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Thursday, September 22, 2016

Revisiting Tom Basso: How Important is Your Entry Really?

Feature Article

Revisiting Tom Basso: How Important
is Your Entry Really?
By Justin Paolini

jc paolini
Many aspiring traders focus on setups and entries. I would say 90% of their time is actually dedicated to perfecting entries. That is one way to miss the forest for the trees. Back in the 1990’s, Tom Basso and Van Tharp had already issued research conclusions on the relative unimportance of entries in producing good trading results. Their “Coin Flip” study showed that across 10 futures markets, a simple random entry with a trailing stop made money.

Assuming they did not cherry pick the situations for the test, is the relative unimportance of entries still valid now? Does the random entry still work or have the markets changed? We decided to answer that question with a research project using current Forex data.

Tom Basso’s Coin Flip Study

In his book Trade Your Way..., Van Tharp explained how he and Tom Basso came up with their idea to test a trading system using random entries:

"I was doing a seminar with Tom in 1991. Tom was explaining that the most important part of his system was his exits and his position-sizing algorithms. As a result, one member of the audience remarked, 'From what you are saying it sounds like you could make money consistently with a random entry as long as you have good exits and size your positions intelligently'”. – Van Tharp, Trade Your Way...

Here are the very simple rules Tom Basso used to test the viability of a random entry system:

1) Hypothetical $1 Million account this is required in order to simulate diversification amongst futures contracts, withstanding margin requirements and drawdowns.

2) Select markets that have more of a tendency to trend so at that time, this meant commodities and futures markets. In particular, the markets tested were Gold, Silver, US Bonds, Eurodollars, Crude Oil, Soybeans, Sugar, Deutsche Mark, the Pound and Live Cattle.

3) The exit is 3X Average True Range (10 day period) subtracted from the close. The trailing stop can only get closer to the current market price, not further away.

4) Position sizing strategy: risk 1% of equity per position

5) Selected markets must be liquid (so that trades can be entered and exited immediately with low slippage).

6) Always be in the market (so as soon as one trade closes, another is opened).

We used these same rules to run simulations in MT4 with the help of our resident programmer Craig Drury. We tested the six FX Major pairs along with Gold from January 1st 2014 to June 30th 2016 (except for NZDUSD which because of data errors, was tested only until the end of February 2016). Effectively, we tested the random entries through trending and range bound environments over the entire test period. Unfortunately, MT4 doesn’t have a Monte Carlo generator so we had to do all the runs manually (20 runs) and it was a lengthy process.

Feature article Chart 1
Random Entry Trades taken as per Basso’s Rules in EUR/USD coded by Craig Consulting on MT4

Our findings? We found no significant deviations from the core concept: Tom Basso’s system’s rules using the Coin Flip entry remain as sturdy today as they were back in the 1980s/1990s.

Feature article Chart 1
An example of the output in Excel —
Tom Basso’s Random Entry is in fact profitable in most cases.

As you can see, the random entry method ends up with a profit in most cases (and this was a robust finding across all runs). While the profit factor is also interesting, there were very few trades overall and the system produced a very low win rate. Van talks about the psychological part of trading and even with robust statistics at your disposal, you can see how traders would find it very hard to stomach this kind of a system in reality.

It was at this point that additional questions and possible complications to the test arose. We asked ourselves: just how random was Basso’s system?

To keep the discussion short & sweet, here are our thoughts:
  • Truly random entries should be random in both direction and timing. Being in the market at all times is not really random. Basso’s “randomness” simply asked the algorithm to be “long or short” randomly at a given starting date and then randomly picked long or short after each trade closed. So this means the starting point and initial conditions were likely very influential in the results.
  • The markets weren’t randomly selected. Forex and commodities exhibit autocorrelation (trendiness) just like the futures contracts used in the original study. This is another bias to Basso’s test as stocks do not exhibit the same degree of autocorrelation in returns.
  • The exits weren’t random at all, are they? The rules for exiting were very clearly defined as to not be random at all. Basso was not testing a purely random system — and neither did we. So we’re not saying that it is possible to obtain decent results simply flipping a coin in the market as to when to get in and flipping a coin as to when to get out.

In fairness, Basso was not testing for profitability of a system with completely random entries and exits. Instead, he simply devised a test to see if exits were much more important than entries. That test was positive but even then, Van said traders can do a lot better than using just a random entry — and still not spend most of their effort on entry refinement. Our initial research results got us wondering about the possibility of putting additional randomness into the test and seeing what came out. When we did, we found both confirming results on some fronts and surprising results on others.
One of the confirming conclusions that will emerge in next week’s part 2 article of this series is that the exit strategy influences returns more than the average trader expects. In particular, we used a trailing stop which is particularly suited to trending markets. When random entries were paired with trailing stops in range-bound environments, positions were “chopped up”. In a trending environment, though, they really “bucked the trend.” The importance of the environment (or as Van labels it — market type) turned out to be one of the more surprising results from the tests.  

Join us next week for more about the additional research results and the rest of our conclusions.

Editor’s Note, Van added this comment: "One key to getting the random entry system to work was the 3 times volatility trailing stop (which I think I remember as 20 days). That kind of stop meant that positions could go through a lot of chop before a trend started. If the stop was shortened to 2 times ATR, even with a 200-day period — it really wouldn’t do it (my guess but I’m not sure). Another key to the system — it was ALWAYS in the market with the random part being long or short. And yes, the starting point was important, but I remember the study using 10 years’ worth of data — so then the starting point wasn’t that important in the end. I actually thought the system would have stopped working because the big commodity trends ended so I’m surprised they got it to work."

About the Author: Justin Paolini has 10 years of experience trading FX. He has studied Van Tharp’s trading principles and incorporates many of those in the weekly blog posts he writes. He currently works for Forex signal provider FX Renew as a trading coach.

1 comment:

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