and 867 will give heed as to possible trade opportunities with another at October highs to mark a resumption of the trend.

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Dr. Declan Fallon, Senior Market Technician, Zignals.com the free stock alerts, market alerts, stock charts, stock screener and stock portfolio manager website
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NASDAQ Breadth Top-Heavy

The rude health of the Nasdaq has been evident by the strength from its internals; 74% of constituents are on point-n-figure buy signals, 71% are above their 50-day MA and an incredible 80% are above their 200-day MA. Such conditions can't continue forever so what should one be looking for?

During the depths of despair encountered over the latter part of 2008 the percentage of Nasdaq stocks above their 200-day MA languished below 10% for the best part of 5-months. The percentage of stocks above their 50-day MA enjoyed a brief rally from 10% to 70% before heading lower. While the bullish percents struggled to challenge the 50% mark.



If one was to flip this scenario on its head and apply it to the courent situation. the likely view going forward is the next 4-5 months will see the Nasdaq break lower with sizable downleg, perhaps taking it to a wide band of support running between 1,650 and 1,750. From there it will mount another challenge on September highs - possibly breaking through to continue the rally.

It's highly unfeasible the Percentage of Nasdaq Stocks above their 200-day MA will drop below 50% (this would require a crash-like move in the market); so expect this to meander in its upper range as stocks remain well above this key long-term average.

There is greater potential for a reversal in the Percentage of Stocks above the faster moving 50-day MA and Bullish Percents given the tight daily action of recent weeks will have set-up new point-n-figure signal-conditions and allowed time for the 50-day MAs to catch up with price action - making the latter vulnerable to breaks.

There is little to suggest the next major move down will not set-up another good tradable rally higher; perhaps overshooting a little past the 200-day MA. The May reaction low c1,664 is looking a good place for bulls to put up a defence. What happens on the second attempt at September highs will dictate market conditions going forward.

I have entered a Zignals Call for a push down to the low $33s for the QQQQ with a stop on a break of September highs.


Over the near term, look for the narrow action to continue until there is a decisive break of the Nasdaq 50-day MA.

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Dr. Declan Fallon, Senior Market Technician, Zignals.com the free stock alerts, market alerts, stock charts, stock screener and stock portfolio manager website
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NASDAQ Sep 22nd 2008: 2,179 - Sep 22nd 2009: 2,146

Where has the year gone? Looking at the two market dates you would think very little happened over the intervening period, except for the almost 50% drop, 100% rally the market has endured this past year. So what has gone and what might we expect to come?

Last June I took a look at the S&P and studied the relationships between the 20-day, 50-day and 200-day MAs and the index. In June I concluded:

The take home lesson is for the next month or two further downside is not just likely but probable; only in 2003 did a rally develop soon after the match. For the other five of the six matches the S&P lost between 7% and 30% of its value before it finally turned around.

From a buyers perspective there is little incentive to be long S&P futures or stocks until a firm break of the 200-day MA occurs.

The good news for bulls is once the S&P gets past the 200-day MA there is likely to be a very tradable rally.

In October 2008 I followed up with

# We are likely a couple of weeks from a bottom, but it is not impossible for this to take longer

# During this period the market will see sharp losses, perhaps trimming 10-20% off where the markets lie now (Monday will be the start)

# The subsequent rally will be short lived and will morph into a retest of the low

# The retest will be the time to buy heavy

# A significant bull market has a good chance of emerging from the quagmire - remember markets lead economic news.

In November I talked about a potential "Obama bottom" and then concluded

The worst looks to be behind us but we won't really know until we see what happens when the 200-day MA comes into range; a solid cut through and it will be up and away; however, a negative response to the 200-day MA test could produce a 1932/2002 style scenario in 2009 bringing with it another big step lower. If there is a silver lining to the worst case scenario it's that the current picture suggests we have already reached the extremes of the 2002 capitulation and not the pseudo-capitulation generated after the September 11th attacks.

So where do we stand now?

On the 16th of September 2009 the S&P was 20% above its 200-day MA, 8% above its 50-day MA and 4% above its 20-day MA; the largest difference between the 200-day MA and the S&P in recent weeks.

Just to show how extended the market is, the largest difference on record (since 1950) occured on the 3rd November 1982 with a 23% extension from its 200-day MA. September 16th ranked 33rd out of 14,571 data points! Quite the reversal!

Going back into the time machine, the neon coloured eighties was littered with this MA set-up:


Which suggets the next few years could see a modest bullish turn (the next cyclical bull market?):


Even over the short term action tends to follow the wind and find support at the MAs, with one big exception:

1955:

1975:

1980:

1982:

1983:

1986:

1987:

Given the S&P's sharp move off of lows it would appear momentum is set to continue in favour of bulls as sideline money steps in on weakness. But look for this rate of ascent to slow as markets work off overbought conditions and MAs 'catch up' with the index.

The 50-day and 200-day MAs should provide support and buying opportunities for new long positions. Stops can be placed on a decisive break (>1%) of the 200-day MA, protecting against any 1987 like outcome. But even here, the losses of 1987 did little to erase the bulk of the gains the S&P had chalked up earlier during the decade.

Although pre-1950 was excluded from the dataset it would appear unlikely a major downleg will follow.

Could it be argued we're at a 1937 style top? If so we may see a very sharp sell off (a la 1987) - one which could see the indices lose half their value - but not one to violate March lows to any great degree (something Elliot Wave Theorists are looking for).

There is plenty of expectation for a major downturn but this expectation may yet be to early. A major downturn is inevitable at some point of the future, but when it occurs markets might have long since sailed higher.

The trend is certainly your friend here...

How can this work for you? Track your interests using Zignals Stock Alerts; set alerts to trigger at 50-day and 200-day MAs, or approaches to these MAs (if thinking of buying).

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Dr. Declan Fallon, Senior Market Technician, Zignals.com the free stock alerts, market alerts, stock charts, stock screener and stock portfolio manager website
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ISEQ Bull Rally

With all the focus on NAMA, the rally in the Irish Stock Market has largely gone un-noticed.

Its first inkling of a reversal was in February 2009 when the 35-,40-,45-, and 50-day weighted moving average ribbon tightened in response to a slowing intermediate trend. It was mid-April when the faster 5-, 10-, 15- and 20-day WMA ribbon cut through the slower ribbon on its way higher - kicking off a new bull rally. July saw a bear trap as the faster WMA ribbon cut through the flat-lined slower ribbon, only for the market to rally and re-instate the rally by the start of August.


However, even in the context of six month rally there is no inclination the rate of advance is set to slow. Channel resistance won't become an issue until the ISEQ makes it into the 3,500s. The widening of the slower ribbon band points to increased trend strength, which also suggests a sideways consolidation - rather than a hard move down - will be the preferred corrective phase when it comes.

Compared to global exchanges the ISEQ has not enjoyed the stellar returns (thanks to its heavy financial weighting), but if you are looking for stumbling blocks there isn't a whole lot of trouble until the ISEQ gets to 4,100 or the last congestion area from tightening ribbon bands at 4,450.


Maybe there will be something to cheer for 2009?

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Dr. Declan Fallon, Senior Market Technician, Zignals.com the free stock alerts, market alerts, stock charts, stock screener and stock portfolio manager website
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