How To Create Profitable Trading Strategies (Backed By Data)

Key Concepts

• Four-Step Framework for Creating Profitable Trading Strategies: A structured approach to developing and validating trading systems.
• Reading the Right Stuff: Emphasizes the importance of learning from trading books that provide tested systems.
• Extracting the Essence: Identifying the core concepts and logic behind a trading strategy.
• Objective Set of Rules: Translating abstract concepts into concrete, actionable trading rules.
• Testing the Trading System: Validating a strategy through backtesting or forward testing before live trading.
• Trend Following: A strategy that aims to profit from sustained price movements in a particular direction.
• Herd Mentality: The tendency for individuals to follow the actions of a larger group, particularly evident during market fear.
• Safe Haven Assets: Assets like gold, bonds, and certain currencies that tend to appreciate during times of economic uncertainty.
• ATR (Average True Range): A volatility indicator used to measure market fluctuations.
• Donchian Channel: A technical indicator that identifies the highest high and lowest low over a specified period.
• Chandelier Exit: A trailing stop-loss indicator based on ATR.
• Backtesting: Simulating a trading strategy on historical data to assess its performance.
• Forward Testing: Testing a trading strategy in real-time market conditions without risking significant capital.
• Equity Curve: A graphical representation of the cumulative profit or loss of a trading strategy over time.
• Maximum Drawdown: The largest peak-to-trough decline in the equity curve.
• Winning Rate: The percentage of trades that result in a profit.
• Payoff Ratio: The ratio of the average profit of winning trades to the average loss of losing trades.
• RAT Formula: An acronym for the four-step framework: Read, Extract, Test.

1. The Problem: Trading Strategy Uncertainty and Emotional Trading

The video begins by addressing a common problem faced by traders: uncertainty about the effectiveness of their trading strategies. This often leads to a loss of confidence, frequent switching between strategies, and emotional decision-making. The speaker aims to provide a solution through a structured framework.

2. The Solution: A Four-Step Framework for Creating Profitable Trading Strategies

The core of the training is a four-step framework designed to help traders develop and validate their own profitable trading strategies.

Step 1: Read the Right Stuff

• Key Point: Focus on trading books that contain complete trading systems with backtested results.
• Rationale: This provides a foundation, preventing the need to "reinvent the wheel." Authors' reputations are at stake, suggesting that systems in reputable books are likely to be functional.
• Actionable Insight: The speaker offers a link to a list of recommended trading books with backtested systems, available via email subscription.

Step 2: Extract the Essence

• Key Point: Understand the fundamental concepts and logic behind a strategy, not just its superficial components.
• Analogy: The essence of a car includes the steering wheel, engine, and chassis, while the air conditioner or windscreen are "nice to have" but not essential.
• Example: Trend Following:
  • Concept: Trend following strategies perform well in bull and bear markets, especially during crises and recessions.
  • Explanation: During periods of fear and uncertainty (e.g., a crisis), the "herd mentality" drives people to sell risky assets and move towards safe havens. This creates strong downtrends in risky assets and uptrends in safe havens, which trend followers can profit from.
  • Question to Ask: "What are the concepts behind a strategy?"

Step 3: Turn it into an Objective Set of Rules

• Key Point: Translate vague concepts into a tangible, objective set of rules using an "If X happens, then do Y" structure.
• Methodology: A series of seven questions helps transform concepts into a complete trading system:
  1. Which markets are you trading? (e.g., currency pairs, stocks, futures)
  2. Which time frame are you trading? (e.g., 5-minute, daily)
  3. How do you manage your risk? (e.g., limiting losses to a percentage of the account)
  4. What are the conditions of your trading setup? (Defining specific criteria for a trade opportunity)
  5. When do you enter a trade? (Identifying the entry trigger)
  6. Where to exit if you are wrong? (e.g., stop-loss, price-based stop-loss)
  7. When to exit if you are right? (Take profit or trailing stop-loss)

Step 4: Test the Trading System

• Key Point: Validate the trading system through backtesting or forward testing before risking real money.
• Rationale:
  • Validation: Ensures the system works before live trading.
  • Identification of Strengths and Weaknesses: Understand when the system performs well and when it underperforms.
  • Expectation Management: Builds confidence by knowing historical performance.
  • Faster Feedback Loop: Allows for quicker improvements and iterations.
• Analogy: Testing a car with a test drive before buying to avoid a "lemon."

3. Case Study: A Futures Trend Following System

The speaker then provides a detailed example of applying the four-step framework to create a futures trend following system.

Step 1 (Applied): Reading "Following the Trend" by Andreas Cleno

• Book: "Following the Trend" by Andreas Cleno is highlighted as a valuable resource for futures trend following.

Step 2 (Applied): Extracting the Essence of Trend Following

The core concepts identified are:

1. Trade in the direction of the trend: Buy breakouts and short breakdowns. Moving average crossovers can also be used for entries and exits.
2. Trail your stop-loss to ride the trend: Avoid fixed profit targets to allow for unlimited upside potential.
3. Trade as many markets as possible across different sectors: This increases the probability of capturing trends and ensures that profits from winning trades can cover losses from smaller, unsuccessful trades.

Step 3 (Applied): Turning Trend Following into Objective Rules

• Markets: Currencies, metals, commodities, bonds (for diversification).
• Time Frame: Daily time frame.
• Risk Management: 2% risk on each trade (meaning a maximum loss of 2% of the account if a stop-loss is hit).
• Trading Rules:
  • Long Entry: If the price closes at the highest over the last 200 days, go long.
  • Long Exit (Trailing Stop-Loss): Use a 6 ATR trailing stop-loss (with a 20-period ATR lookback). The stop-loss moves up as the price moves in favor.
  • Short Entry: If the price closes at the lowest over the last 200 days, go short.
  • Short Exit (Trailing Stop-Loss): Use a 6 ATR trailing stop-loss (with a 20-period ATR lookback).

Step 4 (Applied): Testing the Trend Following System

• Tools:
  • Donchian Channel (modified): To identify the highest/lowest close over the last 200 days. The modification focuses on the closing price.
  • Chandelier Exit Indicator: To implement the 6 ATR trailing stop-loss.
• Example Walkthrough (Gold):
  • The speaker demonstrates how a breakout above the 200-day high triggers a long entry on the next day's open.
  • The 6 ATR trailing stop-loss is set.
  • The trade is held as the price moves favorably, with the trailing stop-loss progressively moving up.
  • The exit occurs when the price closes below the trailing stop-loss.
  • The example shows a successful trade capturing a significant portion of a trend.
• Backtesting Results (2000-2024):
  • Equity Curve: Generally sloping upwards, with pullbacks during choppy or range-bound market conditions.
  • Performance during Crises:
    • 2008: +65%
    • 2020 (COVID): +8%
    • 2022 (Russia-Ukraine War): +56%
  • Losing Periods: Acknowledges that the system does not win every month or year, citing examples of losing months and years (e.g., 2009, 2012, 2013).
  • Overall Statistics:
    • Total Return: 2,864%
    • Average Annual Return: ~14%
    • Winning Rate: 45% (meaning more than half of trades are losses)
    • Payoff Ratio: 1.74 (average winner is 1.74 times larger than average loser)
    • Maximum Drawdown: 37%

4. Tweaking and Expanding the System

• Flexibility: The trading system can be tweaked and adapted.
  • Breakout Length: Adjust the lookback period for breakouts (e.g., 50-day, 100-day).
  • Trailing Stop Duration: Modify the ATR multiplier for the trailing stop (e.g., 3 ATR) or use alternative methods like moving averages.
  • Entry/Exit Methods: Explore different entry types beyond breakouts, such as moving average crossovers.
  • Market Expansion: Add more markets (indices, currency pairs, commodities) to increase opportunities.
• Creating Multiple Systems: A single strategy (like trend following) can be used to create multiple distinct trading systems (e.g., long-term vs. short-term trend following).

5. Pros and Cons of Trend Following

• Pros:
  • No correlation to the stock market.
  • Performs well in bear markets and crises due to herd mentality.
• Cons:
  • Low winning rate (around 40-45%).
  • Psychologically challenging due to prolonged drawdowns (months or even years).

6. The Importance of Multiple Trading Systems

• Argument: Having multiple trading systems (e.g., trend following, mean reversion) helps smooth out returns and improve risk-adjusted performance over time. This mitigates the psychological difficulty of enduring long drawdowns in a single system.

7. Conclusion and Recap: The RAT Formula

The video concludes by recapping the four-step framework, referred to as the "RAT Formula":

• Read trading books with backtested systems.
• Analyze and extract the essence of strategies.
• Turn concepts into objective rules.
• Test the trading system.

The speaker reiterates the offer for the list of recommended trading books and encourages viewers to apply the framework.