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    The Dennis Rule how to stop chasing your equity curve

The best risk management is not to take a risk at all

One of the first things you hear about winning at investing and trading is to let your profits run and cut your losses short. Everyone accepts this as normal.  However, they are missing the point.

Richard Dennis sees it this way: “You have to minimize your losses and try to preserve capital for those very few instances where you can make a lot in a very short period of time. What you can’t afford to do is throw away your capital on suboptimal trades.”

Too many traders pay lip service to what the great ones say, they know it’s the truth but fail to act in the same way. To do what Dennis suggest you need a method, a model that tells you when you have a great trade on the horizon.

Poker Analogy Improves Understanding

In the game of poker, the rules force each player to make a bet. These bets are called blind antes. They are made by each player when he is to the left of the dealer in draw or flop-style poker games.

Here is the key and the exact rule Richard Dennis made about trading. There are blind bets in poker because a player can sit there for as long as he likes and not play. He can wait to try to catch a premium hand before he makes a bet, a good bet.  Here is one of the clearest examples of the impact of money on the player, forced by the “rules of the game.”

If the player antes $100.00, and he is dealt a “5,” and “7” unsuited low cards and someone raises the bet before the flop – the draw cards – the odds of him winning or losing are the same. The money has no impact on the odds.

However, human nature will push him to defend his $$100 blind bet.  But doing so in this example hand of a “5” and “7” unsuited, which have about zero odds of winning, defending your ante is foolish. The player needs to walk away. But what if the player had been dealt a pair of Aces? A much better hand to win with where the player does not need help from the draw cards.

Human nature could make it worse if our poker player betted large in the past on a “5” and “7” hand where he got lucky and won big? How what is his posture? He may be prone to make a “bad bet” and in a big way. Yet the outcome has nothing to do with his past winning experience making a poor bet.

Placing “defensive bets that have little chance of “catching” a good card or cards to win is going to lose and break the bank over the long run.

A big point to understand is the poker player needs to know what the premium hands are, that is which ones “stand-alone,” that can win without any help from the draw or flop cards. Likewise, the trader needs to know the setups that precede the big winning trade positions.

The game of trading has the built-in advantage of not forcing the investor to take a risk, he/she can stand aside until he is 100% certain.  You wait for the setup, the precondition you know precedes a winning move for you. That is the hard and fast rule from Richard Dennis – a cofounder of Turtle Trading.

The Everyman Trader is not Helped by Old School Thinking

Conventional thinking and the common approach to investment/trading is forecasting price targets and direction followed by calculating risk and reward based on trend and targets.

However, the way of the masters uses the Dennis Rule, which is direction neutral, it looks at the market’s context. The Market Wizards look at the setup- first to judge risk and reward, based on the market’s background.

There are many ways to successfully apply the Dennis Rule that fits your personal risk/reward personality or your fund’s investment policy. But I will only focus on one here because I use it. Personally, it is dramatic in its results and built for the aggressive trader or a hedge fund trader.

There are many reasons why no one else talks about the Dennis Rule. For one, it is not transactionally motivated, so it does not get the attention of the Sell-Side of the industry, nor is it a liquidity provider, it is not based on you the idea that you must be in it to win it.  Getting your head around that meaning puts your miles ahead of the majority.

To understand the method, it does not matter if you trade mechanical strategies or trade a plan based on advisory or visually trade indicators. The only difference is who or what is seeing the data stream.

Here is the Dennis Rule put another way, “Stop trading for the average, only trade when it’s clearly a great opportunity.”

To drive home the significance of this idea you need to contrast it to an industry standard. One of the pioneers of systems trading -Robert Pardo – in his original text said the following:

“Let us consider the plus side of the discretionary trader. It is quite simple. The biggest plus is that, to date, I do not believe that a systematic strategy has yet been created that equals, let alone exceeds, the performance of the greatest discretionary traders.”

If you understand this and accept this as true that a robust trading system or a static assembly-line mechanical plan will not make anyone rich, again you are way ahead of the trading mob.

In other words, you are taking a risk each trade just to be average, to make an average win. A good trading plan or a system – the way it is defined and developed by Bob are statistically robust therefore they are generic. They are designed to deal with all the major conditions in the markets going back over the longest period as possible. They are meant to provide the trader with an average winning trade each time he takes a position on a regular basis over the long term.

This goal of Algo-strategy trading is the heart and soul of the system trading school of thought. The industry is happy with this, because it is “transactional” and many system’s traders do well, not great but they can make money. If it is your goal to make an average amount of money each day or week to supplemental income, with  the use of automatic systems it is very doable, as long as you understand you are taking risk not to make riches but only to be average at best, as that is the best you can expect from a good trading strategy.

To be great you need to think like the great ones think

Volatility breakout systems are based on the premise that if the market moves a certain percentage from a previous price level, the odds favor some continuation of the move in the same direction. This continuation might only last one day, several days or go just a little bit beyond the original entry price, as long as the net profit is worth the risk.

With a breakout system, the trade is always taken in the direction that the market is moving at the time. It is usually entered via a buy or sell stop. The bit of continuation that we are playing for is based on the principle that momentum tends to precede price.

There is also another principle of price behavior that is at work to create trading opportunities. That is, the market tends to alternate between a period of equilibrium (balance between the supply and demand forces) and a state of disequilibrium. This imbalance between supply and demand causes “range expansion”, (the market seeking a new level), and this is what causes us to enter a trade.

There are several ways to create short-term volatility breakout systems. I have found that different types of systems based on range expansion test out quite similarly. Therefore, whichever method you choose should be a matter for your own personal preference.

There is a full range of good breakout systems from the “Turtles” method with the 4-week high/low channel breakout to the following one-day breakout strategy.

The strategy takes the high low range of the previous day multiplies that by 55% and adds the result to the next day’s open for the entry buy trigger and subtract it from the open for the short entry stop price for the day. If filled, the opposite level is your day stop and the exit is on the open next.

Without money management stops – both stops loses and profit stops – here are the results of the basic code on the mini Nasdaq 100 futures.  The table above shows the monthly performance of the strategy.

For the two-year period it made $289,060 where it adds a contract after a winner and reduces back contracts to one lot after a loser.

But look at the historical risk, with several months of losses over 30k. Plus, look at all the months that had typical or average months. The average month is an $11,000 profit. But how can you trade over the long term for an average month when your potential risk is over $30,000? You need to base your trades on the “Dennis rule.”

Pardo points out that the “Proof of this concept is available by the mere consideration of a shortlist of some of the household names of the greatest discretionary traders. This shortlist of the greatest would include legendary billionaires such as George Soros, Paul Tudor Jones, Bruce Kovner, and T. Boone Pickens.”

One of the legends I admire and studied is Stanley Druckenmiller, and it is his notion of risk management that I set out to understand and replicate. As it turns out he did not have a corner on the idea. The proper idea of risk management goes back hundreds of years to Livermore – “…it’s the waiting not the trading.”

It is the Dennis Rule that Livermore uses, and it cuts across all the legends from the beginning of trading history, the Market Wizard series and today’s Hedge Fund greats.

The best risk management is not to take a risk at all.

The modern-day hedge funds control risk by not taking a risk, but once everything is 100% correct based on their comprehensive system or investment checklist, they enter the position and, in the words of Druckenmiller, “go for the jugular, they leverage up throughout the trend to maximize profits. This is what the Turtle Traders do with their trend following systems, mark to the market at the end of the day.  It is what Soros calls his “one-way trade.”

This idea is easy to understand, once you cut through what the retail industry and the media publish every day, pulling on your fear and greed. They overlook the above idea of waiting, ignoring or they consider it trash. The financial media and part of my industry even see investing or trading only from an “act now,” “happening now,” breaking news environment making it transactional and Vegas type of gambling, which is the opposite of taking no risk, aka risk management!

Everything the legends do is just the opposite of what many in the industry promote. They only pay lip service to the great ones and use their wisdom to take Social Media polls.  But once you take to heart what the legends say and what it means to implement their wisdom you have advanced your capabilities beyond the majority.

By now you have realized you need a method that tells you when there is a low risk with a high reward condition.  The reward side of the idea – opportunity management – is once you are in a position, you go for the gusto; you leverage up systematically to maximize your profits. The Soros “one-way trade.” In this way you can trade 10% of the time with 10% of your capital and return on your account a return that beats the average return of the long-term S&P. Or you can go “all in” to make a fortune.

To execute these two key rules, you need a strategy to get you in and out of the market profitably, the basic trade plan if you will. These are the robust trading strategies or formulas based on the Pardo tradition. There are many, hundreds of them that are sound with better than average profits. But what is key is they all have periods of profit run-ups and drawdowns; and this is what you want to control via a system’s model.

The model I developed is called the Technical Event Model (TEM). Technical because it is 100% price based. It tells you when to trade the strategy and when not to trade it. It will tell you if it is a good time or a bad time or a great time for any traditional, well tested and robust strategy. For the professional advisor and capital manager I call it the New Paradigm, a new way of thinking that turns a strategy into a comprehensive investment or trading SYSTEM.

Because of the popularity and common knowledge, the industry has I will use the robust day trading volatility breakout strategy for one example. But the model is universally applicable.

Breakout systems are designed to capture the next immediate move after the market moves past a certain point. The trader is not concerned with any long term forecast or analysis, only the immediate price action after the trigger is hit.

Volatility breakout systems are based on the premise that if the market moves a

certain percentage from a previous price level, the odds favor some continuation of the move in the same direction. This continuation might only last one day, several days or go just a little bit beyond the original entry price, as long as the net profit is worth the risk.

With a breakout system, the trade is always taken in the direction that the market is moving at the time. It is usually entered via a buy or sell stop. The bit of continuation that we are playing for is based on the principle that momentum tends to precede price.

There is also another principle of price behavior that is at work to create trading opportunities. That is, the market tends to alternate between a period of equilibrium (balance between the supply and demand forces) and a state of disequilibrium. This imbalance between supply and demand causes “range expansion”, (the market seeking a new level), and this is what causes us to enter a trade.

There are several ways to create short-term volatility breakout systems. I have found that different types of systems based on range expansion test out quite similarly. Therefore, whichever method you choose should be a matter for your own personal preference.

There is a full range of good breakout systems from the “Turtles” method with the 4-week high/low channel breakout to the following one-day breakout strategy.

The strategy takes the high low range of the previous day multiplies that by 55% and adds the result to the next day’s open for the entry buy trigger and subtract it from the open for the short entry stop price for the day. If filled, the opposite level is your day stop and the exit is on the open next.

Without money management stops – both stops loses and profit stops – here are the results of the basic code on the mini Nasdaq 100 futures.  The table above shows the monthly performance of the strategy.

For the two-year period, it made $289,060 where it adds a contract after a winner and reduces back contracts to one lot after a loser.

But look at the historical risk, with several months of losses over 30k. Plus, look at all the months that had typical or average months. The average month is an $11,000 profit. But how can you trade over the long term for an average month when your potential risk is over $30,000? You need to base your trades on the “Dennis rule.”

To focus and trade only the above-average opportunities, part of the TEM model is the use the implied volatility data from the CBOE. VX is the ticker symbol for the CBOE VIX Index Future. VX is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. The predictive nature of the VIX Index makes it a measure of implied volatility. The index is derived from an option’s price model and shows what the market implies about the stock’s volatility in the future. It is not one that is based on historical data.

In the above chart, I have high-lighted when volatility – VX- is oversold when you apply one of your favorite overbought/oversold oscillators on it. For TEM I use the %BB which is my Bollinger Band Oscillator.

The oversold reading is saying that the market’s concern about a big change in the markets price is very low, hence it is oversold and ready to cycle back to the other extreme.
Now based on a calendar month, not a week but a typical accounting month, when VX is at an extreme you engage the above system for the month and continue to trade the next month, if VX has not hit an extreme in the other direction, an extreme overbought.

So now instead of being at risk for 24 months, you are only in the market for half of that time. You have doubled your average monthly return to over 20k; and lowered your historical risk to $3,900 only 10% of the risk potential trading suboptimal trades.

This is the new way of thinking and the new approach to systems trading, the new paradigm; and the results are in the following table.

With the adoption of the Dennis rule and having a tool, a model that tells you the coming period, be it a week, or a month or longer calendar period, will be the best to engage your trading plan, your trading strategy will be optimal. Traders can now manage their money without their profits and losses managing them. You are now in control with a price-based model that makes your plan a comprehensive system.

Contrary Thinker’s Volatility Reports is the advisory blog and newsletter publications based on this new model. Contrary Thinker also provides for TradeStation and NinjaTrader platforms TEM indicator plugins, clip and paste User Functions for system trader’s code.

Many thanks,

Jack F Cahn, CMT

Capital Managers and Professional Investment Advisors visit: www.ContraryThinker.com

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