Tuesday, February 28, 2012

10 Heresies of Finance

I set a reading list for new programming hires before they ever interact with customers. OneStepRemoved's newest programmer, Jon Rackley, comes with an outstanding background in programming, but almost no market knowledge. Jon is under my wing for the next few months. My goal is to fully indoctrinate him on my market views.

One of the most useful, high level overview of trading dynamics is Benoit Mandelbrot's The (Mis)behavior of Markets. My philosophy is that before you attack a problem, you first need to understand the problem. Building trading robots is the problem that our customers face every day. One reason that many would-be automated traders fail is that they understand very little about how markets function. They try to solve a problem that they don't understand very well.

Mandelbot's "10 heresies of finance" sums up my view of markets quite well. I made Jon read the book as part of his job training because has no trading experience. If you're relatively new to markets or think it's time to step back and re-evaluate your approach, then I highly recommend this book.

The 10 heresies of finance



  1. Markets are turbulent.

  2. Markets are far more risky than the standard theories imagine. Mandelbrot does do a very good job throughout his book explaining how unpredictable and complex market behavior really is.

  3. Market timing matters greatly. Big gains and losses concentrate into small packages of time. He calls this trading time.

  4. Prices often leap, not glide. That adds to the risk.

  5. Time is flexible. Some times of day are more important than others

  6. Markets in all places and ages work alike. Human behavior never changes, even if the mood does

  7. Markets are inherently uncertain. Bubbles are inevitable. We will always be greedy

  8. Markets are deceptive.

  9. Forecasting prices may be perilous, but you can estimate the odds of future volatility

  10. In financial markets, the idea of “value” has limited value.


Jon found Mandelbrot's comparison between wind turbulence and market dynamics the most compelling part of his argument. It's conceptually difficult to accept the idea of human behavior acting like the wind. The math of the two behaviors is identical, which is somewhat difficult to accept emotionally. What I like about the argument is that it makes for a beautiful metaphor.

When a storm comes up, it's noteworthy. The average wind speed picks up. People notice that part. What everyone really notices and gossips about are the wind gusts. Staring out the window and watching the family oak tree bend a quarter way to the ground makes an impression.

Wind gusts are essentially market volatility. Events like a collapse of the euro or a surprise NFP number are the violent gusts of wind that make the jaws of traders everywhere drop to the ground. One gust begets another gust, packing themselves densely in time. Mandelbrot would reference the
increase in gusts as trading time speeding up.

If you enjoy these types of ideas, you might find our free resetting moving average indicator useful. It builds on Mandelbrot's fractal approach to markets, negating the idea of a true average. The resetting moving average tries to act as a minimum reference point by changing its period in step with market volatility.

Sunday, February 26, 2012

Wyoming House advances doomsday bill

CHEYENNE — State representatives on Friday advanced legislation to launch a study into what Wyoming should do in the event of a complete economic or political collapse in the United States.

House Bill 85 passed on first reading by a voice vote. It would create a state-run government continuity task force, which would study and prepare Wyoming for potential catastrophes, from disruptions in food and energy supplies to a complete meltdown of the federal government.
The task force would look at the feasibility of
Wyoming issuing its own alternative currency, if needed. And House members approved an amendment Friday by state Rep. Kermit Brown, R-Laramie, to have the task force also examine conditions under which Wyoming would need to implement its own military draft, raise a standing army, and acquire strike aircraft and an aircraft carrier.
The bill’s sponsor, state Rep. David Miller, R-Riverton, has said he doesn’t anticipate any major crises hitting America anytime soon. But with the national debt exceeding $15 trillion and protest movements growing around the country, Miller said Wyoming — which has a comparatively good economy and sound state finances — needs to make sure it’s protected should any unexpected emergency hit the U.S.


Read more: http://trib.com/news/state-and-regional/govt-and-politics/wyoming-house-advances-doomsday-bill/article_af6e1b2b-0ca4-553f-85e9-92c0f58c00bd.html#ixzz1nXq3mKqw

How to work with mt4 brokers with non-standard symbol suffixes

Many MT4 traders have the problem that brokers will change the default symbols in MT4 (i.e. from EURUSD to EURUSD.usd)

We wanted to have some programmatic access to the symbol list, outside of manually right clicking on market watch window.

EES posed this question in MQL4.com here: http://forum.mql4.com/46521

..and received an excellent resource: http://codebase.mql4.com/6134

This could be useful if a programmer wanted to automatically update the symbols he is trading, or for the development of multi-currency strategies.

Some brokers also may have multiple suffixes for the same pair, allowing for different order processing rules (or different spreads).  Some may even offer 2 EURUSD suffixes in the same account.

Having automated use of available symbols allows an EA to not be locked to trade only the symbol where the EA is attached.  For example if you have a multi-currency strategy that trades EUR/GBP every time a EUR/USD signal is generated, it would be possible using this method to automatically find EUR/GBP by searching for EURGBP in the symbols list.

Tuesday, February 21, 2012

Martingale Lessons

In the spring of 2011, there was no denying it. I adopted a decidely jaded view of the stock market and had grown to despise an industry full of self proclaimed oracles. Most of these people in my view were a bunch of textbook salesmen and women selling various dreams of financial security and fame.

Through sheer stubborness I remained invested and recovered from the down years of 2008 and 2009. However, single digit gains were taxing my patience. I was miles from my longterm goals. There was no doubt I would be working well into my 60s and if I suffered any type of dementia, it was not hard to imagine myself greeting people at Walmart. When I stumbled upon Forex, you could say I was open to a change.

The Allure of the Martingale



Through my work as an expert advisor programmer, I became involved in coding all manner of peoples trading strategies into small trading robots called expert advisors or custom indicators. I am still surprised by all the permutations of indicators, chart patterns, money management mechanisms, etc, that trader are dreaming up out there.

I would code them all up according to their specifications, slap them in a backtester to put them through their paces, fix any problems. Rinse and repeat until all was working to everyone's satisfaction. Many if not most were flawed for one reason or another, some would work exceptionally well in one type of market but perform poorly in others.

Some were tied to faulty indicators that would change their earlier output signals. Some were based on what I viewed as various arcane chart patterns which seemed one step removed (no pun intended) from witchcraft. Others were complex to the point where they would rarely trade and when they did would do so at the most inopportune time.

After perhaps a year of this, I received a Martingale strategy to code for an overseas customer. After coding and running his EA in the strategy tester, I remember becoming very excited with how well it was performing on every time period and data set in all markets. I spent more time testing this EA that day than most, even though I was not finding any problems with the coding. After seeing so many crash and burn that week, I enjoyed watching it do its thing.

To be sure, it was not the first Martingale I had seen and I had always discounted that ilk as being to closely tied to Vegas and gambling. But, like the ones I had seen before, it was doing a bangup job of piling up cash during my test runs. I guess after seeing the nth Martingale doing that I could no longer ignore this method of trading.

That afternoon and for many days following, whenever my thoughts would wander ideas would pop into my head as to what sort of Martingale I would program in MetaTrader for myself. It was truly something of an epiphany. Up to that point my whole view of forex was that of a high stakes market best left to big banks, institutional investors, and governments. I had never thought of running one of these programs on my own money.

Like most Martingales, mine would double its lot size with every loss. I suppose what was different about my Martingale from many but certainly not all others, is that mine would reverse the direction of its trades. This would solve trending markets, the achilles heal of single-direction-trade martingales. It would also use a Take Profit and Stop Loss that would be somewhat sensitive and self-adjusting to Average True Range. This was my answer to excessive volatility. Finally, I put in logic to have hidden take profits and stops. This would satisfy my probably unwarranted suspicion of brokers.

I'm not going to get too detailed on leverage, margin requirements and such. With a Martingale, you need to consider how many levels you're going to let it go before it gives up or resets its lot size. And don't kid yourself; it will go deep more often then you would think. You need to make sure you have enough money in a Martingale trading account to support your biggest possible trade.

Happy Days and Riding the Martingale bull



I went through the trouble of setting up a forex account and started trading. The first month felt underwhelming. I recall the EA only did a little better than breakeven but my enthusiasm was still intact. The fact that I did not lose any money comforted me, making it feel safe to press on.

I continued tweaking the EA and adjusting how I would use it. By the end of the 2nd month, mostly through trial an error I found the EA worked best on the EURUSD and the 15 min period. That's when the results started to give me that euphoria that I had so badly wanted. By the end of the fourth month, morale was sky high.

I'm not going to give actual numbers since I used to always suspect other type articles of fish tails when they did that, but it was enough to make me a changed person. If you can recall the nursery rhyme "Sing a Song of Sixpence". The line "The King was in his counting house, Counting out his money" pretty much sums it up. That was me. It almost felt illegal and I actually hid the results from others fearing that I would jinx everything if I mentioned it. I would often pick up a calculator or paper and pencil calculate out what the sum might be after 5 10 20 years at the current rate of returns.

When a Martingale goes bad



I'm not a market statistician or financial wizard of any sort, so I can't give a very elegant explanation of what happened. I do know that the financial problems in Europe during the fall of 2011 provided an extremely volatile and choppy market that did not agree with my reversing Martingale EA. It resulted in some whiplash-packed trading weeks and numerous reality checks.

All my gains for the year and then some were wiped out during a few weeks. The deceptive thing about a Martingale is that 99.9% of time it will look good and make money. When you test it, it is likely you won't catch it at its worst. It feeds a sense of denial. In this case results were good for several months before it lost money.

Once it starts losing, the trades become big very quickly. If you happen to be asleep when this happens, you're in for a big surprise as you rub the sleep from your eyes and peer at your monitor in the morning. I know some of you are thinking, "well, duh", and to be honest, knowledge of this possibility was always in the back of my head. I thought since the Martingale was a reversing one and would adjust to volatility I was at least somewhat immune to this. I suppose it could have been much worse with a more conventional Martingale.

Another thing to watch out for is meddling. When things started going bad I slipped into the bad habit of supervising the EA. I would stop trades just before they were about to recover and the net result was usually to make things worse.

Summary



Since that time, I have scaled back use of the Martingale. In some type markets I won't even run it. I also added a non trading window feature to it. Specifically I can set it up to shut itself down at specific times of the day. Now when I go to bed, if there are multiple big financial news reports scheduled for the morning, I set the EA to go inactive before and for sometime after this time to let the associated volatility work itself out.

I sleep better when I know it won't be running at night. It's no longer producing killer returns for me as the volatility will usually make you money, but I don't have to worry so much about the times when it will create losses, either. There's a price to pay for peace of mind. If that means trading less often, I'm all in favor.

Monday, February 20, 2012

EA Trading vs Manual Trading

A client from Malaysia emailed yesterday asking about the merits of trading with EAs. He went through the usual motions of buying "quite a number of EAs [that] promised to make millions and ended up crashing or losing my live accounts." He is not the first, nor will be the last to experience the roller coaster.

He watched a number of videos on YouTube that emphasize the importance of discretionary trading over automated forex robots. They claim, correctly, that a human being understands subtleties that computer programs miss. They then stretch the argument even further and say that EA trading is a fallacy. Given his bad luck, he wondered to what extent that I agree with the argument.

The wrong people are involved in selling EAs (usually)



The argument oversimplifies a difficult concept. Many of you know that I'm a self-confessed math geek. I like numbers. They are logical and they do not vary. What appeals so strongly to me about trading is that you can take a complex process and mold it into a set of logical rules to follow. It's a wonderfully challenging problem. You'll never crack it entirely, but I know from experience that you can develop something that works.

My gripe with most commercial EAs is that the people selling them are not traders. They are internet marketers that stumbled into a highly profitable niche industry. They tick the right boxes for their audience.

Most US forex traders are white men between the ages of 40-65 with an unusually high tendency to earn six figure incomes. The marketing gang knows that themes of financial security and the idea of an job that's not miserable sells well. They focus more on getting that message across than developing a decent product.

EAs are only as good as their designers. OneStepRemoved has designed 1,000+ EAs. I've never seen anyone accidentally program a profitable expert advisor. The ones that do turn out well almost always have years or even decades of trading experience. The rules that they propose usually include subtle distinctions that differentiate between various market conditions and types of volatility.

Those types of people are not marketers. They spent their career trading. It's part of the reason that the meagerly stocked talent pool of traders does not get come into contact with the marketing crew. The other problem is that the guys coming up with strategies worth selling have no incentive to do so.

Unless you're FAP Turbo or MegaDroid, the potential income for most trading robot oriented business is six figures. I've worked with several multimillion dollar trading educators. They seem to do better in the long run owing to the relationships that they form with their customers. They are the exception rather than the rule.

Now look at how much a truly profitable trading strategy can make. Millions. No marketers or affiliates required. No web site. Just a computer and a server. There's no effort required beyond passive monitoring. If you had a trading system that generated blockbuster returns, would you even bother with trying to form it into a business? I wouldn't.

Traders like this do exist. It's just that they're about 0.01% of the trading population. I know this from my brokerage experience because once in a blue moon I fielded their phone calls. They were the perfect clients. They traded all the time, rarely called (only people losing money call their broker) and when they did, it was for some routine matter like withdrawing profits.

The only thing that stood out about them was their account balance. These people are the source of the dream, and they're what keep the remaining 99.99% of algorithmic trading developers going.

Knowing how sweet the setup is if you have something worth selling, and also knowing that the financials really don't make sense for selling a blockbuster system, I honestly would not consider purchasing an EA from the internet. I would never yield control over my account to something that behaves in a manner that I don't understand.

When the drawdown inevitably comes, I would have no way to feel comfortable that the strategy is actually viable in the long haul. I would suspect that the end is nigh and that I better shut down the account before the losses accumulate. How anyone can make an informed financial decision with strictly marketing material is beyond my understanding.

What most expert advisors miss



Trading rules restrict discretionary traders in a way that I find beneficial. It cuts down on their tendency to over-trade, forcing them into situations where patience more often that not wins out.

Todd over at Triple Threat Trading runs a trading education business. He loves to go on and on about how he makes customers quantify their approaches as a set of rules. It's easy enough to lose money in forex or futures.

The rule based approach minimizes those hazards. Following rules eliminates many of the unknown variables from your performance evaluation. Knowing that you followed the rules and still lost reduces the blow to the ego. It's easier to say "the rules lost" instead of "I lost."

The logic naturally flows into the idea of automating the strategy. The chief advantage is that the computer does not fatigue or tire. It follows the rules blindly. So long as a human remotely monitors the execution, the semi-automated approach often works well for established, rule based traders.

Making a trading robot does create new problems like deciding whether to only trade during active sessions or to leave the expert advisor on 24 hours a day. These are usually problems that resolve themselves with a few months of hands on experience.

The main lesson that I learned while running my forex account up this year with a gray box EA is how important it is to stay patient. Most of the systems that I trade personally tend to eat losses way too quickly. I have yet to determine how to quantify patience in trading terms, despite my love for quantifying things.

Certain rules do work dramatically better during different market conditions. The key is to separate the conditions, then apply the strategy selectively. Most expert advisor designers try to develop a strategy that works all the time.

It doesn't work that way. When the EA starts to hit a wall on the design, the trader responds with new additions and tweaks to force the performance to improve the general performance.

What I'm working on now is a set of rules to identify various market types. I like to think of it as "don't compare lawn mowers when it's raining." There's a time and a place for each approach and behavior. The trick isn't so much the rules, but deciding when to apply them.

Categorizing the market helps make the strategy selection process far easier. If the market is highly volatile and ranging, then select a scaling strategy that works well in ranging markets. If the market is trending quietly, then perhaps a basic trend strategy would work perfectly well.

Friday, February 17, 2012

How to handle the Trade Context is Busy error

The trade context is busy error causes nightmares for scalpers and high frequency traders. MetaTrader chokes when they open up too many charts or place too many order. The problems stem from how MT4 processes and receives information from the broker server.

The OrderSend() command, which MQL programmers use to open a trade, also tells the MT4 client terminal to await a server response. Everything locks up. The code cannot do anything until the server permits the client terminal to continue. More importantly, the trading terminal does not allow any additional trades to open.

Example


Consider a scenario where you trade EURUSD, AUDUSD and USDJPY currency pairs on H1 charts. MT4 must await an incoming tick before MQL allows it to make a trading decision. I discussed this issue several months ago with time based orders.

The ticks of multiple currencies often group together during liquid hours. If the terminal receives the incoming ticks within a few hundred milliseconds of each other, MetaTrader creates its own bottleneck.

The AUDUSD tick comes in first. The Expert Advisor sees a trading opportunity and decides to open an AUDUSD trade with OrderSend(). 150 ms later a EURUSD tick comes in and creates another trading opportunity. The EURUSD EA, which runs on a completely different chart, is not allowed to trade.

Retry delay for Trade Context is Busy


Our Expert Advisor programmers check for "Trade Context is Busy" errors before sending orders to the broker. When the situation exits, the EA checks the trade context every 50 ms up to 50 times.

It is not uncommon for MetaTrader orders to take a second or more to execute. The original AUDUSD trade from our example is still hanging out there. The EURUSD EA enters a 50 ms cycle where it constantly asks, "Did the trade context open up?"

Then the USDJPY tick comes in 70 ms after the EURUSD tick. USDJPY encounters the same trade context issue, kicking it into a separate, "Is the trade context busy" loop.

When the AUDUSD trade finally executes, it leaves the EURUSD and USDJPY expert advisors in a frantic race to discover the newly opened trading window. The first EA that discovers that the trading context busy error disappeared will send its request first. The second EA, unfortunately, cannot communicate with the first. Although the second EA will discover that the trade context opened up, it will receive a trade conext is busy error when it attempts to trade; the firs EA already sent a trading request. The second expert advisor allots itself a maximum of 10 failures before it gives up on the trade.

Assuming that the EURUSD discovers the new trading window first, then the USDJPY receives its first failed order attempt. The USDJPY once again inquires about the trading context every 50 ms. The EURUSD trade eventually executes, allowing the USDJPY to finally enter the market.

Most of our customers never notice this delay, which means that we did our job. There is, however, a breaking point where MetaTrader simply cannot issue enough orders at the speed the trader desires. Any combination of charts where 10 or more orders go off near-simultaneously will result in missed trading opportunities.

MetaQuotes designed MT4 with the trade context error in order to limit the processing requirements of the brokers. As I've stated repeatedly, the brokers get MetaQuotes' preferential treatment because they are the ones paying MetaQuotes' fee. MetaTrader is not a high frequency trading platform. It's not in the broker's interest to support high speed trading. It usually opens them up to too many traders taking advantage of arbitrage opportunities.

Friday, February 3, 2012

High Frequency Forex Seminar

One exciting opportunity popped up while I'm in Dublin, Ireland, next week. Best of all, it's free and open to the public. If you're in the western Europe and would like to discuss trading in person, I'd love to meet you.

Trinity College Dublin invited me to present a graduate level seminar to MSc students in Finance and Alternative Investments on Wednesday, February 8, at 6 pm. The seminar will be hosted in the MBA room, which is on the second floor of the business school. The topic will be high frequency market making in forex.

Topics for the high frequency forex trading seminar (about 10 minutes per subject):

Market making versus price taking
Comparing frequency to expectation. The more you trade, the more you make
Liquidity risks and self-feedback loops
Technical approaches and limitations

Backtesting for Efficiency

Your forex backtests are absolutely worthless if you do not test the statistical entry efficiency and exit efficiency of the strategy. Everyone that runs a backtest inevitably reports the dollars earned as the outcome. Other factors exist like the average win to loss, the profit factor and the Sharpe ratio, but they do not tell you anything useful until the final step of designing an automated trading system.

The correct approach to testing a strategy should focus on the question, "is my strategy a piece of garbage?" Most people try to prove themselves right. The real test is to not be able to prove yourself wrong. The only way to do that is through a statistical approach.

Entry and Exit Efficiency

Efficiency puts a hard number to what percentage of an available trading range that a strategy captures. The trading window starts on the bar where a trade entered the market. The window closes when the trade exits.

The total available window is the highest high minus the lowest low in the window. Calculating the entry and exit efficiency simply measures what percentage of that window that your strategy tends to capture. Take the average of all of the trades and you get the overall efficiency.

Entry efficiency formula

Formula for a long trade: (Highest high - entry price) ÷ (Highest high - lowest low)
Formula for a short trade: (entry price - lowest low) ÷ (Highest high - lowest low)

Exit efficiency formula

Formula for a long trade: (Exit price - lowest low) ÷ (Highest high - lowest low)
Formula for a short trade: (Highest high - exit price) ÷ (Highest high - lowest low)

Take an example where you buy a hypothetical currency at 150 and sell it at 170. The lowest low between the time of entry and exit was 140. The price then ran all the way up to 200 before settling back down to 170, which is where the exit took place.

The entry efficiency is (200-150) ÷ (200-140) = 50 ÷ 60 = 83%. Nearly anyone would agree that this makes for a great entry.
The exit efficiency is (170-140) ÷ (200-140) = 30 ÷ 60 = 50%. Most would agree that the exit would have ideally occurred sooner than it did.

Efficiencies do not change by instrument or time frame

One major problem that we encounter with forex backtests is the limited data set. This is especially true for those interested in testing long term strategies like those on the H4 or D1 charts. The wonderful thing about entry and exit efficiencies is that they do not vary from chart to chart or even period to period.

I like to jump down to M1 charts for efficiency testing. The data is nearly endless. I never have to worry about running out. The great thing is that I know when I shift back to the H4 chart, the efficiencies should not change more than ±5%.

If you see the efficiency vary too much, then you may not have enough trades to form a statistically significant group. My experience tells me that 75 trades usually gets very close to the actual efficiency. 100 trades or more is better. When I run tests on M1 charts, I often get several thousand trades over the course of a few months. Numbers that large can tell you with a great deal of confidence just how robust a strategy's parameters truly are.

Usually, you can assume that any results that fall within 45-55% are the result of a random, stochastic process. When I see backtests that creep right up to those barriers like 54.9% or even 55.1%, the results inevitably tank back to around the 50% mark.

Random trade outcomes and dollar profits

I wish this section was about how to make money with a random efficiency. Alas, we must cover how randomness can result in unjustified eurphoria.

I've been interested in the concept of randomness for several years now. Mathematicians refer to it with the more opaque name of a "stochastic process". Despite the non-sensical name, it's just a fancy way of saying the study of randomness - how it changes, its distribution, how far it "walks", etc.

Yesterday, I used the analogy of coin flips to describe how Martingale strategies are probabilistically doomed to failure. One interesting concept that I did not mention relates to Brownian motion. Even with a set of random outcomes, trades will go on a random walk away from the starting point.

Einstein gets the real credit for solving the math behind the concept, even though his name is not on the term. He demonstrated that the distance a random process will follow is the square root of the number of trials. If we decide to flip a coin 60 times, we know that 50% of the time should fall on heads and the other 30 on tails.

It actually turns out that we should expect a very slight bias in the number of either winners or losers, although we do not know which one. It's random. The precise bias, whichever way it prefers to go, should equal √60, which works out ~7. The heads outcomes should typically range from 23-37, with the tails outcomes making up the difference.

Seven trades out of sixty strongly alters the percentages, even if we know that it's really supposed to be 50%. If heads only came up 23 times out of 60, that's 38%. The problem is not with the coin. It's with the number of trials. As you do an increasing large number of trails, the random bias decreases in significance in terms of the percent accuracy. 50,000 trades, for example, should show a surplus of roughly 223 trades in favor of winning or losing. The accuracy range falls within 1% of 50% on either side, a dramatic improvement.

Risks of curve fitting

Curve fitting a random efficiency relates to the idea of Brownian motion. Let's say that we use a strategy that I know will never show an entry or exit efficiency: the moving average crossover. I've gone through this strategy six ways from Sunday, almost exclusively at the behest of clients. It does not work as a fully automated strategy. There is no secret set of fast and slow periods that will unlock the hidden keys to profit.

Most traders, experienced or not, abuse the backtester by searching for a set of parameters that yield the most dollar profit. They curve fit their test to optimize for maximum profit. What really happens is that the traders optimize for amount of random drift that already occurred.

When I used the example of 50,000 trades creating a natural drift of 223, I cited it with the purpose of showing how little it reduces the error in the real percent accurracy. The other consequence for trading systems is that as the error percentage decreases, the natural bias in your outcomes increases. Blindly running the optimizer only selects the set of combination that yields a combination of two criteria:

  • The drift that happened to work out in favor of that set of parameters
  • The profit and loss that varies with those parameters. The dollar profit naturally changes because the two moving averages cross at different points

You need a tool like efficiency to guard against these types of random outcomes. It's the only method that I know of that definitively states whether or not a strategy behaves in a random manner. I especially like the fact that it breaks those elements down into two of the three basic components of a trading strategy: the entry, the exit, and the position sizing.

Efficient strategies do not work all of the time

Position sizing marks the final obstacle to building your fully automated trading strategy. A set of rules that yields a statistically efficient entry that is paired with an efficient exit does not necessarily make money. The value of each trading setup can vary, too.

Each strategy contains different sets of winners and losers. Each winner and loser varies in its dollar value. Whatever money management approach that you take requires balancing the ratio of the winners and losers in a way that normalizes the outcome of each trade. You ideally want to eliminate the variation in dollar value. 20 pip trades should earn or lose you exactly as much as the 100 pip trades.

That seems counter-intuitive. Most traders want to win in proportion with the size of the opportunity. It's better from a system perspective to entirely ignore the size of the opportunity and to make each trade worth the same amount. Betting more or less with each trade effectively normalizes the value of each trade.

Using a stop loss stands out as an obvious candidate to fix how much a trade is worth. The severe disadvantage is that it almost always negatively affects the exit efficiency. Whenever I can get away with it, I always recommend using a market based exit instead of an arbitrary stop loss. Traders usually scream at the top of their lungs when they hear me say this. I'm just speaking as a systems developer. The numbers are what they are.

Monday, January 30, 2012

Martingale Strategy

Fear constitutes the strongest emotion facing any forex trader. Fear of losing, in particular, keeps many in bed with one eye on the monitor while the other rests. Martingale strategies theoretically remove that problem by ensuring that a strategy always comes out on top.

The idea is to bet more after a loss, usually twice the amount of a previous bet. Let's do an example where the value of winning and losing is identical. We either win $10 or we lose $10.

The first bet puts $10 at risk. We start out on a run of bad luck, resulting in a $10 loss. Now we double the risk. We either get paid $20 or will lose another $20. We lost again. So far we are down $30. We double the risk again, so now we're either going to make $40 or lose another $40.

So far the strategy doesn't seem that bad. 3 losses in a row only occurs 12.5% of the time (0.5 * 0.5 * 0.5). This is as bad as it gets the majority of the time. But, for the sake of the example, let's continue.

We lose again. Now we're down $70. Double the risk to either make or lose $80.
Another loss. The floating loss grows to $150. The risk grows to $160.

You're no doubt noticing that the risk numbers are getting a little more uncomfortable. For the sake of making it clear how quickly they can get out of hand, I created a small table below.

Consecutive lossesFloating loss
6-$160
7-$320
8-$640
9-$1,280
10-$2,560

However, if tenth trade rescues the account, you earn back everything that you lost, plus the $10 that you originally attempted to earn. Although you sweat bullets during a cold streak, the strategy comes out on top the vast majority of the time.

Here is where the problems start to roll in. I did not say all of the time. In the real world, you do not have an infinite supply of money. If you have a $5,000 trading account and risk $10 on the first trade, then you can only withstand a maximum of 10 consecutive losses; you don't have enough money to make it to the 11th loss.

Measuring the payout of a Martingale strategy


Consider a game of coin flips where heads means that you win and tails means that you lose. The odds are 1:1, 50%, that you will win or lose on any given flip. Although the probability of winning remains constant at 50%, the actual distribution of those wins and losses will come in the form of hot and cold streaks. Tossing the coin ten times does not always result in 5 winners and 5 losers.

Throwing a coin 10 times will result in 10 consecutive wins 0.09% (0.510)of the time. Conversely, 0.09% of the time also results in 10 consecutive losses. So, the coin flips results in behavior that looks anything like a random outcome 0.18% of the time. The scenario that keeps us up at night - fear in forex trading never goes away - is that that unlucky streak of 10 winners will actually come to pass. 0.09% of the time occurs once in every 1,111 trials.

The next question to consider is the number of wins required to make this worthwhile. Everyone's goal post is different, but it's safe to assume that doubling the account balance makes anyone a happy camper. Earning $10 for a total of $5,000 means that you must have a total of 500 winning Martingale sets. Each set is the group of trades required to earn that $10. Sometimes, the first trade wins and that finishes the set. Sometimes it takes 7 trades. Sometimes (gulp), it takes 20.

500 winning sets requires 1,000 total trades. We get this number by dividing the winning sets, 500, by the probability of winning, 0.5. If the closeness of that number to the scary threshold of 1,111 jumps out at you, it should.

Remember that the evil 10th consecutive losing trade could possibly occur at any point at or after 10 total trades. It could occur after 100 trades or, very rarely, after 10,000 trades. On the whole, it will occur 0.09% of the time, although it will randomly cluster. No method exists to predict where.

Think of the issue graphically. Our hurdle of 1,000 trades to double the account constitutes the danger zone, or the bad space. The safety zone is only the total trades at risk, 1,111, minus the benchmark of 1,000, which is a safety zone of 111.

A graphic of the area of danger and safety within a Martingale strategy

As the sea of red danger zone relative to the green safety zone makes clear, the odds of coming out on top are not exactly in your favor. Specifically, you face a 90% chance of blowing up against a meager 10% chance of doubling your money.

Look for more fertile strategy strategy ideas and money management techniques. I like the simplicity behind Martingale, but that's about it. A simple mathematical analysis tells you that it's not going to end well the vast majority of the time. If you wish to continue a Martingale trading strategy, it only gets worse from this point forward.

Other Martingale problems



The odds are not really 50%. We assumed that the price either goes up or down. We forgot to consider the spread. Pairs like the EURUSD show a typical spread of 1.0-1.5 pips at most reasonably priced brokerages. That, unfortunately, affects the probabilities. The price must move an additional 1.5 pips to reach the exit point.

A Martingale system trading a 10 pip interval now must earn 11.5 pips to cover the 10 pips it risks. The wins will only occur 46.51% of the time instead of the theoretical 50%.

Moving the size of the pip interval does help bring the probability closer to 50%. A 25 pip interval achieves 48.54% accuracy, while a 50 pip interval yields 49.46% accuracy. Going further and further up the ladder gets closer and close to 50%. It never quite gets there, though.

The other assumption that we made is that markets are akin to tossing a coin. Well, that's definitely not the case. Although markets exhibit a high degree of randomness, they do show periods of time where they are distinctly non random. They are, in fact, fractal. Mandelbrot enjoyed stumping on the fractal nature of markets at every opportunity. The assumptions that we made with the coin tossing analogy do not always apply. I strongly recommend reading The (Mis)behavior of Markets if you're interested in a layman friendly explanation of the topic.

Thursday, January 26, 2012

Robust Expert Advisors

When you want to program an Expert Advisor, it is important to consider how you are likely to use the file. The most common mistake that I see new MQL programmers make is that they rely too heavily on memory. Events like a power failure, a hard drive crash or weak internet connection can wreak havoc when trading with an Expert Advisor. The EA should ideally be able to pick up and run whenever you are able to restore conditions to normal.

Memory issues


Problems sometimes result from something mundane like changing the settings. I learned that the hard way when a client came to our Dallas office for two weeks to order a very complex EA. Everything worked perfectly in the backtester. The overnight tests, however, never lasted for more than a few hours before something went haywire. I instructed the client not to change the settings; just turn it on and leave it alone. For whatever reason, the importance of those instruction never sank in. It took me ages to realize that his definition of "leaving it alone" didn't quite mesh with mine. The little tweaks that he made during trading messed with the settings that I stored in memory.

I can instruct a client to use software in a certain manner. More often than not, they deviate from the instructions to some degree. It's human nature. I learned from those challenges, like any professional should. Our programming templates changed in structure to minimize the need for special instructions.

Global variables


Global variables are a common tool to avoid the issue of relying on memory. When an EA is removed from the chart, the global variables that it created are accessible for you, the EA or any other EA to read from anywhere inside of MetaTrader.

Although the use global variables sounds sophisticated, it's actually a very simplistic approach. MetaTrader maintains a hidden text file in its installation directory with the variable name, the value that it is storing and the time it was last modified. Whenever more than 6 weeks elapsed since the last time MQL used the global variable, MetaTrader automatically deletes it.

A Martingale system might opt to use a global variable to track a simple statistic. Martingales are wild with their approach to risk, so a trader could realistically want to know at a glance the maximum level traded. Global variables make a trivial task out of that need. If the next level to trade is greater than the global variable, then the MQL code should update the global variable.

The only item to remember is that the global variables expire after six weeks. The EA might need to refresh the information by resetting the global value to its current value. Doing so would keep the variable fresh from MetaTrader's perspective.

A screen shot of global variables in MetaTrader 4

Read information instead of storing it



I prefer to rely on MQL's OrderSelect() command to recreate whatever information I need. Although it is more complex, the advantage is that the EA can function any time, any place, exactly as designed. If the hard drive crashes, it's not a problem from a recovery perspective. You are still in trouble during the down time, though. You can load the same EA on your MT4 account and have it immediately reconstruct the information.

Taking the above Martingale scenario, we could reconstruct the number of levels traded by comparing the open and close times of trades. If trade #1 has a close time of 2011 Dec. 5 00:00 and trade #2 also has a close time of 2011 Dec. 5 00:00, it tells us that they are part of the same trade group. So far, we have 2 levels traded. If trade #5 closed at 2011 Dec. 5 00:00 but no trades did thereafter, then we know that we traded 5 levels total. The EA can then loop through all possible combinations and pick out the highest number from that.

The approach of reading from the order history is a bit of overkill for this simple example, but it comes in handy when you need to calculate more complicated information dynamically and with a minimal risk of error.

How Backtests Simulate Ticks

One common issue that comes up with backtestingis that it often does not match what happened in the real market. This isn't really a deficiency, at least from the perspective of your charting provider. It relates more to the data provided. Inaccurate historical backtests come up in any charting package, including NinjaTrader and MetaTrader.

Consider a typical bar. It has a high, low, open and close. That's only 4 data points. If you're looking at something like an H1 bar, there could be several thousand ticks - maybe tens of thousands of ticks - that comprise that entire bar. And you're trying to encapsulate it by only referencing 4 points.

MetaTrader brokers in particular do not want to provide tick data. The sheer volume of information would put a lot of strain on the servers. The brokers are the ones paying MetaQuotes for MT4. Their concerns go ahead of you as the trader. Thus, no tick data is available unless you go to a ton of extra effort.

That leaves the backtester guessing what should have happened at all of the points in between. Strategies that trade intrabar or EAs that place the stop and take profit so closely together that they might get hit on the same bar are particularly vulnerable to bad assumptions.

Example:

You placed an order to buy a forex pair at 100, which is also the open. You set the take profit at 105 and the stop loss at 97. The low of the bar is 96, the high of the bar is 110 and the close is 102. Is there any way to know whether the stop loss or take profit hit first?

No, you cannot tell. The price might have fell from 100 down to 96, climbed up to 110 and then fallen to 102. Alternatively, it may have climbed from 100 to 110, then fallen to 96, then climbed back to 102. More than likely, the price followed a complex path that vaguely resembles one of those paths.

MetaTrader and NinjaTrader have no way of knowing which answer is correct. They do their best to work around the gap in knowledge. NinjaTrader simply assumes the worst case scenario, which is probably the best policy to avoid false positives. If a stop or take profit both hit within a bar, then NinjaTrader assumes that the stop loss was hit first. There are no exceptions. The slightly good news is that if your NinjaTrader backtest looks abysmal and faces this issue, it may not be as bad as you first thought.

MetaTrader approaches the backtest assumptions differently. It tries to build the path of the bar by inferring from the relationship between the high and low and the open and close. If the bar closes up, I believe that MetaTrader assumes that the low comes first, then retraces up to the high of the bar before settling back down to the close. I don't have a theory on the algorithm that powers what happens in between; it's usually not relevant. If your stops and take profits are so close that the up/down bar assumption cannot sort it out, then no amount of backtesting will provide an accurate answer until you finally import tick data.

The spread at the time of entry, and thus the cost of trading, are also unknown. This can heavily distort the results. MetaTrader makes assumptions about the spread. Although it generally reflects the average spread, it's a safe bet that it does not reflect the actual spread at the time you traded. Whether or not the assumed spread works out in your favor over hundreds of trades varies from Expert Advisor to Expert Advisor.

NinjaTrader can work around the tick assumptions, but you must anticipate it within the strategy's programming. I plan to write a future blog post that will explain how to force NinjaTrader to use tick data for both the bid and ask to generate accurate backtests in NinjaTrader.

Wednesday, January 25, 2012

Iran's Ahmadinejad ups rates to stem money crisis

http://www.reuters.com/article/2012/01/25/us-iran-economy-rates-idUSTRE80O0V520120125 (Reuters) - Iran increased bank interest rates on Wednesday and indicated it would further restrict sales of foreign currency, hoping to halt a spiraling currency crisis after new Western sanctions accelerated a dash for dollars by Iranians worried about their economic future.
"The economy minister has announced that (Iranian President Mahmoud) Ahmadinejad has agreed with the approval of the Money and Credit Council to increase interest rates on bank deposits to up to 21 percent," the official IRNA news agency reported.

Thursday, January 19, 2012

EES VPS for Forex Traders

Elite E Services offers Virtual Private Server for Forex traders, close to our EES FX Trading Environment (in the same data center) as well as a CNS bundling package for premium accounts.

To learn more, visit: http://eesfx.com/portal/trading/vps

See bundling info at CNS: https://cp.commercialnetworkservices.net/announcements.php?_m=news&_a=viewnews&newsid=31

http://helpdesk.commercialnetworkservices.net/index.php?_m=knowledgebase&_a=viewarticle&kbarticleid=195

EES also offers dedicated servers for professional traders at http://fxsystemhosting.com

Wednesday, January 18, 2012

Local currencies: 'In the U.S. we don't trust'

NEW YORK (CNNMoney) -- It may seem like Monopoly money to outsiders, but a growing number of communities across the U.S. are using homegrown local currencies to stimulate their economies and protect themselves from the nation's broader economic woes.
While there were only about 20 active community currencies in the United States in 2009, there has been a recent resurgence, with at least a dozen communities developing their own currencies in the past couple of years, estimates Loren Gatch, a professor of political science at the University of Central Oklahoma who researches these alternative currencies. In addition, currencies that have been around for years have seen a spike in interest, with membership doubling in some cases.
http://money.cnn.com/2012/01/17/pf/local_currency/index.htm

Friday, January 13, 2012

EES Article FX Trader Mag

See Elite E Services recent article in FX Trader Mag - registration is free and you can download online.

"Expert Advisors and Retail Forex"

Also EES recently was published in Stocks & Commodities magazine (January, 2012) "A Practical Guide to Forex Arbitrage"  see an excerpt here: http://www.traders.com/index.php/sac-magazine/current-contents/forex-focus