The "For Sure" Historical Pattern
That doesn’t exist.
What I am going to address in today’s article has never been addressed by anyone else in the industry to my knowledge. Despite this, it can definitely make a huge difference in how you look at the next system you trade.
Systems come in two categories. Understand the difference between these two categories and you will never look at systems and/or system trading the same way again.
I am going to give you these two categories and then I am going to provide the tracking results from a category that most never distinguish. The first category is the most commonly known and traded type of systems. It is known as historical based trading systems. Historical based systems are the systems that are based on historical movement in the market. All systems that use patterns and all systems that use technical analysis of any kind fall into this category. Cycles, waves, fib retracements, stochs, volume, all of them are historical based trading systems.
The second category, which is also the one I want to focus on with today’s article is FACT based systems. There is a huge difference between these two types of systems and before I get into what a Fact based system is, let me give you a few stats.
I had a software program specifically developed for my own research and use. In this program, I have been tracking every single option that has met the minimum criteria I have set up since October of last year. I have had the software since 2003, but I had some changes made last year to enhance the ability of what I could track.
Since October 10 th of last year, it has tracked every option that has met my minimum criteria. The total number of options across a group of commodity and futures markets since that date that has met my criteria through 2-17-06 stands at 2,256.
Basically, how this works is that wherever the closing price was on the date the option met my criteria it stuck in a portfolio until the expiration date of that option. Either the option expired in the money or out of the money, no exceptions, no other exit criteria. It meets the criteria, it gets listed and tracked through expiration without doing anything else. Do you want to know how many of those options expired worthless?
2,160. That’s 96% of these options expiring worthless.
The total premium from all the options that expired netted at $955,822.14.
Very few individuals have the kind of capital that is necessary to actually trade all of these options, very few. But the strategy used to pick these options out is a FACT based strategy.
I hope this gets your attention as to the importance of distinguishing between fact based systems and historical based systems.
So what is a FACT based system? It is a system where the premise and to some extent the source of the potential profit of a trade is based on the fact that some event will happen with 100% certainty or that there is a fixed probability of one event happening, and/or set of events happening.
All extrinsic option selling strategies fall into the fact based category. Why? Because the premise and to some extent the potential profit of a trade is based on the fact that time, under all circumstances, will pass.
No matter what a market does, it cannot change this fact. It will happen with 100% certainty. No wonder so many strongly frown against selling options. I mean, I can see the logic as to why you would never want to sell an option based on this, don’t you?
Seriously though, the historical for sure pattern doesn’t exist because there is nothing factual that is going to happen, or MUST happen with a certain fixed probability. If a certain pattern has been followed by the market moving down 75% of the time in the past, this is not a fact based situation. That probability is not fixed, it just is what happened. There is no mathematical calculation that could be applied to determine that probability BEFOREHAND.
As you can see, the difference between these two categories is dramatic, and important. All to often traders approach historical based systems with expectations that are not appropriate for this category. There is a place for historical based strategies and there is a place for fact based strategies. It is my belief that the majority of someone’s trading account should be allocated to fact based trading and a smaller portion of the trading account should be allocated toward historical based trading strategies. A majority of traders have all of their trading capital allocated to historical based trading systems.
Of course, option selling is not the only fact based type of strategy. Back in 1999, I stood in front of a group of 200 traders and I guaranteed the profitability of a single trade. Basically, this trade was based on the FACT that heating oil comes from crude oil. It takes approximately 4 barrels of crude oil to produce 1 barrel of heating oil. This is fact. As a result, heating oil should never be priced below the price of crude oil. It is not necessarily going to be 4 times the cost of heating oil because other things that are produced from the same barrel as well, but it should definitely be priced higher. As it turns out, for a short period of time, the price of a heating oil contract was LESS than the price of a crude oil contract. The trade was simply to create a spread by buying heating oil and selling crude oil.
Of course, the spread almost immediately increased to about $2,500 on the plus side.
This is just another example of the difference between fact based systems/trades and historical based systems.
As stated earlier in the article, most traders do not trade any Fact Based system at all. In fact, most don’t even realize that there is a difference between the two. As a result, where it is my belief that a majority of a trader’s portfolio should be involved with Fact Based systems, most traders have 100% of their trading involved in historical based systems.
I want to reiterate that there is a proper place and there are advantages with some historical based systems. There are also a few disadvantages that are usually associated with Fact Based systems.
Disadvantages of Fact Based systems:
The biggest disadvantage of Fact Based systems is a slower and maybe even smaller profit potential. You are not going to see someone take a $10,000 account and turn it into over $100,000 in 90-days with a Fact Based system. The reason is because in order to take advantage of the fact that provides the fixed probability of success, you have to abandon the kinds of exits most traders use on historical based systems.
For example, in my Options for Profits strategy that was used to track the 2,256 options listed above, protective stops are NEVER used. Why? Because it would nullify and neutralize the entire advantage that was provided by the fact that time will pass.
And, I will note here that whether you are selling options or buying options, the use of a protective stop to exit in either situation is, well, there is just no other way to put it, the stupidest exit strategy you can use with options. I don’t have time to explain why this is the case in this article, but don’t let the fact that protective stops can not be used to take advantage of the factual situation impede you from learning more about it.
The reason that growth potential may be slower is simply because we have to ratchet down our trade size in order to make sure that we are able to take advantage of the factual probabilities and not get ourselves into a situation where we are overtrading.
Advantages of Historical Based Systems:
The biggest advantage of historical based systems not because they even come close to measuring up to the quality and probability of fact based systems, it is because with most historical based systems, you can apply a powerful money management strategy that can increase the profit potential of the system 10 fold or more with relatively small additional risk.
As a result, a larger portion of trading accounts should be placed in fact based trading strategies while a smaller allocation should be made toward historical based trading systems. The fact based trading systems will give you the probability of success while the historical based systems combined with powerful money management strategies can give you potential in both size and speed of profits. However, the probability of success with historical based systems is much, much smaller, which is why it should get a much smaller allocation of your trading account.
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