I’m working on this exercise to see if I can earn profits with a price-based mechanical trading setup. I’ll be coldly unemotional, like Mr. Spock. I’ll also share the setup for a system I back tested for profitability, and will follow my progress and results here in adapting Mark Douglas’s exercise called “Learning to Trade an Edge Like a Casino,” based on my favorite easy-to-understand setup from John C. Carter’s Mastering the Trade. What I won’t do is claim that this is any kind of advice. I’m writing to share what I’ve learned, which helps me to learn more.
Goal
The goal is to demonstrate and learn that trading is a system of probabilities, and to achieve emotional detachment from the trading process.
Casual blackjack players who amble into the casino without a strategy can annihilate their stakes before draining their first complimentary gin and tonics. The people who show up with basic strategy have a lovely time, play for hours, drink their drinks, but still bust out eventually. On the other hand, the seasoned player who sits at the table and soberly employs a rigid strategy with a system based on probabilities and skills for card counting can tip the odds in a way that might prompt casino security to politely escort them from the building with a only a meager portion of their potential winnings. The casino has a system and it makes money, but only if the suckers don’t know how.
At the micro level, individual trades are independent occurrences, random in relationship to one another. At the macro level, outcomes over a series of trades produce consistent results. (Douglas). At a casino, the house can’t control any individual hand of blackjack. However, the rules establish an edge for the house that delivers a sustained percentage over the thousands of daily hands, even accounting for the big winners.
To build this mindset and skill into traders, Mark Douglas proposes an exercise to achieve the mechanical stage of trading development. This is where the trader is learning a system and applying it consistently to build trust and confidence from probability-based thinking. No discretion. No fundamental analysis. No gut feel, no CNBC, no newsletter hype, no reading of tea leaves, no crystal balls. This is purely a technical exercise.
Meanwhile, Dr. Alexander Elder, in The New Trading for a Living, argues that there are mechanical traders and discretionary traders, but the best traders—including most professionals—apply their own discretion to mechanical systems instead of blindly following them. But that’s OK! This exercise is to build understanding of probabilities for a system independent from the temptations and emotions that can enter the picture with discretion, which is the next stage of development for a trader.
The idea is not even to choose the most profitable system or make a bunch of money. It’s simply to learn to trade consistently, so this exercise will work even with technically simpler and financially weaker setups.
Sources
Exercise: Trading in the Zone, Mark Douglas, 2000, Chapter 11
Basic edge setup: Mastering the Trade, Third Edition, John F. Carter, 2019, Chapter 17
See also My Learning Library for Trading.
Setting Up the Casino Edge
I chose the High of Low Period (HOLP) from Mastering the Trade in the 60-minute timeframe for this exercise. Some traders refer to HOLP as CAHOLD, or, Close Above High Of Low Day, and it is a popular beginner’s strategy taught by TD Ameritrade in their trading courses. Douglas calls any system or setup that yields positive results a “trading edge.” The edge defined by HOLP was relatively simple to grasp and program into TradeStation for back testing.
Figure 1: The High Of Low Period Setup
However, I added a couple of my own ingredients based on test results. The first thing I noticed was that HOLP performs poorly when a market retreats from a top. It should also never be used in a downtrend (I use weekly charts as the measure for this), where its short-side partner, LOHP, Low Of High Period, or CBLOHD, Close Below Low Of High Day, applies. I looked at the trades over time and wondered how I could avoid some of those losers over the past six months, so I tested a rule that would stand aside from a HOLP entry when the MACD histogram is falling. This performed better in a 60-minute timeframe for S&P 500 Micro Mini Futures, but worse on the daily.
Another powerful indicator to help address downturns is the Spike Bounce, based on the Monthly New High – New Low Index developed by Kerry Lovvorn and Dr. Alexander Elder at spiketrade.com. I’ve set my rules to enter only when Spike Bounce is in Buy mode.
The daily timeframe is significantly more profitable for this setup as I tested it, but I chose the 60-minute timeframe because it will generate more trades over a shorter period, and employs lower risk per trade than working from daily charts. Back testing also shows that 60 minutes was more profitable than 30- and 15-minute timeframes over the past year.
Naturally, back testing doesn’t prove anything about future performance, so I’ll need to choose a market in an uptrend for the exercise and be ready to take some hits when the market bounces off resistance. For the exercise’s 20 trades, I’m not allowed to waver from my rules. This is the most important reason for it.
Trading Rules
| Trading Edge | HOLP (Long) |
| Market | S&P 500 Micro Mini Futures (MES, uptrending), 3 contracts |
| Variables That Define the Edge | Market must be on an uptrend in weekly timeframe Spike Bounce must be Buy Market must trigger a 17-bar low Timeframe: 60-minute US Cash Session chart. Entry: When price closes above the high of the low barEnter at closing price at 1pm Pacific (end of cash session at 4pm ET) Exits and taking profits: Initial stop loss is the low of the low bar. On the third bar in the trade, trail the stop to the low of the previous two bars. Sell just after the close of the bar when price closes below the trailing stop. |
| Execution | 20 full trades without deviation, and no time limit for completion of the exercise. |
Figure 2: Final TradeStation Strategy Settings for the Exercise
Back Testing Results
Back testing this 60-minute timeframe, there were more losers than winners. However, the winners were bigger, resulting in a 1.8 profit factor. Daily testing yielded 3X+ on both S&P 500 and NASDAQ e-minis for this system. Much better, but I am sticking with the 60-minute timeframe so I can learn more quickly from the exercise.
Excerpt from TradeStation Strategy Report
Performance Graphs
Figure 3: Equity Curve for Chosen Setup
Figure 4: Monthly Accum. Profit for Chosen Setup
Figure 5: Monthly Profit for Chosen Setup
Strategy Automation
I used TradeStation’s EasyLanguage to write code that automates entry and exit signals and plots them on a historical chart. It’s clear why this setup works best in a bull market because in downtrends it’s like a guy falling from a treetop and bouncing off each limb on the way down. However, with a market that is in an overall uptrend, the profitable trades earn much more than the losers lose. Using the Spike Bounce signal helps identify those times to stand aside.
I did not take the time to code the Spike Bounce indicator into the strategy. With a profitable automated basic strategy standing on its own, my hypothesis is that if I have good mechanical results with the HOLP strategy alone and add the Spike Bounce signal, I’ll create more profit by avoiding some losers.
Figure 6: TradeStation Strategy Entries and Exits
Results
Figure 7: Trade Performance as of 11/29/2021
Lessons Learned
- Absolutely amazing. I am astonished at how frequently and strongly I second-guess the rules, and how much I have learned in just the first few trades with no ability to make decisions outside of the rules. It took considerable effort to stick with it. I did a good job following the rules, but not without serious reservations working hard to thwart my efforts. I noticed so many emotions—fear, greed, excitement, remorse, and others. For example:
- On the very first entry signal: “Golly, is this really the right time to get in?”
- On the first exit: “Am I getting out too soon?”
- Throughout the exercise, so far: “What if I…” or “I should have…” or, “I could have…”
- And after following the rules, here we are…
- The strategy played out similarly to how it tested with about the same number of winners as losers, and with the winners being bigger at $300 average compared with $150 average loss for losing trades.
- Futures move far and they move fast, nearly 24×6, so it requires constant vigilance, discipline, and attention to the screen during the day with hard stops in place overnight.
- It was good that I included what might be considered a discretionary tool to the strategy in the form of the Spike Bounce signal, which has modes of “Buy,” “Neutral,” and “Standby” based on correlating a monthly new high/new low index with the S&P 500. I suppose it’s not discretionary because I’m not choosing when to use it or when to ignore it. This rule forced me to stand aside when the signal is anything other than “Buy.” Looking back on the historical data, this wipes out a number of downturns where the HOLP model I programmed would blunder though with loser after loser, which is what generates the negative months in the automated strategy report (Figure 5).
- The Spike Bounce signal’s drop into “Stand By” mode saved me from the Black Friday plunge across the markets, when those few who were trading during the post-Thanksgiving session panicked on news of the Omicron COVID-19 variant. If I’d followed the HOLP signal alone, I would have wiped out all of November’s gains.
- Futures can be a vehicle to generate real income more quickly than with stocks and ETFs with my small account size. The initial risks and 3 contracts micro e-mini contracts I’m trading are easily within the max 2% portfolio risk rule, the leverage makes for strong upside potential, and once in the trade for two hours, this initial risk is wiped from the table, except for any nasty gap down. I’m using overnight hard stops to manage that.
A Word of Caution
Dr. Elder has this to say about futures in Come Into My Trading Room:
“The mortality rate among futures traders is over 90 percent… Easy margins attract gamblers and adrenaline addicts who quickly go up in smoke. There is nothing wrong with trading futures that money management won’t cure. Futures are very tradable, as long as you observe money management rules and do not go crazy with an easy margin. You have to be more than disciplined—to trade commodities you must be colder than a freezer. If you cannot follow money management rules, better go to Las Vegas. The entertainment value is just as high and the outcome is the same, but the drinks are free and the floor show more glitzy.”
It’s best to create a profitable system, manage risk, stick with it, and set yourself up like the house than to play like the chumps who gamble in it.
Closing Thoughts
Mission accomplished. I’ve proven to myself that I can follow rules and weather emotions that can occur during an open trade. I’ve also developed a tool for my toolbox in the HOLP/LOHP strategy that should help with entries and exits in the future. This is not a comprehensive system. It’s just a set of simple rules I could use to play out probabilities and test my emotional mettle.