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March 7, 2006

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Historical Based Trading vs. Fact Based Trading, Part II

Name: Ryan Jones



Learn More About Today's Author
Years Trading: 19

Favorite Movie: Gladiator

Historical Based Trading vs. Fact Based Trading, Part II

What is the difference between a system based on historical patterns that has won 60% of the time and a system where the probability is FIXED that you will win 60% of the time in the future?

Before I move forward, let me assure you, that despite what some of you may be thinking, there are many types of systems where the probability is FIXED that you will win 60% of the time in the future, and it has nothing to do with past performance. So don’t think that it doesn’t exist. In fact, it is quite simple. But I’ll get to that in a minute.

The difference between the two systems provided in the first paragraph is the difference between a historical based trading system and a fact based trading system.

Last week, I broadly covered this with a few examples given in option selling. Regardless of what you think about option selling, it doesn’t change the FACT that, if approached properly, the probabilities can be FIXED in your favor, and in some cases, HEAVILY fixed in your favor.

The options example that I provided was created by a software program designed specifically for my options strategies. Since October 10 th of last year, the program has tracked all options that have met a certain criteria all the way through expiration. Out of 2,256 options tracked, 96% of them expired worthless. That does not happen by accident. It happens because the probabilities are FIXED that the options tracked will expire worthless. The main fact behind this fixed probability situation is that in all cases, if nothing else happens but the passage of time, the option will expire worthless. And, as we all know, this is a fact that will occur.

I’m not going to get into the other ingredients that are involved in the example of tracking more than 2,256 options, but I am going to make sure that everyone reading this understands the importance of a fact based strategy.

As I mentioned last week, the historical based trading system has its proper place. However, it is usually over-emphasized by most traders, to the point that it is the only type of system being considered. Part of this is due to an huge push in this industry by 95% of the businesses providing only historical based systems, tools and education. A good majority of those businesses have probably never even explored fact based strategies.

What I am going to explain is how simple creating a fact based system can be. Now understand, this is for illustrative purposes only to show the simplicity of creating a 60% FIXED probability situation. This is the beginning from which to build a system based on the fact that the probability is fixed at 60%.

Ready? All you have to do to create a fixed probability of 60% that the system will win 60% of the time is to set a stop loss at 60 points away from the entry and a profit target 40 points away from the entry. You now have a mathematically fixed probability that the market will reach the 40 point target before it will reach the 60 point stop loss. This is fact and it is divorced from historical price action.

The obvious problem with this is that the size of the losses are going to be 60 points and the size of the wins are only going to be 40 points. The net result is the sum of 40 losses at 60 points per loss is 2,400 in losses while the 60 winners at 40 points each is a gain of 2,400. The net profit in such a scenario is -0-.

But like I said, the purpose of this was to show you how simple it is to create a situation where the probabilities of winning 60% of the time are fixed on a mathematical basis (not taking anything else into account). It is a starting point.

This is one of the main arguments against option selling strategies. The example I gave above showed where 96% of the options expired worthless. Rightly so, the focus is immediately turned to the average win and average loss statistic on the options that did NOT expire worthless.

Just to give you those statistics, the average size of the 94 options that did not expire worthless came in at $1,521.28. The average size of the 2,162 options that did expire worthless came in at $508.

The options that did not expire worthless were approximately 3 times the size of the options that expired worthless. This means that in order to breakeven in this scenario, for every 1 loss suffered, you had to have 3 wins. This means that the strategy MUST produce better than 75% winners in order to turn a profit (not including commissions).

If the number of options that expire worthless remain at 95%, the average loss would have to increase to $9,500 per loss in the above scenario for it to breakeven.

Going back to the scenario above where a 60% fixed winning probability is offset by the win/loss ratio that is necessary to create the winning probability, the win/loss ratio must be addressed in order to have a net advantage. This is not as simple as creating the 60% probability without addressing the win/loss ratio, but it is not impossible either. You simply have to think outside of the box a bit. You have to begin to think outside of momentum and oscillators and price patterns and any technical indicator based on past price action. You must think forward.

In order to do this, you have to start asking yourself questions about what you KNOW will happen in the future, or what the probabilities of something happening in the future are. They can start general and then move to more specifics. And, once you separate what you KNOW will or will not happen, or what you know the probabilities to be, then you begin to separate future action from past price action.

For example, we know that price action has a higher probability of seeing a 40 point move in either direction than a 60 point move in the opposite direction. We also know that the market will move either 40 points up or 40 points down before it moves 60 points up or 60 points down.

For the sake of space, I jumped to that last one to get to my point. What if there was a way to create a situation where it doesn’t matter which direction the market moves, but if it moves 40 points, you have a fixed probability of winning?

There are actually several situations that can take advantage of this. There are many option strategies that are designed to profit whether the market moves up 40 points or down 40 points. However, the problem is that the move has to occur within a certain time frame…and that is the unknown. So if the market doesn’t move within that time frame, losses occur.

But forget about the options strategy for a second. What if you could create a strategy that would profit if the market went 40 points in either direction before it hit 60 points in the opposite direction? Doing this is impossible without risk, but there are ways of doing it with certain fixed probabilities at certain points in the market movement. This is not at all as simple as just placing a 40 point profit target and a 60 point stop loss, but this shows the general direction that thinking about Fact Based strategies will take you.

Finally, I want to give you one last example of a Fact based trading strategy. Stocks can, have and some will go to zero in the future. Some companies go bankrupt and stock holders lose everything. Need I mention Enron?

However, commodities will never go to zero barring a completely unforeseeable event that is not only unforeseeable, but unimaginable. They will not go to zero, they will not go bankrupt. This is a known fact. The question is, how can you take advantage of this fact? The obvious answer is that you simply buy the commodities when they are at low prices and wait for them to rise. Again, it is not quite that simple as you have to take into consideration other things, like when is low really low. Or how long can it remain low, or how low can it go. You also have to take into consideration things like dealing with the futures markets in order to get involved with the commodity, which include other things such as carrying costs associated with the futures prices, rolling, etc.

I point this out to say that even though the logic for a fact based system can be very, very simple and straight-forward, there are other things that complicate the issues and these other things should be carefully taken into consideration rather than simply jumping into things because the logic sounds great. The purpose of the last 2 articles have been to encourage you to begin to examine the value and benefits of Fact Based trading strategies and systems rather than put all of your eggs into historical based trading systems.

If you are interested in learning more about Fact Based trading systems, I would encourage you to sign up for the Truth About Trading free email service by going to the following link. After signing up, you will also be sent more information on taking advantage of commodities based on the example above and information on a Forex trading system that was designed around the idea of taking a profit if the market moved in either direction as mentioned in the above examples as well.

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