PowerTrendSystem – Risk / Reward Considerations
Here’s how to think about the Risk / Reward profile of the system Alerts
There is a Defined Maximum Loss on any Given Alert – and Unlimited Upside Potential
Some users at first glance might misinterpret certain alerts as having a sub-optimal risk/reward ratio, so I wanted to create this page to address that and explain in more detail how to look at it.
The first thing to consider is that we aren’t just shooting for the 2 Targets.
While the basic “beginning strategy” is to just trade 2 MES contracts and shoot for T1 and T2, once a user graduates past that starting level, the idea is that we have unlimited upside potential adding another Contract (or more) as a “runner”.
On long-rage days in the market (which are guaranteed to occur from time to time) after we’ve locked-in gains at both Targets, the potential exists to capture 20, 30, 50+ additional points with runner contracts.
The System is Calibrated for a 70% + Hit Rate on Target 1 which Necessitates a Slightly Wider Initial Stop
We are taking on a little extra risk up-front in order to achieve a 70% + chance of eliminating the risk entirely by getting trades to breakeven quickly. (read that again, it’s one of the most important points)
The number one goal of our strategy is to get a trade to breakeven quickly and eliminate all the risk. If the system achieves that 70% + of the time, that’s where the real edge comes in.
We are giving price a little extra breathing room when we enter a trade to reduce the frequency of stop-outs. The system sets the initial stop just enough distance away from the entry so that we won’t get knocked-out of the trade by normal price fluctuation and small counter-trend moves – or random price spikes.
Think about this idea. Suppose we set the initial stop to 1-tick above or below the previous 5-minute price bar (depending on whether the trade was short or long). How often do you suppose the initial stop would get hit only to watch the price actually continue in the direction of our original trade? Half the time? Try it on Sim and you’ll see.
The system has a “Max Fixed Stop” of 18.00 points per contract, but ES has the potential to move an unlimited number of points in our favor
It’s the “Unlimited Upside Potential” once a trade is at breakeven that makes using a slightly wider than normal initial stop “quant out” over the long run.
In volatile market conditions when the 18 point max stop is in play, T1+T2 can be 3x or greater than the max stop. And as mentioned, runner contracts have no upside limit. In more average market sessions or days when the price action is dull and the ATR’s are relatively small, price has a tendency to make quick erratic moves (maybe for a split-second). The system stop is designed to avoid getting hit under those circumstances by giving price a little extra wiggle-room.
Keep in mind that if the average ranges on the 5-minute price bars are 8-12 points, you can’t use a 6-tick (or even a 2 point) stop. You’ll just get stopped-out over and over.
The Aggressive Trailing Stop, Virtual Breakeven, and the “Runner” Contract in the Power Trend System changes the risk / reward profile entirely.
First let me mention that in our initial beta version, we had the software set to “get stopped out of a trade” on the very first “ratchet” of the Trailing Stop (which is the current Aggressive Protection Level). Through extensive back-testing and analysis we determined that leaving the Initial Stop where it was until Target 1 got hit produced better results overall. However the idea of using the Aggressive Protection Level as a discretionary tactic was beneficial in certain instances, which could primarily be determined by looking at the chart and making a judgement call based on the price bars.
In other words, the data shows using the Initial Stop was the best course of action the majority of the time. However, in the future after we’ve had a chance to forward-test and analyze the data more (especially over the dull Summer months) we may choose to “change it back” so that an Alert gets closed (stopped-out) at the first Aggressive Protection Level prior to Target 1 getting hit.
We are starting off running it a little more “wide open” so to speak with the idea we can always “restrict” things more at any point.
There’s nothing worse that getting stopped-out of a trade that immediately turns back around and goes on to make a huge move, and you’re left behind. This is another reason we chose to start off with the wider initial stop and NOT close a trade if the Aggressive Protection Level gets hit.
Here’s an example of an Alert to help demonstrate ways of looking at it
Everything is pretty self-explanatory, but it’s interesting to note the summary at the top indicating a “Runner” Contract scored +33.50 points in addition to the +26.75 points locked-in at T1 and T2. Also notice the trade started off with the 18 point “max stop” and 4 minutes later the Aggressive Protection Level kicked-in and reduced the risk significantly. It might be a good ideal to use the APL on Alerts where the max stop is in play. That Alert actually had +47.00 points of “traction” as you see and it’s possible to see certain sessions where price moves a lot more than that. Again, the upside is unlimited.
The best risk-management strategies fall under the category of Position Sizing.
Studies have been done (Thorpe / Market Wizards) that demonstrate a wider initial stop than most traders would assume produces better overall results. This is because a wider initial stop is less likely to get hit due to normal price fluctuation and normal counter-trend moves. If the original trade setup is valid, we don’t want to get knocked-out of a trade prematurely.
The initial stop is intended to prevent a catastrophic loss in the event the market goes against our trade significantly. We’re willing to take a little extra “heat” on a trade because it “quants out” statistically over a long series.
If we want to achieve a higher hit rate on the Targets and less of a hit rate in the Initial Stop, the tolerances have to be set accordingly. We introduce a little extra risk initially with the idea that we have a much better chance of staying in the trade and “getting to breakeven” a higher percentage of the time. At which point the upside is unlimited.
Closing your trade at the Aggressive Protection Level (first ratchet) is a completely viable option if you prefer a tighter tolerance on your initial risk.
Here’s what you’ll find doing that. Some Alerts you’ll be better off and will take smaller stop-outs using the APL. Those Alerts will go on to hit the Initial Stop and take a bigger hit than you did, and you’ll be glad you used the tighter stop.
But other Alerts will hit the APL and then turn around and hit both Targets and proceed to make a gargantuan move in the direction of the trade. While the idea is to take profits at both Target 1 and Target 2, many traders will incorporate additional contracts to hold as Runners and could end up with +50 or more additional points on days where ES makes a big move.
You could always choose to protect half your position with the Aggressive Trailing Stop and let the other half ride with the Initial Stop.
To Summarize:
The tighter the initial stop, the more likely it will get hit. There’s always a trade-off. For the initial launch of the Power Trend System we decided to use a slightly wider stop (in relation to the 2 Targets) and analyze the results going forward. We can use the “Traction” display to measure the “heat” we took on any given alert and see if we would have been better off using the Aggressive Protection Level to close the trade, or if leaving the Initial Stop in place produces better results (as past data shows).
In the future we may choose to either set tighter tolerances for the Initial Stop or go back to the original strategy of closing trades if the Aggressive Protection Level gets hit. As I mentioned, a couple months of forward-testing should give us an idea of which option is better. In the mean time you can choose whichever stop strategy you prefer on a trade-by-trade basis or just choose one or the other.
I hope this helps explain things and I’m happy to answer any questions you have or go more in-depth about anything mentioned above. If you have questions just email me at info@investingsystems.com