The full title of this book is Optimize Your Trading Edge: Increase Profits, Reduce Draw Downs, and Eliminate Leaks in Your Trading Strategy by Bo Yoder (2008).
The key idea of this book is that all strategies work, but only some of the time. So what is needed is to identify when a strategy alternates between its payout / payback cycle and reduce your risk exposure during the payback period.
Two other major ideas include: (i) it is better to go for low accuracy / high reward-to-risk ratio strategies, as opposed to high accuracy / low reward-to-risk ratio strategies, and (ii) analyze the crowd when reading charts and pay attention to the market’s reaction at points where you expect large order flow to come in.
These are all good points highlighted by the author, and should help to improve your trading edge. Overall, I think this book is a good read. The writing is clear, not overly verbose, and the key points are well presented. Coming in at 200+ pages, this can also make for a quick reading.
The book comes with some spreadsheets that you can use to plot your equity curve to help identify the payout / payback cycles. Those are available after signing up for Bo Yoder’s mailing list @ http://www.boyoder.com/events.html.
Analyze Your Trading Systems from a Cyclical Perspective
- For every style of trading, there is a payout / payback cycle where there is a natural constant shift from market alignment to market misalignment.
- Focus on strategies that (i) stay in the payout phase most often, and (ii) offer the most accurate payout / payback cycle predictability.
Identifying and Reacting To Your Payout / Payback Cycle
- Calculate your expectancy per trade.
- Analyze your trading log to identify the sine waves of payout / payback cycles with respect to your baseline profit expectation per trade.
- Identify any keystone event that tends to precede a change in the cycle.
- Reduce your trade frequency and aggressiveness during payback periods.
Risk Management and Position Sizing Using the 10K Rule
- Determine 1 unit of risk
- 1 unit = the amount ($) of risk taken for a position.
- Set 1 unit in a way such that your account would be wiped out if your strategy experiences its worst draw down ever for 3 consecutive times.
- Express the worst experienced draw down of your particular trading strategy in terms of the number of risk units lost. Multiply that by 3, and equate that to your account size to back out the dollar value of 1 unit of risk.
- Monthly cap
- I don’t care to expose myself to more than a 10% draw down on my equity in a given month.
- Intraday Trading
- Most day trading strategies produce 10 to 20 units of profit during their payout cycles, and 5 to 10 units of loss during payback.
- I tend to risk 0.25% to 0.5% on my intra day positions.
- Swing Trading
- Swing trading strategies tend to produce 5 to 8 units of profit in payout, 3 to 5 units of draw down when in paycheck.
- I tend to size my swing trades for a 1% risk.
- Expected Return for Risk Taken
- For every $100 risked on an average trade, a skilled professional speculator should expect to realize approximately $10,000 in income per year. [My note: This means that if $100 is 1% of equity, you would expect to make 100% of your equity per year.]
Analyze Negative Excursion to Determine Stops
- Measure the average negative excursion of your trades to determine the stop-loss level that will deliver the % accuracy rate that you require.
Go For Low Accuracy High Reward-Risk Strategies
- The majority of traders spend enormous amounts of time and money searching for ways to increase their accuracy, failing to realize that they could dramatically increase their bottom line by focusing the same amount of energy on increasing their average risk-reward ratio.
- A trader must be willing to accept the more volatile equity curves that a low accuracy/high risk reward trading model delivers, but the added profitability at the end of each quarter should more than offset any mental stress.
- As is often the case in this perverse business, the biggest edges and most dramatic profitability come from the low accuracy/high risk-to-reward trading strategies.
- Develop edges built around the market open, around the market close, around seasonal tendencies, and the relationship of stocks in similar sectors.
- Minimum Profit Objective (i.e. minimum reward-to-risk ratio) = (100 – Win Rate) / (Win Rate). The statistical break even win rate for a 2:1 trading strategy lies near 34%.
Explore Entry Upon Qualification to Improve Your Reward-To-Risk Ratio
- A common strategy is to identify a trade as a qualified candidate, but only enter when the stock crosses a trigger level (e.g. break above the previous day’s high).
- Analyze how much your accuracy would suffer if you had entered the trade as soon as you identified it as a qualifying pattern, and how much your reward-to-risk ratio would increase (since your entry price would be better, so your risk is lower and your reward is higher). Then calculate your trade expectancy and compare with your previous system to see if the increase in reward-to-risk would more than offset the decrease in accuracy.
Pyramid When Market Offers Enhanced Reward-to-Risk Scenario
- Once in a great while, support will be retested and a double bottom reversal pattern will form. These situations, although rare produce nearly twice the average follow-through, and therefore justify some additional risk exposure.
- When double bottoms show themselves, plan to exploit the additional edge by doubling your position size. Although you will lose twice as much if these re-test positions fail, you will capture nearly six times your average gain when they succeed.
Pyramid When Market Confirms Your Original Position
- When you achieve a good entry that quickly turns to profit, and price action allows you to reduce your stop size to half its original level, you can double your position size such that your net exposure to the trade remains nearly the same. This doubles your upside potential while maintaining your original dollar levels of risk.
Handling the Three Forms of Selling That Occurs to a Stock
- Selling due to trend change and unwinding of profitable positions
- Trade stock with a short bias
- Selling because resistance levels are being challenged and positions are being lightened or exited
- Trade stock with a long bias
- Buy continuation patterns to follow the trend
- Selling because a chart pattern has failed and stop-loss orders are being triggered in the market
- Either do a scalp trade on the short side
- Or “fade” it by going long after price action indicates a rinse job
Always Analyze the Crowd When Reading a Chart
- The majority is always wrong, the market will always move against the directional opinion of current consensus.
- When looking at a chart, always determine based on the recent history of the price, (i) what constituencies (i.e. types of traders) are in the market / on the sidelines, (ii) where did each constituency enter / exit, (iii) where are the crowd’s psychological trigger points and stop-loss levels likely set?
Observe How the Market Reacts to Surge in Expected Order Flow at Key Spots
- The 20-period EMA often provokes a surge in order flow because the majority of traders watching the market have trading strategies built around this purely technical level. When it is tested, it is guaranteed there will be a surge of buy orders entering the market. The public has been taught that buying the pullback to the 20-period EMA is the “holy grail buy signal”.
- These pullback setups offer the savvy speculator a chance to observe how the market reacts to surge in bullish order flow. If the market reverses, and gives every indication that support is manifesting itself, then an entry can be taken on the assumption that the trend is about to resume.
- Another common crowd trigger point is seen when the market breaks out to a new high or low. Since you can count on a ton of buy signals bringing bullish order flow into the market any time a stock breaks out, the informed speculator can sit back and take entry based on how the market reacts to the crowd’s order flow.
- Sometimes it is best to align your position with the herd, but fading the crowd is another strategy that can offer rich rewards to the chart reader who waits to see how the market will react to the increase in order activity.
Gopher Trades – Trading Breakout Failures
- Breakout failures are like the “Whack-a-Gopher” game, and are better trades compared to trading with the crowd.
- When you trade a breakout in the traditional manner, you are “hoping” others will take the same action and ensure your success.
- When you trade a breakout failure, you just need traders to react in fear and cut their open positions. You rely not on hope but on the clear human psychological need to avoid pain. Hence this trade offers an increased accuracy rate.
Magnet Trades – Trading Between Liquidity Pools
- Markets are drawn toward areas of high liquidity. The “magnet trade” is essentially ping-pong movement between two liquidity pools. The area between two areas of dense liquidity, is an “air pocket” of illiquidity.
- E.g. say the market forms a base near highs or pennant pattern on its intraday chart. There is also an area of resistance overhead in the form of the 200-period SMA.
- To take advantage of a magnet trade, initiate a position after a test of range lows. Set your protective stop-loss order at an arbitrary level (e.g. average width of the last 10 bars) far enough below the lows of the range to avoid any whipsaw losses due to “normal” volatility. Set a limit order to take profits just below the 200-period SMA.
Control Your Stress With High-Intensity Physical Activities
- When my trading made me feel stressed, I did exactly what my body expected me to do … fight or flight! Just find some high-intensity physical activity that will increase your heart rate and burn off the increased blood sugar and glycogen from your muscles (just a couple of minutes is sufficient).
- Not only will it help your physical and mental health, but you’ll be surprised how focused your trading will become. The mental errors and outright mistakes that are common in the beginning years of your trading career will vanish and your precision in execution and attention to detail will dramatically increase.