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77 ¹ As you may remember from chapter two, many brokers don’t pass through your order to the market, and they control the price that you trade at. As such, they could briefly push the price beyond your stop level, trigger your stop, and make an easy profit. If you don’t believe this really happens, then offer to buy any experienced OTC trader a few drinks. By the end of the evening you will have heard countless stories about broker misbehaviour related to stop losses.
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77 ² For example, it costs an extra 0.3 of a point to place a guaranteed stop on gold spread bets with my broker. That might not sound very much, but it’s enough to almost double the annual risk adjusted trading cost of the Starter System, from 0.028 up to 0.057. That is too high a price to pay for peace of mind. If your leverage isn’t excessive you shouldn’t need to use guaranteed stop losses.
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77 ³ Technical note: This result is from the fundamental law of active management framed by Grinold and Kahn. The law states that
the information ratio is proportional to the square root of the number of uncorrelated bets (the information ratio is similar to the Sharpe ratio, but is adjusted for a benchmark rather than the risk-free rate). If we trade four times more often then we increase the number of uncorrelated bets by a factor of four, hence doubling the information ratio.
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77 74 As you’ll see later in the book, diversifying your trading across multiple instruments can easily improve your expected Sharpe ratio (SR) by a factor of 2.5. A fund making a SR of 1.05
on an individual instrument would have an overall SR across all of their instruments of 1.05 × 2.5 = 2.625. This is very high.
Some professional traders will occasionally make this level of return for a year or two, but very few have consistently made that kind of Sharpe ratio.
Chapter Six
Trading the Starter System
The previous chapter discussed the design of the Starter System.
In this chapter I explain how you actual ly trade it.
It is always easier to understand something when you’re shown how it’s done. So, this chapter includes specific examples for each of the leveraged products I’m covering in this book: stock margin trading, spot FX, futures, CFDs, and spread bets. I explain how I calculated the initial trades that were appropriate when I started writing this chapter in June 2018, and how trading subsequently panned out over the rest of the year.
Warning: the calculations in this chapter may seem rather lengthy and time consuming. But don’t forget that you will be doing them with a spreadsheet. Spreadsheets for all the calculations in this book are available from the boo k’s website.
That doesn’t mean you can quickly skim through the boring bits in each chapter, as it is really important to grasp the details behind the spreadsheet. Traders make money by having an edge, and one of your edges will be putting in the hard work of understanding how the system is put together. Also, if you don’t understand the system, then you won’t be able to develop as a trader and start adapting the calculations to use in your own unique trading strategies.
Before you start trading
Writing your trade plan
Firstly, you need to determine how much capital you have to trade with. You will need at least $1,500 or £1,100 to trade the Starter System (I explain why in a couple of pages). If you have more, wonderful. You will have a wider choice of instruments you can potentially trade. But only put money in your trading account
you can afford to lose, and NEVER trade with borrowed money .
Trading with leverage is dangerous enough without putting your credit rating, or your hou se, at risk.
I suggest you put all your trading capital into your brokerage account. If you do this, then, unless you are extremely unlucky, you won’t need to pay margin calls when using the Starter System, since it keeps leverage well below maximum allowable limits.
Keeping some of your capital outside your account might seem a prudent way to protect yourself from broker bankruptcy, but it will mean you might face margin calls. Once you start replenishing your trading account with extra cash it can be difficult to stop, even after you’ve drained your notional pot of trading capital. If all your capital is in your account, then hopefully you won’t be tempted to pony up more funds if you start ma king losses.
Before you transfer cash to your broker, it’s important to be clear what the rules of your trading system will be. Together these rules make up the trade plan. For the Starter System the tr ade plan is:
Trade Plan
Choose instrument and product to trade First you need to choose your instrument and product. As I explained in chapter five, you should always choose the cheapest product and instrument that you can afford, given the minimum capital requirement. Table 13 shows the instruments I’m going to 20 20
use for examples in th is chapter. 77 75
Table 13: Costs and minimum capital for example instruments and products as of June 2018
Costs calculated according to method in appendix B. Minimum capital calculated using method in ch apter five.
Before trading you should calculate your own figures for risk-adjusted trading cost, using the formulas in appendix B, with your own brokers commission, trading spread and funding spread.
You should also recalculate the minimum capital, using formula 21
). To do these calculations you also need the instrument risk. I discuss how to estimate risk later in the chapter.
In this chapter, I’m going to use the following minimum capital in my examples. Each trade will live in a separate notional trading account, with capital as follows: Gold futures spread bet £1,200
Corn fu ture $40,000
Euro Stoxx 50, CFD on fu ture $13,000
AUDUSD sp ot FX £1,100
S&P 500 margin trading of the SP Y ETF $7,100
These values are double those in table 13, as per my recommendation from chapter five to use twice the minimum capital, and have also been rounded up. Here capital is only specified in GBP or USD, however traders in other countries can also use the Starter System, as long as the relevant product s are legal.
Get relevant instrument parameters
To translate the exposure you need for a given instrument into contracts or a bet per point, you will need the appropriate position sizing parameters for the instrument you ’re trading: Table 14 shows the relevant parameters for each of the example products, as currently provided by my brokers.
Table 14: Trading parameters for example products
• The minimum is actually one share, but the costs are prohibitive unless at least ten shares are traded.
Tasks on day one
In this section, I describe the tasks that need completing on your first day of trading, using the four example instruments.
All the example calculations here were done on 19 June 2018, when I began writing t his chapter.
Get a price series and last price
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You need a history of daily closing prices 77 76 for your chosen instrument for the opening and closing rules. This history should include the previous day’s closing price, which you will use to calculate your position size and stop loss level. Fortunately, 20 20
there are many websites with free daily closing prices, 77 77 and you can also get prices from your broker. Most websites allow you to download historic prices into a .csv file, which you can then transfer into a spreadsheet for further c alculations.
To calculate instrument risk, you will require at least 20
trading days of daily prices, excluding weekends and market holidays. For the opening trading rule, you need at least 64 days of d aily prices.
Once you have a spreadsheet of historic prices, you can add each days new closing price as an additional row. If you miss a few days then you just need to return to your source of historic prices and grab the mis sing prices.
The wacky world of back-adj usted prices Most of the examples
in this chapter are for dated products , where we trade an instrument with a specific expiry date. This is because dated products are almost always cheaper to trade than their unda ted cousins.
However, this gives us a problem, which is best illustrated with an example. Suppose we’re using a dated instrument to trade gold, where there is normally a new dated instrument every two months.
Imagine that it’s May 2020, the current dated bet expires in mid-June 2020, and we’ve been trading the current incarnation of gold for a month.
Instead of the 64 days of closing prices that are required to calculate our opening trading rule, we only have a month (about 20 days). To solve this problem, we need to stitch together the prices of previous dated gold expiries to create one long series of prices. Prior to the prices we have for June 2020 expiry, there will be prices for April 2020, February 2020 and so on.
Then, every time we start trading a new dated expiry, we can just glue the prices on to our exis ting series.
However, this solution brings its own problem, which becomes clear if we look at the current price of gold for different expiries. As I write this chapter the gold contract dated April 2020 is trading at 1,342.3, and for the June 2020 contract the price is 1,349.3. This is a 7-point difference. If I was to stitch together the April and June prices, then the price of gold in my spreadsheet will apparently jump by 7 points in one day.
But in reality, gold hasn’t actually gone up in value by 7
points. This artificial jump will make our estimate of natural instrument risk a little higher than it should be, and will occasionally make us open trades we shouldn’t, or close positions that should have been left alone.
There are a couple of ways we could deal with this problem. One approach is to use the underlying price of gold – the spot price or cash price . This isn’t ideal, because we aren’t actually trading spot gold, as would be the case for an undated product.
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Using the spot price will distort our data. 77 78 It’s also hard to get the spot price for many instruments, like bond futures and certain commodities. I wouldn’t recommend this, unless you’re really short of time and there is actually a spot pric e available.
A better option is to apply a back-adjustment to our futures price series which will remove the jumps. The simplest method of 20 20
back-adjustment is known as Panama adjustment. 77 79 Using Panama back-adjustment when I stitched the gold price I’d add 7 points 20 20
to all my previous prices upon switching to the June expiry. 78 70
The price for April 2020 gold on the switch date would be adjusted from 1,342.3 to 1,349.3. It would then be exactly the
same as the June 2020 price on the switch date, and there would be no spurious p rice change.
You can do back-adjustment yourself in your price spreadsheet, using the method in appendix C, on page 307 . Alternatively, some 20
websites 78¹ will provide back-adjusted price series, though you usually need to pay fo r this data.
Once you have your back-adjusted price series you should use it all the time: for measuring instrument risk, the opening trading rule, and for stop loss c alculations.
Figure 5: Price of AUDUSD FX as of June 2018 – not back-adjusted as this is an undated product
Figure 6: Back-adjusted price of Euro Stoxx 50 as of June 2018
Figure 7: Back-adjusted price of Corn as of June 2018
Figure 8: Back-adjusted price of gold as of June 2018
Figure 9: Price of S&P 500 as of June 2018 – not back-adjusted as we are using an undated product
Table 15: Prices of example instruments on day one of trading (19
June 2018)
Notice that the price of the SPY ETF is quoted at one-tenth of the S&P 500 index level, which on this particular da y was 2,760.
Measure instrument risk
Once you have your price series you need to measure the instrument risk : the annual standard deviation of its percentage returns. This is required to decide trade size, to work out stop loss levels, and also to manage existing positions. There are a few different methods you can use, listed here in order of my personal preference:
Table 16: Volatility for example instruments on 19 June 2018
All values estimated from daily clo sing prices.
Check opening rules
As we don’t have a position when we start trading, our next task is to check if one should be opened. We need to calculate the value for the moving average crossover: the difference between a
16-day and a 64-day moving average ( formula 13 ). I explain how to do this using a spreadsheet in appendix C.
Alternatively, some charting websites will calculate the crossover for you. Make sure that you’re looking at daily closing prices if you use the value provided by a website. Most websites default to showing only today’s price movement in five-minute increments, and others like to show prices as bars or candles which also include the open, high and low prices for the day. The website will probably not be using back-adjusted prices, which isn’t ideal, but using a website saves a great d eal of time.
Remember: if the 16-day is higher than the 64-day go long, and if the 16-day is lower than the 64-day go short. If you’ve had a position before which has just been closed, then don’t open up a new position in the same direction as the previous one. Wait until the moving average crossover has reversed direction. See the flow chart below:
Flowchart: Trade decision making
The following charts show the price and moving averages for our five contracts from the beginning of 2 018 to June.
Figure 10: AUDUSD
Figure 11: Euro Stoxx 50
Figure 12: Corn (futures prices)
Figure 13: Gold
Figure 14: S&P 500 ETF price
Note: Figures 10 to 14 show that when I wrote this chapter in late June 2018 the opening rule was long S&P 500 and Euro Stoxx, but short AUDUSD, gol d, and corn.
Position sizing
Before a position is opened you need to work out how large it should be. This is a two-st ep process.
Step 1
The first step is to work out the required notional exposure, using formula 14:
Notional exposure = (target risk × capital) ÷ instr ument risk %
Table 17: Notional exposure for initial trades in June 2018
Instrument risk from table 16. Notional exposure calculated with formula 14 using 12% target risk, and rounded to neare st $1 or
£1.
Table 17 shows the notional exposure calculations for the initial example trades, using the appropriate capital. Before trading in
real life, you will also need to check that the resulting leverage factors don’t breach any margining limits set by the brokers or exchanges. Note that for subsequent trades, I will need to change the capital figure to reflect any profits or losses that have been made, and any changes in estimated inst rument risk.
Step 2
Step two is to calculate how large your position should be in the appropriate units for each product. You need to calculate the required number of contracts or bet per point, using formula 20.
All the prices I’m using here come from table 15, the relevant product parameters are in table 14, and I am using the prevailing FX rates as of 1 9 June 2018.
Which dated position?
In this chapter I’ve recommended that you use dated products like futures, or spread bets and CFDs based on futures, rather than their more costly, undated brethren. But with dated products you need to decide which expiry date to trade. The appropriate strategy depends on the instrument you are trading.
For CFDs, or spread bets based on futures, the broker may limit the number of expiry dates you can trade. They often restrict you to the nearest expiry date, even if other dates are available and liquid in the futures market. Try and get as close as you can to the ide al contract.
For our example products, when I was writing this chapter in June 2018, I chose to
trade these dates:
Corn future:
This is a seasonal commodity with forward liquidity, so I choose to stick to trading December; in June 2018, I was holding De cember 2018 .
Gold spread bet, base d on future:
My spread betting broker only offers the next date that the futures expire, which, for gold in June 2018, was August 2018 .
Euro Stoxx, CFD base d on future:
Only the next dated product is liquid, which for Euro Stoxx, in June 2018, was Sep tember 2018 .
AUDUSD Spot FX and S&P 500 margin traded ETF: Both are undated products so there is no expiry date .
Calculate stop losses
The next part of the trading process is to calculate your stop losses. First the st op loss gap:
Take the current instrument risk . This is expressed as an annual percentage standar d deviation.
Multiply the instrument risk by the current price: this will give you the standard deviation in price points (see formula 22).
Multiply the standard deviation in price points by the trailing stop loss factor, which is 0.5 for the Starter System (see formula 23). This equals the stop loss gap : the amount a price needs to move before your position is closed. The stop loss gap 20 20
will remain fixed throughout the life of the trade. 78 74
Now work out the stop levels ( formula 24): If long , your stop loss level will be equal to the initial entry price minus the st op loss gap.
With a short position your stop loss level is the entry price plus the st op loss gap.
It is most likely you will have to round your stop loss levels.
If after rounding you find that the stop loss has come out a
‘round number’, then you should adjust it. Increase the stop level slightly if you are long; reduce it slightly if you are short. Inexperienced traders tend to set stop losses at round numbers, and you want to avoid having a stop at exactly the same level as many other traders. This is especially important if you have left your stop loss orders with your broker.
Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Page 13