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Chapter 7: Intraday Trading, Security, Time Frame Selection Redux
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The original plan after Chapter Five was for Chapter Six to be about portfolio construction, but instead, I wrote about intraday trading strategies. I am told that one more chapter is needed to do justice to the subject.
It might be best to use intraday index futures trading as an example because this type of trading magnifies every single security and time frame selection problem that people experience in other markets. Also, because futures trading tends to be highly leveraged, the difficulties are often compounded.
Let’s analyze a real life example. On October 8, Richard from MoveTheMarkets.com wrote:
I’m still not trading ES like a pro, though. Gotta get better at it. I’m having a great time programming TS strategies and backtesting them, though. I took the time to learn how to do that this weekend. Turns out it’s really easy. The hard part is making a strategy that backtests profitably.
On October 10, he wrote:
In futures, I made 5 trades for 4 wins and 1 loss. I am still not a very good futures trader; the trades I choose are not ideal at all, even though I have indicators sometimes screaming at me to dive in and make a fortune. Especially today, it was difficult for me because we had so much volume that I didn’t have much time to think. Most good trades passed me by while I considered my options.
But, I do think I am making serious progress. My win rate is around 80% this week so far, which is similar to my win rate for stock trades. My number one problem is still that my average win is smaller than my average loss. That makes it hard for my PnL to get any traction, even winning 80% of the time.
On October 15, he made a video that started with the following slide:
In Summary
Let’s make a list of points from Richard’s comments about his intraday futures trading experience to date:
- Difficult to make a large number of decisions per unit of time;
- Hard to develop a mechanical strategy that “works” across market conditions;
- High win/loss ratio fails to produce meaningful profits;
- Take smaller profits than losses. Discovered that the typical stop required is 8 ticks (2 points), while the typical profit taken is 1 tick (0.25 points); and,
- Trouble jumping on to trends in a trend day.
I am not sure what he meant by “still not trading ES like a pro”, so let’s see if I can address the issues on this list, since they represent 99% of incoming email messages.
Step 1: What is a professional trader?
Trades conducted by an investment dealer (”the firm”) are broken down into two broad categories: agency and principal. Professional traders don’t trade just anything. Traders employed by the firm have defined functions: market making, liability trading, arbitrage, hedging, etc. Larger firms also provide investment management services and may engage in trading for its own account.
Step 2: What type of trading is this?
Pure directional trading, that is, attempting to identify and capitalize on a trend, is rarely done as a principal trade by the firm. This is typically the province of agency trading, that is, these trades are usually initiated by and transacted for clients. When people outside the business discuss trading, they usually don’t even know that they are referring specifically to directional trading 99% of the time. At the firm (and often in academia), directional trading is often referred to as momentum trading.
The firm’s traders occasionally enter a directional play for their own account when they know they have a distinct advantage. They play stocks that the public is known to be “piling” into: the momo-puppies.
Step 3: When do we engage in directional/momo trading?
Obviously, the market is not on fire every day. Trading candidates (the “symbol universe”) must be identified; a tight list is created with a rigorous and methodical scanning procedure. The symbol universe is then traded with complete discipline according to a certain protocol. This is a Whac-a-Mole game for grown-ups: find the momo and play it. Once an area has been cleared of moles, we move on.
The symbol universe changes quickly. There is a high turnover of candidates because people chase momentum. And now, you can see the problem posed to index futures traders: since there is no moving on, we must wait for the moles to come back. Any strategy, mechanical or otherwise, has to deal with this issue. We need to identify times when the market is “hot” and when its “not”.
Step 4: The Win/Loss Ratio
In the long run, a trader that takes small profits and gives up the big moves will go broke:
“One common adage on this subject that is completely wrongheaded is: You can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance. …
What really matters is the long-run distributions of outcomes from your trading techniques, systems, and procedures. But, psychologically, what seems of paramount importance is whether the positions that you have right now are going to work. Current positions seem to be crucial beyond any statistical justification. It’s quite tempting to bend your rules to make your current trades work, assuming that the favorability of your long-term statistics will take care of future profitability. Two of the cardinal sins of trading - giving losses too much rope and taking profits prematurely - are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance.” — William Eckhardt
Memorize this:
“If you make a bad trade and you have money management, you are really not in much trouble. However, if you miss a good trade, there is nowhere to turn. If you miss good trades with any regularity, you’re finished.” — William Eckhardt
Step 5: The Stop Required is “Too Rich”
I released an upgrade of my trading system for TradeStation to clients on Friday. One user implored me to implement various stop-tightening options, and no matter what I tried, the results were unsatisfactory to me, mainly because of the reasons outlined by William Eckhardt above. I could not in good conscience release the system with features that might hasten the users’ demise, even in the name of exploration or back-testing:
The default StopFactor = 1.5. If you wish to test the stops with the TradeStation optimizer, my suggestion is to test the range between 1 and 1.5 at 0.1 increments. StopFactor settings under 1 are insufficient. As I wrote previously, when it comes to directional trading, it is perhaps not possible to tighten the initial stop or trailing stop beyond what volatility dictates. Time and again, we have seen that a wide range of trading “problems” tend to be resolved by trading high-priced, high-volatility issues in larger time frames while simultaneously reducing trade size/ leverage with the use of reasonable stops. I actually succeeded in writing the breakeven code, but it is not included in this release.
The goal of trading and investing is to compound our capital efficiently. It’s not a get-rich-quick scheme. We have to live with the fact that trading entails a certain amount of financial risk. And that risk is most often better managed — counterintuitively, I might add — by trading smaller size in a larger time frame with lower leverage. The trader makes less decisions per unit of time, and account fluctuations are kept to a minimum with low leverage.
Step 6: When is a time frame too small?
Let’s slay this beast for all time, right here, right now. Yes, even though price movement is considered fractal in nature, that is, they look pretty much the same in all time scales, there is a limit to this in practical application. Important information is lost at extremely small resolutions. The price bar or candlestick represents such a small moment in time and contains so little information that it no longer provides enough feedback to the trader.
THIS IS GOOD
THIS IS BAD
This is how you tell good from bad: On a bar chart, if you see many adjacent bars with the same high or the same low, the time frame is just too small.
THIS IS GOOD
THIS IS BAD
On a candlestick chart, if every second candle is a doji, if they all look pretty much the same, the time frame is just too small.
The Afternoon Routine
Let me give you an update of my own trading. I following a specific routine because the tendency is for volatility and range to die down after the first hour, and sometimes, a big trend emerges in the last couple of hours. This has been a feature of intraday stock index futures trading for as long as I have played the game.
My strategy is to trade using discretionary methods (see The Morning Routine below) in the first hour, and then turn it over to the mechanical system from 1400ET to 1600ET. The system is set to OwnCapital = 50000, PercentOwnCapital = 20, meaning that the trader’s capital is $50,000 and the account borrows $4 for each $1 of the trader’s own funds. This works out to 100%/20% = 5 * $50,000 = $125,000 buying power, 4:1 leverage.
ESZ07: The system has been breaking even ever since the front month changed to December on September 13.
The equity curve has been sideways, but since I know that all I need are a handful of decent days each month, I am not sweating it one bit.
Compare the December contract results to the September contract results for trading between June 6 - September 12.
What accounts for the difference? Can you venture a guess?
Back to the Whac-a-Mole analogy. Since we have to wait for the action to come back to our market instead of chase it from stock to stock, we must find ways to measure two important factors: range and volatility.
Range and Volatility Required for Intraday Trading
Let’s take a look at the daily chart of the continous contract. We know that range and volatility go hand in hand, and we must have a certain amount of it for profitable intraday trading.
June, July and August consistently featured a high-volatility trading environment. On this chart, green histogram lines above the grey threshold line are areas of increasing volatility.
June, July and August also consistently featured a high-range trading environment. Green histogram lines above the grey threshold line are areas of increasing range.
September and October have featured a much lower volatility environment. Red histogram lines below the grey threshold line are areas of decreasing volatility.
September and October have also featured a much lower range environment. Red histogram lines below the grey threshold line are areas of decreasing range.
Contiguous areas with green and red histogram lines under the grey threshold are more suited for position trading.
Low volatility/range environments can occasionally have big individual trend days while high volatility/range environments occasionally have dead spots. In general, we come into the day in anticipation of action in a high range/volatility environment while we expect to sit on our hands in a low range/volatility environment.
NOTE: One important thing to remember is that whatever we can trade intraday, we can probably position/swing trade off the daily chart, but it does not necessarily work in reverse.
Putting it together.
The Morning Routine
I trade for an hour most mornings. Or should I say I watch the market for an hour, and trade if there is reason to do so. Friday was one of those days that frustrates traders using indicators. Reading bars one by one is the only alternative. This is the edited transcript of what went down in on Friday morning.
Transcript “log2007-10-19_23-29-04″ for Room “The.Morning.Trader”
[09:22:38 ET] Teresa_Lo joined.
[09:22:42 ET] Suburban_Trader When Goldman analysts called $100 crude awhile ago, I was like ‘yeah right’ but was way wrong
[09:22:46 ET] Teresa_Lo Good morning.
[09:22:48 ET] Suburban_Trader GM T
[09:23:32 ET] Teresa_Lo Well, one thing to remember about those predictions is that they’re like raindances too.
[09:23:48 ET] Teresa_Lo I remember XXXX telling me that when you write a report, you only give 2 prices: target and stop.
[09:24:09 ET] Teresa_Lo And you NEVER update it, because someday it will hit one of those for sure and you will always be correct.
[09:24:43 ET] Suburban_Trader QCOM still waiting for 1000 lol
[09:25:05 ET] Teresa_Lo And who knows? Someday…
[09:26:42 ET] Suburban_Trader Anything can happen..
[09:27:04 ET] Suburban_Trader Wachovia Bank took hit from mortgage chaos
[09:27:38 ET] Suburban_Trader Also CAT news was not taken wel
[09:30:23 ET] Teresa_Lo Here we go. Lower open “on earnings” reaction.
[09:30:47 ET] Teresa_Lo And in a test of bottom position for the major stock index futures.
[09:30:54 ET] Teresa_Lo Except NQ.
[09:31:50 ET] Teresa_Lo Oh, Happy 20th anniversary. It’s October 19 today!
[09:32:09 ET] Teresa_Lo ES is testing yesterday’s low.
[09:32:16 ET] Teresa_Lo YM esting a two-day low.
[09:32:48 ET] Teresa_Lo So I guess we’ll see what happens. Yesterday we had buyers and sellers watching…I think everyone wants to know if this can bounce. Or not.
[09:33:02 ET] Suburban_Trader Options expiration today
[09:36:34 ET] Teresa_Lo A small buy stop at ES 1540.25 seeing that this is a test of yesterday’s low and in the big picture, it is a test of bottom.
[09:36:41 ET] Teresa_Lo I don’t imagine this is the bottom.
[09:37:02 ET] Teresa_Lo but we might get a bar or two. Small target = small size.
[09:39:23 ET] Teresa_Lo YM breaches Wednesday’s low. Trader Vic 2B test of bottom here.
[09:39:35 ET] Teresa_Lo Bar range and volume expanding.
[09:40:58 ET] Teresa_Lo The question here is if bounces will find sellers.
[09:41:19 ET] Teresa_Lo We’ve got the expanded range down bar on volume and now a small bar forming.
[09:41:40 ET] Teresa_Lo I think the only long I want to try is one that heads back up through yesterday’s low.
[09:42:08 ET] Teresa_Lo But you can see the price action…that it might bounce a couple of bars, test the high from the open and then sellers might come in.
[09:44:56 ET] Teresa_Lo If we wish to be ultra agressive on a counter trend long scalp, we have to get up close here, but price action is at the high of the present bar, making it hard to set a buy stop.
[09:45:02 ET] Teresa_Lo “The usual predicament”
[09:45:03 ET] Teresa_Lo lol
[09:45:13 ET] Teresa_Lo 37.75 buy stop now.
[09:45:36 ET] Teresa_Lo Moved it down, 1/4 size
[09:46:02 ET] Teresa_Lo 154000 is the target.
[09:46:39 ET] Suburban_Trader Garzarelli real bullish on markets unless oil hits $125 very quickly to cause a recession
[09:46:51 ET] Teresa_Lo In a way, she’s right.
[09:47:07 ET] Teresa_Lo It’s more psychological now than anything, since a move from $80 to $100 is nothing in terms of percent.
[09:47:21 ET] Teresa_Lo OK, here we go. Ready to take our money, hit and run.
[09:47:28 ET] Teresa_Lo And I have one more chart here…
[09:48:16 ET] Teresa_Lo Take a close look later when you read the transcript. We had the expanded range down bar, and then the next bar was heading down on even higher volume but closed within the range of the expanded range bar.
[09:49:12 ET] Teresa_Lo To me, its like the “me too” sellers go in there too and as the bar drew to a close, they realized that maybe they are wrong and therefore, there is room to fuel an up bar since these sellers are trapped.
[09:49:37 ET] Teresa_Lo We know their usual stop is the high of the morning, and that is why we will take a risk to go in there and do an anti-trend long.
[09:49:40 ET] Teresa_Lo If only for a bar.
[09:49:48 ET] Teresa_Lo So now we have one up bar.
[09:50:00 ET] Teresa_Lo And if we don’t get any love, it’s time to go.
[09:50:05 ET] Teresa_Lo Still below yesterday’s low…
[09:50:50 ET] Teresa_Lo So we get that one up bar…and no matter what we have to crank up the stop.
[09:51:05 ET] Teresa_Lo In case that was all the buying we see.
[09:51:22 ET] Teresa_Lo And count this as Bar 1 of a potential BEAR flag.
[09:51:33 ET] Teresa_Lo Need one more bar and we are home free.
[09:51:53 ET] Teresa_Lo So normally, the procedure would be to move the stop loss to 35.75
[09:52:12 ET] Teresa_Lo and since it was 3 bars down, we would like to conclude this trade on this bar.
[09:56:58 ET] Teresa_Lo OK, the next bar ended an inside bar.
[09:57:48 ET] Teresa_Lo We can leave the trade now as the inside bar is “indecision” and sets up a move either way.
[09:58:49 ET] Teresa_Lo So we had the up bar propelled by the trapped late sellers, and inside bar after they were cleared out and now we see if there is another leg up or if sellers come out to hit it again.
[10:03:18 ET] Teresa_Lo I think there is some impetus from earnings turbulence
[10:03:44 ET] Teresa_Lo plus there seems to be this “other shoe is dropping” tone to reports from all the blogs and financial outlets.
[10:04:12 ET] Teresa_Lo It’s the “next wave of mortgage resets” malaise.
[10:04:51 ET] Teresa_Lo Inside bars resolves in the direction of the sellers.
[10:08:09 ET] Teresa_Lo And we are now near Wednesday’s low on the ES, coming into a Trader Vic 2B TOB.
[10:09:37 ET] Teresa_Lo And it looks like NQ getting a delayed reaction hit all at once.
[10:01:15 ET] Teresa_Lo And technically, this is also a Trader Vic 2B TOB on the 5M ES, no matter how ugly.
[10:02:46 ET] Suburban_Trader MMM just helping Dow bears
[10:18:31 ET] Teresa_Lo And so we are still watching this big 2B on both the 15M and the 5M.
[10:18:36 ET] Teresa_Lo This is an important moment.
[10:26:50 ET] Teresa_Lo Are we gonna sell this bear flag now that everyone knows its going down?
[10:27:11 ET] Teresa_Lo I guess small size
[10:27:21 ET] Teresa_Lo Same setup on the 5M NQ.
[10:28:25 ET] Teresa_Lo If this test of bottom cannot hold, I guess it will be gunning for the 9/25 low.
[10:28:32 ET] Teresa_Lo And you can see it now…
[10:28:44 ET] Teresa_Lo they’ll be talking about how the Bernanke rally gave up all its gains.
[10:37:07 ET] Suburban_Trader IF goog closes its gap that won’t be good for sentiment
[10:38:16 ET] Teresa_Lo Bear flag hits small downside target
[10:38:39 ET] Teresa_Lo So we’ve got Trader Vic 2B on the 5M/15M and 45M ES now.
[10:46:16 ET] Suburban_Trader Seems like they aiming for the Fed day levels
[10:46:17 ET] Teresa_Lo Remember there was a kid’s show called Zoboomafoo?
[10:46:26 ET] Teresa_Lo Hosted by the Kratt brothers?
[10:46:35 ET] Teresa_Lo The famous line was, “They’re going to the closet and they’re headed out the door!”
[10:46:43 ET] Teresa_Lo That sounds like the market.
[10:51:47 ET] Suburban_Trader Oct. 19 (Bloomberg) — David Corkins plans to leave Janus Capital Group Inc. next month after reviving the $12.6 billion Janus Fund, the U.S. money manager’s largest mutual fund. Corkins, 41, who took over the fund 20 months ago, has generated a return of 18 percent this year, beating the Russell 1000 Growth Index’s 15 percent gain. He will be replaced by Janus fund manager and Co-Chief Investment Officer Jonathan Coleman, the Denver-based company said today in a statement.
[10:52:07 ET] Suburban_Trader So fund is only beating Russell by 3% and he a hero? nice lol
[10:57:58 ET] Teresa_Lo If you’re a big fan of support and resistance points, here is a really cool chart
[11:00:01 ET] Teresa_Lo It’s going there in one big expanded bar on the 5M!!!!
[11:00:02 ET] Teresa_Lo LOL
[11:00:22 ET] Teresa_Lo A group puke
[11:00:25 ET] Teresa_Lo And we are there.
[11:00:49 ET] Teresa_Lo I think it’s safe to say maybe it can bounce for a few bars now on the 5M, LOL!
[11:03:16 ET] Teresa_Lo At this point, we expect a bounce…and guess where they’re going to be waiting?
[11:03:19 ET] Teresa_Lo He-he.
[11:03:43 ET] Teresa_Lo 20EMA5 is at 33ish
[11:04:03 ET] Teresa_Lo while Wednesday’s low is at ES 153400
[11:04:14 ET] Teresa_Lo this is going to be fun…
[11:15:05 ET] Teresa_Lo I know technically we can continue selling it on the 4 bar bear flag, but at some point, it gets stretched and needs a bigger bounce.
[11:20:36 ET] Teresa_Lo Now, here we almost don’t expect it to go all the way back to the bottom of the spike…
[11:21:51 ET] Teresa_Lo …we should trade as if a higher low will be made on test and then a swing up to form a two-swing bear flag into the 20EMA overhead.
[11:24:48 ET] Teresa_Lo Let me draw it
[11:25:48 ET] Teresa_Lo One of these
[11:26:02 ET] Teresa_Lo Basically a higher low on the test, swing up and then be hit by selling again.
[11:26:47 ET] Teresa_Lo In any case, if we are still trading on the short side, we have to defend against all these things now because every push down is one closer to a reversal or a larger pattern or a triangle.
[11:27:29 ET] Teresa_Lo The ones that they couldn’t get were all the ones this morning where no moving average could have helped…but a lot of indicators will now be in the buy zone and then aim for the 20EMA overhead.
[11:30:18 ET] Christopher So T. - You are saying (if I am correct) we test 1525 on the ES - don’t quite make it and then move up to the 20EMA at which point we can expect sellers to come in and push the price back down
[11:30:46 ET] Christopher Then it can be expected to swing back up again toward the 20 EMA?
[11:33:23 ET] Teresa_Lo Yes, so if we are short…we have to make sure we defend against a higher low.
[11:34:05 ET] Teresa_Lo In this case, today’s one-way market overwhelmed the attempt to put in the higher low…
[11:34:08 ET] Teresa_Lo But you know what I mean.
[11:34:23 ET] Teresa_Lo And now if it bounces, we have to watch for the same thing again after this Trader Vic 2B TOB.
[11:35:16 ET] Christopher Let’s say I am short ES - where would you defend that position and how?
[11:36:01 ET] Teresa_Lo You know that you should take profit on target on the 5M
[11:36:08 ET] Teresa_Lo so that is already done
[11:36:20 ET] Teresa_Lo and now it’s a Trader Vic 2B
[11:36:23 ET] Teresa_Lo let me go back with one more chart
[11:37:26 ET] Teresa_Lo I’ve cleaned up the lines…can you see the staircase action?
[11:39:29 ET] Christopher Yes - I see the staircase action.
[11:45:08 ET] Teresa_Lo I’m writing up the release notes for InVivo right now.
[11:45:22 ET] Teresa_Lo While the rest of us watches to see if the bounce can go to the 20EMA5
[11:50:33 ET] Teresa_Lo And also, the 20EMA5 overhead is typically the first upside target of a Trader Vic 2B long setup while the last swing low is the second upside target.
[12:02:39 ET] Teresa_Lo Second upside target is hit and now here come the “Grail” sellers.
[12:03:04 ET] Teresa_Lo And now, we will see if the Grail FAIL sets up.
[12:03:11 ET] Teresa_Lo You know this one from the book.
[12:04:17 ET] Teresa_Lo Grails only work in very strong trends, and more often than not, it goes down a couple of bars on contracting volume and then rams back up to take out their stops, which are placed above the high of the bar at the 20EMA5. In this case, just above 31.25
[12:04:24 ET] Teresa_Lo Search and destroy mission.
[12:01:22 ET] Teresa_Lo Oh…here is comes. Will they have to bend over?
[12:17:54 ET] Teresa_Lo Here we go…get ready to take profits if you are long for the “Grail Fail”.
[12:18:07 ET] Teresa_Lo We have target.
[12:18:12 ET] Teresa_Lo Now watch for volume.
[12:35:01 ET] Teresa_Lo this is the last chart of today.
[12:35:54 ET] Teresa_Lo So with the Grail Sellers gone…we watch to see if traders step up to buy what they think is a higher low…and the upside target now is the 20EMA15 overhead where we know that a Grail Sale on that time frame will set up.
[12:36:08 ET] Teresa_Lo But it’s now complicated…so we are done. Let the system do it for us.
[12:37:10 ET] Teresa_Lo Speaking of the system, the license keys have just been sent.
[12:37:12 ET] Teresa_Lo It’s over!
[12:37:17 ET] Teresa_Lo (At least for TradeStation)
[12:37:18 ET] Teresa_Lo LOL
[12:37:47 ET] Suburban_Trader OK you can breathe again lol
[12:41:22 ET] Teresa_Lo I
[12:41:29 ET] Teresa_Lo am really happy with this release.
[12:41:47 ET] Teresa_Lo It’s everything that I could do in one shot.
[12:41:56 ET] Teresa_Lo I don’t think I could have done even one touch better.
[12:42:08 ET] Teresa_Lo Oh and here we go…a little more uppage toward the 20EMA15.
[12:43:56 ET] Teresa_Lo Have a great weekend.
[12:44:07 ET] Suburban_Trader Good weekend all!
As usual, trading was turned over to the system starting at 14:00 Eastern. A short position was initiated at ES 1525.00.
At 16:00 Eastern, the system covered the short position at 1508.25 for a 16.75 point gain.
In Conclusion
At the firm — between the clients, the commotion, the desk and floor traders — I simply learned by osmosis over the years to distinguish between “hot” and “not” trading environments and what to do in response. It has been very difficult for me to articulate and explain what we just know from years of sitting in front of the screen. This time, I truly hope I have managed to capture, quantify and convey the information.
Questions and Comments
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