Are you tired of being spoon-feed trades without knowing how to come up with the ideas on your own? Many traders fall into the trap of being fed the fish but never really knowing how to go about fishing on their own. This post and next week’s aim to fix that.

The Words that Would Not Go Away

I’ve had a mental breakthrough recently about something that Dr. Brett Steenbarger lodged into my mind during one of my Chicago visits at his office. How could he have known that this thought would percolate in my head for so long?

Well I finally am able to pour it out by applying his trading approach to the suite of tools we offer here at Trade-Ideas – using The OddsMaker.

Creating and Testing Themes in the Market

The market is always giving answers to traders. If you don’t ask the right questions, it sounds like gibberish. It’s just like the scientific method of problem solving. Create a hypothesis and test to see if it is correct – in a trader’s case it’s about creating an opinion about certain patterns and testing if the market is rewarding such patterns. For example I might have the opinion that jittery market conditions brought on by the fear of investment bank failures means that normally positive, momentum like moves will revert back to the mean. I therefore will look and see if fading 30-day highs with certain position management rules (e.g., hold time, stop loss amount, etc.) is being rewarded by the market. But I’m getting ahead of myself.

The First Step

The first step in testing such a theme means starting with broad questions and eventually adding layers to get to specific biases that (when tested and backtested) reveal advantages and odds for profitable trading – like the example above. Using a tool like The OddsMaker makes this exercise much easier in time and capital saved. I start with a description of a trading universe extremely general but with high volume and:

• a Min Price of $10
• a Max Spread of 25 pennies
• a Max Distance from Inside the Market of 0.1% (helps avoid the presence of trading on bad prints when backtesting)
• a Min Daily Volume of 250,00 shares/day
• a Min Current Volume of 3 (meaning stocks should be trading 3x average volume at the moment of the trigger event/alert)

This strategy represents a large universe of stocks. Using The OddsMaker lets me trade all of them using data from the last 3 weeks, so I decide to see which side (Long or Short) is more profitable to trade under the following position management rules:

• Exit the position if it goes against me $0.40
• Trade anytime during the market session
• Hold each trade for no more than 20 minutes

Here’s what The OddsMaker reported for each side (to fully understand what all the numbers mean, refer to The OddsMaker Manual):

• SHORT: 792 / 1500 = 52.8% down $0.01 in 20 minutes; Average winner = $0.3099, Average loser = $-0.2391, Net winnings = $94.34, Best = $4.79, Worst = $-0.40; Casino Factor = 100%
• LONG: 579 / 1500 = 38.6% up $0.01 in 20 minutes; Average winner = $0.295, Average loser = $-0.2492, Net winnings = $-42.44, Best = $3.98, Worst = $-0.40; Casino Factor = 0.01%

From these results I observe that the net winnings over the last 3 weeks are greater on the SHORT side. The market is telling us the path of least resistance (i.e., to profits) rests with the shorts. But this strategy still needs work. We cannot expect to trade 1500 times as the denominator above records.

The trick is to add more filters that further define the profitable universe in which we want to trade.

Next week I’ll finish where this strategy is going. Today’s point is simple – let the technology work for you in pointing out where the greater odds exist. If a trader chooses to go long, s/he knows their contrarian stance and can adjust risk parameters like stop losses, position size, and other variables accordingly.

Last 5 posts by David Aferiat

• Tooltip: Spank Father Time While Improving Your Trades - November 5th, 2009
• Format and Themes for Upcoming StockTwits Episodes Videos - October 27th, 2009
• Signposts: A Method of Market Forecasting Which Strategies to Employ - October 26th, 2009
• New Version of Trade-Ideas iPhone Application is Now Available through iTunes - October 14th, 2009
• Like Gump But Without The Smarts: More SOES Stories Trading Lessons - October 13th, 2009