Earn a Second Income Trading the Stock Market
In this video Nick explains high frequency trading and how it is possible to earn a second income by keeping your day job whilst trading on the side.
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We’re going to talk about being more consistent with your trading and trading for a second income. I am going to be disclosing a strategy, so please be aware that should you take that on board, you do so at your own risks. Read our risk statement here.
Over the last few years, I’ve had numerous people ask me about trading for a second income. It’s quite startling what kinds of questions I get and how people are actually trying to go about it. For example, I had a single mom contact me. She had $12,000 to her name. She needed to generate $60,000 a year to run the household. And she’s actually never traded before in her life. So, it’s a very difficult proposition to think that you’re going to come out of nowhere and make 600% a year just to cover household expenses.
I’ve been very lucky in my career over the last 28, 29 years. I’ve come into contact with a lot of traders that do trade for a living. I come from the trading floor of the Sydney Futures Exchange back in the 90s. So, a lot of the people back then still trade today. I’m in contact with a lot of them and I’ve learnt a lot of lessons from them.
What is Situational Irony?
Situational irony is when there is an action that has an effect that is opposite to what was intended. Specifically the outcome is completely opposite to what you expect. A lot of situational irony occurs when trading for a second income or trading for a living.
We’ll discuss 2: work ethic and making money.
The traders I used to work with all grew up in the business. We were taught to trade inside big banks and broking houses. The average mom and dad isn’t exposed to that. So, I thought I would contact a proprietary trading firm called Aliom Trading, which is a proprietary (prop) trading firm here in Australia.
UPDATE: Aliom is no no longer trading. They merged with another company. The content is still relevant.
Aliom ran a trader’s academy. In other words, you applied and, if accepted, you went into a free six-week trading incubator. The first two weeks are classroom and theory. And then four weeks on the simulator.
It’s free. If you are successful after the initial six weeks and they think you’ve got what it takes to be a trader, they will then seed you with their capital. Out of every 1,000 people that apply, only 20 get that far. You have zero downside risk, and they will pay you a percentage of the profits that you make. Commission usually starts at 50% gradually moving up to 80%. Now, the reason why this is applicable is because anyone can apply. It obviously takes a certain kind of person to be accepted, but at the end of the day, it’s open for everybody.
Aliom create a professional trading environment. And the first and foremost situational irony is worth ethic.
Some of you may know that I live in Noosa Heads in Queensland. Noosa Heads is a desirable place to live. There are a number of professional traders here. A lot of people from around the world come here for holidays. In my 18 years living in Noosa, I have not witnessed one professional trader sitting on the beach trading on his laptop. The only people sitting with laptops on Noosa main beach are the Swiss backpackers using the free wifi.
Situational Irony 1: Work Ethic
At Aliom they arrive in the office at 7:00 am. They work out of an office in inner Sydney. The office is not fancy. Pre-market reading and research starts at 7am, morning meeting at 8:00 and all traders must attend. The US night session opens, the Australian market opens. The Australian market closes. These guys sit there, there were 40 traders the last time I was in their dealing room. 40 people sitting in front of consoles. The room is dead quiet, numbers are ticking over. It’s not boisterous, it’s not rowdy.
I come from the trading floor of the Sydney Futures Exchange back in the 90s, and it was the best place to work when the market was firing. For the other 98% of the time, you sat there and you twiddled your thumbs. The same thing happens here. If there’s nothing going on in the market, if there’s no volatility, these people can’t make money. And as a result, a lot of them have to stay past the Australian closing session at 4:30 and wait for the European market to open to see if there’s any volatility, any price movement there.
A lot of the traders stay through the European session until about 10:00 pm. Because volatility is required to make money, some of the biggest volatility we see is in the US markets, specifically around the bigger data releases like non-farm payrolls, PPI and CPI. Depending on the time of the year, those data releases can come out anywhere around 1:00 or 2:00 AM, which means that if you want to capture that volatility, you have to trade through the night.
During big economic number releases, Aliom has a full trading desk in operation. 40 prop traders sitting there at 1:00 or, 2:00 AM. This is what work ethic looks like. There’s no long lunches, no sitting on the beach trading, there’s no going to the pub with your mates in the evening and that kind of stuff. These people, when they’ve got positions are running a 24 hour business.
Trading for a living is like running a small business.
It’s like running a bakery. You start at 4:00 AM, baking bread before customers start coming through the door at 6:00 AM or 7:00 AM. You keep your doors open until the customer flow stops, which is sometimes 6:00 PM, 7:00 PM. Then you clean up, get organized for the next day. You probably go home, do your books, order stock then start again.
Situational Irony 2: Making Money
Some of the traders I know work 12, 14, 15, 16 hours a day. They make a lot of money but they put in a lot of effort too. At the Aliom Trading Academy, you get paid 50% of the profits you make. To start earning the average Australian wage, about $60,000, takes 15-18 months. And they suggest that you have savings in place to support you before you’re ready to trade for a living and during lean times.
Let’s profile three traders. Each trader has the same kind of returns. You can see here, year one through year 10, this particular trader or all of them start with $100,000. You can see their return on investment there. Year one they make 143% return, year two 91%, year three 81, year four 46. And look at that, five and six 100% plus years. Now, I would suggest that anybody that comes out of the gate making returns like this in their first six years has trading for a living written all over their forehead.
But let’s look at the reality. Trader number one signifies a lot of the kinds of traders that I’ve come to know. And that is, they spend everything they make each year and they don’t tend to put stuff aside when the lean times come along. After tax and whatnot, you can see some years they make a reasonable income. But have a look at year seven there, their income is only $19,000. Now, that’s all good and well, I guess if you’re 22 and you’re living at home with your mom and dad and don’t have any overheads.
But if you’re late 30s, early 40s, early 50s and you’ve got children, you’ve got overhead, mortgages, commitments and so on and so forth, the last position you want to be in is having an income of just 20 grand which is not going to get you very far, which is exactly why Aliom trading suggests that you’ve got to have savings to dip into when those lean time comes. And have a look at their total income there after 10 years, $606,000. That’s the average wage in Australia, $60,000 a year. And these guys are working 14, 15 hours. On a per hour basis, you wouldn’t do it.
Let’s take a look at trader two, she’s a little smarter. She’s looking to take an income of $80,000 each year. But what she will do is reinvest the excess funds. So, the first couple of years, you can see she takes an income of $80,000. Her capital trading balance keeps going up on a year to year basis. And when the lean times come along, year seven for example, she’s a lot better off than the other trader. She’s made about $40,000 income instead of the 19,000. So, she’s somewhat better off. She’s got a bigger balance. And in time, that account will continue to grow and she will continue to prosper. But for the first 10 years here again, total income $680,000. Really not a great deal more than an average wage.
Let’s go to trader three, trader three is someone who is a little bit more commonsense, a little more grounded. They stay working, they have a second job. They don’t have to dip into their capital at all. And when the lean times come along, they’re not specifically under a great deal of pressure because they still have their day job. This particular trader reinvests all their profits. Now, these are just rough numbers. If you’re an accountant, you’re probably going to pull me up on certain things. But just as a rough guide, this is what it looks like.
Now, you can see the difference of what happens during the lean years. Now, remember the lean years for most of the other two traders was year seven. Now, this particular trader really didn’t have a lean year because he got his day job and he’s leaning against that, if you like, for his income. But his capital builds up to such an extent that eventually he is very, very well capitalized and he can survive off it, even during lean years when and if they come along.
Profits must not only cover your everyday expenses, but also have to grow the account. I once met a gentleman in Toowoomba here in Australia that had just left his day job and was deciding to trade for a living. He had $5,000 in his account. I mean, it’s just completely unrealistic. You’re not going to be able to grow your account. And most people aspiring to trade for a living do not have a self-sustaining capital base. I don’t know what that sum of money is. But it’s not $5,000 and it’s not $50,000. It’s a significant amount of money because you have to be able to get through those lean times.
Lake Wobegon Effect
Some of you may have heard of me talk about the Lake Wobegon Effect. I first spoke at that at the ATAA Conference way back in 2009. Basically, it’s the tendency to overestimate our own abilities. And that goes on two sides of things. So, first of all, your ability to make money. There’s probably people there in the audience, I’ve certainly met people who start trading in their first year that’ll make $70,000, $80,000 and think, “Wow, I’m home and hosed,” and off they go, only to find a year or two later it wasn’t their skill, it was the bull market that actually made them all the money. So, they overestimate the amount of money they can make.
The other thing a lot of people overestimate is their ability to deal with the stress when lean times come along. If you’ve got a family, if you’ve got expenses, if you’ve got commitments, it becomes a very, very different game when you’ve got to sit down and grind out an income each day from the markets. What I like to do with people who contact me from trading, and don’t get me wrong, I’m not a negative kind of person. I’ve taken measured risks in my whole career. And I just think people have to look at this stuff from a different angle. So, I try and reframe their way of doing things.
Now, one of the presentations I’ve been doing, or this particular presentation, I generally at this stage walk around the audience with a checkbook and write out checks for $30,000 or $40,000 and ask people would they like a check for $30,000 given to them on this day for the rest of their lives? Invariably, everybody says yes. And I ask the question, “What would you do with that if you could keep your day job, but at the end of the year have $30,000 to spend without guilt on anything you want, would that be a good position to be in?” Invariably, they say, “Yes.” People say, “I’ll buy a new car. I’ll buy a boat. I’ll renovate the kitchen. I’ll take the family on a holiday.”
If you can be in a position where you keep your day job and at the end of the year, you have a nice bonus come in, if you like, of $30,000 or $40,000 or something like that and you don’t have that stress through the year of requiring to live off that trading income, you’re better than 99% of the population out there. And that’s what I try and put across to people. Think of it, rather than trading for a primary income, make it a second income and you can go and spend that money on whatever you want at the end of the year, or you can put it back in your trading account and build your capital. But you don’t have that pressure hanging over you when things get a little bit tough, which they will.
Now, let’s move on to more strategy and the way that you can become a lot more consistent. And I’m going to use a few little tricks here to show you this. What I want to show you first is how a particular trader had one losing day in the last 1,238. Imagine that, one losing day in the last five and a half years. Now, I’m not saying that you can get to that point. But I’m going to show you exactly what that trader does and how you can move towards that. I’m also going to show you what casinos teach us about trading, and it’s not gambling.
In fact, the first trader there in line one who had one losing day in the last 1,238 is doing the exact same thing as what casinos do. And if ever you’ve been to Las Vegas, you know these casinos make a ton of money. So, we want to learn from them, what are they doing? And as a result, what these will teach you is to become a more consistent trader. When I talk about consistency, I’m talking about winning more often than not, not necessarily in each trade, but on a monthly basis.
For example, one of the strategies that I use has 83% winning months. As you’ll see shortly, some of these traders have 99.9% winning weeks. So, what we’re going to do is just run through the key consistency, what casinos and high frequency firms already know, okay? A high frequency trading firm are technology companies that represent significant amounts of volume on the world exchanges. They operate here in Australia, a big hoo ha in America at the moment because you’ve got the Michael Lewis book, Flash Boys, which basically says these high frequency firms are ripping the market off. So, we’ll talk about them in a little second. But it’s important to know what they’re doing and how they make all their money.
We’re going to talk about some strategy basics, selecting a universe, commissions should blow your mind what I’m going to show you here. And how to use technology to make the most of this. What I’ve learnt over the years, and call me a little bit ignorant, but I come from a trend following background. A trend following background basically means I’m quite comfortable taking lumpy profits sporadically. But the average man in the street, they like to take small profits more often. But what’s important to understand here is they don’t do that from a monetary perspective. Most people do it for a comfort perspective. Whereas, the casinos and the high frequency traders out there, they take small profits more often for maximizing their profitability and their consistency.
So, Virtue Financial is one of these high frequency firms in the US. They have a staff of about 15 people. In the last five and a half years, they’ve had one losing day. They’ve had 99.9% winning weeks in their business. Trade Works is another high frequency firm. They have a staff of seven or eight. They have 86% winning trading days and they have 99% winning weeks.
Now, casinos are interesting as well. Casinos have 84% of winning days on average. But if you’re a light gambler, you’ll lose 83% of the time. A light gambler is someone who’s really going there with just a couple of hundred bucks to spend and is there for the entertainment factor, rather than being a serious gambler. So, when it comes to the serious gamblers, interestingly enough 94.3% of them lose. So, what’s going on here is the quantity of trading and gambling being done.
The high frequency traders are responsible for … Trade Works, for example, does 1% of the daily volume on the New York Stock Exchange. That’s just a massive amount of volume. It’s said that high frequency firms are now doing 70% of the volume on the US stock market. So, they’re doing a lot of trading. Now, extend that lot of trading into a lot of gambling and take a look what happens here. The casinos are winning, the heavy gamblers are losing 94% of the time.
So, it’s all coming down to the frequency of the trades or the frequency of the hands that are being played. There was a survey done of 18,000 gamblers in the US. And there was one particular gambler, a 56 year old Swiss man who on average was betting just $9 per hand. And over a three week period, he lost $110,000, even though his average bet size was just $9. So, it comes to the frequency, rather than the size that was making the casino all that money.
So, what I want to do here is just give you a visual representation of how this works. Now, this is an expectancy curve. Basically, above the curve, doesn’t matter what kind of a system you operate, you will be profitable. So, what we’re looking at here is the win loss ratio and the winning percentage. They work hand in hand, in tandem. So, the higher the winning percentage, the lower the win loss ratio will go, and we’ll explain that in a minute.
So, the asterisk on the chart here shows a typical trend following strategy. So, a typical trend following strategy for an equity trader, if I use my own as an example. I have a win rate of about 45%, 47% over the longer term. And I have an average win percentage of about 2.5 to three to one. So, I have a positive expectancy over the longer term. So, what I’m going to do here, I’m just going to brin up an Excel spreadsheet that will give you a bit of an idea on what that looks like over a one year trading period.
Let me explain what this is. This is like a little Monte Carlo simulation of 20 portfolios that are trading that trend following strategy. The blue line across the bottom is the zero line. This represents one year’s worth of trading, 40 transactions a year, 45% win rate, win loss ratio of 2.5 to one. The red line represents the average of all those 20 portfolios. You can see the red line on average will be profitable at the end of every year on average. But you can see for extended periods of time, you can see some of these portfolios stay underwater.
The recording here is not enabling me to actually change this, but I can usually change this and get some of these portfolios to be below the zero line at the end of the year. What my point here is, that this is a low frequency strategy that only does 40 transactions a year. It doesn’t get to exploit its edge a great deal over short periods of time. And as a result, you can see the first six months here, some of these portfolios actually remained below zero and weren’t overly consistent.
Over the longer term, yes, you can’t lose money trading this. But over short periods of time, you can have periods where you’re actually underwater or you can even have a year where you stay underwater. Let’s take the exact same portfolio, but remember the portfolio has a win rate of 45% and a win loss ration of 2.5 to one. This chart is the exact same strategy. The only difference is it trades 800 times a year instead of 40. In other words, it’s exploiting its edge a lot more. And as a result, it becomes a lot more consistent. You can see here at the end of one year, not one portfolio is in a losing position. And it was only the first month or two over here to the left that some of the portfolios were in a losing position, but they came out of it very, very quickly.
And this is exactly what trade frequency is all about. It increases your consistency simply because it exploits your edge that much quicker. It pulls you out of draw down a quicker and it makes you a lot more consistent. And generally, you’ll rarely have a losing year if you can increase your trade frequency to a significant amount. Now, this is based on 800 trades a year, which is what my strategy basically does. Those high frequency traders, they’re doing 10,000 trades a day, if not more. 20,000 trades a day. And that’s why they can go through and not have losing days.
I know the Sydney Casino, some of the games there do not have croupiers anymore. For example, Roulette. Roulette is now all done by little computer banks. It looks like little mini ATMs. And what happens is you put your credit card into that. And the simple reason is a croupier takes time to deal the cards or spin the ball or change money, say hi to people, be polite. It takes time. Time is money. So, when you put a credit card in the slot, your money’s there, direct debit, bang, bang, bang, you can roll the ball in Roulette a lot quicker and play more games per hour than what you can if you have a croupier. So, as a result, what the casino is doing is simply increasing their frequency of dealing. And what that does is automatically increase their consistency and their profitability.
The interesting thing here obviously to do more trades, for example, what we just had a look at with those two portfolios, the trend following strategy was holding positions for six to eight months. It was doing about 40 trades per annum. If we want to increase the trade frequency, we can’t hold a position for six to eight months. These high frequency trading firms, they hold positions for seconds. So, what we want to do, and especially if we want to keep our day job, we want to try and get our trade frequency up, which means we have to get our holding period right down. And I’m talking days, not hours because we want to keep our day job, but days. Not weeks, not months or anything like that.
And this presents a little bit of a paradox that has to do with our expectancy curve here. Basically, think about how far a stock can move in six or eight months. It can move a long way. Obviously if we’re holding a position for one or two days, it can’t possibly move that distance, not on average. So, as a result, what happens is if we’re only holding a stock for one or two days, our win loss ratio has to decline. The win loss ratio on this chart is shown on the vertical axis on the left there.
So, what has to occur is it has to go down. And what then needs to happen to create a positive expectancy, our win rate has to go up. So, if we have a win loss ratio of one, we need a winning percentage of trades greater than 50% in order to create that positive expectancy. What this tends to make people do is look for strategies that have extremely high winning percentages, you know? 80%, 90%.
Now, what that causes is data mining, curve fitting, optimization. Some of you may have read, for example, Larry Williams’ book, Long Term Secrets To Short Term Trading, a classic example of a book full of data mining. He outlines numerous patterns in that book, all of which have winning percentages in excess of 80, 85, some even up to 95%. But the problem is because he’s data mined, because it’s all curve fitted, those patterns and those strategies are not robust enough to move beyond or into the future. They will break down.
Howard Bandy is another example of someone who optimizes the absolute Nth degree out of everything he does. And as a result, he actually has a book called Mean Reverting Strategies. And he shows a couple of strategies in there which have 80, 85% winning percentages. But the problem is, they’re optimized to that particular symbol. When we need trade frequency, we have to trade it on a lot larger group of symbols, and it falls over. It simply doesn’t work. But the intriguing thing is, these casinos and the high frequency trading firms do not have strategies that win 80, 90, or 95% of the time. In fact, quite the opposite.
Trade Works, for example, the high frequency firm we discussed a little earlier on with 86% winning days, 99% winning weeks, on a trade by trade basis, their win rate is only 50-60%. Not much better than tossing a coin. And casinos, the major games in casinos, poker, Black Jack, Baccarat all have an edge of less than 3%. I mentioned earlier on about that Swiss gentleman. He was just betting $9 each time. Now, he lost on 84% of the days he was playing. But because of his frequency, i.e., doing 1,000 hands a day, he lost $110,000 over the course of three weeks. He probably didn’t even realize he was losing so much money. The casino was just taking a little bit of the piece of the pie on every single hand. He didn’t even realize what was going on, they just slowly crept in there.
So, the bottom line with high frequency firms is not a strategy that wins 90% of the time. It comes down to the frequency of their trading to exploit their edge, exactly the same as what casinos do. Bottom line, opportunity equals frequency, equals profit. So, the question now is how do we do that? Well, here’s charts of some Aussie stocks that you’d be well familiar with, BHP, Fortescue, Woolworths, and Santos. It’s said that stocks or markets trend only 30-35% of the time. The other 60% of the time or 65% of the time, they chop backwards and forwards. And you can see here that all of these stocks are kind of doing that, they’re rotating backwards and forwards, backwards and forwards.
So, 65% of the time, they’re chopping around, very, very noisy, back and forward, back and forward. So, rather than attempting to follow trends, because remember we need trade frequency, we need opportunity. So, under the assumption that trends don’t come along that often, what we want to do to increase our opportunity and our trade frequency is trade the noise. So, we want to try and ride all these little bumps back and forward, back and forward as many times as we can, because as you can see on these charts here, and for that matter, the majority of charts that you will ever pull across, that’s the kind of thing that happens more often than not.
So, this is what we want to try and do. Buy the weakness, sell the strength, buy the weakness, sell the strength. So, what we’re going to do now is just take a look at a couple of examples on how you can try and do that. There’s nothing scientific about this. Remember, we’re not looking for the holy grail. We’re just looking for something that wins somewhere around the 60% mark, but occurs a lot. And that way, we can find our opportunity. Some easy ones, for example, over bought, over sold points, using oscillators such as an RSI, a CCI, or a stochastic or any of those kinds of things.
We just want to find over bought, over sold levels. Think of a rubber band. If we go back to these charts and think about a rubber band extending from the bottom of each chart to the top. And we want to stretch that rubber band and then stretch it a little bit more. Chances are, it’s going to come back and snap back. That’s the kind of things that we’re looking for. Think of that rubber band. So, we want to find, for example, over bought, over sold levels using Bollinger Bands. That’s a classic example. Bollinger Bands, standard deviation, you know? Three standard deviations, 99.5% of price action is retained inside of that. Therefore, if it moves outside, chances are it’ll probably flip back in. Looking for sequential movements up or down.
There’s a gentleman called Keith Fitschen who some of you may have heard of, has one of the most successful trading systems in the world for the last 20 years called Aberration. Well, he now has another short term mean reversion strategy. And that strategy operates based on a stock moving up for eight consecutive days. What happens on day nine is it tends to reverse. Or if it goes down for eight consecutive days, on day nine, it tends to reverse. So, that’s called sequential up or down days.
You want to find extended price movements in terms of percentages. As an example, there’s a very popular ETF trading strategy out there that waits for an ETF to move 2% from the day’s opening to the day’s close. And it tends to revert straight back the next day without fail. It has a win rate of about 85%. So, obviously a stock that extends dramatically in one direction for a period of time will have a more probable expectation of reverting back to the mean.
However, my experience and our research shows that using two of these determinants together increases the strategy quite dramatically. For example, let’s take a look here. If the stock closes higher on five consecutive days and on the fifth day it also gaps higher, it’s probably got a higher chance of reversing than just taking the five higher closes or the gap up on its own. For example, if you get a stock that moves outside a three standard deviation Bollinger Band and the RSI, it is in extreme over sold point, i.e., less than five. It’s got a better chance of reversing. So, these kinds of things you can use. But our experience shows that doing two of them together increases the chances of success.
Remember, opportunity equals frequency, equals profits. There’s no point having a strategy that trades an ETF, a single ETF symbol 20 times a year with a 90% probability of success. It’s not going to make you particularly wealthy. What we want to find is some kind of method that we can use right across a big universe. So, let’s have a look at Australia, for example. There’s 2,952 equities currently listed on the ASX. The problem with Australia is first of all, liquidity. Very, very low liquidity. We’ll talk about that in one second. I would suggest in the Australian market, really from a scalability perspective, because if you want to do this for the long term and you’re going to be consistent about it, you need to be able to scale it. So, really the top 300 stocks are about as far as you can go in terms of liquidity.
But then if we look at the US market, we’ve got four exchanges there with about 8,000, 8,500 shares and significant liquidity in most of these. So, for example, the New York Stock Exchange, really the top 700 stocks are scalable to some extent. Same with the NASDAQ, probably the top 300 stocks are very, very scalable. So, my point is that the US market is a lot larger and will therefore offer you a lot more opportunity.
Some people have asked me about doing this strategy on the futures markets, but the problem with the futures markets, really there’s only about 50 of them. There’s just not enough markets. Can it work on a foreign exchange market? I’m sure it could. They’re very, very noisy markets. You’ve just got to make sure the pairs aren’t too correlated and that kind of stuff, but I’m sure it would. I’ve not personally tested it. What we’re going to be talking about here is doing it on equities.
The next thing to consider about choosing a universe, I just briefly mentioned liquidity. And an extension of liquidity is what is called slippage. Slippage is the difference between the theoretical price of where you want to buy and where you actually buy. So, for example, let’s say you wanted to buy Fortescue at $4.20, that’s where your strategy said to buy it. But using a stop loss, you actually got filled at 4.25, you’ve got five cents slippage.now, you might be thinking, “Well, that’s not a great deal of money.”
Well, I did a little exercise recently. I went back through three years of my trading on the ASX and I calculated exactly my wanted buy points, my theoretical buy points according to my strategy, and my realtime buy points in the market. And on average, I was paying $92 per trade for the last three years on every single trade. In other words, the slippage was costing me over 11% per annum. So, not only did I have to overcome the commission drag, but the drag of the slippage meant that I had to be making more than 11% just to break even. And that’s way too much. Now, I was trading the top 200 stocks. So, it just goes to show how illiquid the Australian market is at this juncture. And if you’re going to scale this kind of a strategy, it’s going to blow up in your face.
The other thing here is commissions. Now, this slide here is quite startling. Let me disclose for the moment that I have used Interactive Brokers for about 15 years. I do not get paid by Interactive Brokers for producing this slide. I’m just a happy user. We do have a relationship for one of our strategies where people that require a little bit of help, and we do get paid by Interactive Brokers for introducing clients for that for a very small period of time. But this is a real portfolio of ours over the last three years or so. And what I’ve done is compared the net profits of using Interactive Brokers trading the US market. Now, they charge $1 per trade to trade the US market.
So, you can see here that the strategy has made a profit through Interactive Brokers of $65,500. That’s a net profit. Interactive Brokers received $7,020 worth of commission. The average Australian CFD provider charges $15 to trade the US market. Using the exact same trades, everything being exactly the same, you pay the CFD provider almost $42,000 worth of commission. In other words, the CFD provider is making significantly more money out of it than what you are. This is in the US market. A lot of people just can’t be bothered.
It’s like the old mortgage problem. People can’t be bothered to change their mortgage provider, even though over the longer term, it will save them a lot of money. The same thing happens over here, people just can’t be bothered to change brokers. But when you look at it from this perspective and see how much money it’s going to cost you, you’d be stupid not to. It’s hard enough to make money in the markets as it is. Why make it harder by paying a broker a lot more money? They’re taking on no extra risk or anything like that for the opportunity. They just do it because they can do it.
So, Interactive Brokers is who I use to trade US stocks, $1 per trade. It’s not mates rates, anybody gets the exact same rate as me. It’s an obvious choice if you’re going to do this kind of trading. Don’t get me wrong, my longer term trend following strategy that I operate here in Australia, I do it through Macquarie Prime, it’s $19.95 a trade. It doesn’t bother me because I’m only doing 30 or 40 transactions a year, the drag is not a great deal. But when we start talking about higher frequency trading, i.e., in excess of 100 trades a year is kind of the benchmark, really you want to get your commission drag down as much as you can.
This is an example strategy just to give you a bit of a feel of what’s possible and how to go about it. Please understand, I do not trade this strategy. It is simply an example strategy and I wouldn’t trade this strategy. But it’ll just give you some ideas of the way to think about doing this kind of stuff for yourself.
So, let’s go back. These are the kind of markets, this is the kind of noise we want to trade, up and down, chop, chop, chop, backwards and forwards. We want to think about that rubber band stretching and stretching and stretching and snapping back. We want to buy that excessive weakness and sell that excessive strength. So, here’s an example strategy. The long entry is a close about 100 day moving average. That ensures there’s a long term trend up in place.
Then what we want is a dip, a decline back below a five day moving average. And that ensures we’ve got some short-term weakness in place. And then we want some sequential weakness as well. So, this is part two of that weakness. So, three consecutive lower lows. So, a close above 100 day moving average uptrend, a dip below the five day moving average coupled with three lower lows. And then what we’ll do is we’ll buy the next day if prices fall a little bit further.
So, that’s an extension of our rubber band, just stretching it a little bit further. The exit, pretty simple. We’ll just exit when we get a profitable close. We’ll exit the next day, okay? So, if today’s close is greater than yesterday’s close, exit tomorrow at market. Doesn’t matter if the trade is a win or a loss, we just want today’s close to be above yesterday’s close.
The exact same criteria for the short side. We don’t want to optimize and start saying, “Well, you’ve got to trade the short side differently, blah, blah, blah.” We want to keep it as robust as possible. So, the orders are exactly the same. The criteria is exactly the same in reverse. Let’s have a look at a few examples. Here’s the Bank of America. You can see we’ve got the 100 day moving average at the bottom there and prices are above that, which means the trend is up. And you can see we’ve got the five day moving average in blue. We’ve got a peak up here, and the prices has come back below the five day moving average. One day down, two days down, three consecutive lower lows below the five day. Stretch a little bit further, and we’ll buy at 17.01. The next day, we’ve got a lower close. Day three we’ve got a higher close. That’s the first profitable higher close, or the first higher close. And we can exit on the next open at 17.28.
Prices then dip below the five day moving average again. And we’ve got an extension. We buy at 16.53. Two days later the price pops up and we can exit at 16.55. Pretty simple kind of example. Let’s take a look at another one, JP Morgan, prices are above the 100 day moving average. We get a dip below the five day moving average, three consecutive lower lows. Buy on an extension of the fourth day down. We buy at 56.71. One day up, profitable close. We exit on the next open.
Short setups are the exact opposite. So, here we’ve got prices sitting below the 100 day moving average. They pop up through the five day moving average, three higher highs. Extension up. Prices stabilize there. We get short at 36.18. Stabilize the next day and then we cover on the following open. And here’s another one doing the exact same thing. So, three days up through the five day moving average. A bit more of an extension up to sell short at 31.37. We’ve got a lower close on that day, so we get to cover or exit our short position on the next open.
So, let’s have a look at the actual statistics, let’s put it to the test. So, what we’re going to do here is we’re going to start with $100,000. We’re going to go back to January ’95 and cover all those kinds of events. We’ve got the Asian currency crisis, we’ve got the tech crash. We’ve got September 11. We’ve got the ’02, ’03 bear market. We’ve got the big bull market. And of course, we’ve got the GFC. We’re going to run it across the Russell 1000 and we’re going to include all historical and delisted securities for that period of time. So, we’re removing survivorship bias. We only want to look at shares that trade more than 500,000 on a seven day average. We want to take 20 positions and we’re going to allocate a fixed $10,000 per trade. We are not going to do any compounding here, which means profits are not going to be reinvested.
We’re going to use 50% leverage. In other words, we’re going to be controlling $200,000 worth of stock. So, this is a non-compounded equity curve of that particular strategy. Now, that doesn’t look too bad on the surface. But you can see that big acceleration there about three quarters of the way through and that’s the GFC. That’s non-compounded. Compounded I don’t show the equity curve because it looks a little bit silly. But we’ve got an annualized return of 50%. Strategy’s made 20,500 trades. Little bit biased to the long side. Win rate of just 61%. Win loss ratio of 0.83. Maximum draw down of 30.8%. So, really, 30.8% is a little bit on the high side in my view. My experience suggests that most people really start to struggle when the draw down goes above 20%. Still a good rate of return, don’t get me wrong. A lot of trading being done there. That is net of commissions, by the way.
If we have a look at the yearly breakdown, so this is the month by month and you can see the yearly return on the right hand side of the screen here. And take a look at 2008. So, that’s right in the midst of the GFC. It’s made a 379% profit. And that’s what that big acceleration in the equity curve was because of the short side trades just made so much money. Now, really, that’s an aberration. I look at the GFC as kind of … I won’t say once in a lifetime because I’ve been around for 29 years and I’ve seen a few things already. But we can’t be dependent on something like that being so overwhelming in our results.
So, reasonably consistent all the way through there. You’ve got a couple of lean years. Take a look at 2010, you only made 1.4%. But there’s no losing years, so we’re getting that consistency. Now, interestingly enough, a lot of my research and simulation, I can’t find a strategy that makes much money on the short side. Not enough to stand on its own two legs. So, let’s take a look at trading that exact same strategy, but on the long side only. You can see here the equity curve is actually a lot smoother and it’s not too far from where both the long side and short side were. It’s certainly a lot smoother, it didn’t have that big acceleration during the GFC. It would have sat out of the market and just sat in cash.
So, if we compare on a compounded basis, long only versus the long and short, here are the results. So, we’ve got a 42% annualized return for that 50.3. Trade frequency is down 12,500. Now we’re only trading on the long side only, not on the short side. Win percentage pops up a little bit to 63.9. Win loss ration remains the same. And interestingly enough, draw down just pops up a little bit there as well, 34.2%. It’s not periods of time like the GFC that impacts on the maximum draw down. It’s quite interesting if you study the data going back, you find these little days where the market just went nuts.
Obviously recent history, the flash crash is one of those. I was trading through that, and my account that month, May 2010, my account, I think I dropped 5.5% for the month. So, although it was the biggest point decline in history of the Dow Jones, it didn’t do a significant amount of damage. If we go back to somewhere like, for example, August 1997, the S&P 500 was trading along very nicely in a nice stable uptrend. And one day, it dropped 6.5% straight out of the blue.
Now, the reason it dropped, it was the start of the Asian currency crisis. The Hang Seng fell 15% on that particular day. So, there was a flow over straight into the US. But interestingly enough, on the next day, it bounced back 5.5%. Little glitches like that can put a dent into your equity although this type of strategy will recover very, very quickly. It can be a little bit difficult to actually trade through those kinds of things. So, if we have a look at the long side only statistics, a lot more stable, okay? A lot more stable. It did have a losing year, interestingly enough in 2011. But on a year to year basis, much more stable and less lumpy than what the long and short one actually did.
Let’s just talk about a few little things here, a few little technicalities. These kinds of strategies tend to generate a lot of orders. Now, when we’re using a cash account, certain brokers, well all brokers because of the T plus three settlement will not allow you to actually use the cash if a trade is being settled and will only allow you to place trades to the value of the cash available in your account. So, for example, we were using that strategy with 50% leverage. In other words, our $100,000 we were extending out to $200,000. Now, if you had a cash account, you wouldn’t be able to do that. And in some strategies, we have to place a lot of orders. And I’m going to show you shortly how my strategy sometimes we have to place 100 orders in a given day.
Now, out of that 100 orders that we place, maybe only five or six will get filled. But we don’t know which five or six will get filled. So, the only way we can place all those orders is actually use leverage. So, we can go and place them all in the market, five get filled, the other 95 get canceled, and away you go. You can’t do that with a cash account.
The other benefit of using a leveraged account is that you can fund positions in a foreign currency without the currency exposure risk. For example, my account holds Australian dollars and I can trade US shares because my Australian dollars are able to fund those positions. So, I receive credit interest on my Australian dollars in my account. And I’ll pay debit interest on the funding of those US positions. But what that enables me to do is keep my capital, the majority of my money, not all of it. But the majority of my money in Australian dollars, which means I don’t have any currency exposure should the Aussie dollar rally hard or whatever may occur.
You do have currency exposure for very brief periods of time. The average holding period for these kinds of trading systems is only two or three days. So, you do have a very, very brief exposure. But it’s not like a buy and hold investor where the Aussie dollar can move 10, 15, 20% against you and drag your account backwards. Because of the interest rate differentials between Australia and the US, never in the last 10 years have I had a debit interest in any given month, which means that my Australian dollar interest is greater than the funding cost of my US. So, you have a cost of carry.
Now, technology is very, very important. I’m going to show you a little bit of what we do here. Now, you may have balked if I said I’ve just placed 100 orders in a given day. You think, “Gosh, who’s got the time to place 100 orders in any given day?” I agree. It’ll take you forever, which is where technology comes into it. So, what we’re going to do here, what I’m going to do is I’m going to open up AmiBroker. This is an off the shelf software that you can buy for $300. I don’t sell it. It just does everything that we need to do. Now, what I’ve done here is I’ve set up our own high frequency strategy. And what we’ve got here is a position sizing algorithm actually inside AmiBroker.
So, let’s assume your account balance is $76,423. And let’s say that we want to allocate 5% of our capital to each trade. So, what we’re doing here is we’re looking at the S&P 500. That’s the constituent list that we want to trade. And we hit the explore button. Now, what this is going to do, it’s going to run through the S&P 500. And I’ve programmed the computer to not only find my buy and sell points, but also calculate the exact price I need to buy at and the exact quantity shares I have to buy. And then what I’ve done is I’ve formatted this explore report right here that you can see. I have formatted it to be exactly the same as the Interactive Brokers platform.
Now, you can see here there’s not a great deal of orders. What is there? 15, 20 orders. So, let’s just go back a couple of days because there has been a little bit of trading back in the past. So, I know Friday was a very busy day. Here we go. Here’s all the orders coming out. So, you can see here, there’s quite a few orders, about 50 or 60 orders. Now, here’s what happens. I simply right click, select all of these orders, copy them. I go to my Interactive Brokers DDE spreadsheet, which is provided free of charge by Interactive Brokers. I paste those orders in there. Remember, my software has already calculated exactly how many shares to buy and all that kind of stuff. And then all I have to do is highlight those orders and select the button here, place modify. And 50 orders will be sent directly into the platform and placed automatically for me.
It doesn’t matter if I have two orders or 200 orders, it’s literally copy, paste, push of the button and every single one of those orders are placed with the correct limit price and the correct quantity based on my own account balance. So, this kind of technology makes it very, very easy to trade and place a lot of orders and trade a higher frequency type of a strategy. So, don’t be too overwhelmed by it. It’s not that difficult to do.
Now, let’s just have a look at our own high frequency strategy that we released about 18 months ago. Again, this is a non-compounded equity curve. Trades long only on the S&P 500 market. And here is the equity curve compared to the S&P 500 back to 1995. We can actually go back to about 1960 and we have done that. We’ve gone and looked at periods of time such as during the early 70s. Certainly over ’87 during the crash then and all those periods of time to see how the system has performed. But you can see here it’s a very steady upward equity curve.
There’s a few flat periods in there when the strategy switched off. So, you can see the GFC there, the second major decline in the S&P 500, our strategy basically went to cash and stayed the way for a period of time. But it’s an onward, upward consistent kind of march. That’s what we’re after. Now, what we do because we use leverage, we have to also use or manage our exposure to the market.
One thing you may have seen with that example strategy earlier on, there was no stop losses used. Stop losses actually impair the performance of these strategies. Some of you may have come to this conclusion. And our own strategy doesn’t use stop losses. Now, some of you might be thinking, “Well, that’s just deadly.” But what we have to do is mitigate the risk other ways. And the way we do that is two ways. The first way is limiting the amount of orders that we actually trade. The more aggressive you want to be, the more orders or the bigger the universe you want to look at. So, what we do here is we only look for stocks in the S&P 500 trading between one and 100. There’s quite a lot of them. But if you want to lower the exposure, you only look at stocks trading between $1 and $50 as an example.
So, the top left hand corner is the most aggressive, so it’s going to trade any signal in the S&P 500 with stocks between $1 and $100 and we’re going to buy 10% or allocate 10% of our capital to each one of those signals that comes along. That would be an aggressive stance, you’re going to get a lot of signals and you’re allocating a lot of capital to each one. The annualized return there is 50%. You’ve got a maximum draw down of 27%. You can see it’s made 16,500 trades over the period. Reasonably good numbers right there. And if we want to be a little bit more conservative, you can move to the top right.
So, this is trading stocks between $1 and $100. But rather than allocating 10%, we only allocate 5%. So, you can see your annualized return drops down to 23% as does your draw down, it drops to 14.5%. So, it’s very important that you trade within your own risk tolerance. There’s no point wanting a 50% return if you can’t take a 27% draw down. You can’t have one without the other. And as I said earlier on with the Lake Wobegon effect, on paper you might think, “Yeah, I can handle a 27% draw down.” Well, I’ll tell you, you probably can’t. Maybe you can, but most people can’t.
So, the rule of thumb here is slowly but surely creep in, build a buffer with your capital, and then slowly increase the anti. Down the bottom left, bottom right, that’s trading stocks between $1 and $50 using a 10% allocation. And then $1 to $50 using a 5% allocation. You can see the statistics. It’s linear. The more exposure you have, the greater your return, but also the greater the risks that you’re exposing yourself to.
The great thing with this kind of strategy is that it can pull itself out of draw down very, very quickly, even when there’s a big hit that comes along every so often. So, in the last 18 months as an example, the biggest draw down we’ve had I think is 4.05%. And we’ve had 84% winning months. So, it’s quite consistent. But it’s still early days as yet.
If you’re interested in following this kind of strategy in more detail, take a look at our High Frequency Strategy which is found within our Power Setups service.