A bit about Ed's trading system
January 27, 2008
I can use two methods for day trading the Rydex mutual funds, what I call System 1 and System 2. System 1 is trading just about every day, while System 2 makes trades only once or twice a week. Occasionally, it might even be less often than once a week. I came up with System 2 because of the downside of System 1, which is the fact that, while overall it is profitable, it loses money for stretches of several weeks or even a couple months or so. Having these dry periods is frustrating—either losing or staying on the sidelines, waiting until the ebb and flow returns to a profitable period. With System 2, trades are made less often, but they have a high percentage of success, less of a risk. With just a few good System 2 trades a month, one can still make a very large amount of money.
Here’s how System 2 works. It basically is an offshoot of System 1, because while System 1 is based on daily predictions of the index market directions (such as Dow or NASDAQ), System 2 trades pick only those daily predictions that have the highest probability of success. How do I have these probabilities quantified, you may wonder. Well, I’ve found that overall, on a daily basis, correct predictions outnumber incorrect predictions. This is why System 1 works in the first place, because if it was a random 50-50 ratio, there would be no significant profits. Overall, the percentage of correct predictions is over 70 percent for the daily predictions. Next, it turns out that a high percentage of time (85 percent or more), anytime there is an incorrect prediction for the day, it is followed by a correct prediction. A small percentage of the time (15 percent or so), an incorrect prediction is followed by another incorrect prediction (that is, two consecutive times). Three incorrect predictions in a row are extremely rare, in fact, over a two-year period, this has only happened once. For this reason, using the prediction for a trade after an incorrectly predicted day is a relatively low-risk trade (85 percent or better). If you can be right 85 percent of the time, you can be pretty sure of making nice profits. The probabilities look even better with System 2 as it turns out that not only do correct predictions outnumber incorrect ones (85 percent), but the days of correct predictions average more money made than is lost on an incorrect prediction. Specifically, over a two-year period, the average number of Dow points gained per day on a correct prediction using System 2 is 131 points, while the average number of Dow points lost per day is 63.
The result appears to be a can’t lose scenario. Based on this model, all the probabilities are in favor of making lots of money. Of course, this is based on a theoretical look at a two-year history of this system. I haven’t yet tried this System 2 method with real trades. The only way to really see if this works is to go ahead and do it, which I am going to do. The first time I tried it a while ago (only one trade) was a big loss, and, because I had already been feeling down from a bad period of System 1 trading, I was thrown into a depression of discouragement, resulting n me staying out of the market. I have rested my emotions, and I feel like I am ready to take the plunge again. To ease myself in, though, I may start off trading only a small portion of my money, instead of the entire amount, as I have done in the past. I am eagerly awaiting an incorrect prediction day, so I can try this system out.
Using System 1, I’ve analyzed historically (back-tested) my system for two years, counting up the Dow points gained with my daily predictions, and how that would translate, or correlate, to making money day trading Rydex Dow 2x and Inverse Dow 2x. The results would be similar trading the NASDAQ 100 with the Rydex OTC 2x funds.
Just about every month the number of correct predictions for the daily market (whether it would go up or down) were better than wrong predictions. But for my system to work and make money, it seems, from my preliminary analysis, the resulting excess number of Dow points (differential) gained from correct predictions over wrong predictions must go above a threshold of about 400 points or so. This has happened in 14 months out of 24. Thus, overall the gains would have outnumbered the losses. A positive differential of 300+ points is kind of borderline and may or may not mean an overall profit. I’ve given a point value ranging from -3 to 3 depending on the Dow points differential, with -3 being a horrible month of mostly losses, and 3 being incredible gains.
There have been some stretches of months with phenomenal profits, and some stretches of months with bad performance. Why is the system not consistent? Why, for instance, would the first few months of 2006 have been so profitable if I had been using this system then? And why was August to November of 2007 very good for me (when I first started), and then it turned around in December? I don’t know if there is a real answer, other than the fact that there is a randomness to the market, a natural ebb and flow, cyclical movements that just happen and are beyond our control, which causes results to vary. The good news is that this system seems to work for the most part, over the long term.
I think I have a way to deal with the bad periods, which can last several months before becoming profitable again. During bad periods I have identified safer, less risky days to make trades (80 to 90 percent of the time they would be safe, meaning making money or at least not losing much). This means I would not trade every day, but only on those occasional days when the risk is less—but this would only be about once or twice a week. I call this less frequent trading “System 2.” If you have a lot of money that you are trading, this can still be quite profitable by having winning trades once a week or so and not having many losses. The money management strategy is to go to this safer trading if your overall percentage gain drops down to a certain level, as mine has dropped from 69 percent to 50 during the last few weeks. Or if you are a new trader using my system and have started and are in the hole, just do the occasional safer trades and you will be in the black before you know it.
If you look at the “results after wrong day” (my code word for selecting a relatively safe, low-risk day for trade, after a day that would have been a definite loss—System 2), up to 1.17.07, the number of Dow points gained on these days traded is 6494, the number of Dow points lost is 938, for a net gain of Dow points of 5596, for an average of 1235 per month. The ratio of days with positive Dow gains to negative Dow (losses) is 74 percent (46 to 16, or 46 out of 62).
There has been a bad stretch since 12.26.07, which would be discouraging to someone starting off then. But looking at the whole picture, the retrospective track record looks good. If I use this system over the long haul, I’m optimistic it will prove to be very profitable.
