Advanced Option Strategies

Enhanced Strategies for Trending Following System Trading

Proper trade management for system based trading is vitally important. Today’s commodity markets are moving with higher levels of price volatility and risk than in the past. Within a market’s overall trend there exist many short-term correction moves or spikes in volatility that warrant close attention. The implementation of a proper enhanced entry/exit strategy can greatly improve a system’s overall performance.

First Things First! Not a week passes that I don’t speak with someone who is frustrated or completely disheartened by lackluster results from a system or program promising otherwise. With the evolution of system based trading and its availability in the public domain, I have witnessed an explosion of systems in the financial arena. Distinguishing good trading solutions from poor ones can be a daunting task. Here are a few basic tips to have in mind when selecting a strategy.

The strategy must have an actual track record of performance. Does the system developer trade his/her own strategy with his/her own money? Does the real-time performance of the system correlate with the hypothetical or back-tested performance figures? If the answers to these questions are yes, then you’re off to a good start.

A good trading system will have outlined proper capitalrequirements based upon current risk exposure (defined by current market volatility and markets traded). Such capital requirements will change as a function of changing market conditions. Trading strategies with fixed startup requirements based upon historical draw downs are not necessarily accounting for risk.

Good trading strategies will manage trades in accordance to current market conditions and levels of risk. Trading systems that manage trades in a fixed manner are not properly accounting for risk. Just as market conditions change so should trade management.

Enhanced Strategy: As with all things in life, trend-following systems have weaknesses and strengths. The most notable weakness with trend following logic is its inability to account for sudden changes in market dynamics, often created by temporal news and short-term changes in market psychology. Such changes lead to “giving back” of potentially measurable open trade profits. Those who have experience with mechanical trading systems know how disheartening this can be. You may have witnessed systems do a reasonable job of electing winning trades only to return most, if not all of those winnings, or worse yet, “stop out” at a loss. In my experience a combination approach is best. Even with the best of trend-following systems, the “human element” of an experienced trader can greatly improve a system’s performance (winning rate). This is achieved by proper trade management or proper use of an enhanced entry/exit strategy with respect to current market conditions.

Some General Enhanced Entry/Exit Strategy Tips: 1. Understand your system’s weaknesses and strengths and the markets traded. I start by doing a portfolio analysis of each individual market to determine the size of the average winning/losing and largest winning/losing trades. This familiarizes you with the general landscape of the market(s) territories, trading marks and measures. I don’t suggest you entirely abandon the mechanical nature of a sound trading system. For example, you wouldn’t trade against the direction of the trend or the system’s signal. Upon entry, sound enhanced exit strategy logic based upon the market’s dynamics can improve overall winning rate and bottom line.

Often times markets will pull back after a signal has been generated providing a lower risk point of entry. Although, you may run the risk of missing out of a move the probability of this happening is generally very small. Markets don’t move in straight lines, and often with a little patience provide better entry points, thereby reducing risk. Those of you who have strictly followed a trend-following system’s breakout signals have likely noticed this to be true.

Once a position has been elected I police for anything, both fundamental and technical that could negatively or positively impact my open position(s). I have been in positions that had large or unusual price action following the effects of news or other market concerns, which were rarely lasting. Such events occurring in your favor creates the opportunity to secure quick and potentially substantial profits, which are usually short-lived. Doing so not only locks in profits but allows you to reconsider the same position after the market re-adjusts. Often when a market reacts to news or concern it will commonly re-adjust as quickly as it reacted, so you must manage positions closely.

Outside of news and knee-jerk reactions, once my average profit per trade has been achieved and or exceeded, I again turn to the technical and fundamental conditions surrounding the market to determine the validity of the elected trade and trend. If it appears the underlying market is trading in a range, experiencing strong support/resistance or simply isn’t maintaining the original bias, I will look to take profits. I’m most interested in capturing at least 50% of any positive trend or move the system elects. Typically, a trend system on auto-pilot (100% mechanical) will capture less profit (or in some cases turn winning trades into losers). This is because from a trend-following system’s perspective, a price pullback against the trend’s direction is necessary to signify the end to a trend. During this pullback or “giveback”, profits are left on the table.

There are times the markets will simply defy enhanced management and you will miss part of a larger move. However, remember this is a rarity. Range-bound or sideways markets are largely the cause of draw down and “give back” for trend following systems. It has been debated as to the frequency that markets will trend. Typically markets trend somewhere between 10% and 40% of the time while going through periods of consolidation the rest of the time. Reducing risk with enhanced entries and wisely taking profits off the table with the use of enhanced exits can greatly improve your net result and your overall experience with trading.

A Final Word: Over the years, I have discovered some sound and effective trading systems in the public domain but even these trading systems have limitations. Such limitations can in part be overcome with the use of proper trade management. It takes most traders years of experience to properly implement such enhanced entry and exit strategies. However, with patience, discipline, and an open mind one can learn to master this approach. Such strategies will undoubtedly prove to be invaluable and lead to more success with trading.

Disclosure: There is a substantial risk of loss in trading futures and options. Past performance is not indicative of future results. No system or trading program can guarantee profits or freedom from loss.