Obey your Trading and Risk control rules

In an earlier blog entry I defined a stock strategy as a combination of   Algorithms + Goals + Symbols + Trading Rules.    It is tempting to take the output of the Bayes Analytic engine and apply the recommendation without obeying the rules.     Based on results from test trading earlier this year this is a very bad idea which can cause what is profitable strategy to be less profitable.      This concept is also draws from ideas described in  “When Good traders Loose“.

Violate Risk control rules and wipe out months of stock trading profits

Earlier this year I started test trading a strategy called OptBayes1  and it was pretty successful up nearly 25% over a 3 month period with about 120 trades.  The strategy  was showing a consistent slow crawl forward in spite of some loosing trades along the way.     Then a period came when the Strategy recommended going short on SPY and long on VIX after it had been correct for the several  trade cycles.     Some of the strategy rules are:

  • Restrict the amount of acceptable to risk for any single directional trade.
  • Limits the total set of risk in any single cycle eg:  if you already hold a call on  QQQ even if the system finds a new and even better opportunity for a call on QQQ you are limited in both the number of outstanding trades and total value at risk from calls on QQQ.
  • Limits the ability to make trades that bet on essentially the same thing eg: a call on QQQ is likely to respond in the same way as a call on SPY so from a risk control perspective they both contribute to the same risk limit.

I was highly confident  since the strategy had delivered several consecutive wins and it’s recommendations agreed with my read of the market.    I ultimately ignored my risk control rules to triple the investment and wiped out the strategy’s profits since beginning of the test.     If I had followed the rules it would have been a loss but a relatively small one.

It  was a good learning experience and I have been able to further improve this strategy so I needed a new test trading cycle anyway.    Stay tuned for the next cycle results.

Trader following rules up 25% while the one violating the rules is down 9%

The trading rules for this strategy specify activation of a trailing stop after the  given stock purchase has delivered a specified minimum gain.   The idea was that the  strategy was selecting purchases based on probability of delivering a  minimum % gain but we quite often saw a larger gain before the movement reversed.  We needed to capture the larger gain when it was available.     One trader implemented this as specified and a second trader put in a simple limit sale at the targeted minimum gain because their web client did not support automatic activation of delayed activation trailing stops.    The stock trader who followed the rules was up 25% over the same period when the other stock trader was down 9% and they where both using exactly the same set of recommendations and with a similar number of trades over the same period of time.

A common temptation can double the loss on a loosing trade

 Options tend to loose a portion of value every day as they creep toward zero.   This means that holding an option for a long period of time is a good way to loose money unless a major market move occurs.    The rules for this strategy require selling if the option has been held for given period of time without meeting the goal.  This sale must occur even if it will incur a loss.   I experience a strong temptation is to hold the option for a few more days hoping the market will turn around.    After extensive tests holding past the rule limits seldom delivers a positive result and nearly always causes a greater loss than if the option where sold when the rules specified.   Quite often the loss due to holding a few extra days is more than double the loss which would have occurred if the option was sold in accordance with the rules.     If the rules are wrong then change them and test the changes but do not casually violate them.


Joe Ellsworth
CTO of Bayes Analytic


Required Disclaimer

Forex, futures, stock, and options trading is not appropriate for everyone. There is a substantial risk of loss associated with trading these markets. Losses can and will occur. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using this methodology or system or the information in this letter will generate profits or ensure freedom from losses.  Forex and Option trading can result in losses that exceed the original principal balance.

Hypothetical or simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not been executed, the results may have under-or-over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profit or losses similar to those shown.

Even results from Live cash trading can be subject to specific market conditions that may not repeat in the future and as such, duplicate results from future trading is unlikely to duplicate past results.    Changing the dollar amount traded can cause different behavior in live trading markets especially when trading large positons that can exceed the liquidity available in the market and cause changes in pricing behavior.

Bayes Analytic LLC provides software that can produce trading signals.  The customer is responsible for choosing a configuration and parameters for the software that meets their own goals.  The customer is responsible for conducting their own tests and only the customer can activate the software to start trading.   The software runs in an account the customer has logged into and then activated the software.   Bayes Analytic has no control of,  influence over or visibility to the signals specific to given user because we have no visibility into configuration parameters the user has chosen to operate with.    The Bayes Analytic software is provided without Warranty on a As Is, Where is basis.  It is the customers responsibility to test the software to ensure it meets their trading requirements.   Every time Bayes Analytic releases a new version of the software the customer should conduct new tests to validate the new version continues to meet their requirements because every software change could have unexpected side effects that may not be obvious until the customer has tested it in their environment with their configurations.   The Bayes Analytic software may run as a script inside of other software packages or talking to API that Bayes Analytic has no control of or Influence over so the customer should test entire ecosystem to ensure it meets their trading requirements.    Bayes Analytic may provide the software in source form since that is required by some trading systems but it remains the exclusive copyrighted property of Bayes Analytic and may not be reverse engineered or redistributed.    The customer is responsible  for choosing their own broker and installing the Bayes Analytic software so it can trade using the desired account.  Bayes Analytic has no control over or influence of the broker and many brokers have different ways of quoting spreads,  charging commissions,  flow of orders and latency of information.  As such a strategy and software that performs well at one broker may and probably will require changes to perform well at other brokers.  It is the customers responsibility to test the software with their selected broker to ensure it meets their trading requirements.

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