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statistical robustness

SUBHADIP NANDY

Who am I ?

Net experience in the markets of 18 years

Was the Research Head of one of the biggest commodity prop

firms in India

Successfully designed algos on MCX and MCX-SX

Trading approach is 100% system oriented

I train on trading systems on the F&O space

What is a trading system ?

buy and sell signals for a given security. Trading systems can be developed

using many different technologies, including Microsoft Excel, MATLAB®,

TradeStation, R, Python, Metastock, Amibroker and other platforms and

languages. The buy and sell signals from these platforms may appear in a

file for you to execute or be programmatically executed using a

brokerage that supports automated trading.

What are the advantages of a trading

system ?

Removes emotion from trading

Saves time

You can outsource some of the work

Backtesting can be done across market condition

Statistical stress testing can be done to check whether the system is robust

or a function of blind luck

What are the dis-advantages of a

trading system ?

Requires TA or quantitative knowledge

Requires programming language expertise

Can be difficult to optimize

Requires large initial cost in terms of time and money

Creating a trading system

Now that we are aware what a trading system is along with it’s pros and cons,

we can get down to the core business of creating a trading system.

1. Define a trend

2. Define a breakout

3. Combine the two and create a specific price for entry

4. Set a logical stoploss point which defends us in case the trade does not go

the way we want but leaves enough space for the market to move and then

go in the direction of our trend

5. If we take the entry, then what should be our position size depending on our

equity

6. Where to exit

What is a trend?

Basic assumption

to the main trend is temporary and

sooner or later prices go back in the

direction of the major trend

Basic system guidelines

• A trend detector

• A pullback detector

• An entry method through a price breakout which confirms the

continuation of the trend

Trend Detector

While devising or using a trend detector, one should be aware that any method to

determine trend is always a lagging indicator . To keep things simple without using

esoteric mathematics, we use the simplest of all trend detectors, i.e a simple moving

average. Using the rule that “indicator length should be half the cycle length”, we

assume the basic cycle of a futures start to expiry time of 22 days ( 22 days are there

per month for trading on an average). Taking slightly higher than half, we use a 13

period simple moving average(SMA).

Whenever prices are above the 13SMA, we consider the trend to be bullish and

whenever prices are below the 13SMA, we consider the trend to be bearish.

There is no magic involved in the number 13 as you will see for yourself that any other

moving average works just as well in this system.

Pullback Detector

A pullback is defined as when prices go against the trend, i.e, prices fall in a rising trend

and vice versa

• A basic/simplest pullback could be defined as when Today’s Close < Yesterday’s

Close in an uptrend and vice versa

• How far prices will pullback against the major trend is impossible to predict with

certainty

So whenever we get a lower close compared to the previous day and prices are above

the 13SMA, we consider that to be a pullback in a bullish move. Exactly the opposite

holds for a bearish move

Price Breakout

A price breakout can be defined as a price move in the direction of the major trend

which is large enough to imply that movement has resumed in the direction of the

underlying trend

We take 55% of yesterday’s range, and if prices move in the direction of the major trend

by that amount since opening, we expect prices to move in that direction throughout

the day ( the number of 55% is statistically derived)

Yesterdays Range = Yesterday’s high – yesterday’s low

What we are trying to do through the combination of these rules is to catch a ‘trending

day’ which runs in the direction of the main trend

Trend Day

A “ trend day” occurs when there is an expansion in the daily trading range and the open

and close are near opposite extremes. The first half-hour of trading often comprises less

than 10%-15% of the day’s total range; there is usually very little intraday price

retracement. Typically, price action picks up momentum going into the last hour — and

the trend accelerates. A trend day can occur in either the same or the opposite direction

to the prevailing trend on daily charts. The critical point is that the increased spread

between the high and low of the daily range offers a trading opportunity from which large

profits can be made in a short time. We are only interested in trend days in the direction of

the major trend which would increase the probabilities of our success

A trend day generally continues it’s movement in the direction of the trend for the 2 nd day

also

The system so far - BUYs

• Prices need to be above 13SMA

• Today’s close < Yesterday’s Close

• Range =Today’s high – Today’s low

• Breakout Filter = 55% of Range

• Entry price = Tomorrow’s Open + Breakout Filter

The system so far - SELLs

• Today’s close > Yesterday’s Close

• Range = Range =Today’s high – Today’s low

• Breakout Filter = 55% of Range

• Entry price = Tomorrow’s Open - Breakout Filter

Stoploss

In some cases the trend will not continue and reverse, hence a stop is required

• Using the same logic of the breakout filter being statistically significant, if prices move

in the opposite direction by that same amount after entry, we are out with a stop

• That means the OPENING price becomes our stoploss

Exits

As we are expecting the trend to continue throughout the next day, we exit at the

close of the 2nd day. This serves three purposes:

1. We let the trend continue to it’s maximum.

2. We always trade thru ATM options, so no risk of unlimited loss ( extremely important

for position sizing)

3. Minimum amount required to trade directional naked options thus improving return

on equity ( no futures margins required)

** Experienced option traders can use strategies given the IVs, greeks and time to

expiration

System conditions summarized

For Buys : If prices are above the 13SMA and today’s close is lower than yesterday’s

close, then if prices move up 55% of today’s range from tomorrow’s opening price, we

buy with a stoploss set at the opening price

For Sells : If prices are below the 13SMA and today’s close is higher than yesterday’s

close, then if prices fall by 55% of today’s range from tomorrow’s opening price, we sell

with a stoploss set at the opening price

The Trend Breakout System by Subhadip

Nandy ( codes for Metastock)

2. Name it “Trend Breakout System ver 1.0 “

3. Click “Symbols”, then click “New”, Name is “Buys”

4. Input this formula – (Ref(C,-1)>Ref(Mov(C,13,S),-1)){ previous close great er t han 13SMA} AND

((Ref(C,-1)<Ref(C,-2))) {t he close of yest erday is less t han t he close of t he day before} AND (H> O+ ((

Ref(H,-1)-Ref(L,-1))*.55))) {t oday’s high is great er t han t oday’s opening plus 55% of yest erday’s range}

5. Under Graphics, choose the UP ARROW symbol, colour BLUE, click OK to save

6. Now create the SELL signal with a red down arrow, code will be – (Ref(C,-1)<Ref(Mov(C,13,S),-1))

{Close less t han 13SMA} AND ((Ref(C,-1)>Ref(C,-2))) { previous close great er t han t he close of day

before} AND (L< O- (( Ref(H,-1)-Ref(L,-1))*.55))) { low of t oday less t han t oday’s open minus 55% of

yest erday’s range}

{} cont ains t he comment s, Met astock will ignore what ever is writ ten wit hin t hese parent hesis

Now if you select the ‘Trend Breakout ver 1.0’

and attach it to a chart, it will look like this :

Fixed Risk Position Sizing

Let us assume that the trader is ready to risk x amount per trade

His system provides a precise stoploss ( R) ( this is terribly important as no

money management is possible without a clearly defined stoploss point)

Hence, his position size per trade will be x/R 4. Let us explain this simple

concept with an example. Say a trader trading Nifty futures as per the Trend

Breakout System is willing to risk Rs.20,000 per trade

Situation 1 : SL is 100 points . Hence the quantity the trader will trade is x/R =

20000/100 = 200 Nifty fut

Situation 2 : SL is 50 points Hence the quantity the trader will trade is x/R =

20000/50 = 400 Nifty fut

Situation 2 : SL is 20 points Hence the quantity the trader will trade is x/R =

20000/20 = 1000 Nifty fut

Position Sizing conditions

us make the following assumptions :

We use a net capital of 5 lacs.

We use a risk of 2% of capital per trade

3. Our risk per trade will be Rs.10,000/-

Depending on this fixed risk, we take

positions

Backtesting performance 2018

Equity Curve 2018

PnL distribution per trade

Stress test

Stress Testing explained

Let us consider the year of 2018. The number of profitable trades in the initial backtest

was 20. We consider a standard error ( simply root of 20) which comes to 4.47 and it’s

rounded off to 4. We now assume that in real life trading, the number of profitable

trades will be 4 less than that shown in the backtest. So in real life trading, we assume

that the number of profitable trades will be 20-4 = 16. Then we multiply the average

profit per trade with this new number of profitable trades to get the “Curr(ent) Win”

figure which is obviously much reduced than the original profits.

We do the same standard error calculation for the losing trades thus increasing the

number of losing trades from 15 to 19 and increase the total loss amount.

This is what you can realistically expect and this figure remaining positive even

after taking adverse trades into account proves the robustness of the system.

This result is known as Pessimistic returns. If a system shows a loss after this test,

then probability is high that the system will not perform well in real trading.

Parameters to test the system

Parameters in detail - I

Win ratio : (Total wins/total trades) . The probability of wins, total wins

divided by total number of trades.

Payoff Ratio : (Average profit per profitable trade / Average loss per losing

trade ) The return expected per rupee of risk, must be greater than 1.

Trade Expectancy : (win ratio * avg win)/(loss ratio*avg loss) This must be

positive for the system to be ultimately profitable

Top 10% winnings : Total amount earned in the highest 10% of winning

trades

Top 10% losses : Total amount lost in the biggest 10% losing trades

Parameters in detail - II

Net – Top 10% wins : This figure must be positive, i.e, whether the system is

still profitable after deducting the top 10% winnings

Returns minus positive outliers : Returns calculated after deducting the top

winnings

Tops wins minus top losses : Best 10% wins minus best 10% losses. This figure

must be sufficiently positive

Ratio of top wins to top losses : This ratio must be greater than 1. Anything

greater than 2 is great, the more the merrier

Net minus all outliers : Returns calculated after removing the top 10% of

wins and losses. In terms of a bell curve, removing the outliers both sides

Parameters in detail - III

Returns % minus all outliers : the net returns after outliers removed on both sides

Profit factor : (gross profit / gross loss) The profit factor is defined as the gross profit divided

by the gross loss (including commissions) for the entire trading period. This performance

metric relates the amount of profit per unit of risk, with values greater than one indicating

a profitable system. We all know that not every trade will be a winner and that we will

have to sustain losses. The profit factor metric helps traders analyze the degree to which

wins are greater than losses.

Max drawdown amount : A drawdown is measured from the time a retrenchment begins

to when a new high is reached. This method is used because a valley can't be measured

until a new high occurs. Once the new high is reached, the percentage change from the

old high to the smallest trough is recorded. Drawdowns help determine an investment's

financial risk. Both the Calmar and Sterling ratios use this metric to compare a security's

possible reward to its risk

Parameters in detail - IV

Luck factor : (% of highest winning trade / % of average winning trade). This

explains how much a single trade contributes ( is lucky) to the

performance of the system. We are looking for a low figure on this one. A

system with a luck factor of 6 or 7 means that 6-7 times the average profit

came via a single trade. Hence, in real trading we might not come across

such a trade

Recovery factor : ( total net profit / absolute drawdown) This figure must be

greater than 2, a lower figure would suggest that the system is not robust

enough to cover the drawdown

Pessimistic returns : Standard error adjusted returns

Anatomy of a trade – 11th March

On 8th March, the closing is above the 13SMA and the close is lower than

the close of the day before

8th March High = 11084 , Low = 11033, Range = 11084-11033= 51

55% of 51 = 28 points

Anatomy of a trade – 11th March

Buy > 11074+28 = 11102

SL = 11073

Position = 10,000/28 = 357 ( roundoff to 375 or 5 lots of Nifty fut)

ATM options is 11100

If trading options, we buy 750 ( 10 lots of 11100 CE )

Exit on 12th March at 11336

Profits in points = 11336 – 11102 = 234

Profits in amount = 234 * 375 = Rs. 87,750 /-

Real-time chart – 11 &12 March

Use of options – The naked call/put

We always buy ATM call/put, so effect is roughly 50% of futures move

Options eliminate black swan risk

A naked call-put buy is the simplest trade possible

Position sizing dependent on risk profile

Average price of naked ATM option is 120 on average

Max loss can be 100 points on the option

Trade in options, not futures

Thank You

www.quantgym.com

Twitter : @SubhadipNandy

Email : quantgym@gmail.com

Mobile : 97480 52739

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