From the Share Wealth Systems R&D Team

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System Quality Number

Before I take you through the statistical differences of the Pre December 2011 SPA3 Edge versus the Revised Edge, I need you to understand an important step forward I made while on this journey. While it’s not entirely new in the realms of measuring statistics and systems design, it played a major role in helping to achieve our predefined research objectives.

If you remember, our two core objectives at the start of this process were to:

• Increase returns
• Reduce drawdown

To achieve these objectives, we first needed to make each trade more similar to one another. As stated in a previous blog post, the more similar individual trade outcomes are, the more flexibility one has with their money management. This then increases the probability of limiting drawdown and increasing returns in their portfolios.

Ralph Vince made the statement, “The most important preparation a trader can do is to make as certain as possible that he has a positive mathematical expectation in the future”. While I am a big believer that every investor must trade and invest with an Edge – expectancy is a calculation that determines whether an edge is present or not – it does not measure the variability of outcomes of trades that comprise the edge.

So what is SPA3′s edge? In the graph above, all the blue dots are on the breakeven line of the Expectancy curve, i.e. an Expectancy of 0. This is calculated using the formula, Expectancy = [(Profit Ratio + 1) * Win Rate] – 1. The green dot is where SPA3 without Risk Tables (prior to this round of research) is positioned on the Expectancy curve with a Profit Ratio of around 2.7 and a Win Rate of around 40% resulting in an Expectancy of around 0.48 = [(2.7 + 1) * 0.4] – 1.

Thomas Stridsman in his book “Trading Systems that Work” takes this concept expectancy even further. He points out: “The point is, by keeping the standard deviation of outcomes lower, while at the same time also decreasing the ratio between the open profits and closed out profits, we can be more aggressive (and flexible) when it comes to position sizes traded in our portfolio, according to a fixed fractional trading strategy.”

So far in this series of blogs we have discussed reducing End of Trade Drawdown which is the same as “decreasing the ratio between the open profits and closed out profits” that Stridsman refers to.

In order to test and determine whether we can keep the “standard deviation of outcomes lower”, firstly all trade outcomes must be expressed in terms of the risk taken on each trade. This could be the distance to an initial stop for each trade or could be the average loss per trade as measured over a large sample of trades. In this exercise we have used the average loss per trade.

Assume the average loss across all trades in a sample is, say, -7.54%. Express every trade outcome in terms of the absolute average loss, e.g. if a single trade had a profit of 15.18% then ÷ abs (-7.54%) = 2.013. Do this for every trade in the sample.

Then calculate the standard deviation of all the trade outcomes expressed in terms of the average loss. This is the measurement of the variation of trade outcomes = Average Loss Standard Deviation:

It is then used in the formula Expectancy ÷ Standard Deviation of trade outcomes to produce what is known as a statistical t-score or, as Van Tharp calls it, the System Quality Number (SQN). This is basically dividing the Edge by the variation of trade outcomes. The lower the variation of trade outcomes, i.e. the more similar the trades are to each other, the higher the resultant will be.

SQN takes Expectancy beyond just expectancy. It brings the variation of trade outcomes into the equation.

SQN = Expectancy ÷ Average Loss Standard Deviation * 10. This is not exactly the same as Van Tharp’s calculation as our view is that he gets a little caught up with the number of trades over which to measure the SQN. Therefore, we have merely multiplied by 10 for comparison purposes to other systems but this could be omitted from the calculation. You can read up on the SQN by searching for it on the internet or in Van Tharp’s more recent books. You should also search for discussions on SQN as there are some caveats about how to calculate it.

The lower the Average Loss Standard Deviation (being the divisor), the higher the SQN. Now you should understand why the variation of trade outcomes is important in a trading system. The SQN arrives at a single number in order to measure what potential portfolio equity curves could eventuate from a particular system, before risk and money management is applied. SQN, compared just to expectancy, is a better indication of what type of equity curve can be expected and the breadth of position sizing that could be used with the system. SQN is merely a statistical measurement that helps determine whether the system should be discarded or taken to the next research step which is a far more laborious and time consuming process but is the ultimate step in the process of determining how well a system may be able to perform depending on what risk and money management rules are applied to it. I refer to portfolio exploratory simulation which we are still getting to in this series of blogs.

An acceptable SQN is > 1.5 but preferably should be > 2.0. An SQN with < 1.5 could be traded, especially if it has a high average win, but it should be realised that this would be a riskier system and therefore should be assigned a smaller position size.

It should be recognised that the SQN should NOT be the only metric used to determine whether an edge should be traded or not. For example, a system could have an SQN of 5 over a large sample of trades due to a very low variation of trade outcomes but only capture an average move of .5% in the market, i.e. average profit per trade. If minimum brokerage is .25% then the entire average move is wiped out by brokerage (buy & sell) so this high SQN system should not be traded. In reality, such a trading system could only be traded with very large position sizes where brokerage is relatively reduced as trade size increases.

Therefore, the more similar trades are to each other the better the trading system is for flexible position sizing and the more similar portfolio equity curves will be to each other.

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From the Share Wealth Systems R&D Team

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The core concept that changed everything!

This latest round of SPA3 research has been a real eye opener for me. As investors we are taught that we need to cut the losing trades from our portfolios and let our profit trades run. After all, this is the very essence of a trend follower. Isn’t it?

For decades, books and educators have been teaching investors that a position should not be exited before the trend is deemed to have come to an end in the timeframe being traded (I too was one of these educators). However, through this research I was able to conclude that the age old adage of cutting your losses short and letting your profits run simply is not the optimum way to trade all market conditions.

Since October 2009 the ASX All Ordinaries has moved in a number of large and volatile sideways patterns. Whilst sideways markets have been experienced in the past, there has not been such a sustained and wide ranging market in Australia since the All Ordinaries has been tracked on the combined ASX board starting just over 30 years ago. The problem of a sustained and wide range trading market is that the very definition of letting the profit trades run means that the trade remains open until the trend is confirmed over. This is trend following. In a volatile and ranging market this confirmation is often delayed and any open trade profits are regularly eradicated. This is called whip sawing and is detrimental to trend following approaches.

So what’s the big change? The simple introduction of a profit stop attached to the volatility of the trade helps to lock in profits as the trade rises. It also reduces the overall portfolio risk and the exposure to end of trade drawdown.

Here is an example of how a Profit Stop can improve trading results. Assume a $10,000 position was placed in the trade below. The trade was opened the following day after the green entry signal and closed the following day of the red exit signal. The total move captured would have resulted in a 36.73% Profit or $3673 excluding brokerage.

Chart 1: No Profit Stop

The chart below has the Profit Stop set at the appropriate level for this volatility trade but now there are two trades rather than one. The first trade, again assume a $10,000 trade, had a 61.22% move which equates to $6,122 profit. The second trade, also a $10,000 trade has a -5.56% move which is a $556 loss. The net profit between the two trades in the example below is a $5,566 Profit.

Chart 2: Profit Stop

The difference between the two examples is an 18.93% or $1,893 Profit in favour of the Profit Stop.

Now, pay very careful attention to what I’m about to tell you here because if you understand this, you’ll truly see the power of the Profit Stop. The examples above clearly highlight the effectiveness of the Profit Stop’s ability to lock profits into a rising trend. But it doesn’t end there. The Profit Stop also helps control trade risk.

There is a distinct difference between open trade profit which sits in the market unrealised and what I call collateral which includes realised profits. As positions rise, the risk to the position size increases and if end of trade drawdown occurs, it happens on the entire position size including the unrealised profit. The key to understanding this point is that the Profit Stop helps remove open trade profit and resets a new entry with a new position size. So the retracement or end of trade drawdown occurs on a smaller position size, being the newly opened position.

Looking at the chart above (Chart 1) and assuming a $10,000 position, the stock hit a high of .42₵ or an unrealised amount of $17,142. When the position retraced from the high, the percentage fall was 20.24% and this occurred on the entire $17,142. This is in contrast to the Profit Stop (Chart 2). Assume the first trade had a $10,000 position size like the example above, the Profit Stop was triggered for a $6,122 profit and $16,122 was removed from the market. Assume the re-entry was a reset $10,000 position size. From an entry of .36₵, the trade would be exited for a 5.56% loss or -$556. The point being that the end of trade drawdown happened on a much smaller amount. Whilst the example highlights the difference on a single trade, imagine the effect this principle can have on an entire portfolio over many trades over many years. The principle not only decreases trade risk but also portfolio risk.

Sounds simple doesn’t it? Well, it is simple. It’s also obvious too – but only in hindsight and only when brought to one’s attention. I have explained this new principle of “Cut your losses and cut your end of trade drawdown” to both customers and non customers at recent events and the concept resonates with most.

If the Profit Stop challenges your current beliefs, then hang in there. We’re getting to a point where we will show you the outcomes both statistically and with portfolio equity curves. As they say, the proof is in the pudding.

If you are interested in learning more about the groundbreaking Research and how the SPA3 system can help your investing – Register for an obligation free demonstration

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From the Share Wealth Systems R&D Team

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New Exit Signals

The objective of the 2011 SPA3 research was to increase returns and reduce portfolio drawdown by implementing new timing and money management concepts. No mean feat. But on the positive side we had an existing system in place to measure the success or failure of any new concept we tested.

A decision was made early to split the research into two separate streams so a focus could be maintained. The first phase would focus on timing and once complete, Money Management would become the focus.

Timing

As with any research, numerous trialed concepts we’re proven to be ineffective and these were excluded from being used in the system while other concepts showed great promise. In all, no new entry criteria (timing) would make it’s way into the new look SPA3 but groundbreaking improvements were seen when new exit criteria (timing) were introduced.

Four new exit signals were found to offer enough improvement, some more significant than others, during Portfolio Simulation Testing to make their way into the SPA3 trading system. They were:

• Profit Stop
• Trailing Stop Loss (TSL)
• HMRDCS
• MFE Time Stop

Let me explain the technical principles behind each of these new signals. Stay with me here because these exit signals, mainly one of them, have changed my paradigm and the way that I look at the market.

Profit Stop:
The Profit Stop is a percentage profit target which differs depending on the volatility of the stock at the time of entry. The volatility is measured by the ATRVE (ATR exponentially smoothed then divided by current close price). The lower the volatility of the stock, the lower the profit target.

Different Profit Stop methods were researched and simple percentage targets based on price volatility were decided upon. Varying percentage targets were researched via a process of optimisation over a large sample of trades and default percentage levels were selected for the ASX by volatility level.

Click the link below to view a presentation by Gary Stone on the Profit Stop.

Click to play – Profit Stop

Trailing Stop Loss (TSL):
Various Trailing Stop Losses were researched. The objective of using a TSL as an override is to reduce the size of the average loss trade, reduce the variation of trade outcomes and to improve the overall system and for each volatility level. However, when a TSL is introduced, the average profit per trade, the win rate and the expectancy are negatively affected. Therefore it becomes a trade-off between allowing some relatively larger loss trades through to allow winning trades to continue without exiting them prematurely.

Research demonstrated that a TSL does not have a positive effect on all types of trades. Lower volatility trades are affected negatively by a TSL while more volatile trades can benefit from a TSL, but not too close a TSL.

As with the Profit Stop, research showed that a percentage TSL based on stock volatility was as good an option as any other researched and is far simpler to understand and implement. Varying percentage TSLs were researched via a process of optimisation over a large sample of trades and default percentage levels were selected for the ASX by volatility level.

Click the link below to view a presentation by Gary Stone on the Trailing Stop.

Click to play – Trailing Stop Loss

HMRDCS:
The HMRDCS (High Market Risk Daily Confirmed Sell) is a filter and exit signal that is only used when the Overall Market Index, $XAO on the ASX (Australia) is in High Market Risk status, as defined by SPA3 overall market timing.

It is designed to filter out trades that are signalled during a High Market Risk that have potentially occurred too early. In so doing it will also filter out trades that would have gone on to be a juicy winner. However, these trades are typically signalled by another signal a little later in the price discovery cycle. Overall, more loss trades are filtered out than winning trades and, as such, this filter improves the system’s edge.

MFE Time Stop:
The MFE Time Stop is an exit signal that is used to hold onto the profit for trades that become profitable but don’t quite reach their Profit Stop target.

An MFE Time Stop is only applicable to trades that reach a minimum 61.8% of their Profit Stop target. If the 61.8% level is reached then the MFE Time Stop will instigate a time limit, based on falling trading days after the 61.8% level is reached, for the trade to continue higher. If it doesn’t continue higher within a number of trading days then the time stop will exit the trade.

These new SPA3 exit signals have made a profound impact on the overall performance of the systems expectancy and profit ratio. Before we look more closely at the old versus the new SPA3 statistics I want to share the core concept that changed everything.

If you are interested in learning more about the groundbreaking Research and how the SPA3 system can help your investing – Register for an obligation free demonstration

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From the Share Wealth Systems R&D Team

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Consequences of reducing End of Trade Drawdown (ETD) and increasing Win Rate

Whilst reducing the ETD and increasing the Win Rate are the objectives in order to reduce the variation of individual trade outcomes, doing so will also result in a decrease in the:

• Average win
• Average return per trade
• Expectancy
• Average loss
• Average hold period
• Standard Deviation of trade outcomes

The first three are metrics that one would like to remain higher, however to reduce the ETD different exit concepts need to be overlayed on the base trading system concepts which will also reduce the average hold period and hence the average winner and the average return per trade. Unfortunately that’s the way that it works, increases in one area of a trading system will result in reductions in another area. It’s the overall portfolio result that is important.

A reduction in expectancy is not necessarily a bad thing. If the expectancy of the revised system remains on the same expectancy curve as the original system then this is fine.

The last three are metrics where a reduction is positive, although the average hold period shouldn’t be reduced so much that it changes the time frame of the system to become too active a system.

Reducing the average loss is a very good outcome but the most important is a quantum reduction in the variation of trade outcomes as measured by the standard deviation of trade outcomes. This is because a reduction in the standard deviation of trade outcomes leads to an increase in a metric called the System Quality Number (SQN) by Van Tharp, which is basically the statistical metric called the t-score or t-test.

If you are interested in learning more about the groundbreaking Research and how the SPA3 system can help your investing – Register for an obligation free demonstration

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From the Share Wealth Systems R&D Team

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Know the system

Before starting to improve SPA3, we needed to know a whole lot of metrics about the system as it stands. All trading systems based on technical analysis criteria will have a set of price action patterns or indicator criteria to be met to signal an entry or exit, SPA3 included. The price action pattern or indicator values will be determined by the relative position of the current price action to past price action. This is important when designing or changing signal criteria, but to have the data required to know what to change and why, the system designer needs to “know the system.”

When getting to “know your system” a change in paradigm is required. The designer needs to know the characteristics of the trades that ensue from the entry and exit criteria. To do this, all trades need to be viewed as starting from 0% profit and day 0 rather than in the context of price action leading into the trade.

The diagram below is an example of many different trades over a multiple year timeframe that resulted from a particular trading system, without any risk or money management applied. This is called a straw-broom graph.

Click the link below to view a presentation by Gary Stone on the above straw-broom graph.

Click to play – Know Your System 1

Note the following:
1. Every trade is unique.
2. Every trade is a different length.
3. Some trades start out as losses and remain losses.
4. Some trades start out as winners and remain winners.
5. Some trades start out as losers (winners) and end up winners (losers).
6. The slopes of the trades are different.
7. The resultant closed trade profit varies across all trades.
8. There is an “average” slope and an “average” length and an “average” profit that can be visually determined from the diagram that would be different if viewing a similar set of trades from a different trading system.

When getting to “know your system”, all of these characteristics can be expressed in numbers, more specifically, statistical numbers of particular metrics. As shown in the diagram below, each trade may have a Start Trade Drawdown (STD) but will have a Maximum Adverse Excursion (MAE), a Maximum Favourable Excursion (MFE), an End of Trade Drawdown (ETD) and a Closed Trade Profit, as shown below. The MFE is also called the maximum open trade (or unrealized) profit.

Click the link below to view a presentation by Gary Stone on the above diagram.

Click to play – Know Your System 2

The MAE and STD could be 0% if the trade rises immediately and never falls below its entry price. The MFE could be 0% if the trade immediately falls and never rises above its entry price. There will always be an ETD > 0% unless the MAE and MFE are also both 0% which is a very low probability event when trading liquid instruments.

Whilst minimising the MAE and maximising the MFE might seem obvious objectives, this is largely controlled by the randomness of the price movement in the instruments being traded while the trade is open, in the timeframe that the system is attempting to capture profits. The obvious way to increase MFE is to allow the trade to remain open longer, i.e. increase the timeframe for the system. The obvious way to decrease the MAE is to cut the time that a trade is open. Yet another paradox in trading!

As described above, one of the two key metrics that has been targeted to be improved to achieve the stated objective of this revision project is to reduce the End of Trade Drawdown. This means to reduce the distance between MFE and Closed Trade Profit.

Next time I’m going to discuss the “Consequences of reducing end of trade drawdown and increasing the win rate”.

If you are interested in learning more about the groundbreaking Research and how the SPA3 system can help your investing – Register for an obligation free demonstration

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From the Share Wealth Systems R&D Team

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Where to start a system revision process?

In the previous blog we discussed the research objectives and today I’m going to focus on the actual process.

Ultimately the two main outcomes that a trader would like to control is the degree of risk (drawdown) and the degree of reward that they would like to achieve in their portfolio within the constraints of:

• How much capital they have to trade with.
• How much time they have to devote to the trading process.
• What their risk profile is, measured mainly by how much drawdown they can tolerate.
• Their trading methodology (includes trading system, risk management and money management). The only things that a trader can control are what they trade, when they trade and how much they place in their trades. These three decisions for every trade ultimately determine their drawdown and returns.
• The level of their trading psychology.

We know that active investors have a diverse range of maximum drawdown or pain they can tolerate ranging from < 10% to as much as 60%. However, most investors would use similar position sizes and risk management criteria in their trading, despite having very different drawdown tolerance levels. This doesn’t make sense. If one investor was prepared to risk 10% of portfolio capital while the other is prepared to risk 60% then risk management and position sizing has to be different. The reason that most investors don’t see this from the outset is that:

• most books contain similar suggestions about money management, e.g. the 2% and 6% rule, and,
• there are very few functional portfolio level risk and money management tools available and those few are priced above the range that the great majority would be prepared to pay for such functionality. Also, most retail investors wouldn’t have the knowledge and/or time to research to this level because it simply is not discussed in popular main stream books, i.e. we don’t know what we don’t know.
• Most investors tend not to consult with themselves and ask how much drawdown can I handle. It’s only after the pain threshold is reached that investors either throw in the towel or search for a solution.

So if the two main outcomes that a trader needs to control are their level of portfolio drawdown and their portfolio returns, what is the main determinant that controls these two outcomes? The answer is: the risk and money management controls that are used for each individual trade and for their overall portfolio. The position size is THE biggest determinant of size of outcomes, both positively and negatively.

To be able to achieve one’s reward objectives whilst remaining within one’s risk objective constraints becomes the main balancing act that a trader needs to manage on an ongoing basis.

This means that a trader requires as much flexibility as possible with their risk and money management rules to have the confidence to increase and reduce position sizes (even to $0) as required to increase returns without overstepping their stated risk objective, found in their Trading Plan Objectives Statement.

The degree of flexibility that a trader can have with their risk and money management rules is determined by the variation of individual trade outcomes which in turn, when combined with risk and money management rules, leads to the degree of variation of potential portfolio equity curve outcomes, in terms of return AND drawdown.

This is a key, possibly THE key statement in this material. Ensure that you grasp it. If not now, then return here when you have read the entire set of blogs.

This means that the more similar each trade is to another the more flexibility a trader will have with their risk and position sizing rules which leads to a higher confidence level of achieving their anticipated portfolio outcome, as stated in their Trading Plan Objectives Statement (see Blog on 29 Nov 2011).

Therefore, making each trade as similar as possible to each other becomes a trading system design objective in order to reduce the variation of possible trade outcomes.

To achieve this, specifically the two main measurements to improve within the trading system are to reduce End of Trade Drawdown (ETD) of individual trades and to improve the Win Rate of the trading system. This is the place to start the revision process, with ETD and Win Rate of the trading system which will then flow back to risk and money management.

Now that I’ve laid out the logic behind the research, we’re going to move into the meaty stuff. Please don’t be scared as I plan to convey my message simply. I want to leave you with the idea that to improve your trading results you must look at things differently than you do now. So my primary goal is to challenge and possibly change your thinking so that you can take this knowledge and improve your results.

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From the Share Wealth Systems R&D Team

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If you read the previous journal, you’d be aware that I’m ready to disclose research my team and I have worked on for the better part of 2011 – research that excites me greatly.

My hope is that as you work through this you’ll experience that light bulb moment when everything clicks. That shift in perspective and paradigm that allows you to see things differently. The Japanese call it ‘Satori’ which literally means “understanding”. It is often referred to as an ’AH-HA’ moment – when you suddenly ‘get’ something you have not been able to see or grasp before.

Whilst the research is specific to SPA3, I will use it as an example environment that I hope will challenge you and make you question how far your learning has to go when it comes to investing your money in the market.

Introduction to the Research

“The most important preparation a trader can do is to make as certain as possible that he [or she] has a positive mathematical expectation in the future.” Ralph Vince – author of “The Mathematics of Money Management” and “Portfolio Management Formulas”.

Back in the mid to late 1990’s when SPA3 was first researched and then released, ensuring a positive mathematical expectation was a major objective. As were the position sizing and risk management rules that have been devised over the years for SPA3.

However, we have taken Ralph Vince’s quote a step further and have determined that the most important preparation a trader can do is to:

• make as certain as possible that their trading system has a positive mathematical expectation in the future,
• ensure that resultant trades from the trading system have as low as possible standard deviation of trade outcomes,
• devise a risk management and money management regime that best matches the quality and characteristics of the trading system and the trader’s reward and risk objectives, and
• conduct portfolio level risk and money management exploratory simulation over a period of time that includes different types of markets including up, down and sideways markets.

The step further is the portfolio level risk and money management exploratory simulation. As important as Ralph Vince’s statement is, this set of blogs will hopefully demonstrate that the exploratory simulation is even more important than just having a positive mathematical expectation.

Objectives of the Research

As SPA3 is an existing methodology, objectives had to be set for the revision exercise.
The first and main objective was to improve performance. Improving performance has a number of inter-related objectives. The obvious performance measurements are:

• Increased returns, and
• Reduced drawdown.

These are achieved by improved timing, particularly exit signals, and by improved risk and money management.

The second objective was to improve the flexibility of SPA3 risk management and money management. This included:

• being able to start trading with the SPA3 methodology with starting capital as low as $10,000,
• having a range of portfolio level risk management rules and associated money management rules that could support many and varied customised trader risk profiles, from the very risk averse to the risky.

This second objective is relevant for any system, not just SPA3, as individuals that design their own systems need to be able to start small and risk aversely and then grow capital and potentially take more risk through larger positions.

The third objective was to improve tradability. The aim is that it would become easier psychologically to trade with SPA3 regardless of previous trading experience or the trader’s risk profile. This would be achieved through more sensitive exit signals and through greater flexibility with the risk management rules at the portfolio level, especially when first starting a portfolio.

In the next blog we’re going to look at “Where to start a system revision process”.

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Welcome to a new year of The Gary Stone Journal.

Thankfully for investors, 2011 has gone by the wayside. We can now look forward with a fresh mindset in the hope that 2012 will bear more fruit.

I’m incredibly excited to be sharing this information with you as I believe it to be groundbreaking in the area of active investment. For the better part of 2011, my team and I have worked tirelessly, researching new and cutting edge timing and money management concepts for SPA3, our #1 trading and investment system. In December 2011, the first phase of this research was released to our customers and I am now prepared and ready to share it with anyone and everyone who is eager to learn.

You may ask, “If it ain’t broke why fix it?” This is a valid question to ask, especially of an existing methodology (SPA3) that has an edge, which has been commercially available since 1998 and has outperformed the market over many years.

However, research never ends in the markets. Acquiring a trading system, as is trading, is not a destination, it is an ongoing journey. Trading is best viewed as a never ending iterative process comprising of:

• research,
• discovery (markets, method, mind & personal), and
• trade execution,

to generate a continuously rising equity curve with drawdowns within the trader’s risk objectives.

As is the case when undertaking any research project – there are no guarantees. It is an arduous task that can only be measured alongside your initial objectives once out the other side. Thankfully, I am extremely confident that the concepts and rules devised through this process will add tremendous value and have a profound impact on the long term performance of SPA3 portfolios.

As always, this whole process has been a learning journey full of dead ends and beneficial conclusions. Fortunately we were able to come across a number of ‘game changing tools’ that tested our theories in pictures rather than just statistics. I’m not talking about your everyday portfolio equity curve type tools that are available at the retail level; I’m talking about Portfolio Simulation Testing that billion dollar hedge funds use in their modelling. The biggest benefit from this is that you’ll literally see, in a single picture, what effect risk and money management rules have on performance.

The good news is this: if you spend the necessary time reflecting on this material, I’m sure you will find the real answers you’ve been seeking. I’m a big believer that if you’re not going forwards, you are going backwards. Nothing stands still and as such there will always be room for improvement.

The great thing for our customers is that we’ve conducted this research on their behalf and for their benefit. We’ve mechanised the research into SPA3 and given our customers the process in order to follow the improvements. This is all part of the ongoing service we offer when purchasing SPA3.

I am happy to make this information available and I hope you will appreciate the 1000’s of hours of research, blood sweat & tears and financial investment that have been poured into this process.

We have some wonderful material to work through over the coming weeks that I’m sure will change the way you look at investing in the stock market forever.

Let the learning begin tomorrow!

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Process management entails regular processes and routines that are followed to enforce adherence to the signals and rules or the system or strategy, risk management and money management components of the Trading Plan.

All successful traders and investors have a meticulous set of processes and routines that they follow with discipline and consistency. They have a daily routine that involves market analysis, review of existing positions, trade placement and record keeping. They ensure this happens at a similar time and place each and every day. These traders are process driven in both their engagement of the market and the application and understanding of their trading system. They are NOT overly concerned with the results of individual trades (either winners or losers). They are concerned only with the application of the rules of the system (the process) as they know that over a large sample their trading system’s edge will allow them to be profitable, provided they stick to the process!

Discipline is required at all stages during the process of active investment until executing the process becomes effortless, habitual and flawless. 

Here are some considerations for inclusion in your Process Management section of your Trading Plan that will assist you in becoming process orientated rather than focused on the outcome of individual trades;

• Set aside a specified time every day to undertake your market analysis, trade identification, and trade management. This includes running scans and assesing existing open trades in a portfolio.
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• Undertake this role in a dedicated space that is quiet and comfortable, and where you are able to focus 100% on the task at hand.
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• Keep details of all trades in a portfolio manager, diary or spreadsheet, so that you know all the details of your open positions and pending orders.
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• For trade entry, ensure that only instruments specified in your trading plan are entered; if your trading universe is shares, don’t suddenly decide to have a random trade in the gold market simply because everyone seems to be talking about trading gold!
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• Always position size according to the rules you have specified in your Trading Plan and especially do not size too big during very positive market periods.
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• Always predefine your entry and exit criteria for every trade, prior to trade entry, i.e your trading system/strategy rules. This may also include the protective stop loss level as well as profit taking levels or prices at which the trailing stop may be adjusted.
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• Develop a process for monitoring and managing open positions, and recording these details.
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• Develop a process for monitoring market conditions to determine when you will have money in the market and when you will move partially or totally into cash, i.e. part of your risk and money management rules. For those trading multiple systems and/or multiple markets, this may also include moving funds between these systems according to individual performance.
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• Maintaining a journal with entries for each transaction that details all that you are thinking, feeling, saying and doing at the time of the transaction. Measure these journal entries against what your Trading Plan states. This will capture your trading journey over time so that you can review your growth and degree of improvement.
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• Mindset processes. This is to do with trading psychology. In this section you state how you will organise your thinking and mindset to remain focussed, consistent and objective in executing your processes and what regular and specific actions and processes you will take and deploy to achieve this so that current market conditions do not hijack your process. Examples include:
  • Repeating aloud, every time a trade is executed, carefully crafted auto-suggestion sentences such as Mark Douglas’s Five Fundamental Truths and / or Seven Principles of Consistency and / or any other trading affirmations that you may have constructed.
  • Mental rehearsal, before the markets open, of executing your processes flawlessly or visioning yourself executing your processes flawlessly according to the rules in your Trading Plan.
  • From a big picture view, visioning the edge and equity curve analysis of your edge playing itself out in your trading environment. This assists in building trust in the big picture outcome for your edge so that you do not get derailed by the small picture short term outcomes. It keeps you true to your processes rather than becoming attached to short term outcomes that take you off track.
  • Conducting breathing exercises to achieve calmness, a feeling of peace and a reduced level of arousal; or breathing exercises to achieve focus and create a link between mind and body, to achieve self-control to remain true to your methodology processes.

Managing the trading process will enable you to remain emotionally detached from the outcome of individual trades and will allow you to focus on managing the performance of your trading system or systems according to the predefined rules of your trading plan.

All this will lead to the ultimate aim of becoming consistent and objective which in turn will lead to achieving your mission in the markets and your reward and risk objectives as stated at the outset of your Trading Plan.

Do not take short cuts with your Trading Plan. If you don’t have one or it is not completed to the standard discussed in the last 6 Blogs then “get to it”. Now that you have this knowledge you have no excuses not to do it.

This is the last post of the Trading Plan series and the final journal entry to conclude 2011. The Share Wealth Systems Team wish everyone a very merry Christmas and a happy and safe 2012.

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The risk management component of the Trading Plan deals with the various risks in the market and money management deals with how you will manage those risks. Risk and money management are the key components of any Trading Plan as it is the preservation and trade management of your capital that will allow you to achieve or fall short of your mission and your goals. These two areas of the Trading Plan will be the biggest determinants of the size of returns and drawdowns, once an edge is in place as per the previous section of the Trading Plan.

If one manages to destroy their trading capital then there isn’t much hope of achieving the stated aims! If however, you have strict and well documented rules for the management of your risk capital (i.e. your money), then not only can you engage the market with consistency, commitment and confidence free of doubt, hesitation and reseravtions, but you can also go a long way to ensuring that you will achieve longevity in the market without being tormented by the fear and greed monsters.

These two facets of the Trading Plan determine how much of your trading capital to deploy on any given trade of strategy at any given time depending on certain pre-defined criteria to do with any number of risk items including but not limited to:

• the overall market,
• particular sector risk, if applicable,
• inter-related markets,
• individual trade risk,
• portfolio risk as determined by portfolio run-up and or drawdown,
• diversification levels across systems and / or market sectors,
• market timing, i.e. level of overbought or oversold, and
• trading environment risks, such as computer failure, internet failure, broker failure etc.

To help determine how much risk you are prepared to take you need to ask yourself the following questions:

• What are the various risks that could affect my portfolio? Many of these may be totally unknown to us, and may not even be able to be known because they may never have occurred before or entered our conscious thoughts. The World Trade Centre attacks of September 11, 2001 fall into this category as does the Japanese tsunami of March 2011. What is important is to recognise that events such as this can happen, and we need to document what we will do if such an event occurs.
• How do I determine all the risks that could affect my portfolio? This may be even more difficult given that we may not even know what some of these risks may be but stating how you will go about answering this question will ensure that you step into a process to find the answers.
• How often do I assess this risk (daily, weekly, monthly, never – buy and holders are in the never category)?
• How do I deal with assessed risk in any given moment?
• How much money am I prepared to risk of my overall portfolio?
• How much money am I prepared to allocate to individual trades?
• How much money am I prepared to risk on individual trades?
• How and at which point will I take profit from open trades and will I close the whole trade or only a portion of it?
• How and when will I exit losing trades?
• Am I going to trade with leverage and if so how much and under what defined circumstances will I increase or decrease leverage and to what limit?
• Under what circumstances will I reduce exposure to the market or increase exposure to the market?
• What criteria need to be in place to step aside from the market altogether and go 100% into cash?
• What criteria need to be in place to re-enter the market and with how much capital? You need to define when you will have your money in the market and when you’ll have it out. There may be times when you will have your money in cash rather than in the market, and other times when you will be fully invested in the market or markets you are trading. The criteria for these periods need to be clearly defined.
• Does this all fit within my risk profile as stated in the Goals and Objectives Statement of the Trading Plan?

These and more questions need to be answered in the Trading Plan. Not having answers to these important questions can lead to indecision and hesitation in the heat of the moment in the market which will lead to trading mistakes. Most mistakes are made when under pressure and pressure is most often present when the market is going against your positions and the risks that need to be dealt with are all coming to the fore.

Do the preparation before you get into such circumstances. The more unambiguous your criteria are in answer to the questions listed above the less indecision there will be, the more consistent and objective you will become and the more successful a trader you will become.

Can’t wait until next week? Read the next blog in The Trading Plan series:
The Trading Plan – 5. Process Management

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