Before trading a particular market it might be a good idea to first ask, how much potential profit can I squeeze out of the market? This would then lead to an even more important question, is this market worth trading? But how do you answer these questions?
There are many ways to estimate potential profits, but a rather simple idea I recently discovered was found in the June 2012 issue of Technical Analysis of Stocks and Commodities. The article is called “First, You Design The System”‘ by Sunny Harris.
In the article Sunny proposes the idea of tracking all ideal trades on your preferred trading time-frame over one year. For example, let’s say you’re trading a five-minute chart of S&P E-mini futures market (ES). On this chart you mark the absolute perfect highs and lows for an entire year. You then total up the points between those swings and write those down. Then take those points and multiply it by the big point value of the ES market. In this case we would multiply the total points by $50 and get your total ideal profit. Of course nobody can capture all of these trades perfectly so we take a percentage of the total. Sunny recommends 40%. What this means is approximately 40% of each move is captured. This annual profit estimation is what I call the Potential Annual Salary (PAS).
Below is an example chart of the ES market. I used a TradeStation Show Me indicator to highlight the ideal highs and lows. These can be seen on the chart by a blue or red dot. The red dots are swing highs and the blue dots are swing lows. From these swing highs and lows we simulate trading from both sides of the market by recording points between the swing highs and lows. We then add up all the points and multiply by the big point value of the ES market.
In this case the ES market from July 1, 2011 to July 1, 2012 produced 1,885 trades with an ideal profit of $854,900 (gross profit minus slippage and commissions). Taking 40% of this value we get $341,960 as our PAS.
Again, Sunny recommends using about 40% of the total. This seems to make some sense. Capturing 40% of any given trending move is probably about right. However, in our analysis we are tracking every single trade that occurs on every single hour that the market is open. This is not likely to happen in the real world. Thus, I think this percentage should be a lot lower.
If I was to reduce the recommended percentage from 40% to something lower, what would I pick? Well let’s first consider that we will not be trading the entire time the market is open. Estimate the number of hours per day you trade when the market is open. For our example, let’s say only 30% of the time we are actively trading the market. For the ES market is essentially mean we are only going to be trading about seven hours per day.
Next, let’s consider we are not going to be trading every day. We will be taking some time off for vacation and other of life’s distractions. For our example let’s say we plan on taking off about five weeks. These five weeks are in addition to the dates and times the market is not open due to holidays which is already built into our calculation. If we take off five weeks out of the 52 weeks in the year we are trading about 90% of the time.
Let’s bring these values together to compute our new percentage. First we can take our original 40% (swing capture rate) and times it by both the 30% (actively trading time) and the 90% (vacation exclusion) figures. This comes out to about 10%. So, we can reliably capture about 10% of our ideal potential profit.
I created a TradeStation strategy that estimates the ideal trades and computes the PAS value. This strategy generates an Excel spreadsheet that contains all the ideal trades along with the final PAS value. It can be used on any market on any time-frame. However, I’ve only tested it on daily bars and intraday minute charts. The code is available at the very bottom of this article.
Given a 5-minute chart of the S&P where do we stand on our revised PAS calculation? The ES market produces a $92,329 PAS value. What does this value mean? It does NOT mean if you trade ES you are going to make $92,329 in one year trading one contract. This value is to be used as a benchmark to compare against other markets. For example, let’s say you’re not sure if you should be trading the ES or the mini Dow (YM) market. What you could do is compare the two market’s PAS values.
If you test YM you get a $69,334 PAS value. This tells us there is a theoretically higher annual profit potential trading the S&P E-mini when compared to the mini Dow. Let’s compare those two PAS values with the PAS value of the Japanese Yen currency futures. The Japanese Yen futures produces a PAS of $93,666. This is higher than both the YM and ES markets. Testing the Euro currency futures (EC) produces a PAS of $149,439. This tells us out of these four markets, the Euro, has the most profit potential.
The strategy code also calculates another important figure which is the buy-and-hold value. This is simply the value of a long position which was held during the duration of the market study. This value can be helpful as well. At times the buy-and-hold calculation may be better than the PAS value. In this case, this means trading the given market may not be worth it. Simply buying and holding may produce better results. This condition did not happen with the futures market I looked at above.
Of course there are many reasons to trade a market besides the PAS calculations. Different setups and trading techniques work better on different markets. Each market has its unique feel to be sure. Each market may be more tradable during different times of the day, which may or may not be possible for you to trade. The allure of trading what is trendy can be exciting too. However, taking into account which markets may hold the best potential for profit may be a good metric for you to consider. For example, in the video that accompanies this article I take a look at trading Apple stock. In my study of trading Apple on a 5-minute chart, I found that trading it was not worth it. Why? The buy and hold out performed the PAS calculation! If you are interested, see the video.
Below is a video where I explain the PAS concept and the inputs to the EasyLanguage strategy.