A Trip Down Memory Lane

I took a brief respite the other day, following the tumultuous June period for Trend, to recount my trading history and identify any seminal writings that sparked my desire to become a classic trend follower. Of course, there were the great books by Michael Covel and Andreas Clenow, but one particular thread on a retail trader’s forum called Forex Factory was perhaps the most instrumental driver. I returned to that thread the other day, and it is as fresh as it ever was.

One of the key ideas that brought me to embrace “Classic Trend Following” was this thread on Forex Factory that had me enthralled since 2008. The thread was called “No Free Lunch but all the Free Coffee you can drink.” In this thread, we are introduced to Peter Crowns, a Chicago Pit trader on the CME who was taught an approach in the early 90s that changed his life. The DIBS (Daily Inside Bar Setup) strategy, which emerged from this context, proved to be a powerful method for Peter to capture breakouts from periods of consolidation.

A Brief History of the DIBS Strategy

In the days of open outcry trading, Chicago pit traders relied on sharp instincts and quick decision-making to exploit market inefficiencies. These traders didn’t have access to the sophisticated charts and technology we use today. Instead, they used their deep understanding of order flow and market sentiment to identify inside bar opportunities. By observing the patterns of buying and selling pressure, they could anticipate periods of consolidation and the potential for breakouts.

Striving for Infinite Yield

The concept of “infinite yield” in trading refers to maximizing returns with minimal initial investment, ideally achieving returns so high that the yield becomes theoretically infinite. While “infinite” may be a bit of a stretch, the term is used to hammer home the principle of striving for massive nonlinear returns in liquid markets with fat-tailed properties. Here’s how DIBs exploited this concept:

Inefficient Markets and Fat Tails

1. Market Inefficiencies:
   • Inefficiencies in the market occur when securities are not perfectly priced, often due to information asymmetry, psychological biases, or other factors. These inefficiencies can be exploited for substantial returns.
2. Fat Tails:
   • Financial markets often exhibit fat tails, meaning that extreme events occur more frequently than predicted by normal distribution models. These fat tails present opportunities for significant profits, as large price movements can be captured by well-timed trades.

Techniques for Achieving Infinite Yield

There are many strategies that traders use to strive for infinite yield, and the DIBS strategy is just one possible approach. Here, we’ll delve into how the DIBS strategy works and how it incorporates the concept of infinite yield.

Applying the “Hot Hand” Filter

Before diving into the specifics of the DIBS strategy, it’s crucial to apply the “hot hand” filter with a focus on both long and short trades. This filter helps identify and focus on trading instruments that are currently showing strong momentum or consistent movement, increasing the likelihood of entering profitable trades. By using this filter we naturally migrate towards the tails of the market distribution of returns and reduce the noise and false breakouts.

How to Apply the Hot Hand Filter:

1. Momentum Identification: Look for instruments exhibiting strong trends or momentum. This can be determined by analyzing recent price action, volatility, and other technical indicators signaling strength or weakness.
2. Selection Criteria: Use various criteria to identify “hot” instruments:
   • Trend Strength: Indicators like moving averages can help identify strong uptrends for long trades and strong downtrends for short trades.
   • Recent Performance: Select instruments that have shown significant price movements in recent periods (e.g., last few days or weeks).
   • Volatility: Focus on instruments with higher volatility, as these are more likely to produce significant breakouts from inside bars.

By applying this filter with a focus on both long and short trades, you ensure that your trading efforts are concentrated on the most promising opportunities, setting the stage for effective execution of the DIBS strategy.

Implementing the DIBS Strategy

Once you have identified the “hot” instruments for long and short trades, you can proceed with the DIBS strategy:

1. Identify the Inside Bar:
   • Look for a candlestick that is completely within the high and low range of the previous bar.
   • This pattern indicates a potential breakout as the market consolidates.
2. Maximize Position Size on Entry:
   • The inside bar setup allows traders to maximize position size on entry while risking a small amount. By using a very small bet size on every trade, combined with an initial stop just outside the inside bar’s range, losses are kept contained. This approach results in hundreds of small whipsaws, but the intent is to achieve infinite yield to cover these small losses and profit from fat-tailed market opportunities.
3. Determine Entry Points:
   • Place a buy stop order just above the high of the inside bar for long trades.
   • Place a sell stop order just below the low of the inside bar for short trades.
   • Enter the market in the direction of the breakout.
4. Set Stop-Loss Orders:
   • For long trades, place a stop-loss order just below the low of the inside bar.
   • For short trades, place a stop-loss order just above the high of the inside bar.
   • This manages risk and limits potential losses if the breakout fails.

Techniques for Effective Exits

While entering trades using the DIBS strategy is straightforward, knowing when to exit can be complex. Premature exits can leave substantial profits on the table, while delayed exits can erode gains. Therefore, a robust exit strategy is crucial to achieving optimal results. Here are some common techniques based on the principle of the trailing stop:

1. Trailing Stop-Loss Orders:
   • Fixed Point Trailing Stop: Move the stop-loss a fixed number of points or percentage behind the market price to lock in profits while allowing the trade to run.
   • ATR-Based Trailing Stop: Use the Average True Range (ATR) to adjust the trailing stop based on market volatility, providing a dynamic exit approach.
2. Technical Indicators:
   • General Indicator Strategies: Utilize indicators like moving averages or the Parabolic Stop and Reverse (SAR) to inform trailing stop adjustments. These indicators can help identify potential reversals and signal when to move the trailing stop closer to the current price.

Portfolio-Level Controls for Managing Unrealized Profits

Some practitioners of the DIBS strategy take a different approach to exits. Instead of using individual trade exits, they employ portfolio-level controls to manage their unrealized profits, allowing positions to run unbridled. Here’s how this approach works:

1. Breakeven Management: Once a trade reaches a breakeven status, it is considered to have minimal risk. Future profits are viewed as ‘free trade profits.’
2. Running in Perpetuity: Trades are allowed to run indefinitely, only being closed out if they revert to the breakeven level. This builds substantial unrealized capital over time.
3. Capital Management: Traders can elect to draw on this unrealized capital when needed, but the principle is to let the entire portfolio run unhindered, maximizing potential returns.

Combining Exit Strategies

Often, the most effective exit strategy is a combination of several techniques. For example:

• Primary Exit: Use an ATR-based trailing stop to ride the trend.
• Secondary Exit: Use general technical indicators to inform trailing stop adjustments, ensuring trades are reviewed and adjusted as needed.

Conclusion

Exiting trades effectively is vital for maximizing returns and achieving infinite yield in trading. By incorporating a variety of trailing stop techniques and adapting to market conditions, traders can enhance their DIBS strategy and improve their overall trading performance. Additionally, utilizing portfolio-level controls allows traders to manage unrealized profits and let trades run unbridled, further maximizing potential returns. Remember, the goal is not just to enter trades successfully but to manage and exit them in a way that maximizes profits while minimizing risks.

To be clear, I don’t use this technique today and have never fully tested it. Such a method is likely to encounter a huge number of small losses before latching onto an outlier, but the possibility of a massive return-to-risk ratio is mind-boggling. The noise of today’s markets may require some refinements, but the concept was instrumental in leading me down a path toward Classic Trend Following. The thread is still there on Forex Factory, and there have been numerous sister threads on the subject. In closing, I suppose I need to tip my hat to the anonymous trader who got my creative juices flowing.

Thank you, Peter Crowns.