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Trading Opportunity: The Figure of Merit
Traders are always searching for the ideal, or at least, a winning, trading
model. Experience shows that given an exact model saying buy here, sell
there, one person may win while the next loses. Why is this? Likely the
differing results arise because a model is inevitably in two parts. Part
one is the calculational piece that spits out buys and sells. Part two is
the input from the trader, all depending on the trader's market knowledge
and attitude toward risk and treatment of gains.
Trading Model Development
Internet: http//www.cisco-futures.com
Email dljones@cisco-futures.com
Dow Index versus S&P
Donald L. Jones©
March 13, 2004
This article is about evaluating your own trading using trading risk and trading
opportunity. No, it is not a study of diversification or market timing. It is
about knowing what you are doing, putting yourself in a position to win. You
can trade blindly or you can understand how
the approach you are following, your 'model', fits the market(s) you are
trading. You can generate a Figure of Merit for your model. That measure
is the ratio of potential (opportunity) to the risk (P/R) on a trade by trade
basis. With a little work you can calculate the P/R ratio from the trades you
have completed. We illustrate the principle with the CISCO Basic Model,
comparing the Dow Index to the S&P.
Model/Market Evaluation: The Concept of Figure of Merit
You can evaluate any model you use by taking the entry price and checking
what the market did after entry. You entered and the market immediately went
against you. You had little opportunity to make a profit. Or, you entered and
the market went your way. The market offered you an opportunity to make a
profit. You probably did not exit at the top (or bottom), but if you had you
would have made the maximum profit possible. This maximum is what we
call potential or opportunity. Virtually every trade has opportunity. Every
trade carries risk. For most cases risk is the stop you placed on
entry. The ratio of opportunity divided by risk is the Figure of Merit (FOM).
FOM puts you in a position to evaluate both your model and yourself.
If your trade is in a certain market that typically offers little opportunity,
you probably should find a different market to trade. If the
average potential (opportunity) is small compared to the average risk, again
you have a decision to make. If opportunity is adequate and your returns
are not, you need to examine the "you" aspect of your trading.
Markets change. Opportunity, the average maximum profit one could make from
a trade, may change over time. Today's marvelous model may be tomorrow's dog.
If you regularly measure the opportunity of your completed trades, the FOM,
you can tell when your market is going into a funk.
Using CISCO Basic Model for Opportunity and Risk
Opportunity for day traders is measured from entry. It is simply the best
return possible after entry, tracked to the close or stop-out, whichever comes
first. Measuring opportunity requires first setting up a model for entry.
We use the CISCO "Basic Model" to identify a balanced market breakout. Basic
Model locates the price range of a balance and uses the upper and lower limits
of the range as the breakout entry points.
You can read about balanced markets at:
Overlay Demand Curve Background.
Basic Model also gives us a measure of risk. Comparing the Overlay to a
quasi-bell
shaped curve, we can think of a breakout as marking the change in distribution
from balance to trend. When a breakout fails, with price coming back into the
original distribution, the failure is confirmed when price penetrates back
about one-eighth of the original upper limit - lower limit range. An eighth
of the original balance is called an Octant. One octant then, is the risk.
After entry, risk may be used as a trailing stop.
The breakout Basic Model is very simple. Go long (short) at a price
one tick past the upper (lower) limit. Track the trade with a trailing stop
of one Octant.
Example of an Overlay Demand Curve
The Overlay in Figure 1 is a single-distribution, balanced market
for a single day. Ten days of Market Profiles of the December 2003 DJ future
from October 8 through October 21 are linearly added, making the composite
Figure 1. To learn how TPOs are generated by the Market Profile see:
Market Profiles Background.
The upper limit of the distribution is 98000 and the lower limit is 95900.
Risk, the Octants, are at 97750 and 96150, respectively. For tomorrow,
the market of October 22, you know where the breakouts may occur and what
the risk is if a trade is initiated.
Ten Day Overlay for a Balanced DJIA Market
TPO VOLUME OVERLAY AND PRICE ROTATION PROFILE
DEC 03 DJIA (CBOT) DAY
10 08 03 TO 10 21 03 (Ten trading days)
PRICE DYS L/F ROT PROFILE * TPOS TPO VOL OVERLAY *
98400 1 5 1 X
98350 1 5 3 XX
98300 1 5 3 XX
98250 1 5 3 XX
98200 1 5 2 XX
98150 1 5 2 XX
98100 1 5 2 XX
98050 1 5 2 XX
98000 2 56 5 XXXX <== Upper Limit
97950 3 567 7 XXXXX
97900 3 567 9 XXXXXXX
97850 4 4567 12 XXXXXXXXX
97800 4 4567 14 XXXXXXXXXXX
97750 5 9 45679 18 XXXXXXXXXXXXXX <== Upper Octant
97700 5 9 45679 21 XXXXXXXXXXXXXXXX
97650 5 9 45679 24 XXXXXXXXXXXXXXXXXX
97600 6 9 456789 21 XXXXXXXXXXXXXXXX
97550 6 9 456789 22 XXXXXXXXXXXXXXXXX
97500 7 9 3456789 27 XXXXXXXXXXXXXXXXXXXXX
97450 7 9 3456789 28 XXXXXXXXXXXXXXXXXXXXXX
97400 7 9 3456789 33 XXXXXXXXXXXXXXXXXXXXXXXXX
97350 8 9 13456789 38 XXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97300 7 9 1346789 46 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97250 7 9 1346789 52 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97200 7 9 1346789 51 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97150 7 9 1346789 48 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97100 7 9 1346789 42 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
97050 7 9 1346789 33 XXXXXXXXXXXXXXXXXXXXXXXXX
97000 7 9 1234789 22 XXXXXXXXXXXXXXXXX
96950 5 12378 15 XXXXXXXXXXXX
96900 4 1278 14 XXXXXXXXXXX
96850 4 1278 11 XXXXXXXX
96800 4 1278 8 XXXXXX
96750 3 127 9 XXXXXXX
96700 2 12 8 XXXXXX
96650 2 12 10 XXXXXXXX
96600 2 12 13 XXXXXXXXXX
96550 2 12 13 XXXXXXXXXX
96500 2 12 12 XXXXXXXXX
96450 3 Z Z12 16 XXXXXXXXXXXX
96400 3 Z Z12 11 XXXXXXXX
96350 3 Z Z12 8 XXXXXX
96300 3 Z Z12 5 XXXX
96250 3 Z Z12 7 XXXXX
96200 2 Z Z1 7 XXXXX
96150 2 Z Z1 10 XXXXXXXX <== Lower Octant
96100 1 Z Z 11 XXXXXXXX
96050 1 Z Z 13 XXXXXXXXXX
96000 1 Z Z 13 XXXXXXXXXX
95950 1 Z Z 8 XXXXXX
95900 1 Z Z 3 XX <== Lower Limit
95850 1 Z Z 1 X
95800 1 Z Z 1 X
95750 1 Z Z 1 X
95700 1 Z Z 1 X
95650 1 Z Z 1 X
Figure 1. Overlay Demand Curve: Ten days, DJ, October 15 - 21, 2003.
Price is descending in the first column, the X's on the right are volume,
peaking at 97250. The column 'ROT PROFILE' identifies the days' prices,
day 9 (Oct 21) ranged from 97750 to 97000, day Z, ten days back (Oct 8),
was 96450 to 95650. The next column, 'TPOS', is a count of the Market Profile
TPOs that went into the Overlay. 'TPO Volume Overlay' column is a visual
depiction of the TPOs in the TPOS column. Upper and Lower Limits are the
limits of this Overlay distribution. Upper and Lower Octants are the risk.
A Trade on October 22
At the close of October 21 the limits are 98000 and 95900, risk is about 260.
On Oct 22, price traded below 95900, with a short
entry at 95890. After the entry, price went as low as 95550. The Potential,
the maximum this short trade could have possibly returned after entry, is
95890 - 95550 or 340 points. 340 points is the Opportunity. Opportunity is
the return the perfect trader would attain. Risk is one-eighth of the
limit-to-limit range or about 260. For this day, the potential-to-reward
ratio (Figure of Merit), is 340/262 or a modest 1.3.
Using the Basic Model, CISCO's Advice Engine daily surveys the entire futures
market and prepares a list of possible trades. The only criterion for inclusion
in the Advice Engine report is that the market be in balance. Advice Engine
examines all the futures on the day's list. The ones deemed most probable
to be profitable are placed on a 'Select' list.
Research
All traders have seen trading models offered for sale. These are effectively
black boxes, generally with a number of conditions. It is difficult to
do your own trading research with such information. That is not the case
with the Advice Engine tables. Entry is on breakout from a 10 day Overlay.
Risk is the Octant. Overlays are posted at the close of each day and checked
for breakout the following trading day. If there was a breakout, the Potential
opportunity is posted with the results. These data are not open to discussion.
The market either broke out or it did not. If it did, the Potential is directly
measureable and the risk is known from the balance limits.
Your model is doubtless not the CISCO Basic Model. But the principles involved
the the Figure of Merit concept are the same for all models. The CISCO Select
Tables can be your test bed. The data is available. Use that data to familiarize
yourself with application of the principles and then turn to your own data.
Applying the Select Data Tables to DJ and SP
We have seen that opportunity/risk measurements can find markets to trade and
markets to reject. We can test ourselves against the ideal. Currently,
there are about three years of history in the Advice Engine Select database.
These data can be used for all sorts of studies. Mentioned so far are the
single future study, i.e. the one you trade. Another question might be
which of two futures offer the better trading situation? We take that up
in the study in Figure 2, comparing the DJ and SP.
Opportunity/Risk Table: DJ vs SP
Del Rsk-DJ Rsk-SP Potl-DJ Potl_SP P/R-DJ P/R-SP #Tds-DJ #Tds-SP
Mar 01 369 1269 1009 2265 2.85 1.78 19 16
Jun 01 323 1246 1043 2775 3.23 2.65 20 19
Sep 01 274 1154 1054 2375 3.85 2.64 15 24
Dec 01 378 1121 612 1786 1.62 1.80 19 15
Mar 02 342 1260 637 1583 1.86 1.52 4 3
Jun 02 251 884 348 1358 1.39 1.86 6 3
Sep 02 387 1434 980 3127 2.53 2.58 7 6
Dec 02 391 1222 879 1990 2.25 2.26 17 10
Mar 03 307 1026 527 1505 1.72 1.97 15 17
Jun 03 307 981 958 2658 3.12 3.19 6 3
Sep 03 270 964 708 1548 2.62 2.05 16 17
Dec 03 186 664 357 1110 1.92 2.25 22 25
Average 315 1101 759 2006 2.41 1.82 13.8 13.2
Figure 2. Figure of Merit for DJ and SP.
Definition of columns: Del is the delivery month, Rsk is the average risk
for that delivery month, Potl is the average opportunity for the delivery,
Figure of Merit, P/R, is the Opportunity-to-risk ratio; and #Tds counts the
number of trades for that delivery.
Note: Conversion to $: DJ x 1, SP x 2.5 (both full contracts). The ratios of
of Potential-to-Risk, Figures of Marit, are independent of the dollar
conversion.
Results
An average Figure of Merit for DJ of 2.41 versus SP of 1.82
shows DJ to be 32 percent better on an opportunity-to-risk basis
[(2.41 - 1.82)/1.82 x 100].
On the face of this measure, a trader has a much better play in the DJ.
There is an apparent correlation between the average P/R ratio and the number
of trades in that quarter. Dow futures showed an opportunity-to-risk ratio
of 3.85 for the September 2001 quarter and a mere 1.39 for the June 2002
quarter. No matter how well you trade, the June 2002 quarter offered only
36 percent of the opportunity of the previous September.
As the market falters, opportunity tends to falter as well. Remember,
these data points are for a quarter year, averaged. If one searched the
individual trade by trade data, the tip-off to avoid that market (or treat
it differently) would appear within a short while into the dull period.
The dull period is characterized by fewer trades and poorer
opportunity-to-risk ratios for those trades that do occur. So, if you
see trading possibilities becoming rare and then the opportunity diminishes,
beware!
Of the results, by far the most important is that you, the trader, can have
an unbiased set of data against which to develop and evaluate your own trading
model. There is nothing mysterious about opportunity-after-entry and you
certainly know your risk. So you can continuously rate your trading model
(is it generating adequate opportunity?) and your trading (are you converting
enough of the potential to your bottom line?).
Decision Time: Which to Trade: DJ or SP?
Trading decisions are often qualitative and personal. The data in Figure 2
shows approximately the same number of trading opportunities for each of DJ
and SP. The three year study in Figure 2 identifies the slow periods,
e.g. December 2001 through September 2002, to be about the same for both.
An important factor is the risk capital required. DJ takes only about
one-third that of SP. The SP Potential is larger, but the Figure of Merit
favors DJ.
So which would you choose? Whichever it is, you now have some quantitative
comparisons to help your decision!
Additional Trading Information on the CISCO site
CISCO Home Page:
http://www.cisco-futures.com/
Market Profile:
Market Profiles Background
Overlay Demand Curves:
Overlay Demand Curve Background
Liquidity Data Bank:
Liquidity Data Background
BuySell Data (CBOT):
Liquidity Data BuySell Background
Short HomeStudy Course:
ShortHomestudy Page
Long HomeStudy Course:
Homestudy Page
Trader Control Package:
Swing Trader Package(TCP) Page
Advice Engine:
Advice Engine Background
Auction Market Theory:
Auction Market Theory
Trading Model Dev.:
Trading Model Development
Day Trading Supp/Res:
Day Trading Support and Resistance
Volatility and Stops:
Volatility and Stops for the DayTrader
About Donald Jones and CISCO
Don Jones has been researching and trading the futures markets for over
30 years. Along the way he initiated the use of tick data for Market Profiles
in 1987, created the Overlay Demand Curve to find market condition (1988),
published maybe the first ever study showing that markets were not
efficient (1973), developed a sophisticated Market Profile generator for
day traders (2000), proposed a 'current' volatility for option traders (2003)
and more recently has continued work on Auction Market Theory first published in
2002. CISCO maintains Liquidity Data Bank history dating back to 1987
and Market Profile history to the same date.
CISCO developed early trader training courses based on auction market
principles in 1989, upgrading them from ongoing research to the current day.
The Short Course (5 months) emphasizes a combination of
market condition and Market Profile information that is of most interest to
daytraders.
Long Course (12 months) is more oriented to the needs of the
swing or position trader.
Both courses promote learning through doing, one
written lesson per month accompanied by daily trading practice.