I should have updated the blog on Monday, as (EFU: 177.11 +12.57%) stopped out just 46 cents from the low of the day. Instead, I spent the better part of the evening planning my revenge on the @#^& Pacific Exchange lowlife who filled my purchase of EFU at $163.92. 

Had EFU not stopped out, the position would be getting closed out tomorrow, as the RSI(2) closed today well above 80. The gain would have been approximately $2,000. If anyone out there took this trade and is still in it, be careful with any market order to sell on the open. My advice would be to try a limit order, or to wait a minute or two after the open, while closely watching the bid/ask spread.

The bright side of this trade was that I stayed in it, even after my egregiously bad fill. If I can sell the position tomorrow at a price close to this evening’s close, I will still pocket 14 points. Not bad for a trade that went against me by 15 points on the first day.

I will make the final decision over the weekend, but I am leaning heavily towards making all future trades of the Big Bamboo with an 8% stop and 2% risk. The 4% stop is too tight, even when on the right side of the trade from the get-go.

Special Note: Try out the new Disqus comments format. I plan to put up a poll in the near future to see if you all like it better, or not.

This system has been stopping out of many trades over the past month. These trades would have been profitable had a looser stop been applied. BHH suggested that the best stop should be developed independently of the equity curve. Once the optimum stop has been identified, position-sizing would then be used to create the equity curve that is consistent with one’s goals, psychology, and tolerance for risk.

The above stats compare the basic system, which uses a 4% stop with 1% risk per trade against an 8% stop and 2% risked per trade. When using a percent-risk formula for position-sizing, a larger stop means a smaller position. We know that a larger stop is needed to adapt to the increased volatility. The 8% stop with 2% risk accomplishes the goal of increasing the win percentage while maintaing a nice equity curve.

I included commissions of 1 penny per share, and .2% slippage on each trade. The 8%/2% model increased the win percentage to 76%, which is a significant improvement over the 4%/1% model. The drawdown increased minimally. CAGR climbed to a phenomenal 131%.

Note that the statistics above cover only 1 year of data.

The equity curve shows that both models track very similarly until volatlity increases. Once the increased volatility takes hold, the 8% stop continues to perform well while the 4% stop model begins to suffer.

Draw Down Percentage from Highest Equity is also promising. While the 8%/2% model has a larger draw down between trades 58 and 66, note that the 8% stop has completely avoided the draw down in which the 4% stop is currently languishing.

I’m seriously considering changing the Big Bamboo System to an 8%/2% model, but I have a strong feeling that as soon as I do, volatility will taper off, and the change will have been unnecessary. If any changes are going to be made, I will likely decide after this week.

I have to say that was not how I intended to hedge my longs.

I think that the Big Bamboo has racked up another loser, as it appears that EFU stopped out, having surpassed the 4% stop by about half a point.

For those of you who took this trade and didn’t get screwed by the market makers, It looks good going into tomorrow.

I’d rather be wrong once, than wrong twice. And that kind of sums up my thoughts about getting long Friday. I’ll explain more about what I mean by that a little later. But first, I want to talk about this spreadsheet.

This sheet is similar to one that I use to analyze my long or short positions. The equity represented is not the equity represented in my account, although the relationship between the positions, sizes, and stops is accurate. The point is to understand how a percent-risk method operates. These positions were purchased using 1% risk and a 1.25ATR(10) stop. That means for each position, $500 is being risked, and the stock will be allowed to move .25 more than its average daily range before it stops out.

Looking at the Cost column shows that the more volatile issues, such as Dollar Tree, Inc. (DLTR: 38.53 -3.68%) and Bucyrus International, Inc. (BUCY: 25.18 +0.72%) , were purchased in smaller amounts. As DLTR moved over 4% against me, a smaller position helped to mitigate the pain. The most important thing I see is that 4 of 5 positions still have a ways to fall before they will stop out. It makes sense to let them trade for another day.

————————————————————————————-

Trying to guess the direction of the markets can be a foolish pastime. I started some long trades Friday, after believing Thursday’s action was bullish. I was guessing that the bullishness would follow-through. And I was wrong. So what am I going to do? Nothing at this point.

If I override my stops, or close the positions out, then I am guessing again that the markets will continue down. That could compound my first error doubly, if I am wrong.

All of the charts of the stocks I bought are still bullish. My stops are set (see spreadsheet). If every position stops out (5*.5%), I am out 2.5% of total equity, as I am only risking .5% of total equity on each position (the spreadsheet shows a risk of 1%). It makes sense to give these positions some time, and not make another emotional trade.

The other alternative to re-adjusting the longs is to hedge. And that is exactly I want to do by taking the latest Big Bamboo System pick. My hedge position will be about half the size of my long positions. As the system pick is a diETF, it does not need to be as large as the combined long positions.

Highlighted in a pleasing green hue is the Big Bamboo selection for Monday. I have included some recent studies below, for review.

Big Bamboo, Analysis of Trade Drawdowns

Big Bamboo, Refining Stop Strategies

Big Bamboo: The Esoteric Art of ATR Stops

In light of recent studies, the Big Bamboo will continue to use a 4% stop. However, I have a new study completed which shows the equity curve using 8% stops with 2% risk per trade vs. the 4% stops with 1% risk. It is very interesting. I’ll have it published soon.

As I have some long exposure that I would like to hedge, I will be taking this trade tomorrow.

My gut reaction about today says that we have seen the first day of the best rally since the March-May rally. Since my systems are not giving any signals here, I’m going to have to make some discretionary purchases.

The following stocks are some of the ones I’ll be taking positions in. You might notice there are a variety of bottom, breakout, and pullback plays.

Technically speaking, across the indexes, today was beautiful. I feel strongly that today was a very powerful reversal.  If you want a good look at why the reversal today has me so excited, take a look at the work WeeklyTA is doing over in the Peanut Gallery.

Apollo Group, Inc. (APOL: 70.56 +3.69%)

ATR% 6.00

Bucyrus International, Inc. (BUCY: 25.00 +16.01%)

ATR% 14.4

Dollar Tree, Inc. (DLTR: 40.00 +6.87%)

ATR% 6.00

Hawaiian Electric Industries, Inc. (HE: 27.55 +4.75%) This one is for Gio!

ATR% 4.1

LHC Group, Inc. (LHCG: 32.85 +4.85%) One of my systems picked this one last night, as well as Almost Family, Inc. (AFAM: 49.65 +11.95%) . It seemed like sure death to buy these on the open, so I didn’t. You win some and you lose some.

ATR% 6.5

(TBT: 63.20 +4.64%)

ATR% 3.5

I have listed the ATR% after each chart. This percentage is the volatility normalized so that each security can be compared to the other, in terms of volatility. To use this percentage, think about it this way. Buying 10K of BUCY and 10K and TBT is not equal, in terms of volatility. BUCY is more than 4x as volatile as TBT. If I want to keep my risk on each position to a certain percentage of equity, then I will have to set a larger stop on the more volatile issues. Therefore I would be buying fewer shares of BUCY in order to give it more room to move while still risking the same amount as on the other positions.

Believe it or not, there are still some great short setups out there. In order to find these, do not look in sectors that have been beaten down for the last 9 months. Instead, look to a sector such as Oil and Gas, which has recently rolled over, to find some stocks with some good downside juice left to be squeezed.

Petrohawk Energy Corporation (HK: 14.55 0.00%) is one such stock. Note the interaction between the peaks and the major moving averages. Also note how the stock is in a downward channel.

Getting short 3 days ago, at the 3rd failed attempt to regain the 50 day moving average, would have been about as perfect an entry as one could hope for. There is a divergence in the MACD, Stochastics had already rolled over, and volume has been weak as the stock tried to come off the bottom.

The criteria above make for a very reliable way to profit from shorting stocks. If one is patient, and searches charts of recently beaten down sectors, he will find that these setups appear frequently.

Frankly, I miss the days when it was easy to make a buck by playing momentum. Stocks that were going up, kept going up. One could take a position and not worry night and day about having it blow up in his face.

With that in mind, I thought it might lift my spirits to post a couple of charts I might consider playing if the world was not going to hell in a handbasket. Ahh…for a little momo…a little post earnings annoucement drift…

American Science & Engineering, Inc. (ASEI: 69.00 +15.21%) reported on Monday, November 10th. Q2 profit grew 63%. Volume swelled today, and the stock had a huge percentage gain. This would be an excellent candidate for a PEAD play, should the markets firm up.

Optimer Pharmaceuticals, Inc. (OPTR: 9.18 +99.57%) is a biotech, so all the usual caveats apply. OPTR just released results for their new C. Difficile drug, which had better results than the ViroPharma Incorporated (VPHM: 11.32 -9.94%) gold standard, Vancocin. Volume, and the 100% gain on this one should put it on radar screens, assuming the Dow not see 1,000. That’s right, I said 1,000.

The recent work by BHH which compared varying percentage and ATR stop levels was very instructive. The relationship between stop levels and profits cannot be ignored. As the 1.25ATR stop looked as if it performed well in B’s tests, I decided to go back and run all of Bamboo’s real-time trades as if they had been positioned using a 1.25ATR stop rather than the 4% stop.

I think the results are very interesting.

Below is the Big Bamboo tracking spreadsheet with the standard 4% stop.

The next spreadsheet is the Big Bamboo using a 1.25ATR stop.

Highlights of the differences between the 4% and 1.25ATR stops

• Total profit on 4% stop is almost double that of the 1.25ATR stop: $8,817 vs. $4,817
• 4% Return is 17.64% vs. 1.25ATR Return of 9.63%
• Avg. Trade is $735 vs. $401
• Positions are much smaller for the ATR stops, getting even smaller as volatility ramps up in October
• ATR stops have 91% win rate vs. 50% for the 4% stops
• Some of the stops are greater than 20% from the entry, giving the positions freedom to gyrate

BHH’s tests contained much more data than is represented in these 12 trades. Remember that ATR stops will allow for bigger position sizes than what is calculated with these trades, as soon as volatility tails off. This example then is really showing the extreme results of using ATR stops, as the volatility in October was extremely high.

Perhaps the best result of using ATR stops was that during an extremely difficult month, the system had only 1 losing trade. This shows the ability of the system to generate profits, with smaller positions, during very difficult market conditions.

The study demonstrates how percentage and Average True Range stops affect Net Profit, Win%, Average Trade, and Profit Factor.

B’s post is here: Big Bamboo Stop Study

The value of using a multiple of ATR for a stop is that the stop will constantly adjust itself for volatility,  and win percentage will theoretically improve. The drawback to this method is that during periods of high volatility, position sizes will be smaller than with a fixed percentage stop, which will mean profits will be smaller on winning trades.

In many ways, the ATR stop vs. Percentage stop is as much about the trader as it is about the system. If one has a large appetite for risk, and does not need to be right more than 50-60% of the time, he would probably rather have the large profits associated with percentage stops. However, if one is more comfortable with the odds of winning 70% of the time, and can accept smaller average winning trades, an ATR stop may be more appropriate.

Finally, Damian from over at Skill Analytics reminded me that traders can get hit with larger than expected losses when using ATR stops. This would occur when volatility has died down, which would cause the ATR stop to get tighter and tighter. If a system is using a percent-risk formula for position-sizing, as the stop gets tigher, it is buying bigger and bigger positions. If volatility suddenly returns, the system may experience some large losses, until the ATR stop has time to catch up with the market volatility.

Sometime this week I will be running hindsight trades on the Big Bamboo to see what the current results would have been if it were using ATR stops.

Above are the 6 most recent losing trades from the Big Bamboo system. I’ve included the maximum drawdown incurred for each trade.

As I mentioned in a previous post, with volatility more than doubling in October, the stops that worked well in backtesting should probably be doubled as well. This would take our optimum 4% stop and increase it to 8%.

Indeed, an 8% stop would have changed 3 of the six losing trades into winners (I’m not going to count EFU since it was so close to 8%).

As I know that some of you are taking at least some of these signals, I would recommend that you do not use the 4% stop until volatility decreases. I have not decided yet whether I will alter the system to use an 8% stop in tracking future trades.

After examining these trades, I feel even better about the system. I am likely going to start trading it for real, by the rules, soon. If I do, I am leaning towards using a 10% stop.

Side note: Some of the entries listed above are different from the entries used in the Big Bamboo tracking spreadsheet. The opening prices used in tonight’s post came from a different data vendor. I left them unchanged, not matching all of the prices used in the tracking spreadsheet, to emphasize that in backtesting, having bomb-proof data with absolutely no errors is crucial. With the exception of EFU (off by almost 2 points, our listed open being $151.09), the difference was usually not more than .20 cents. The discrepancies were not great enough to render tonight’s analysis invalid.

Lately, I’ve been focused on my strategy trades and development of new strategies. With the markets being so difficult for most traders to be successful, it has seemed useless to scan for setups, the way I used to do. I would rather focus on more productive activities, until the markets stabilize and volatility levels off.

As for today’s activity, it should not have been much of a surprise to anyone. For what its worth, I’m still bullish. I will be looking to exit from my short positions soon and begin looking long again.

I have no new signals tonight, on any of the systems I trade, including the Big Bamboo

Don’t get me wrong, I thoroughly enjoyed the first 12% of the move up, when I was long. However, the last 3% has started to vex me.

Lucky for me, my initial purchases in the diETFs were position-sized with a worst-case scenario in mind. This scenario is that the indexes take a trip all the way to the 50 day average, without zigging and zagging.

Tomorrow I will get some (QID: 60.38 -6.50%) , and more (TWM: 93.25 -1.84%) and (MZZ: 86.25 -4.29%) . I’m still long (SMN: 62.80 -11.55%) , but will not add to it.

One thing I feel certain of is that this is no time to let yourself become complacent.

Related Stocks:  MZZ, SMN, TWM

Well, this is what I wanted to happen. I wanted the readers of the blog to experience the psychology of a drawdown and losing streak in real time (but hopefully not in their real accounts).

This morning (TWM: 93.25 -1.84%) gapped down beneath the stop, so I closed the position out at the listed open. This unfortunate circumstance is a very real threat to anyone using stops that are left on overnight. The gap beyond the stop caused the system to experience its biggest loss on a single trade, equal to rougly 1.25% of equity.

(SRS: 110.00 -11.11%) was also stopped out, but did not gap beneath the stop on the open.

But back to the drawdown. 6 losers in a row is the longest losing streak the system has ever experienced, in the two year history available for the ETFs it trades. The win/loss percentage is now beneath the 2 year average of 60%. Perhaps this is a good time to consider trading the system, formally, by the book. I will be sure to note here on the blog should I do so.

My fear is that the Big Bamboo switches to the long side, just in time for the next leg down. If it does, it won’t stay that way for long, but it would be tough on the psychology to catch the wrong side of a move, twice in a row. Should that happen, the hypothetical 20 losses in a row may become a reality.

For now, the Big Bamboo is still looking short.

No New Entries for Wednesday

Related Stocks:  SRS, TWM

This morning the system entered (TWM: 95.00 -0.78%) and (SRS: 123.75 +7.17%) . It will go into Election Day short. The new positions are highlighted in gold and are marked-to-market as of Monday’s close.

I purchased TWM in my own account and was given a .20 price improvement over the listed open. RealRisk shows that both positions gapped open.

TWM came within 5 pennies of stopping out at the 4% stop level, if the stop was offset from the actual entry. If the stop was entered based on Friday’s close, then the position did not come quite as close to stopping out.

SRS finished the day up 5.67% from the entry. At this rate, if it meets the exit criteria sometime over the next few days, it will likely be a huge winner.

No New Entry Signals for Tuesday

Related Stocks:  SRS, TWM

In the meantime, PBS just released a 1 hour special on fractals. It is able to be viewed online, and is divided into 5 parts to make for easy viewing. The link is below…

Hunting the Hidden Dimension

Enjoy, and feel free to leave any thoughts generated from the special in the comments section.

(SMN: 70.20 -2.90%) was stopped out on Friday at $68.18; This was the fourth loss in a row for the Big Bamboo.

I went back and reviewed over 2 years worth of trades from this system. It has never stopped out more than 5 times in a row before hitting a winner. There was one instance of it stopping out 5 times, hitting two winners, and then stopping out 5 more times in a row.

I do expect that it will soon hit another winning streak, but I could be wrong. It could hit 20 losers in a row. But that is why we are position sizing using 1% risk. For the sake of argument, let’s assume it does hit 16 more stop-outs, in a row. Because with every loss, each new position will be smaller, we would still show a slight gain for the year, even after 20 losses in a row.

However, what if the system were all in, with 4 positions, and a large overnight gap causes each position to move past its stop more than 4%? That is certainly possible. So lets imagine that scenario happens twice in a row, with all 4 positions losing 8%, instead of 4%. The system would still show a profit for the year.

Running through hypotheticals like this is beneficial for the system trader as it can create a mentality that is strong and resolute. The system trader should be able to withstand the inevitable losing streaks without quitting the system, or signficantly altering it. Identifying some worst-case or just pretty-bad-case scenarios, and then calculating how the system would handle those, is a must.

While all of this sounds scientific and fool-proof, it really is not. Some of you may remember that I started tracking this system during a winning streak because I wanted it to start off with gains. What if I would have started tracking it from its first loser? Right now the system would be down around 4%, and the Big Bamboo may not be known by such a favorable appellation. If we were then imagining 20 losers in a row, we would be looking at a drawdown of greater than 20% from starting equity.

New Entry Signals

Highlighted in a pleasing green hue are the new entries for Monday:  (TWM: 95.75 -8.37%) and (SRS: 115.47 -12.37%) .

Another system I trade (which is tracked on Covestor but is not disclosed on iBC) has also generated an entry for TWM. This system, which I call the Power Double Dip, has made 42 trades with an 85% win rate during 2008, and an ROI of 157%.

But wait, it gets better. As the Big Bamboo will only take 2 new signals a day, I didn’t list the number 3 signal, which is (MZZ: 89.38 -6.17%) . The Power Double Dip strategy is also choosing MZZ to take along with TWM.

I will be entering these diETFs on Monday, but I will be using a different stop strategy from the Big Bamboo. I want to give them some room to move, so I will use a stop distance of greater than 10%.

Related Stocks:  MZZ, SMN, SRS, TWM

The PPT just spit out its godly list of industry rankings. They are ranked by their hybrid score, which is a combination of their technical and fundamental scores. Above are the top 10.

Above is the the number 1 industry (Home Health Care) of the top ten

I have included some charts of most of the Home Health Care group.

Almost Family, Inc. (AFAM: 46.48 +5.64%)

Amedisys, Inc. (AMED: 57.69 +2.41%)

Chemed Corporation (CHE: 42.27 +2.95%)

Gentiva Health Services, Inc. (GTIV: 26.65 +6.51%)

LHC Group, Inc. (LHCG: 35.26 +6.75%)

Lincare Holdings Inc. (LNCR: 26.16 +0.04%)

At the time this was written, the (SMN: 72.73 +0.59%) position was up approximately 4%. The spreadsheet has been updated with yesterday’s purchase price of $71.02 As I had hoped, SMN gapped down hard, and the system bought the gap down. The trade was in the green for almost the whole day yesterday, and that is what I mean when I say that these diETFs can be traded with a tight stop, as long as you are on the right side of the trade from the very beginning. At one point yesterday, the trade was in the money by 10 points.

The RealRisk and stop levels have been left unchanged in the spreadsheet to show the effect of the gap down. The RealRisk shows that SMN gapped down over 5% past our projected stop. Remember, this is a good thing, unless you had set your stop the night before. If you did, I do not think the position would trigger. The 4% stop, based on the entry, is set at $68.18

In my own account, I bought SMN on the open, and received a fill of $70.81. This price shows slippage in my favor by .21 better than the listed open.

I had to go out of town Thursday evening, and was not able to update the blog, but there were no new entry signals for this system for Friday. I’ll run the scan after Friday’s close and update the blog if there are any new entry signals for Monday.

Good trading today, and have a good weekend.

Related Stocks:  SMN

The signal for tomorrow is highlighted in a pleasing green hue.

The 4% stop on this one seems ridiculously tight. Keep in mind that when the system was first being developed, volatility was high, but nothing like it has been in October. Since this exercise of tracking a system on my blog has several purposes, I’ll continue to have the Big Bamboo keep the 4% stop level. I did put up a post with statistics which show how the system performed using wider stops.

Since stops seem to be a hot topic, I have put up a chart of (SMN: 78.20 -8.00%) with the Average True Range (10) stop levels. I want to talk briefly about the pros and cons of using ATR stops.

As evident from the lower pane of the chart, ATR has gone through the roof. In one month, it has tripled. On average, SMN is moving 16.12 points a day. That is a huge spread and makes risk management a real challenge.

The 4% stop being used is .2 ATR, or roughly only 1/5 of the average daily range of SMN. This means that if SMN stalls out, or even moves slightly against this position, the stop will likely be hit.

A stop of 1*ATR can be used, while 1.5*ATR is often optimum, in my experience. However, in the case of SMN, a stop of 1.5*ATR means a stop 24 points lower than today’s close. Using such a large stop will mean buying a very very small position. For the Big Bamboo, were the system to use a 1.5*ATR(10) stop, it would be buying only 25 shares. A 1*ATR(10) would have the system buy 38 shares. Seems almost too small to be worth it.

Of course the benefits to using ATR stops is that there is much less likelihood of getting stopped out, which can increase the win percentage of a system. However, it also can decrease performance due to smaller position sizes. As volatility decreases and gets back to a more normal level, ATR will reach a sweet spot where it can keep trades from being stopped out while still allowing for decent position sizes.

For this trade, it might be worthwhile to determine another stop placement, to allow for a wide swing, but also allow for a larger position.

As I write this, S&P futures are up 2.25%. A large gap up tomorrow would be optimum, as SMN will be purchased at a discount to today’s close.

Related Stocks:  SMN

This morning, almost on a whim (I could not remember futures being up throughout the night without selling off into the morning, for many days), I placed a market order for some (DDM: 35.65 +22.59%) . I was not able to check the markets until after 1:00 o’clock, but was reasonably happy with what was going on. I was able to get a glance again at 3:00, and seeing everything look poised for a strong finish, I went ahead and got some (SSO: 30.20 +22.12%) .  The unrealized gains helped after getting blown out of my (QLD: 32.54 +20.92%) and Provident Energy Trust (USA) (PVX: 5.55 +2.97%) on the futures-locked-limit-down morning.

I really want to see some follow through tomorrow.

As for the (DIA: 91.14 +13.56%) , the clear bullish divergence was resolved somewhat as the MACD crossed. Also note the bullish divergence on the Chaikin Money Flow. The July CMF move was much larger than the October move. More on that in a second.

Volume was good. A close above the blue resistance line would be very bullish. I am looking for about 10-12% move here before serious resistance is encountered at the 50 day average.

On the (QQQQ: 31.86 +11.05%) , note the large Chaikin Money Flow move in September and October. Compared to the DIA, it appears as if there was a large sector rotation out of tech. Does this mean it will lag the other indices? I do not know.

The Qs managed to close just above the sharply declining blue resistance line. However, this is not an exact science. We really want to see the Qs make an obvious move above any resistance at this level.

Again, there was massive bullish divergence on the MACD. The Qs look as if they could run 15% from here, assuming immediate resistance is cleared.

As for the (SPY: 93.76 +11.69%) , pretty much the same analysis as DIA. It needs to clear immediate resistance, quickly.

Similar to the other indexes is the MACD divergence. On SPY, Chaikin Money Flow is also showing a divergence.

Overall, it was a very constructive day. Danny’s indicators are showing the most strength in quite some time. I am hoping the markets can put on another impressive performance, Wednesday.

Related Stocks:  DDM, DIA, QLD, QQQQ, SPY, SSO

Today, (DUG: 56.80 +10.18%) threw the Big Bamboo a curve ball. It took a swing, and missed.

I bought some at the open and was filled at $53.84, which shows .33 slippage (.6%) from the listed open. I was stopped out, as was the system. I used a 6% stop (rather than the 4% being tracked) to give it some room. The volatility makes for challenging risk management. There are starting to be questions in the comments section about alternative stop strategies. I’ll try to get to that soon, in an upcoming post.

Note the yellow highlighted cell. Had a stop been set based on Friday’s close, the real risk of the trade would be almost double the expected risk due to the gap up. I cannot emphasize enough the importance of stops that automatically offset from a market order entry. 

The loss on this trade was slightly more than the expected 1%.

No New Entry Signals for Tuesday

Related Stocks:  DUG

Side Note: Michael Stokes from MarketSci Blog just published a similar, but better articulated piece on standard distributions and the markets. Fat Tails, Normal Distributions, Random Walks, and all that Jazz. Since his thoughts mirror mine, and are therefore somewhat self-similar and recursive, I thought it would be neat and geeky to link back in his blog in this post about fractals.

A fractal is generally “a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole,”[1] a property called self-similarity. The term was coined by Benoît Mandelbrot in 1975 and was derived from the Latin fractus meaning “broken” or “fractured.”

A fractal often has the following features:^[2]

• It has a fine structure at arbitrarily small scales.
• It is too irregular to be easily described in traditional Euclidean geometric language.
• It is self-similar

Because they appear similar at all levels of magnification, fractals are often considered to be infinitely complex (in informal terms). Natural objects that approximate fractals to a degree include clouds, mountain ranges, lightning bolts, coastlines, and snow flakes.

Fractals in Nature (from Wikipedia Fractals)

Approximate fractals are easily found in nature. These objects display self-similar structure over an extended, but finite, scale range. Examples include clouds, snow flakes, crystals, mountain ranges, lightning, river networks, cauliflower or broccoli, and systems of blood vessels and pulmonary vessels. Coastlines may be loosely considered fractal in nature.

Trees and ferns are fractal in nature and can be modeled on a computer by using a recursive algorithm. This recursive nature is obvious in these examples — a branch from a tree or a frond from a fern is a miniature replica of the whole: not identical, but similar in nature.

Fractal Cauliflower

The Mandelbrot Set

Perhaps the most famous of all fractals are the computer generated ones often found in art, screen savers, album covers, and t-shrits. These fractals are typically generated by the Mandelbrot Set, named after Benoit Mandelbrot. The Mandelbrot Set has become popular outside mathematics both for its aesthetic appeal and for being a complicated structure arising from a simple definition.

Even 2000 times magnification of the Mandelbrot set uncovers fine detail resembling the full set.

What Does This All Have to Do With Market Crashes?

At this point, I’m sure fractals seem to have very little relationship to markets and market crashes. While I had hoped to have covered fractals in one article, it appears I’m going to have to flesh out fractals in 2 parts.

For now, the two most important things to remember about fractals (and the financial markets):

1. They are self-similar.
2. They are infinitely complex and complicated, yet can be described with simple definitions.

__________________________________________________________________________________________________

A good portion of this piece is from various Wikipedia articles. I believe I have linked to the appropriate pages to give credit where it is due.

For the ultimate web-based guide to fractals, one must visit the site of Michael Frame, Benoit Mandelbrot, and Nial Neger Fractal, housed at Yale. This is a fantastic resource.

1. Mandelbrot, B.B. (1982). The Fractal Geometry of Nature. W.H. Freeman and Company.

2. Falconer, Kenneth (2003). Fractal Geometry: Mathematical Foundations and Applications. John Wiley & Sons, Ltd., xxv.

“Lastly, the cotton story shows the strange liasion among different branches of the economy, and between economics and nature. That cotton prices should vary the way income does; that income variations should look like Swedish fire-insurance claims; that these, in turn, are in the same mathematical family as formulae describing the way we speak, or how earthquakes happen–this is, truly, the greatest mystery of all.”            -Benoit Mandelbrot 2004

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If there are any economists, investors, or scientists who still believe the movements of the financial markets follow the standard (Gaussian) distribution, 2008 has likely shaken their foundations and fractured their paradigms.

A quick calculation of the Standard Deviation of one day’s close to the following day’s close (in percentage terms), from October 1, 1928 to October 24, 2008, is below. The calculations show that the average daily change on the Dow Jones has been .024%, with one standard deviation being 1.15%. Already, we see the daily change can vary greatly from the average change.

Above is the confidence intervals (orange background) for various standard deviations beyond the mean. If a data distribution is approximately normal then about 68% of the values are within 1 standard deviation of the mean, about 95% of the values are within two standard deviations and about 99.7% lie within 3 standard deviations.

In October alone, there have been 3 days with close-to-close changes greater than 6 standard deviations beyond the mean. The change on October 13th was 11.08%, better than 9 standard deviations from the mean.  The crash in October 1987 would be greater than 18 standard deviations.

These large variances in the Dow Jones data should not be present, unless the day-to-day changes are not normally distributed.

For the rest of this article, I will then assume, as I believe it to be true, that the financial markets cannot be described within a Gaussian distribution.

Of course, to know that financial markets do not conform to a standard distribution is to understand that the Capital Asset Pricing Model, along with Value At Risk and Beta; Black-Scholes Formula and the Modern Portfolio Theory, are hopelessly and inherently flawed.

Indeed, the recent bear market has proven the financial markets to be much more volatile and risky, and anyone using the above models and theories to manage risk are likely finding themselves having to re-work all their models and risk-management formulae. Should they continue to rely on a standard distribution, they will forever be re-working their models, assuming they are not first ruined by them.

Since I have thrown out the idea that the market’s movements will be contained within X standard deviations from the mean, it is then crucial to digest and internalize this:

There is nothing to stop the markets from experiencing large and devastating losses, of a magnitude never before witnessed.

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Part 2 of this series will describe fractals and how understanding them may be the key to understanding the recent market dislocations.

Part 3 will synthesize parts 1 and 2 in a discussion of why and how markets crash.

Benoit Mandelbrot is the expert on this topic. His latest book, The (Mis) Behavior of Markets is a must read for anyone interested in fractals and the financial markets.

The new entry signal is highlighted on the sheet in a pleasing blue hue. Recorded is Friday’s close. The sheet uses Friday’s close to calculate a 4% stop, which is necessary to calculate the position size. At the top of the sheet, our 1% risk level per trade has climbed to $614.00, which allows the system to purchase 297 shares of (DUG: 51.55 +8.07%) . As the purchase will be made on the open, if DUG gaps open, the system will be taking on more risk than calculated; if DUG gaps down, it will be taking on less risk than calculated.

As DUG could easily close Monday with an RSI2 of greater than 80, if this trade works, it will likely only last 1-2 days.

The system also generated an entry into (REW: 124.00 +6.30%) . However, I will override the system and not buy REW due to the RSI2 being greater than 80 on Friday’s close. I had not considered this possibility, which means the trade-by-trades used for backtesting need to be examined to make sure any entries generated with the exit criteria already met get discarded.

The other issue with REW is liquidity. While it does trade better than SCC, there still may be some severe slippage. The system rejects any diETFs without a 10 day average volume of over 100,000. I would say that REW has barely met the requirements for volume.

Good luck on Monday!

Related Stocks:  DUG, SCC

The (SPY: 91.69 +1.16%) , from close of September 29th to today’s close, has lost 17.7%

During this time, the Big Bamboo has earned 22.8%, and was only fully invested for one day, and only 75% invested for 2 total days.

(QID: 77.71 +0.34%) and (SDS: 100.60 -1.85%) were both closed at the open. Their closing prices and dates are highlighed in a pleasing lime green.

Statistics for Average Percentage Gain per Trade and Average Dollars Gained per Trade have been added to the spreadsheet.

I’m anxious to see if the system will continue its losing streak or if the latest trades were just a blip.

Related Stocks:  SDS, SPY

So I decided to take my old nemesis out of the closet and punch him around a little bit, meaning I made some discretionary trades.

I’ve been watching Provident Energy Trust (USA) (PVX: 5.97 -1.32%) both as a play on yield and a play on the energy markets. I got in today at $5.81 My stop is set just beneath today’s low, so it is tight. I’m expecting managers to chase yield as well as I’m expecting OPEC to intervene and decrease supply. I will likely begin taking profits near the $6.60 range, as I expect some resistance in that area.

I also bought some (QLD: 30.33 -0.91%) in the after hours market, shortly after seeing the numbers from Microsoft Corporation (MSFT: 22.32 +3.67%) . My stop is placed just beneath today’s low. There is a lot to like about this chart, but my main reasons for buying in are the bullish divergence on the MACD and the (hopefully) successful test of the lows. If this trade does not quickly stop out, I’m going to attempt to hold out for roughly 10 points of profit, which I think can be easily achieved if any momentum can develop on the upside.

Related Stocks:  MSFT, QLD

(SDS: 102.50 +11.32%) and (QID: 77.45 +5.58%) both closed today with an RSI(2) greater than 80. This means the exit criteria was met and the diETFs will be sold on the open Thursday.

In the spreadsheet above, both open positions are marked-to-market with today’s closing prices highlighted in yellow.

The system will have generated a 75% win rate, in 8 trades. Based on the backtesting, this win rate is higher than expected and will likely trend lower from here.

I have included charts of SDS and QID to show how the trades looked.

No New Entry Signals for Thursday.

Related Stocks:  SDS

(DIA: 90.38 -3.11%)

Note the MACD trying to cross, and the volume decreasing as the pattern develops. A break above the triangle with a run to the 50 day average would yield a healthy profit for a long trade.

(SPY: 95.86 -2.99%) Same analysis as on the Diamonds.

Some technicians may choose to draw their support and resistance lines through the real bodies of the candles rather than just the tails. This would produce a tighter triangle. When drawing these lines, I prefer to stay consistent, and so I almost always draw then through the intraday highs and lows.

(QQQQ: 31.48 -5.18%)

The Qs have not formed a very discernable triangle. The MACD has crossed above the zero line.

All these charts show that should a rally finally take hold, there is an easy 10 points worth of profit before resistance becomes an issue.

Related Stocks:  DIA, QQQQ, SPY

BHH built a new spreadsheet, from my poorly designed sheet. The losses from SCC and EFU are recorded, and the open positions of QID and SDS are marked-to-market. Should QID and SDS stop out, (which could be a real possibility after the Apple Inc. (AAPL: 91.49 -7.06%) earnings), the system will be holding realized gains of approximately $2,500.00

Keep in mind that the QID and SDS trades are still open, so this equity curve will change.

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I want to now take a look at yesterday’s theoretical entry into SCC.

I’ve circled the opening 3 minutes from Monday, 10/20/08. The data window shows that the opening bar traded 2629 shares, with most of them being sold. The next two bars traded 365 and 265 shares, respectively. After that, the price jumped above the opening price, on 400 shares, and then proceeded to trade up to 6 points higher than the open.

As I did not watch SCC trade, I can only trust Susan from the comments section that the spreads were huge. I want to believe that since the Big Bamboo would have been buying 103 shares, into a falling ask, that the system would have gotten a decent fill on the opening bar. It is all conjecture, and we will never know. What is certain is that there was very little liquidity. I intend to look back at the historical trades this system has made, and see how many times SCC has been traded. It may have created unrealistic results, and SCC might be excluded from future system trades.

No New Entry Signals for Wednesday.

Related Stocks:  AAPL, SCC, SDS

(SCC: 136.13 0.00%) did not stop out after an entry (theoretical) of $138.88, although it came close.

In the comments section of the last post on this system, it was noted that the spreads on SCC were huge. This was confirmed by plotting a 1-minute chart in Tradestation. I hope to have more time tomorrow evening to post how uneven the trades were. This throws a huge monkey wrench into the system. It may be that we ignore selections unless they have twice or triple the volume of SCC. It is useless to rely on backtested results if the results do not have a realistic possibility of being replicated. It seems that SCC may be too illiquid to provide consistent results using market orders on the open.

Of course, the other two open positions (SDS: 87.20 0.00%) and (QID: 66.74 0.00%) continue to erode. These two positions can also stop out and the system will still show a positive gain since its short inception period.

This is where we want to carefully observe the performance of the system. We know it will hit losers, but as long as the losers are fewer in number and smaller in dollar terms than the winners, the system will remain an overall winner. Frankly, I am glad it may be getting ready to hit a losing streak, as this means it is an excellent time to start trading the system with real money. After four to six losing trades, I will be looking to dive in. More on that later.

I will update the blog tomorrow evening with a newer spreadsheet for the Big Bamboo System. Right now it is too late to delve into the math and I am likely to make errors, so it will have to be put off until tomorrow

No New Entry Signals For Tuesday.

Related Stocks:  SCC, SDS

Most of these have a MACD that is getting ready to cross the zero line. That would certainly be very bullish.

Universal Health Services, Inc. (UHS: 42.25 -2.24%)

Synopsys, Inc. (SNPS: 18.26 +3.69%)

Cohen & Steers Quality Income Realty Inc Cohen & Steers Quality Income Realty Inc (RQI: 6.86 +1.03%)

Provident Energy Trust (USA) (PVX: 6.21 +3.50%) Huge dividend.

Pengrowth Energy Trust (USA) (PGH: 10.69 +5.74%) Huge dividend

ONEOK, Inc. (OKE: 27.91 +2.80%)

NYSE Euronext (NYX: 29.46 +1.55%)

Merck & Co., Inc. Merck & Co., Inc. (MRK: 28.50 +1.10%)

Motorola, Inc. (MOT: 5.62 +0.18%)

Mirant Corporation (MIR: 16.58 +6.01%)

McKesson Corporation (MCK: 44.83 +2.42%)

Danaher Corporation (DHR: 56.40 -3.21%)

CMS Energy Corporation (CMS: 10.14 -0.10%)

Allied Waste Industries, Inc. (AW: 9.56 -0.21%)

Related Stocks:  MOT, MRK, NYX

Sticking to the rules while trading a system can be difficult. The system stayed long (QID: 70.40 -0.71%) and (SDS: 96.40 +1.31%) despite getting very very close to meeting the exit criteria. Staying long has drawn-down the account 5% from the YTD high.

SDS and QID were marked-to-market (yellow highlighted cells) at Friday’s close. Stop losses have been updated to reflect a loss of 4% from the entry price. One might be tempted to move stops up to breakeven, but the system was not backtested with that variable.

New Entry Signals

On Monday, the system will enter (EFU: 159.79 +3.76%) and (SCC: 145.25 -0.65%) . The spreadsheet has been updated to reflect Friday’s closing prices, for EFU and SCC, the estimated 4% stop on the new positions, and the estimated cost (in the blue cells).

This will be the first time the system as been all in.

Note that I’ve added a Cash calculation, and that the estimated costs of the new positions will be more than the cash the system has. This is due to using the percent-risk method for determining position-size and the marked-to-market open positions being used in the total equity calculation.

As this system will not use margin, on Monday it will only purchase the number of shares it can afford. Keep in mind that this is still not going to be perfect. It is entirely likely that the diETFs will open higher than Friday’s close, so margin may still be used, inadvertently. Having a marginable account becomes a necessity for real-world trading.

For more conservative risk managment, the best calculation to use when setting the final two positions is to figure the proceeds of both open positions QID and SDS, at a 4% loss. Doing so will ensure adherence to the 1% risk per trade. If one uses un-realized gains when calculating future position sizes, he should be aware his actual risk is increased to greater than 1%.

Related Stocks:  SCC, SDS

Another big day for the mechanical system. Honestly, I’m looking at these returns, and I’m asking myself why I’m not trading it yet. This thing is just killing it. Amidst all the failures of indicators and oscillators, this system seems to be getting even better.

(QID: 79.11 +17.46%) closed with an RSI2 of 75.34 and (SDS: 103.56 +18.07%) with an RSI2 of 74.27.

Without a doubt, had I not sold my QID this morning, (at $68.81, which is 6 pennies of slippage from the listed open) and were I actually trading this, I would be selling tomorrow. Look at these last two trades, marked-to-market at today’s closing price (highlighted in yellow). The total P/L is now ~13K, which equals a 26.15% return, in just six trades. The system has never had more than $550.00 at risk on any trade, and has been at least 40% in cash since inception. Keeping 1% risk per trade, the system could now theoretically hit 10 losers in a row, and still be up ~$8K, or 16%.

I am amazed.

Despite all this, despite the success, there is still the desire to override it. And that is why profitable systems can still be traded unprofitably.

SDS and QID will be left open tomorrow and will not be closed until the exit criteria is met.

No New Entry Signals for Tomorrow.

Related Stocks:  SDS

This morning, the Big Bamboo system purchased shares of (QID: 67.35 +6.90%) and (SDS: 87.71 +1.99%) at the open. The large gap-up on the indices was exactly what we wanted to see, as mentioned last night in the comments section. The setup was so sweet that I went ahead and bought some QID on the open, where I received a 5 penny price improvement from Scottrade versus the listed open. I note that as there has been some discussion about slippage and liquidity with these diETFs.

I want to continue with the theme of explaining this system (and system trading) from the inside out. Note the red squares on the spreadsheet. These squares show that had a 4% stop been set based on last night’s close, the diETF would have gapped down below the stop, and the trade would have either not triggered, or  would have been instantly stopped out. While volatility is elevated, it will be very important to use a professional platform for order entries, to enable the stop to immediately be offset from the entry. The only other choice is to wait to receive the entry price, and then set the stop. As this system is designed to be traded by people who work, that is not always going to be a viable alternative.

While the diETF gapped down hard, that sort of action is ideal for this system. Even with a tight 4% stop, the price never was in any danger of stopping out the trade.

Also note that we are now risking $547.00 per trade. As the system makes more and more money, or loses more and more, we will be trading larger, or lesser size.

The stops are now offset 4% beneath the entries listed in the spreadsheet.

To Exit, or Not to Exit. That is the Question.

The exit for this trade is signaled when RSI2 closes above 80. While I will allow the paper-traded system to stay in the trade, I want to talk about why I may close out my QID tomorrow.

Pay careful attention to the RSI2 level, above. While SDS closed up ~8 points from the open, RSI2 barely budged. I’m not sure if this is because of the extreme volatility of late. It may be that today’s move, in comparison to the moves of the past 7 days, is small. Regardless, it makes me a tad worried about using RSI2 for an exit here, until we get a few more days of data to even things out.

Also note the huge ATR(10) of $11.96. Such huge daily swings make setting effective stops very difficult. One almost has to be on the right side of these trades, with well-timed entries, in order to be successful. In order to manage the volatility, one might choose to use stops based on a multiple of ATR(10). I hope to do a post on this topic in the future.

Again, the RSI2 on QID was more responsive than SDS, but not as much as I expected. I am going to have to look at the formula for RSI to determine the reason for this.

But back to the meat of the issue. Do you over-ride the system, and sell? Were I trading this system formally, I would not. However, while I am liking the Big Bamboo more and more, today’s trade was born more out of boredom, due to not having any trades over the past couple of weeks, than a desire to start trading the system. Therefore, I will likely wimp out, and sell the open. I hope that momentum carries through to the downside, and that I also get a price improvement upon closing out the position.

Not to muddy the water, but as BHH and I have been testing a variety of exits, we’ve found another one that is effective, but the jury is still out as to whether it is better than the RSI2 exit. This experimental/alternative indicator is signaling a exit for tomorrow. Maybe I’ll be better able to rationalize my early exit with this new information.

No New Entry Signals for Tomorrow

Related Stocks:  SDS

If you were ever in doubt what capitulation looks like and feels like, squirrel away the memories and feelings from the last several days.

Going forward, I view the meltdown to be similar to an earthquake, where there will likely be a few aftershocks. The markets are in no way “safe” now that we have likely seen an intermediate term bottom, but I do feel that the Armageddon trade is off the table. What I expect in the near term is more of the same: volatility peppered with copious amounts of whipsaw.

On the chart above, the Dow rallied just above the 23.6% Fib line, and is headed for the area of 10,250, which represents the 38.2% retracement level. I will be looking for resistance a little lower than that though, as the Dow approaches the area of the lower channel boundary.

I would like to see the Dow cover this ground in a very short period of time. As I write this, S&P futures are up 2% 3%. Maybe Dow 10,000 can be hit tomorrow. Should it reach this level very quickly, I recommend taking some profits, looking for some shorts, or picking up some diETFs.

A quick message from Debbie Downer:

Traders should keep in mind that the Dow could go to new lows, after rallying and consolidating a while. With the worst stock market slide in history and a severe recession blanketing our country, always keep in mind the Dow 1929-1932 charts.

Debbie Downer would also like to mention that volume was above average today, but not phenomenol. Obviously, the sellers were exhausted during Thursday and Friday’s capitulation.

The two diETFs the system will take are (QID: 63.00 -23.22%) and (SDS: 86.00 -22.44%) , as those have the most volume of the list of signals.

Here is the rest of the list:

(SKF: 123.82 -21.63%) (DUG: 47.20 -36.56%) (DXD: 76.00 -19.15%) (TWM: 95.00 -20.97%) (SRS: 97.46 -13.99%) (SMN: 68.01 -26.86%) (MZZ: 87.37 -21.29%) (EFU: 137.08 -32.47%) (RSW: 134.88 -23.36%) (REW: 91.94 -22.43%)

Exit signal will activate when RSI2 closes above 80.

I will change the category heading of *New ETF Trading System to reflect the new name of the system. I believe it was Anton Cigur that suggested the name. If the system loses tomorrow, it is his fault.

To read more about this system and its statistics, check out the *Big Bamboo category.

Related Stocks:  DUG, DXD, MZZ, SDS, SKF, SMN, SRS, TWM

From Market Sci Blog: When Adaptive Systems Fail (And What I’m Going to do About It)

Graph of the Failure of the Above System: Graphs of Market Sci Strategies YK0101 and 0102 (Click “Next” and then click “Graph”)

A Hedge Fund, Tontine Associates, is down ~65% for the year after being worth 10 billion. Read their explanation for their dismal September-October performance.

From BZB Trader Blog: Sell Fridays (and Mondays)

Ten Year Weekly Chart of the Dow Jones Industrial Average. Note the trendline break (light blue).

I will be extremely worried if 7350 is blown through. The next area to watch will be 6500 (questionable), which will intersect with the trendline drawn from the 1987 crash and up through subsequent lows in 1990-1991. Should those areas fail, there is nothing but air, with support at 4,000.

I will be home and able to trade intraday on Monday. Should the market capitulate and then firm up around the areas mentioned above, I may consider the potential for trading a bounce. It seems Monday is likely to be a pivotal day.

Should the market not firm up, and move decisively below 7,350, I am seriously concerned that America will be facing the nationalization of our banking system. Monetization will be worst nightmare our country will have ever faced.

There is really no purpose to this post, other than to rant and make a few observations. First, I learned some time ago that I am not a very good discretionary trader. I have to stick with my strategies, in order to be successful at trading. As I have had no signals in a couple of weeks, I have been watching the latest market machinations unfold while I sit in 100% cash. With that in mind, you may mistake my thoughts as a thinly veiled attempt, from a man with no conviction, to rub salt in the wounds of bulls and bears alike. Let me assure that is not at all my intent, and my convictions are very very strong.

I have many internet friends who have traded this market with god-like precision. Some have sat short, for many months, and reaped healthy gains. Others have sat patiently in cash, or have played the dips like a maestro with his Stradivarius. Now, at this time when the market is behaving exactly the way it should be behaving, when all the patience and discipline and diligence is paying off, I see most are now looking for the market to do the opposite. However, months ago, when all of the events of the past weeks would have seemed possible, but unlikely, they were preparing for this very event. It is here, and everyone seems unprepared. Or maybe they are prepared, and I’m the one with a severe case of myopia.

I stopped performing technical analysis of the indexes when talk of the bailout juiced the indexes up over 6% in a couple of days. It seemed to me that the markets were actually beginning to trade on and price-in the fundamentals and the reality of the economic situation. When the bailout rally failed to hold, I knew, with 100% certainty, that everything was different. I knew that it truly was going to be different this time. Then, when the bill passed, and the market sold the news, my beliefs were confirmed.

Despite this death-knell ringing out loud and clear from Wall Street, the bottom callers came out in droves. The bears began covering their bets. Traders with many more years of experience than me, people I respect and have learned from, began dipping their toes in, on the long side. These same traders were calling for the day of reckoning, for over a year. Yet when that day seems very near, they are getting long. This is incomprehensible to me. Everything they prepared for, all the rhetoric they have espoused, all the research they have published, everything they have based their reputations on over the past years is arriving, is coming to fruition, and they seem unable to trade the event.

If that is not a sign of impending collapse, what is?

The last hope of the Fed and the bulls has been a rate cut. Did anyone doubt the rate cut would get sold? The real cost of borrowing was already below 2%. What’s the point? The trade seemed so simple to me. Fade the Fed. I’m perplexed that more traders did not see that today was another sell-the-news day. 

The banks are playing a game of Russian Roulette. And if the wrong institution gets the bullet, the whole global financial system gets its brains blown out.

And maybe the realization of that reality, that we really are one accident away from a complete catastrophe, means that we are bottoming. Maybe this post will mark the bottom. That would be poetic justice.

And maybe we are at a tradeable bottom, and we just have another six months to a year of grinding volatility, before we hit the final lows. I can understand how that scenario is a viable possibility.

However, when playing Russian Roulette, you either get the bullet, or you don’t. In a game with such a deadly ending, does it really matter that the odds are in your favor?

I see International Business Machines Corp. (IBM: 90.55 -5.33%) has reported earnings early, and they are better than the worst expectations. Maybe this will be enough to allow market participants to forget that the Fed is out of options and the derivative bubble is unwinding. 

So maybe we dodge the bullet tomorrow. Maybe we get lucky.

Related Stocks:  IBM

Trade Distributions

It will probably b