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05 October 2018
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Weekly Research: October 5th, 2018

TABLE OF CONTENTS




Herding in the most volatile market in decades

In finance and economics, there is a branch called behavioural finance, which tries to theorize, research and document the human emotional aspect and behaviour of financial participants. Behavioural finance suggests psychologically based theories to try to explain deviations in price.

One of the most powerful techniques used in an economist’s arsenal in understanding the behaviour in markets, is trying to find herding behaviour in a certain type of financial market or market index. Usually using mathematical models such as CSSD (cross-sectional standard deviation), HIX (Herding index), VAR models, etc. These mathematical techniques are used to find herding behaviour.

Herding Behaviour is a phenomenon that occurs when individuals try to mimic the trades of others and thus traders copy each other. Two of the most important aspects is price and volume, especially the direction of causality between them.

Think of it like the bandwagon effect in economics. Which is a term that is used by economists to explain certain psychological actions that people take in their everyday life. The bandwagon effect occurs when an individual does something just because everyone else is doing it. For our purposes, people will buy into something just because other people are buying into it and thus we would observe the price rising.

In order to find this type of effect or in other words to find herding behaviour, one would need to analyse the effects between price and volume, and the direction of causality between them.

The importance of finding herding in a financial market is to know whether the current price of an asset is causing an increase in transactions and thus volume or is an increase in transactions causing movement in price.

If one is to find herding in a financial market that would mean that price causes the movement in volume and thus market participants are not doing their own due diligence and are favouring to make trades based upon the movement in price.

This would suggest that market participants are not doing their homework when it comes to analysing the market. They are only buying when the price goes up and selling when it goes down.

However, if one is to find that no herding is present in a financial market then this would mean that volume causes price to move, and thus market participants are doing their due diligence analysis and only then committing to a transaction which would increase volume and thus the price would either increase or decrease.

In this case the market is not psychologically based and does not care what the price is because there seems to a method to its madness, a trader would look to use more due diligent approaches such as fundamental analysis in his/her investment decisions, if this is the case.

It should be noted that when finding herding in a financial market, this does not mean that fundamental analysis does not work. It just suggests that the majority of the time the market does not seem to look at fundamentals and other adequate forms of analysis, it seems to react to changes in price mostly. It does not mean that fundamentals cannot affect price in anyway.

To do a simple correlation analysis between price and volume is not enough. Even though it is useful to know, a simple correlation between price and volume is 0.66, this means that both price and volume follow each other especially over a longer term, but this does not explain which one causes the other.  The graph below shows a scatter plot of the volume and closing price of bitcoin, with volume being scaled down by a factor of one hundred thousand, in order for the data to fit into the chart.

causality

Using other mathematical processes, we can find the direction of causality between variables. We find that the volume of bitcoin does not cause deviations in the price of bitcoin with any statistical significance. However, we also find that the price of bitcoin does not cause deviations in the volume of bitcoin. This is a weird scenario of price not causing volume and volume not causing price. This would mean that using volume analysis only in your trading would not necessary provide any advantage in the predicting of price in the bitcoin market.

But to analyse the deeper meaning of this phenomenon. How is it possible that volume cannot cause price or even price cannot cause volume? This would mean that the bitcoin market is dependent on other factors possibly news events, costs of mining and other factors.

The chart below is a chart showing how an impulse in volume affects the closing price. As can be seen the volume of bitcoin will not significantly affect its closing price, because the graph remains relatively stable.


From this analysis we can conclude that in the bitcoin market, only using volume will not help in trying to predict the price of bitcoin, more specifically depending on volume alone to predict the closing price of the next day is futile. This does not mean that volume cannot predict the longer term trend, it only means that day trading in this type of market is futile when using volume analysis only. More analysis is to be done in addition to volume analysis when making trading decisions on whether to buy or sell.

Screen Shot 2018-10-05 at 1.26.17 AM

We give an example here to demonstrate. Looking at the long green bar marked by point A with its increased volume, looking at this a day trader would expect a follow through in the next candle, for its close to be higher than its current open. However, this is not the case the closing price remains flat, closing near its open price, just as we predicted.

This is as a result of volume not causing price and price not causing volume, thus we cannot expect a follow through in the next day. However, the medium-term trend was bullish, this is as a result of a high positive correlation as discussed above between price and volume.

Using this analysis, we can expect that when we have above average volume in one direction in this market we can expect a follow-through in the long run but not a short-term continuation.

Knowing this gives us an advantage because we can enter into a long position at the open of the next day’s candle of point A and our holding period would be longer than a day, possibly a week to a month. In this instance day traders should not trade due to uncertainty, rather they should hold on to a longer-term trend.


What is public-key cryptography and how does it work?

Every individual who has been involved with blockchain technology on any level should be acquainted with the concept of public and private keys. These two key types form the fundamental basis of the blockchain, and are responsible for securing accounts and for verifying account identities. But how do they actually work?

Public keys and private keys are two components of a larger cryptographic system called public key cryptography. This is a relatively new branch of cryptography that originated in the 1970s, and is based on the concepts of symmetric cryptography.

Its existence has enabled the internet, online banking and blockchain to thrive. In order to understand exactly how public key cryptography works, it is important to develop a basic understanding of symmetric cryptography.

Symmetric cryptography is an operation that encodes data so that it cannot be accessed without the proper key. It accomplishes this encoding by means of a one-way function.

A simple example of a one-way function is as follows:

Our starting data is → Happy birthday

We apply our one-way function and get the ciphertext  → jcrra dktvjfca.

If someone were to see the letters “jcrra dktvjfca” without having the key, it would be nearly impossible to derive the original meaning of the data. If the user has the key, the data is easy to decrypt. Example:

Ciphertext → jcrra dktvjfca.

Key = shift each letter up two positions in the alphabet → happy birthday

        This concept of one-way functions is what drives a large portion of modern cryptography.

Public key cryptography improves on symmetric cryptography in that two parties can encrypt and decrypt data (as shown above) without ever having to give away their secret method. This mechanism is incredibly important for cryptocurrencies, as it allows users to have private “bank accounts” on the blockchain. Each user can give out their “bank account” number (public key) freely without having to worry about their money being compromised, as a password (private key) is also required to access the account.

Note: the actual implementation of cryptographic systems are quite complicated. In order to ensure readability and comprehension, the examples used in this article focus mainly on the concepts of cryptography rather than the actual mathematics that are used to implement them.

Public key cryptography is typically accomplished through a Diffie Hellman key exchange, which was named after its inventors Whitfield Diffie and Martin Hellman. A simplified example of how the Diffie-Hellman exchange works is as follows:

Step 1: Alice and Bob each create their own private key.

Alice has her own private key → a.

Bob has his own private key → b.

Private keys are extremely long, randomly generated numbers that should be created by special embedded computer chips. Private keys must be enormous and random to prevent two users from ever picking the same key.

If two individuals were to generate the same private key, they would not have unique accounts and would have access to each others funds. To solve this issue, private keys are typically required to feature a large number of digits to mathematically ensure that this would never happen.

Step 2: Each private key is then put through a one-way function that produces a seemingly unintelligible result called the public key. An illustration is as shown:

a → one-way function → pub(a).

Because it is impossible to reverse the one way function, the public key can be given away without ever compromising the security of the private key.  Returning to our example of Alice and Bob:

Alice performs the one-way function and now has public key → pub(a).

Bob performs the one way function and now has public key → pub(b).

Step 3: Alice and Bob now send each other their public keys. These public keys are visible to everyone, but the private keys that they represent are hidden due to the nature of the one-way function that created them.

Step 4: Alice combines Bob’s public key pub(b) with her private key a to get pub(b)(a). Bob combines Alice’s public key pub(a) with his private key b to get pub(a)(b). Because of the commutative property of multiplication, Alice and Bob now have the exact same result. This result becomes Alice and Bob’s shared key, which can then be used to encrypt any data that needs to be sent between them.

The genius of the Diffie-Hellman key exchange is that throughout the entire key exchange, each user’s private keys remain hidden; both from the public and from each other. This way, each user is able to retain an exclusive hold over his/her digital identity.

Why is this important to know how public and private keys work? For the average user, understanding Diffie-Hellman does little to enhance how one transacts in cryptocurrency. However, it is useful as it allows the user to understand the significance of the private key and the usefulness of the public key.

It should also serve as a warning to users that private keys must be stored securely, as anyone else who has access to a private key will have access to the funds of its wallet. To store private keys properly, most users should rely on a hardware wallet such as a Ledger Nano S or Trezor and make a secure backup of the recovery seed.

Users that have a basic knowledge of proper cryptographic protocol are also able to more easily navigate the pitfalls of cryptocurrency. The truth of the matter is that many projects neglect to implement sufficient security measures, and this has many real-world consequences for holders or users of that cryptocurrency.

One very clear example of improper security was the old IOTA desktop wallet. Instead of automatically generating random seeds for new wallets, the developers required the users of the wallet to produce random seeds. This was a highly flawed approach, as humans are notoriously poor at producing random numbers1.

It also encouraged many users to rely on online random number generators to produce their seed. Predictably, many of these random number generators made copies of the seeds that they distributed, allowing the creators of the random number generators to recreate users’ wallets.

This unfortunate event led to many users’ wallets being compromised2. While IOTA’s current wallet implementation has fixed this glaring issue, it is a perfect example of why users need to be extremely cautious when evaluating the security of blockchain projects.

Final Thoughts

Public key cryptography is a modern method of cryptography that allows two parties to share information securely without ever having to divulge their private identity. This mechanism is the backbone for the internet and is the core mechanism that allows blockchain to exist.

Understanding this important concept also has important ramifications for each individual user, including the ability to understand improper security methods and the importance of protecting private keys.

  1. https://gizmodo.com/5946582/the-20-most-common-pins-are-painfully-obvious
  2. https://www.ccn.com/a-number-of-iota-wallets-emptied-by-hackers-due-to-online-seed-generators/

Should Investors be Concerned about Ripple’s XRapid?

If you’ve been following Ripple with moderate attention over the last year, you’ve likely heard of their much-publicized XRapid product.

Well, Ripple CEO Brand Garlinghouse finally announced three companies that will actually be using XRapid, MercuryFX, Cuallix, and Catalyst Corporate Credit Union, at Ripple’s San Francisco Swell Conference.

XRapid basically enables companies to integrate Ripple’s digital asset XRP as a “bridge currency” to facilitate cross-border payments. It is expected to reduce the cost and increase the speed of these payments by increasing liquidity.

This is a significant milestone for the #3 largest market cap coin. Partners using XRapid will essentially holding XRP for limited amounts of time. As adoption of XRapid increases, which the Ripple team estimates it will due to XRapid’s ability to make large international payments much faster and less expensive, more and larger institutions will likely ending holding pools of XRP.

This begs the question: is Ripple XRP worth holding as a casual investor?

Here are a few thoughts to consider.

  1. There is an extremely large amount of XRP in circulation. With 39,935,410,492 XRP in circulation and a total supply of 99,991,826,231 XRP (nearly 100 billion!), the volume tends to work against investors. XRP currently has a market cap of nearly $21B. How much of an appreciation can one reasonably expect in with this sort of volume?
  2. Ripple still owns the majority of XRP (~60B). If you’re holding Ripple, this should be unsettling for a few reasons.
    1. Ripple’s core team can strategically cash out at your expense.
    2. Ripple can essentially keep the price of their token relatively stable by manipulating supply and demand. A major turn off for institutional adoption is the volatility of tokens, so if Ripple wants more banks using it, it’s in their best interest to leverage this tool.
  3. Ripple hit a high of $3.62 on January 4th, 2018, and people were screaming OVERVALUED. However, it’s worth noting this number was pure speculation with close to zero lucrative business partnerships that encouraged the use of XRP. It would be too easy to chalk up Ripple’s all-time high as mania and to reject any notion that the token could appreciate from its current ~$0.51 in that direction.

Final Thoughts

While XRapid is a major announcement for Ripple, it shouldn’t register as anything more than a low-energy “cool” in the minds of investors. Adoption of a cryptocurrency-based product is big for the industry, but all the other factors with XRP nip at excitement for upside.


One of the Most Valuable Startups in the US: Coinbase

Coinbase is allegedly in negotiations with Tiger Global to raise $500 million, placing the company at an $8 billion valuation – more than four times more than its $1.5 billion valuation just last summer. This valuation would make Coinbase one of the most valuable startups in the United States and would help serve as a critical data point that could potentially attract higher amounts of venture capital into the sector.

This valuation places it above several frequent tech household names such as Instacart ($4.35 billion), Magic Leap ($4.98 billion), and competitor Circle ($3 billion).

There are a few notable points to glean:

Coinbase’s unofficial ethos is to legitimize cryptocurrency for the average person. Everything about their offerings screams “Hey, cryptocurrency isn’t scary, you should try it!” From their simple user interface on the Coinbase exchange to relatively functional customer service, they’re easily the frontrunning cryptocurrency company that targets the average investor. If more money means more user acquisition, this could be great for the cryptocurrency industry as a whole. More users mean higher trade volumes, more liquidity, as more importantly – more innovation in the sector by entrepreneurs looking to carve out a slice of the pie.

You can learn more about what Coinbase seeks to accomplish from their shiny-headed CEO Brian Armstrong:


Everybody loves unicorns. It’s great to see a cryptocurrency make headlines as one of the most valuable startups in the United States, especially if it has a business model that works. Unicorns (startups worth over $1B) tend to make more media waves, attract more venture capital into their respective industries, and higher amounts of competition (and innovation).

Coinbase’s valuation is still small peas compared to Bitmain’s. This Coinbase news comes at the heels of Bitmain, one of the most valuable companies in the world. On July 23rd, Bitmain closed a $1B pre-IPO financing round led by China International Capital Corporation giving it a $15 billion valuation. Now, Bitmain has an $18B IPO sticker price in its targets for its upcoming IPO. If successful, Bitmain will surpass one of the largest public offerings in history from a little startup called Facebook.

Coinbase currently supports 5 digital currencies: Bitcoin, Litecoin, Ethereum, Ethereum Classic, and Bitcoin Cash. Will any of these token valuations fly up because of this news? Probably not. Will the new users Coinbase potentially attract purchase one of these five? Probably. If the psychology of cheap coins is any indication of user behavior, Litecoin and Ethereum Classic would hypothetically get an increase in purchases from new users.

Final Thoughts

Every investor must be keen to macro trends, especially if those macro trends are moving towards the path of mass user adoption. Coinbase locking down the title of “one of the most valuable startups in the United States” is something all cryptocurrency enthusiasts can flaunt proudly, even if they’re partial to Coinbase as a company (or their stupid high fees).


Key Crypto Trend/Momentum Analysis for Thursday, October 6, 2018

The ‘big picture’ technical backdrop for BCHUSD, ETHUSD and LTCUSD still remains moderately bullish for the foreseeable future. Two of the coins (Bitcoin Cash and Litecoin) feature bullish pennant patterns on their daily charts, even as Ethereum comes close to testing a major resistance trendline – and with a bullish breakout a real possibility in October 2018. Volume profile histograms, chart swing patterns and money flows also suggest that for now, the ‘line of least resistance’ is still toward higher valuations for all three of these popular coins as October’s price action develops.

Two-day momentum/trend/key technicals for BCHUSD

The previous two trading sessions (Oct. 2-3, 2018) were part of the still-developing pennant formation (daily chart), and as such have very low daily ranges. This continual narrowing of ranges is part of the final completion process of any pennant/triangle pattern, and frequently presages a powerful breakout move.

Six-day momentum/trend/key technicals for BCHUSD

The previous six days worth of price action for BCHUSD were also part of the same well-formed pennant pattern, and you can be sure that many savvy crypto traders will carefully monitor this pattern for a tradable breakout move in the near future.

The Relative Strength Index or RSI (14) is still holding above 50 (bullish) and the long-term Chaikin Money flow histogram (CMF (89) is also holding steady near its zeroline, however, it has not yet crossed from a bearish to a bullish posture. Twenty-two bars have completed since the last major cycle low, and a strong break higher out of the pennant will help convince me that a new cycle low is in place, and with a new rally all but certain. Bitcoin Cash is also near another potential break above its all-important 50-period exponential moving average, something that every swing trader in this coin will be carefully watching.

Figure 1 BCHUSD cycles final

Figure 1.) BCHUSD daily: The bullish pennant pattern may be a precursor of a bullish breakout in Bitcoin Cash, as RSI (14) remains bullish and the cycle oscillator configuration is also moderately bullish. A daily close above the 50-period ema will be a major victory for the bulls, should it occur soon. Created with NinjaTrader 8.

Figure 2.) BCHUSD 6-hour and daily: Bitcoin Cash is trading just below key volume-point-of-control zones on both its six-hour and daily charts. Money flows remain neutral to moderately bullish. Created with MotiveWave Ultimate.

Key takeaways for BCHUSD:

  • This coin still needs to break above key volume-point-of-control areas for the bulls to take charge
  • Expect rising prices into the next near-term cycle high in early/mid- October 2018
  • There isn’t much overhead supply to hold back a strong bullish breakout – not until around 650.00
  • The long-term trend continues to morph from bearish to bullish

Two-day momentum/trend/key technicals for ETHUSD

Ethereum has been in a small consolidation for the last two trading sessions (Oct. 2-3, 2018), and is still the comparatively weakest of the three coins covered in this article. However, the bigger-picture technical structure for ETHUSD still looks promising, even though there are several hurdles that must be overcome. The Relative Strength Index (RSI(14)) is well below its bull/bear dividing line at 50, yet the 89-period Chaikin Money Flow histogram continues to flirt with a fresh zeroline crossover into the bullish camp; this suggests that the ‘big money’ are still patiently accumulating this coin, looking for a big pop soon.

Six-day momentum/trend/key technicals for ETHUSD

The previous six days worth of price action for ETHUSD have been rather boring for trader/investor alike; but then again, as the old trader’s saw goes, ‘Never short a dull market.’ Note how this coin continually gravitates toward the dashed, downsloping trendline, and how the latest bearish pullback is weaker than the first one. A breakout attempt is coming for sure, but knowing in advance if it will be successful is simply not knowable. However, the three cycle oscillators are close to calling a fresh cycle low, and if both the red and blue oscillators turn sharply higher in unison, there could be significant bullish follow-through.

Major supply (resistance) exists between 270 and 285, so be sure to book any swing trading profits before that brick wall is hit. Conversely, there is strong demand (support) between 205 and 215, and should there be a final dip toward this zone, it might be viewed as a ‘gift’ – an opportunity to load up some more coins at a bargain price. Trading with trendline breaks can be tricky affairs; sometimes it’s best to let the initial break play out, waiting for a minor pullback and subsequent breakout to actually enter a trade. Much depends on the overall technical state of the coin and technical health of the broad crypto market, when timing entries in a market, so be patient and pick your entry spot wisely.Figure 3.) ETHUSD daily: With a bullish trendline break becoming more likely every day, Ethereum boasts a neutral to bullish money flow histogram and moderately bullish cycle oscillators; the RSI (14) histogram is still in bearish territory, however. Created with NinjaTrader 8.Figure 4 ETHUSD VPOC 6hr and daily

Figure 4.) ETHUSD, 6-hour and daily: Ethereum’s 6-hour chart (left) reveals a massive volume ‘value area’ that is currently causing much indecision among traders. However, the daily chart depicts a very long and thin volume-point-of-control zone that could lead to a truly powerful breakout, especially on the bullish side. Created with MotiveWave Ultimate.

Key takeaways for ETHUSD:

  • This coin continues to flirt with a key resistance trendline
  • Cycle oscillators are neutral to moderately bullish, money flows still suggest ‘smart money’ accumulation
  • Volume-point-of-control indicators suggest indecision on the six-hour chart, but a major opportunity for bulls on the daily chart
  • The long-term trend is still morphing from bearish to bullish

Technical view for LTCUSD

Litecoin’s technical dynamics are perhaps the most bullish of all three coins covered so far this week; the percentage gains possible on a bullish breakout are larger than either Bitcoin Cash or Ethereum and the potential for a severe decline is relatively small. Similar to BCHUSD, Litecoin has also formed a bullish pennant pattern, one that is going to be garnering lots of attention as it approaches a breakout – in either direction.

Two of LTCUSD’s cycle oscillators are in a high-probability bottoming formation, even as the larger-degree oscillator remains at a high value; this is very, very bullish, given that the coin is already moving higher into a volume ‘hole’ on its six-hour chart and is also trading ABOVE its daily chart volume-point-of-control zone. This is a classic chart setup for the bulls to pounce on, and with money flows bullish on virtually all of its Chaikin Money Flow histograms, Litecoin looks like it may be the coin to watch over the next week (month) or so.

Should the bulls push the coin up and out of the pennant pattern, expect lots of traders to jump in. Be careful with breakout patterns though; you need to have a well-thought-out plan to time your entry and be aware that the ‘smart money’ will typically try to scare retail traders out of their positions by suddenly dropping price lower after the initial break. Then they pick up more positions at bargain prices, driving prices even higher. And at the retail trader’s expense, of course.

Waiting for the Relative Strength Index (RSI (14)) to make a daily close back above 50 might be a safer way to enter a long swing position in Litecoin; you won’t get in at the ‘best’ price, but you’ll most likely be trading alongside the pros, and after any shakeout move occurs.

Figure 5.) LTCUSD daily:. With a cycle bottoming pattern unfolding, generally positive money flows and plenty of room to run higher before supply zones are hit, Litecoin looks like the highest-reward, lowest-risk opportunity for the bulls this week.  Created with NinjaTrader 8.Figure 6.) LTCUSD, 6-hour and daily:   Litecoin is already moving higher into a volume ‘hole’ or ‘vacuum’ on its six-hour chart, even as it is already trading above a key VPOC on its daily chart. Next major resistance is between 76.00 and 83.00. Created with MotiveWave Ultimate.

Key takeaways for LTCUSD:

    • Cycle oscillators suggest that a daily chart cycle low is likely, with 5 to 8 days of rally a possibility

 

  • Volume profile histograms paint a very bullish near-term/medium-term picture

 

    • A possibility of a strong bullish breakout from the daily chart pennant pattern
    • Extended price targets (‘supply’ or resistance zones) exist between 76.00 and 83.00

 

  • Strong support between 47.00 and 50.00 – it’s a ‘buy’ zone, too

 

  • The long-term trend continues to transition from bearish to bullish

Quick-take: NEOUSD, daily chart

NEOUSD (daily chart) now in a Bollinger Band ‘squeeze’ formation:

Figure 7.) NEOUSD,  daily:  A very atypical and potentially powerful opportunity for traders is highlighted by this combination of ultra-low Bollinger bandwidth and a dead-on VPOC spike at the current price level. Look for a strong move in either direction fairly soon.  Created with MotiveWave Ultimate.

* Bollinger Bandwidth is now the lowest in more than 6 months

* A Bollinger Band ‘squeeze’ setup has formed

* This extremely low volatility situation coincides with a key VPOC

* NEO is trading right at/near the VPOC level – a state of tenuous balance

* Breakouts in either direction could be powerful, especially on the bullish side

VPOC = ‘volume-point-of-control, which is a key battleground between the bulls and the bears

Summing up this week’s look at Bitcoin Cash, Ethereum and Litecoin:

  1. All three coins are approaching key bullish breakout junctures.
  2. Of the three potentially bullish breakout setups, Litecoin appears to offer the best reward to risk ratio of all; its VPOC histograms are signalling ‘all clear’ for the bulls to really ramp price higher in this particular coin.
  3. Ethereum, although in a generally bullish technical situation, may need the most time to transition into a bullish mode; it’s still well below its 50-period ema and its RSI (14) is still mired beneath the key 50 level.
  4. Bitcoin Cash’s 6-hour and daily charts are looking very attractive for the bulls; need to see at least two of the cycle oscillators turn higher along with a bullish break out of the pennant before the bulls really start to pound the table. The 89-period Chaikin Money Flow should also close back above its zero line to confirm the bullish shift in sentiment.
  5. Remember, this is the cryptocurrency market, and NOTHING is certain, especially in this relatively unregulated, manipulation-prone corner of the financial markets. Always use sensible position sizing and risk control regardless of how bullish or bearish a particular chart pattern or trade signal setup appears to be.

Trading Education 101:

Essential Stats to Monitor Your Trading System Performance

Simply glancing at your crypto broker account statement at the end of the month to determine your net gain is not going to cut it as a meaningful measure of your trading performance. No, you need to dig deeper, using several key stats that can help you to determine the various strengths and weaknesses of your particular methodology.

Here are the three essential stats you need to monitor your system with –

  • Profit factor: Total dollars won divided by total dollars lost
  • Average winning trade divided by average losing trade: (Self-explanatory)
  • Winning percentage: Winning trades divided by the total number of trades

Yes, there are dozens of other stats you may also wish to use, including maximum closed trade drawdown, r-multiple, largest winner, largest loser, number of days between entry/exit, Sharpe ratio, etc., but believe it or not, these three stats will reveal virtually all of the key internal dynamics driving your system output. Keep things simple.

Interpretation and practical uses of these three stats

Profit factor

A good swing trading system should ideally have a profit factor of 2.00 or higher; longer-term trend-following systems (weeks or months in duration) should boast a profit factor of 3.00 – or even higher.

Here are the forward-test stats for a short-term swing trading system I developed over the past year (average holding period about two days); the profit factor is 3.71, the average win/average loss ratio is 2.06 and the winning percentage for the system is 64.29%. The equity curve is very attractive, with only minor drawdowns over a sequence of forty-two trades. Profit factor is your ‘go-to’ stat in every case, and a number well above 3.00 suggests that you have a very robust, well-developed system to trade, one that continues to pile up cash across all of its series of winning and losing trades. (This system is not for sale, at least not yet)

Average win divided by average loss

The system’s avg win/avg loss ratio is also very high, coming in at 2.06. This stat is informing you that winning trades are permitted to run until logical exhaustion points are triggered, even as losing trades are cut as soon as the system rules call for an immediate exit. Great stats like these are the result of following the system rules, and that without exception; begin ‘cherry-picking’ winners and losers and I can almost guarantee that even the best system will crash and burn in due time.

Winning percentage

The win percentage is also an important stat, but it cannot alone be used to determine if you have a great system or a pile of digital debris on your hands. For example, imagine a system that wins 80% of the time; sounds great, right? But look closer. Perhaps the system has a profit factor of only 1.40, and, even worse, the ratio between the average winner and average loser is a paltry .80. This is a system to run away from, and quickly; I can almost guarantee that you will never be able to trade a system with such small profit margins, and especially not when considering the costs of commissions and slippage.

This particular system wins 64.29% of the time, which is very respectable for a swing trading system in any market, including cryptocurrencies. Considering its high-profit factor of 3.71, and its outstanding avg win/avg loss ratio of 2.06, even with a winning percentage as low as 50%, it would still be hailed as an excellent trading system.

An offer you can refuse – unless you’re a sucker

Using a Mob-style hierarchy to rank these three stats, the winning percentage of a system would be viewed as one of the ‘soldiers’ (important, but not exactly the brains of the operation), avg win/avg loss ratio is the ‘Underboss’ (a driving force in this family of stats) and profit factor is the literal ‘Godfather’ of this trading stat trifecta.

Next time someone tries to peddle a ‘sure-fire’ trading system for $5,000 to you (plenty of system marketing charlatans are already preying on new crypto traders, be forewarned), make sure you investigate all of its key stats, and if they don’t cut the mustard, tell the vendor to ‘fugggghettaboutit! Or, simply invite him to ‘take a long walk off a short pier.’ Don’t be a sucker; carefully evaluate the key stats of any system you are considering purchasing/leasing from a vendor. And use the same stats to honestly evaluate the trading systems you eventually manage to create on your own.

Summary

Remember, when considering any swing trading system, look for the following performance ranges for each of the three key stats:

Profit factor: A range of 2.00 to 3.00 or higher

Avg win/avg loss: A range of 1.25 to 1.50 or higher

Winning percentage: 60% to 65% is ideal

Any swing trading system that cannot meet/exceed the lowest range metric of EACH of the three key stats should NOT be traded. Also, beware any system that claims to win 80% or even 90% of the time; such systems generally have a low profit factor and are literally eaten alive by commissions and slippage due to short trade holding periods. You see numbers like that– run!

For long-term trend following systems, here’s the deal on desirable stats:

Profit factor: A range of 3.00 to 3.50 or higher

Avg win/avg loss: A range of 1.75 to 2.25 or higher

Winning percentage: 44% to 50% is ideal

A smooth and rising equity curve – your primary goal

Finally, here are the key stats of the trading system referenced in this article, along with its equity curve; great system stats produce great equity curves, ones with minimum drawdowns:

Figure 8.) Your primary goal as a trader is to create a steadily rising equity curve in your trading account; by only trading systems capable of meeting the minimum performance metrics highlighted in this article, this goal becomes attainable.

Every system will have periods of drawdown, but as long as the long-term equity curve maintains a healthy, upward-sloping angle of attack, all will be most well. Should the above equity curve seriously degrade (a combination of significantly larger drawdowns and poorer performance metrics), well, then it’s time to re-optimize the system, carefully examining each of its signal generation inputs and position sizing/money management rules.

Sometimes a market’s character changes dramatically over time, and even a great system will have to be laid aside, with new, more relevant systems needing to be developed to replace it.

Begin evaluating these three key trading stats today and then watch how your trading system’s performance experiences a marked improvement.

Disclaimer:

The material presented in this article is to be construed as educational in nature only and in no way does it constitute specific investing and/or trading advice for any specific individual or entity. Speculation in the financial markets involves substantial risk and therefore only risk capital should be used when trading or investing. Always consult your licensed financial advisor before deploying risk capital in the financial markets.


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