Anatomy of a Trade

I was talking to some friends and associates recently about market action and the "setup of a trade."  If you are interested in trading systems, below are some notes from our conversations.

By way of background, our quantitative trading systems are technical in nature and are tuned and researched for market action, time-frame, and execution.  We focus on the intermediate to long-term time horizon -- with shorter-term approaches "in the mix" for diversification and risk management reasons.

In particular, the notes focus on trade entry and execution.  We would all like to enter a trade at the best possible price/trade entry.  On the other hand, we have heard some great traders and "market wizards" such as Paul Tudor Jones, Bill Eckhardt, or Richard Dennis -- say they prefer trades and markets where execution seems bad; or markets that are "running away" from them.

In the long run (based on experience; also, data backs this up) -- our trading strategies are designed so that they can enter trades "at the market."  Sometimes, we'll be able to get a better price; other times, the trade will move away from us (along with profits) -- so going "at the market" is okay.  If we want to "be long" in a market, we should initiate the trade.    

Below is an example of why some market wizards PREFER buying markets that are running away from them. 

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Say, we want to buy Market X and the price is 100.00.

• (A) Trade Initiation -- at trade initiation, our trade expectations might be something like this.  
• 47% chance of Profitable Trade (yes, less than 1/2 the trades are profitable...)
• Avg Gain = 1700 (but avg gain is greater than avg loss); 
• Avg Loss = 1000
• In the long run, this kind of trade action will lead to profits, even with less than 50% of the trades profitable.
• (B) "Bargain" (?!) Trade -- if we wait a bit on pricing -- and the price is now 99.25, we might think, "Oh great, this is a good deal."  However, note that this is not the exact match of all trades in the bucket in category (A).  This "Bargain" trade is a subset of category (A).  
• Note that "noise" will sometimes work for trade entries and sometimes against trade entry.
• However, within the complete dataset of trades, there IS an area where "noise" becomes "information."  
• And roughly, the numbers for this trade might NOW be something like this: 
• 44% chance of Profitable Trade (market is moving against the desired long position)
• Avg Gain == 1600
• Avg Loss == 1100
• Note that this subset has slightly lesser trade parameters -- because there is "more information" based on the lower price. 

Although this example is simplified, our technical and quantitative trading strategies take these factors --  as well as other quant research and volatility / risk management -- into consideration.