Stocks & Commodities V. 5:4 (148-150): Using Maximum Adverse
Excursions for stops by John Sweeney
Using Maximum Adverse Excursions for stops by John Sweeney
So often the key to success is the reverse of what we initially
perceive. Young basketball players are fascinated with the shot,
never suspecting the game is won with fast feet. Traders focus on
winning signals when they should worry about when to admit they
were wrong.
Here it is: It's more important to know when your trade is bad
than it is to know how to get into it. Said theoretically,
"minimize your maximum loss" to win in the long run.
In Stocks & Commodities October 1985 issue, I described how
to determine stop placement quantitatively Subsequently, a reader
asked for a concrete example, so here I want to show how to use the
information on T-bonds.
Again, the lesson is: minimize the size of your largest
loss.T-bond futures are a great trading vehicle. In the December
1986 contract from Oct. 1, 1985 to the present, there's an
excellent period for examination because the market experienced
"dead slow," "strong rally," and "indecision."
First the basics: You need to study past contracts to determine
their Maximum Adverse Excursion under the trading rules you use. I
use a simple trend-following system with all rate contracts and
currencies. The system used here was validated in March 1985 when
market conditions were much different than today. Still, I think
that the stop-setting rules make it viable today even if
refinements weren't possible-which they are.
For this analysis, I ordered four contracts of historical
information for Christmas T-bonds covering 1982 to 1985 from
Commodity Systems, Inc. Then I ran the data through a simulation of
my trading rules and measured the size of the moves against by
positions. The results are in Figure 1.
As in the Dmark and T-bill charts in the earlier article, we see
two different curves, although the results are not as clear-cut.
T-bonds has two winning trades with adverse excursions up to 45
trading points. Bond traders will have no trouble imagining how
this came about! Occasionally bonds have sudden bursts of extreme
range with equally large reactions within short time periods--too
short for the trend-following systems to react and signal an exit.
Thus you get a large adverse move but a system staying in its
original stance.
These two points aside, it's clear that winning trades in bonds
hardly ever had more than 18 points adverse excursion. As a first
cut for this test, I set my stops at 19 points away from the entry
point. This single action avoids 31 historical trades with losses
from $1,000 to $2,000 per contract. I'm trying to minimize the size
of my maximum loss.
Now, how did this work out in practice? Figures 2, 3 and 4 are
charts of December 1986 T-bonds from December 1985 to September 1,
1986. The trades are just as if the 1985 system were being followed
strictly. Following the system's rules I was out at A and long
again at B. The stop for B was set 19 points
Article Text 1Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 5:4 (148-150): Using Maximum Adverse
Excursions for stops by John Sweeney
below the close for the day and was never approached. This trade
was very profitable because it happened to catch a large move.
Looking at Figure 3, I was still long until point C when the
system signaled an exit.
At D, a buy was signaled and the stop was set 19 points below
only to be used two days later (E) as the market continued a
five-wave decline. Note two things here: the loss was small and
very quick. This fit the testing. Duration of wins averaged 20 days
in testing. Losses averaged only two days. Conclusion? The market,
as "seen" by this system, was behaving normally.
At F, I was short only to be stopped out three days later on a
strong up day. Again, a quick, small loss. The same thing happened
at G. Everything appeared normal for this system.
Nothing happened until point J which seemed a very tardy
long--and was. Again, a small, quick loss.
Point L looks like another ideal entry, although only time will
tell how much profit is in the trade. The stop was never approached
here, so now it's a matter of waiting until the system reverses
itself which it would with any close below 100.
In summary, here is a system validated for 1981-1985 trading in
the far more volatile 1986 environment. It had only two winners and
four losers. Winners were large and losses small, for a profit.
Clearly, the system of entry and exit was crummy! Nevertheless, the
loss control made it a winner in a volatile trading environment.
Again, the lesson is: minimize the size of your largest loss.
Figures 4Copyright (c) Technical Analysis Inc.
