Sep
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The task of writing is always complicated by the difficulty of gauging how deep the author should delve into the subject matter. While it is impossible to address the particular needs of each reader, the common denominator is most likely the desire to make money.
The material presented herein is geared toward independent thinkers, individuals willing to roll up their sleeves and take the time to investigate a host of issues that need to be considered and addressed prior to undertaking the challenge of trading.
In the final analysis, some will decide to proceed while others may come to the conclusion that passive participation in the capital markets is more appropriate. Either way, the objective of this book will be achieved if a realistic appraisal of what it takes to succeed in this endeavor is provided.
Back in the 1980s
I went to work at a top investment dealer straight out of university. It was easy to figure out who’s who at the firm. On one end of the spectrum, there were the realistic doers and the charismatic leaders. On the other were the fantasizers and the bunker mentality cranks. I dealt with seasoned market professionals on a daily basis, guys that made money, day in, day out. The best floor traders, desk traders, salesmen, deal makers and executives instantly became part of my universe along with perpetual also-rans that were forever at the cusp of making it, but never did.
By virtue of working for the right people, I gained insight into what works and what doesn’t. I learned to think about the markets in a certain manner by osmosis. Most importantly, by observing the winners and the losers inside the firm, I quickly acquired the mind-set and the playbook prerequisite for consistent performance while receiving a priceless education into the attitudes and perceptions of those who were destined to leave the game.
The Threshold of Pain
Anyone who has traded will know right away why the following words ring true.
Be aware of new, useful information. When you feel yourself growing angry because someone presents a new idea to you that leaves your previous beliefs shattered and previous efforts effectively useless, expect yourself to resist considering the idea fully. No matter how strenuous and long-held old beliefs are, be open to the possibility that you were wrong. Holding on to bad ideas or wrong information because you are heavily invested in it is pretty common. …Obviously not all new information is more correct than what you believe, but that anger is your internal sensor that tells you when someone is presenting new information that threatens your heavy investment with devaluation. Be open to the possibility that the new information is actually better than what you have now. It may not be, but you can sleep on it for a while before you decide. — Bob Redmond
There are simply huge disagreements when it comes to trading and investing philosophy. Starting with the fundamental analysis vs. technical analysis debate, people tend to align themselves with the camp that appeals to them and go from there. In time, our views becomes rigid. We disregard anything that does not fit the mold and even dismiss new findings to the contrary.
…be open to the possibility that you have held on for far too long and that it may be time to let go - even though you feel you have too much investment in it to do so. Investment is only a perception. The truth about history is that it is in the past. And the past is no longer happening. Only now is happening. We imagine a bank account with investments in it, but in reality, there isn’t one. Nothing truly stops you from changing direction right now and giving up an old hobby, a bad relationship, or a terrible job. Take good care of yourself. — Bob Redmond
Inevitably, disaster strikes. While most of us would conduct an exhaustive (but superficial) review of our methods, few will ever question the tenets of our approach to trading because so much investment has been made in one set of beliefs. With time, our thinking process becomes fixed. Our self-esteem becomes one with our dogma.
I have not failed 700 times. I have not failed once. I have succeeded in proving that those 700 ways will not work. When I have eliminated the ways that will not work, I will find the way that will work. — Thomas Edison
If you are reading this because you acknowledge dissatisfaction with your trading results, be encouraged. You have already taken a giant first step to crossing the threshold of pain. Give yourself permission to say, “The time, effort and money I devoted to trading WERE NOT wasted. I learned a lot about what DOESN’T WORK. I REFUSE to allow this experience to defeat me.” By doing so, you are on your way to thinking like one of the winners; you are taking good care of yourself.
Or as they taught us at the old Xerox sales course, “Every no is one closer to a yes.”
The Biology of Fear
I never had much to say whenever clients asked me for insight into trader psychology, particularly how to handle fear. I always paid more attention to the psychology of the crowd and market sentiment. When pressed, my usual response was, “If you don’t know what you are doing, there is good reason to be afraid. If you know what you are doing, then trade smaller size.”
Assessing and reacting to risk is one of the most important things a living creature has to deal with, and there’s a very primitive part of the brain that has that job. It’s the amygdala, and it sits right above the brain stem, in what’s called the medial temporal lobe. The amygdala is responsible for processing base emotions that come from sensory inputs, like anger, avoidance, defensiveness, and fear. It’s an old part of the brain, and seems to have originated in early fishes. When an animal–lizard, bird, mammal, even you–sees, hears, or feels something that’s a potential danger, the amygdala is what reacts immediately. It’s what causes adrenaline and other hormones to be pumped into your bloodstream, triggering the fight-or-flight response, causing increased heart rate and beat force, increased muscle tension, and sweaty palms.
This kind of thing works great if you’re a lizard or a lion. Fast reaction is what you’re looking for; the faster you can notice threats and either run away from them or fight back, the more likely you are to live to reproduce.
But the world is actually more complicated than that. Some scary things are not really as risky as they seem, and others are better handled by staying in the scary situation to set up a more advantageous future response. This means that there’s an evolutionary advantage to being able to hold off the reflexive fight-or-flight response while you work out a more sophisticated analysis of the situation and your options for dealing with it.
We humans have a completely different pathway to deal with analyzing risk. It’s the neocortex, a more advanced part of the brain that developed very recently, evolutionarily speaking, and only appears in mammals. It’s intelligent and analytic. It can reason. It can make more nuanced trade-offs. It’s also much slower.
So here’s the first fundamental problem: we have two systems for reacting to risk–a primitive intuitive system and a more advanced analytic system–and they’re operating in parallel. And it’s hard for the neocortex to contradict the amygdala. — The Psychology of Security, Bruce Schneier
While performing research for this book, I became acutely aware that the fear factor looms large for most traders. Perhaps I don’t have the genes, since Dad survived 28 years fighting in the jungles of Asia with only minor shrapnel wounds. Perhaps working at the firm imparted a huge advantage because I modeled myself after the winners. For whatever reason, I do not experience fear very much, but understanding the problem allows me to be helpful and provide solutions for those who do.
The Psychology of Fear
Time and again, traders would tell me that Mark Douglas’ books were the best.
I hate to admit it, but every time someone brought up the subject of trader psychology, I would quietly roll my eyes. In my mind, the inner game of trading was a non-issue. But I was wrong.
In his book, Trading in the Zone, Douglas does an amazing job of breaking it all down into baby steps. He shows his readers a clear path from fear to enlightenment. What I liked most about it is the lack of “stand in front of the mirror and repeat P.M.A. a hundred times.” Instead, it is action-oriented. The characteristics of winning market participants have been analyzed and presented in detail.
Identifying the Fears
The professional trader knows that to be truly successful, he must be consistent – and to be consistent, he must have the right attitude.Why is it that after a string of wins, he repeatedly gives it all back and more? With confidence shaken, he cannot enter a trade without wondering if he is making a mistake. Doubt gnaws at his every decision. What is different? Is it the market or him? It is at this point that the trader must step back and perform a careful reassessment. Because it is not the market, it must be in his approach. Which of his assumptions are inconsistent with reality, causing him to experience periods of glorious feast interspersed with agonizing times of famine?
Douglas describes the problem that all traders face. “Ninety-five percent of the trading errors you are likely to make – causing the money to just evaporate before your eyes – will stem from your attitudes about being wrong, losing money, missing out and leaving money on the table.” These are what Douglas calls the four primary fears.
So how does one overcome them? The answer lies in examining beliefs and attitudes, because they are the source of all fears. Realizing that they exist is the first step. The trader has walked through door number two. — Matt Blackman, SFO Magazine
Douglas’ treatment of the subject involves understanding what he calls:
The Five Fundamental Truths…
- Anything can happen.
- You don’t need to know what is going to happen next in order to make money.
- There is a random distribution between wins and losses for any given set of variables that define an edge.
- An edge is nothing more than an indication of a higher probability of one thing happening over another.
- Every moment in the market is unique.
…and The Seven Principles of Consistency
- I objectively identify my edges.
- I predefine the risk of every trade.
- I completely accept the risk or I am willing to let go of the trade.
- I act on my edges without reservation or hesitation.
- I pay myself as the market makes money available to me.
- I continually monitor my susceptibility for making errors.
- I understand the absolute necessity of these principles of consistent success and, therefore, I never violate them.
This sums up everything I learned at the office so long ago from watching the winners win and the losers lose. I couldn’t agree more.
No investor is going to be right every time. The secret to successful investing is not to be right all the time, but to lose the least amount of money possible. Everyone will make mistakes, so investors have to be able to admit early on that they wrong, and cut their losses so that they live to invest another day. — Investor’s Business Daily founder and Chairman William O’Neil
While there are numerous ways to skin the proverbial cat, it doesn’t take long to figure out that the common denominator of long-term consistency and performance is a winning mind-set. It is the foundation of success.
In Chapter Two, we will explore the concept of “the edge” and how to sustain a winning attitude in order to Own The Zone.
Sep
1
In Chapter One, we examined the inner game of trading. The first step toward Owning the Zone is to give ourselves permission to explore a different mind-set, to view the activity of trading from a different perspective.
With his Five Fundamental Truths, Mark Douglas presents us with a set of keys designed to unlock the four primary fears of trading: the fear of being wrong, the fear of losing money, the fear of missing out and the fear of leaving money on the table. We learn that these fears stem from beliefs that we can change.
You have to learn how to change your beliefs by reinterpreting what it means to lose, and what it means to be wrong. In essence, you have to change many of the beliefs that cause you to interpret market information in a painful way. You have to create a whole new set of beliefs that allow you to see the market from a carefree state of mind, as well as a set of beliefs that always compel you to act in your own best interests. You want to reach a point where you’re trading without hesitating, very much like the way great athletes perform. — Mark Douglas, TAS&C interview with Thom Hartle
Douglas provided an excellent example of how the Fundamental Truths come into play at critical moments:
There’s uncertainty with every trade?
There is indeed, and that means the market produces patterns, and the patterns in turn will generate an outcome with a higher probability of one thing happening over another. The outcome to each individual pattern is random. But people don’t believe that! And that’s the problem.So what you’re saying is that the outcome of every individual trade is a coin toss?
Yes! The trading public doesn’t understand that, or they wouldn’t have the kind of problems that they do in their trading.If the outcome of every individual trade is a coin toss, and you have a series of losing tosses, it would be easy to become emotionally caught up in the next trade.
Exactly, and this is where the best traders really separate themselves from everyone else. They know at the very core of their trading personality that this trade is statistically independent from the last trade and act accordingly. Everyone else, on the other hand, associates this trade with the outcome of the last trade, or the last two or three trades. If the last two or three trades were losers, then of course they’re associating this next signal with the last two or three trades and they’re only seeing the risk. If the last two or three trades were winners, they’re in a state of euphoria and they’re not perceiving any risk at all, which allows them to make all the errors on the other side of the ledger. They overtrade, or they believe the current trade couldn’t possibly be a losing trade. — Mark Douglas, TAS&C interview with Thom Hartle
What I found most interesting about the interview is that Douglas addresses the downside of losing and the downside of winning. When traders think of performance enhancement, they tend to focus on learning how to deal with the inevitable losses. It’s almost hard to think of winning as a problem, but trust me on this one: there is no trader more dangerous than one that has been on a long winning streak in a bull market. Never confuse luck with skill. I learned the hard way.
Consistency is Flow in Balance
The father of flow is none other than Dr. Mihaly Csikszentmihalyi (pronounced “Mee-high Chick-sent-me-high-ee”).
MC: My hunch is–and, of course, there is no proof of this–that if an organism, a species, learns to find a positive experience in doing something that stretches its ability; in other words, if you enjoy sticking your neck out and trying to operate at your best or even beyond your best, if you’re lucky enough to get that combination, then you’re more likely to learn new things, to become better at what you’re doing, to invent new things, to discover new things. We seem to be a species that has been blessed by this kind of thirst for pushing the envelope. Most other species seem to be very content when their basic needs are taken care of and their homeostatic level has been restored. They have eaten; they can rest now. That’s it. But in our nervous system, maybe by chance or at random, an association has been made between pleasure and challenge, or looking for new challenges.
WIE: So we have a relationship between pleasure and the desire to be challenged further?
MC: Yes. Like most species, we have developed connections in our nervous system between eating and pleasure and between sex and pleasure. If we didn’t have these connections, we probably wouldn’t eat as much or reproduce as much. Survival to a certain extent depends on finding pleasure in those things that are necessary for survival. But when you begin to enjoy things that go beyond survival, then there’s more of a chance to transform yourself and to evolve. And since the state that I call “flow” depends on increasing skill and increasing challenge, then it leads toward complexification, which means greater differentiation and integration, of the organism.
WIE: Let’s go back to “flow.” Could you explain what it is?
MC: …In the early seventies, I spoke with chess players, rock climbers, musicians, and inner-city basketball players, asking them to describe their experience when what they were doing was really going well. I really expected quite different stories to emerge. But the interviews seemed in many important ways to focus on the same quality of the experience. For instance, the fact that you were completely immersed in what you were doing, that the concentration was very high, that you knew what you had to do moment by moment, that you had very quick and precise feedback as to how well you were doing, and that you felt that your abilities were stretched but not overwhelmed by the opportunities for action. In other words, the challenges were in balance with the skills. And when those conditions were present, you began to forget all the things that bothered you in everyday life, forget the self as an entity separate from what was going on–you felt you were a part of something greater and you were just moving along with the logic of the activity.
…From the point of view of the individual, it’s a very positive experience because it does provide the most memorable, intense enjoyment in life. But, it’s not a simple story because there are two dangers with flow in terms of development or evolution. One is that at the individual level it can become addictive to the point that a person becomes increasingly dependent on one set of challenges, and when those challenges are exhausted, the person is left helpless. For instance, one thing that has always struck me is how many of the great chess masters broke down into various forms of neurosis after they beat everybody else in the world and there was nowhere else to go. So that’s one danger, at the individual level–that you stunt your development as a person.
At the social level, the danger is that you end up finding flow in challenges that are zero sum, that is, that somebody has to lose for you to win. For instance, war can produce flow if you are on the front line, and everything is clear, everything is focused, and you know exactly what you want to do, and so forth. So many people come back from war to find civilian life very boring and dull compared to their front line experience. — Dr. Mihaly Csikszentmihalyi
In his Flow with Soul interview, he made special mention of the dark side of flow, something that seems to plague the investment business without end.
Mr. Scholes …and other LTCM representatives met with executives at Conseco Capital Management, the investing arm of the big insurer. They sat around a long table, spelling out their strategy. The fund, Mr. Scholes said, would leverage its capital to take advantage of pricing “anomalies” in global markets.
“You’re not adding any value,” interjected Andrew Chow, the Conseco vice president in charge of derivatives. He added: “I don’t think there are that many pure anomalies that can occur.”
Mr. Scholes gazed at Mr. Chow. Then, sitting back in his leather-padded chair, he dressed Mr. Chow down, deriding him for believing he knew “all the answers.” According to Maxwell Bublitz, Conseco Capital’s president, Mr. Scholes added, “As long as there continue to be people like you, we’ll make money.”
Conseco executives were dumbfounded. “It was very condescending. We booted them out,” recalls Mr. Bublitz. LTCM’s pitch consisted of, “Our resumes are better than yours — wouldn’t you like to invest?” — How Salesmanship and Brainpower
Failed to Save Long-Term Capital, WSJ.com, November 16, 1998
Dr. Csikszentmihalyi’s observations are particularly poignant. The upside of flow is the potential to propel every one of us into a virtuous cycle of achievement and contribution. Flow stemming from zero (or even negative) sum challenges such as gambling and reckless trading can only be described as a vicious cycle of addiction to random rewards.
When traders integrate Douglas’ Five Fundamental Truths into their belief system and apply his Seven Principles of Consistency, the results of a trading program are viewed in a probabilistic way, in a calculated, professional manner.
We are able to identify and head off potential destructive behaviour. There is no fear, no loathing and no beating ourselves when we’re down, no succumbing to the Master of the Universe syndrome when we’re up, no high drama of riding a manic depressive wave that spills over into our private lives, hurting our loved ones.
In trading, we channel our energy into research that sharpens our edge. Away from the market, we interact and contribute to the world around us in a positive way. In essence, we strive to attain and sustain flow in trading as well as in life.
What is an Edge?
Douglas’ third Fundamental Truth and his first Principle of Consistency both refer to an edge, a term that comes up so often in trading. The word is used interchangeably with advantage and generally refers to a special research or trading methodology.
The trading system just gives you an edge.
… The market is the collective action of everyone participating in the market at any given moment. Individuals have behavior patterns. They will do the same things under the same circumstances over and over and over again. A group of individuals will consistently display the same kind of collective behavior patterns. All a technical system does is identify those patterns and quantify them so you have a statistically reliable outcome.
I call that statistically reliable outcome your edge. An edge with a higher probability of one thing happening over another. But that’s it. That’s all systems do. They don’t tell you what’s going to happen next. There are no guaranteed trades. There are no guaranteed outcomes. — Mark Douglas, TAS&C interview with Thom Hartle
In Fortune’s Formula, the fabled Kelly Criterion defines edge as “how much you expect to win, on average, assuming you would make this wager over and over with the same probabilities.”
I consider my trading edge to be a collection of synergistic advantages. Think of a sword. The edge is simply the cutting side of the blade. But it is much more than that. It is handmade by a master craftsman. Its dimensions, specifications and composition are tailored to its owner’s physique, skill, style and expected conditions on the battlefield. In short, a sword is a purpose-built weapon made for its owner.
Knives …are sharpened using a combination of Japanese waterstones, buffers, and wet belt grinders. The result is a razor edge that lasts. We will generally fix problems with blade geometry as well as repairing broken tips, bent blades, or even replacing handles. — The Epicurean Edge, where I buy my knives
In battle, the warrior must be one with his sword. His life depends on knowing when to use the forte and when to use the foible. Fighting with a sword made for another does not guarantee success because each warrior is as unique as his mission. Still, every single one of us can pick up elements of greatness, use a sword that fits our hand, and hone our skills until we too, are masters on our chosen battlefield.
In Chapter Three, we will explore a list of individual elements that really add up, and how to pull them together to give yourself an edge.
Sep
1
In Chapter Two, we discussed the flow that can be experienced when we own the zone. We examined the nature of an edge and defined it as a collection of synergistic advantages.
In this chapter, I will do a case study of how one trader pulled it all together: me.
The Background
First, some reference material:
- 2007.05.31: 20-minute discussion with Tim Bourquin at TraderInterviews.com
- March/April 2005: Excellent article about Mark Douglas’ Path to Consistency workshop, written by attendee Gary Stone
- 2007.05.23: Mauboussin on Strategy: Turtles in Omaha
- Peter L. Bernstein: The Failure of Invariance
After 20 years of discretionary trading, I found myself constrained by its limitations. Even with my experience and photograhic memory, I have but only two eyes, and it was simply not possible for me to watch and trade more than a handful of symbols.
Since 1996, my solution had been to trade stock index futures in the morning, but the bulk of my money was sitting there, doing nothing. OK, maybe nothing is a bit of an exaggeration since there is only one price for risk. Still, I felt there was more to life in the capital markets than just the futures/cash combo.
In addition to potentially increasing returns, there were other motivators such as:
- Eliminating unforced errors that come with being a human trader such as making trades on an impulse, taking profits too soon and taking larger losses than necessary;
- Spending time enjoying life rather than look at more charts outside market hours;
- Reducing stress by not having to get up at 5AM Pacific for the rest of my life;
- Occasional free lunches from diversification and rebalancing; and,
- Clients would be better served by a mechanical trading system.
The Mission
The decision was made to automate the trading and incorporate quantitative methods to build portfolios and manage risk.
The Signals
The first thing traders think about are signals: when to buy and when to sell. It was a good place for me to start since I knew a lot about this subject. But how would I go about coding it all up? It was time for a phone call.
The best problems, like the best toys, are hard to exhaust. You can approach them from a variety of different angles, each new angle making the problem fresh again, and bringing the opportunity to discover something new. Any idea, no matter how crazy seeming, might work and can be worth exploring. Indeed, the harder the problem, the more degrees of freedom one can allow in tackling it. Fischer relished hard problems because he relished that freedom, but in practice he did not try just anything. In his view, if a problem does not yield to known methods, that doesn’t mean we need more sophisticated methods, indeed probably just the opposite. Usually problems are hard not because our technique is deficient but because our understanding is deficient. — Fischer Black and the Revolutionary Idea of Finance
I explained my predicament to The Quant. After much discussion, we agreed on one thing: avoid making forecasts. That is what everyone else tries to do while little attention is paid to crafting a betting strategy or determining which game was most advantageous to play.
In quant language, I would use a probabalistic modelling approach rather than a deterministic one.
A little luck never hurts, but it’s rare for anyone to attribute their success to it, especially anyone on Wall Street, where appearance seems sometimes to matter as much as performance.
Then there’s James Simons, president and founder of Renaissance Technologies, the hedge fund with the best track record of the past decade (up an average 35.6 percent annually since 1989 and 64 percent so far this year). If anything, Simons can’t seem to say enough about luck. That’s in part a reflection of his unusual background. A brilliant mathematician, Simons won the Veblen Prize for geometry in 1976 before tiring of academia and taking up trading full time. Luck, for him, is a matter of statistical probabilities; trading success comes from scrutinizing data to create models that narrow the range of outcomes. — Institutional Investor, Dailyii.com (by subscription)
Our thinking was more in line with Douglas’ Five Fundamental Truths, that my goals would be better served if I put my efforts into identifying a point in time when, in all probability, the prevailing price move was over. Chalk one up for the (Quant) mathematician.
Initially, I thought mechanical trading would present unacceptable tradeoffs because I perceived discretionary trading to be more precise; however, research revealed and proved that proper handling of trade logistics — stuff that is difficult for humans to calculate and manage on-the-fly in real-time — is the real secret of success.
It turns out that pinpoint accuracy is required only for highly leveraged intraday scalping such as the volatile first hour of trading stock index futures. In addition, I confirmed for myself that many practices that lead to profitable trading and investing are counterintuitive.
Anyone with average intelligence can learn to trade. This is not rocket science. However, it’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies. Of the people who can learn the basics, only a small percentage will be successful traders. . . .
Decision theorists have performed experiments in which people are given various choices between sure things (amounts of money) and simple lotteries in order to see if the subjects’ preferences are rationally ordered. They find that people will generally choose a sure gain over a lottery with a higher expected gain but that they will shun a sure loss in favor of an even worse lottery (as long as the lottery gives them a chance of coming out ahead). These evidently instinctive human tendencies spell doom for the trader - take your profits, but play with your losses. — William Eckhardt interviewed by Jack Schwager, The New Market Wizards: Conversations with America’s Top Traders
System Design
To repeat, the goal was to identify reversal points.
Many systematic traders spend the majority of their time searching for good places to initiate. It just seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprisingly well with a good liquidation criterion. In contrast, random liquidations will kill the best system. At ETC we expend a lot of our research effort on liquidations.
Most standard statistical techniques are inappropriate for analyzing trading. Statisticians have developed many delicate techniques that squeeze information from minimal data, but these give false results in this business. I tell traders that if the results don’t sock you in the eye, they’re probably not real. Accordingly, we use only the most robust and assumption free statistical tests, we have an aversion to summary statistics that obliterate important structural elements. For assessing systems, we use a technique called bootstrapping so that the complete distribution of past outcomes can make itself felt in decisions; the distribution is not simply viewed in terms of its mean and variance which can give a distorted picture.
Our aversion to summary statistics that obliterate structure extends to the trading systems themselves. For instance, we avoid moving averages of price in making trades. Such moving averages are popular mostly because they’re mathematically tractable, but they smooth away all the structural information inherent in the price data. — William Eckhardt, 1996
In theory, if we know the mechanism behind price changes, we can predict them. But we do not, at least not me. Therefore, no attempt was made to forecast the magnitude and duration of any directional move.
As an aside, we can contrast this to pattern-based technical trading. My view is that price patterns are manifestations of the investor sentiment cycle, most eloquently summed up by Justin Mamis in his book, The Nature of Risk.
In order to trade profitably with this discretionary approach, one must be a keen observer, someone who can relate and compare current market conditions to historical accounts. In order to be an impartial judge, one must maintain independence of thought and possess a certain cynicism about human nature.
One cannot be a permabull or a permabear because this job entails reviewing evidence while simultaneously holding two opposing ideas in one’s head at all times. We must be able to judge where we stand in the sentiment cycle at any given moment in time.
While rule-based trading of chart patterns not difficult — see TrueBlue Trader Program Course Material — quantifying them for mechanical trading is another matter.
Back to engineering. Once the algorithm for the reversal points was in place, it was time to make the system intuitive to use and esthetically pleasing to the eye.
How it works:
- Price bars are colored blue when the system is long. The pink dots below mark the price where the system will generate a sell signal.
- A CLOSE BELOW the pink dot triggers a sell signal as a downswing begins.
- Price bars are colored pink when the system is short. The blue dots above mark the price where the system will generate a buy signal.
- A CLOSE ABOVE the blue dot triggers a buy signal as an upswing begins.
With the basic signals in place, the real fun began. In Chapter Four, we will examine the role of trade logistics, the oft-ignored, niggly stuff that can bankrupt traders faster than a market crash: position size (leverage, stop loss, pyramiding), trend-filtering and shorting policy.
Sep
1
In Chapter Three, we began a case study of how I streamlined the trading process. This chapter examines the logistics of pure directional trading.
The Devil is in the Details
We’ve all experienced it: an elegant concept that proved impossible to implement. That’s when we learned that behind the success of any great idea, there must be a real-world plan of execution.
New traders often focus exclusively on the development of timely buy and sell signals while the logistics of trading, that is, how to handle the niggly details of the trade, is given little attention. Yet this is often where the battle is won or lost. Why?
When we accept Mark Douglas’ Five Fundamental Truths, that trading as a probabilistic activity, we know that the long-run outcome is a function of the edge. If there is more to a sword than the cutting edge of the blade, then buy and sell signals are only part of our trading edge.
NOTE: If we were discussing card games, all would agree that the game we play, the players we play against, the size of our bankroll and how we bet each hand are equally important as when to hold ‘em and when to fold ‘em.
Directional trading is defined as attempting to profit from long (buy something now to sell later) and/or short (sells something borrowed now to cover later) trades. Let’s break it down into components:
1. The Symbol Universe
What markets to play? Which stocks to trade? There are many approaches to identifying candidates for short-term and intraday trading, but the goal is the same:
Investment philosophy defines an investor’s approach to generating portfolio returns. . . . Market returns stem from three sources — asset allocation, market timing, and security selection — with each source of return providing a tool for investors to use in attempting to satisfy institutional goals. — David F. Swensen, Pioneering Portfolio Management
Funds and institutions must execute in size; therefore, they gravitate toward stocks with liquidity, financial futures and currencies [Griffin, Harris & Topaloglu, 2002]. Competition is fierce and pricing is extremely efficient. Lack of resources puts individual traders at a distinct disadvantage [Griffin, Harris & Topaloglu, 2005].
Serious individual traders pick battles they can win by
- operating in situations and time frames that attract less-skilled noise traders [Black, 1986] and lottery traders [Statman, 2001];
- trading securities that are relatively more difficult for uninformed market participants to value (no dividends, less analyst coverage) and therefore, more prone to bubbles [Hirota & Sunder, 2006] and beauty contests [Camerer, 1997];
- avoiding extreme high frequency intraday trading in order to reduce transactions cost, slippage and the risk of participating in non-meaningful moves;
- trading stocks with certain desirable characteristics [for example, O'Neil, 2004] over longer time horizons such as swing trading with daily charts.
- using leverage in a judicious way; and,
- acknowledging that making better-than-market returns is not necessarily the same as beating a benchmark on a risk-adjusted basis, that the volatility of returns on pure directional trading are apt to be high.
To paraphrase Swensen’s description of the top-down approach, our success depends on a number of factors: where we look for opportunities, our ability to select the right ones, how much we allocate to each and the effectiveness of our trading method. In that order.
2. Capital Required
The market is a mechanism where, in exchange for taking on risk, we get the opportunity to compound our surplus cash faster than we can with T-Bills or bank interest.
A potter makes pots with clay. A carpenter makes furniture from wood. A trader makes money with money. A trader’s capital is the same as a gambler’s bankroll: our goal is to preserve and grow it.
Short-term returns are uncertain. Monthly expenses such as the rent/mortgage should be paid from sources outside of trading, just like investment and hedge fund managers pay overhead with fixed fees charged to clients (as a percent of assets under management).
3. Use of Leverage
A minimum of US$25,000 is required for active stock trading. Switching to options, futures, Forex or CFDs for the sole purpose of circumventing this capital requirement makes little sense. The reason is leverage.
[Long Term Capital Management]’s trading strategies were secret. . . . One thing was disclosed. LTCM used a lot of leverage. That was how they were able to obtain better-than-market returns from a nearly efficient market.
…In 1996 one of LTCM’s investors spoke by phone with several of the partners. . . . [he] learned that the fund was using leverage of about thirty times. For every dollar of investor money, the fund borrowed $29 more. — Fortune’s Formula
Hedge funds employing 20:1 leverage routinely go bust. Failure is typically not due to lack of skill; it happens because the higher the leverage, the smaller the adverse price move needs to be in order to wipe out the capital in an account.
Undercapitalized traders often find it difficult to resist combining small time frames with tight stops and high leverage. But consider this: stops must be calculated and placed to reflect prevailing volatility. They cannot be made smaller on account of the trader’s capital.
Let’s look at a few examples. The 21-day average true range (ATR) for GOOG is 1.85%; therefore, on an average day, we can expect GOOG to bounce around this much. If we wish to allow a trade to go against us by three “typical” bars, we need to budget for a move against our position three times this amount (3 bars x 1.85% = 5.55%) as a minumum stop loss.
The 21-bar average true range for the 5-minute intraday chart of GOOG is 0.108%; the minimum stop loss would be 0.324%. Note that the range on intraday charts varies considerably during the course of a day. For example, the ATR (%) on the 5-minute GOOG chart was three times more in the morning than it was at the end of this day. And this is when the ATR (%) on the daily chart is very low.
The 21-bar average true range for the 15-minute EUR/USD chart is 0.03839%; the minimum stop loss would be 0.11517%.
Let’s do a back-of-the-envelope calculation of how many losing trades it takes to wipe out the account equity, using typical margin for each symbol and time frame.
Swing trading a stock:
50% Own Capital / 5.55% Loss = 9 Trades
Intraday stock trading:
25% Own Capital / 0.324% Loss = 77 Trades (probably closer to 30 with typical range)
Intraday Forex trading:
0.5% Own Capital / 0.11517% Loss = 4 Trades
That’s the killer effect of leverage, and why the typical leveraged Forex trader survives less than 45 days [Wall Street Journal].
Screenshot of the FXCM Mini Account
In practice, it would probably take months to set up 9 swing trades off the daily GOOG chart compared to perhaps a month to make 77 trades off a 5-minute GOOG chart. It certainly would take no more than two days to make four trades off the 15-minute EUR/USD chart.
To stay in the game, the prudent trader trades in accordance with the amount of his own capital. It may feel counterintuitive, but when undercapitalized, the right thing to do is go easy on leverage, reduce the number of shares, and trade in a larger time frame to reduce transaction costs.
4. The Stop Loss and Pyramiding
Stops should be used. They also need to be placed strategically. In directional trading, my practice is to allow sufficient wiggle room to accommodate natural fluctuation. The time to leave is when the magnitude of a reversal has (in all probability) risen above the noise.
Douglas’ Seven Principles of Consistency is reflected in the following:
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 interviewed by Jack Schwager, The New Market Wizards: Conversations with America’s Top Traders
Stop loss placement is a prime example of the right thing feeling counterintuitive. The popular perception is that tight stops are a good thing because it allows us to take small losses. But they also force us to take small profits. Small stops also tend of increase the frequency of trading, adding to transaction (commission and slippage) costs.
So why do traders do it? There are several reasons. First, many traders somehow believe that a high batting average is correlated to superior performance. Second, locking in some profits, however small, makes us feel good. Third, giving back paper profits feels bad. Fourth, highly leveraged directional traders may do not have enough equity to place a proper stop.
My solution? Give a trade the room it needs, even if it means reducing size and moving to a different time frame since we can add to a winning trade (pyramid) as a trend unfolds.
Using Stops to Calculate a Strike Price
Properly calculated stops have another use: directional option trading.
EMC Daily Chart
Example: EMC was the highest volume winner on June 15, 2007 stock scan. I can see that the trading system has been long since March 30, 2007 and pressed this profitable long position twice (on April 26 and June 7) already.
EMC July 2007 Option Chain
If I want to buy it now, what should I do? I could step in mid-trade with options because I know it closed at $17.35 with the stop loss at $16.18 below. The strike price closest to the stop loss price is $16.00, last traded at $1.63.
If the trade does not work out, I want to do two things to recoup as much of my option premium as possible, 1. make sure that I leave the trade with about ten days left before expiry and 2. sell the call just above or at the strike price of $16.00. Why? 1. Because traders never intentionally let a directional bet go to zero since our capital is our lifeblood and 2. at-the-money options have the maximum time value.
Now, the back-of-the-envelope calculations. The July calls expire on July 13 (always the third Friday of each month). We have four weeks. We need to reserve nearly two weeks in case the trade doesn’t work out, leaving us with a window of around two weeks of play. The stock has been going up since March, so in all probability, it is getting late. Two weeks are just fine.
How much do we buy? This is where it gets interesting, because this example also shows how traders with less than $25,000 can maximize their money. If the individual has $10,000 in his account and uses a fixed 2.5% of the initial capital on each trade, it would take 40 consecutive losing trades before the money is gone. What makes more sense is to always use 2.5% of the balance, since he will use more money on the way up and less of it is down.
($10,000 x .025) = $250 / $1.63 = 153 / 100 (shares per call) = 1.53 calls. Round that down to 1. If EMC reverses right after we buy the call, we sell it as EMC trades back to $16.00. If the EMC continues upward until expiration, great. The stops will be automatically calculated as the price rises, and we can use the updated stop loss points to exit the call, just as we would if we were long the stock.
5. Commissions, Slippage and time frame
It is important to select a time frame with a trading range in excess of slippage.
This is especially important when it comes to intraday trading of futures and Forex. Slippage can be considerable. For example, ES features a bid-ask spread of 1/4 point. We must factor in 1/2 point per contract of slippage just from opening and closing a trade. Lack of trading range is another constraint. As a rule of thumb, we can use the 20-bar ATR to check the trading range to make sure that there is enough room to clear slippage, commission and profit.
6. Trends
While it certainly feels good to say that we picked an important top or bottom, it pays to capitalize on trends.
Unfortunately, overcoming the tendency to follow the crowd, while necessary, proves insufficient to guarantee investment success. By pursuing ill-considered, idosyncratic policies, market players expose portfolios to unnecessary, often unrewarded risks. While courage to take a different path enhances chances for success, investors face likely failure unless a thoughtful set of investment principles undergirds the courage. — David F. Swensen, Pioneering Portfolio Management
A trend filter helps the trader avoid countertrend trades when there is an emerging trend, or if there is a trend on a larger time frames.
The TrendFilter helps avoid premature short sales
An Intraday Example
Trend filtering can also be used to simplify multiple time frame trading. Let’s use the S&P E-mini.
Assume that the trading range on the 5-minute time frame is large enough to warrant trading at this time. We know many traders apply the 20-period exponential moving average (20EMA) to their charts. Other types of moving averages set at +/- 5 will also cluster around this value.
From a Keynesian beauty contest point of view, we deduce that traders will attempt to buy a dip to the 20EMA in an uptrend; we also know traders will attempt to sell short a bounce to the 20EMA overhead in a downtrend.
We select the 45-minute (405 minutes / 45 minute = 9 even bars) ES chart as the largest intraday time frame and apply the 20EMA. For stocks, I use (390 minute / 65 minutes) = 6 even bars.
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When it comes to multiple time frame analysis, my experience is that multiples of three is about right. (45 minute / 15 minute) = 3 x 20 EMA = 60 EMA is the equivalent on the 15-minute chart. We apply the trading system with the TrendFilter set on 60. The system avoids whipsaws by passing trades that are countertrend to the larger time frame.
Traders interested in the 5-minute time frame should do the same calculations with a 15-minute/5-minute combination, but to demonstrate the multiple time frame principle, we can use the 45-minute/5-minute as an example. (45 minute / 5 minute) = 9 x 20 EMA = 180 EMA is the equivalent on the 5-minute chart. We apply the trading system with the TrendFilter set on 180. The system avoids whipsaws by passing trades that are countertrend to the larger time frame.
7. Shorting Policy
Short-Selling Challenges
The management of the short side of the portfolio poses several challenges peculiar to selling securities short. First, investors frequently underestimate the resilience of corporate management. Even when the facts and futures indicate that a company deserves classification as one of the “living dead”, managers frequently find a way to escape the inevitable consequences of their circumstances. Second, the portfolio consequences of adverse price movements require greater diversification of short positions. If a stock moves against a short seller by increasing in price, the position increases in size. To take advantage of the now more attractively prices short-sale opportunity, the investor faces the uncomfortable prospect of further increasing the position. Starting with a modest allocation to a particular short idea allows an increase in position size without creating an uncomfortable concentration of a single stock. Contrast the dynamics of a losing short position with the behavior of a losing long position. As the long’s price declines, it becomes a smaller portion of the portfolio, reducing its impact on returns and facilitating new purchases at the newly discounted, relatively more attractive price levels. The simple math of price behavior argues for running reasonably diversified portfolios of short positions. Short sellers face peculiar challenges from success, as well as from fail lure. When the stock price of a fundamentally troubled company crashes, the short seller benefits, but the short position disappears, requiring identification of attractive replacement candidates. While long managers often run with successful investments for years, short managers hope to operate on a treadmill, with frequent turnover of holdings caused by the exit of winning positions from the portfolio. The combination of of price dynamics and high turnover causes successful short managers to follow and hold a larger number of securities.Aside from a peculiar set of investment challenges, short sellers face some unusual technical problems in managing portfolio positions. . . . When the market for borrowing a particular security becomes tight, short sellers face a short squeeze. Security borrowers tend to have most trouble with small, less liquid companies, exactly the type of security most likely to present interesting short-sale opportunities. — David F. Swensen, Pioneering Portfolio Management
The demise of the uptick rule does not make shorting any easier. Swensen’s comments still stand. In addition, several quant friends have also pointed out that short positions seem to be more volatile than long positions, making them hard to manage.
Overall, it makes sense to short only a fraction of the position size that we put on for longs.
8. Allocation of Capital
Suppose there are two stocks. ABC trades at $100/share while EFG trades at $20/share.
A trader pursuing an equal dollar strategy with $10,000 in capital would buy $5,000 worth of each one, namely ($5,000 / $100) = 50 shares ABC and ($5,000 / $20) = 250 shares EFG.
While I am aware of methods that can be used to further calibrate position size to achieve “price range parity”, i.e., account for the differences in volatility and trading range between the two stocks, there is no convenient way to do this in TradeStation and eSignal at this time due to a number of technical reasons. In any event, this might only be useful for traders who are trading a diversified (commodity, currency and financial) futures portfolio anyway. Implementing this type of calculation for a stock portfolio might not be a good thing, since low priced, low trading range vehicles would come to dominate a portfolio in terms of dollars utilized.
The best bet for stock and non-diversified futures traders would be to use the equal dollar method of capital allocation.
9. The Signals
The reversal system from Chapter Three provides buy and sell signals for individual stocks. Stock indices are treated separately and will be addressed in later chapters.
Putting it Together
Trading is so much more than just the buy and sell signals.
In this chapter, we examined the logistics of directional trading and identified individual components. While the list looks long, the fact is that leverage, stops, pyramiding, commission, slippage, trend filtering, shorting policy and capital allocation can be incorporated into the same piece of code as the buy and sell signals to form a complete, mechanical trading system.
The more difficult thing, at least for me, is the symbol universe part. I am a trader, not a stock picker. I come from a tradition where the market picks them for me. In Chapter Five, I will show you how I solved the problem by building a stable symbol universe for trading and engineering a portfolio for the long run.
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In Chapter Four, we identified and examined individual elements of directional trading and how logistics can be combined with buy and sell signals to form a complete, mechanical trading system.
What to Trade?
The next part is deciding what to trade and what time frame to trade in. While traders and investors may prefer certain markets or may be constrained by the amount of capital, there are a number of factors that must be considered regardless of one’s personal preferences and circumstances.
If we accept the definition of trading as “buying and selling, taking advantage of fluctuations in price”, then we can use this as the defining criteria to separate trading from investing. If these two activities are fundamentally different in nature and scope, then it should not surprise us to discover that selection criteria for trading vehicles and time frames are quite different than those for investment vehicles. Good investments may not be suitable for trading, while good trading vehicles might not be suitable for investing.
As I said before, I am a trader, not a stock picker. I come from a tradition where the market picks them for me. The symbols and time frames that I am willing to trade have little in common with my engineered investment portfolio.
For trading purposes, my job is to find the stocks that are moving. I have to play in time frames where there is action. Stock scans pick these out easily based on volume, price change and range criteria. Taken to the cynical extreme, all we really need to know is that moths are attracted to flames.
The mission: find and trade the biggest flames, the bubbles du jour, because superior trading skills and experience confer a large edge upon the disciplined professional. Leave when it is over, when volume and range contract.
The Criteria
This is what I learned from the traders in all my years in the industry:
- Trade high-priced stocks in time frames where there is abundant liquidity and high-range.
- Longs are preferred since stocks that pop up attract everyone’s attention. They show up on all the scans.
- Pressing winners compounds capital quickly because trends can go on for months.
- High-range, low-priced stocks are out because volume dries up quickly when the music stops.
- Shorting is OK, but they have to be hit and run.
- Low-range, low-priced stocks are out.
The Experiment
First, let’s investigate range and momentum of daily charts. We will review intraday trading later in this chapter.
I ran a scan for all non-OTCBB stocks that closed at or over $75 on June 28, 2007. Minimum volume on that day was 500,000 shares while the minimum 20-day volume moving average was set at 1.5 million shares. I removed all ETFs and stocks waiting for mergers and acquisitions to close, and ended with a list of 74.
The list was sorted according to the range of one month ago, defined as the 21-day average true range expressed in percentage. The top 50 stocks were retained. One more sorting criteria was added, the 21-day rate of change of one month ago.
Performance Against the Competition
People often write to ask about the performance of my trading system.
It occurred to me that using the 50 stocks from the scan list would eliminate cherry-picking and well-chosen examples, and decided that this was an excellent opportunity to put my trading system to the test against its closest competitor, eASCTrend 6.0 from Ablesys. This piece of software costs $5,995.00 for a permanent license for one computer. The money management module is an additional $999.00.
eASCTrend vs. TrueBlue (before universal stops were added)
The version of eASCTrend used did not include money management, so to make the comparison fair, both PT.TradingSystem and eASCTrend 6.0 was set to trade long and short exactly 100 shares for each transaction, no commission. All other settings were left on default.
The charts contained data from July 1, 1997 to June 28, 2007. The results were stunning. After 10 years of trading, the total hypothetical profit for the eASCTrend system was $8,883.60 while my system returned $129,385.00.
Over the same period, if my system had been used with default settings to include pyramiding and position sizing, the hypothetical profit was $1,275,542.00 on $500,000 capital.
One important note: A handful of stocks actually bankrupted the system (price bars no longer colored), and upon closer examination, they were all from out-of-favor sectors such as energy that experienced protracted bear markets during the 1990s. These stocks would have never made the list back in those days, giving further strength to the traders’ observation to stay away from the “dead stocks”. As Earth, Wind and Fire sang, “After the love is gone, what used to be right is wrong…”
Performance by Momentum
The list of 50 stocks were sorted by largest price gain in May, since the idea is that the big gainers will attract a lot of attention, which in turn, generates more buying. This is a popular momentum strategy.
Next, my trading system (again, this was before the universal stop was added) was applied to a 65-minute intraday chart where the system was instructed by the TrendFilter to take only buy signals when price is above the 20-day weighted moving average and only sell short when price is below the moving average.
Trading began on June 28, 2006. OwnCapital = 10000 was allotted to each stock, PercentOwnCapital = 50. Total profit over one year of trading was $188,652.52.
The list was separated into 5 “buckets”. The 20 biggest gainers produced $84,147.43 or 44.6% of the total profits. The top two buckets accounted for 58.4% of the total profits.
Performance by Range
When ranked by range, the 20 stocks with the largest range in May produced $78,186.62 or 41.4% of the total profits. The top two buckets accounted for a whopping 87.4% of the total profits.
When the two lists were combined, the top 20 from each list had 13 stocks in common.
Time Frames for Intraday Trading
I have heard it often that traders prefer to trade a certain contract or time frame. In my experience, I found it necessary to be flexible, since I cannot dictate terms to the market; it is up to me to react and adapt to it.
Trading systems typically have difficulty with intraday trading when there are large gaps at the open. My personal opinion is that gap plays are amenable to discretionary setups outlined in The Ultimate Trading Course.
81-period ATR(%) for the September 2007 ES
The range is generally large during the first hour, providing opportunities to do several hit and run trades before the market settles down. After that, range can be expected to contract as the day goes on, often dramatically. The only thing to do is to see if a trend emerges over the remainder of the day.
Intraday time frames can be selected using a rule-of-thumb approach.
Example 1
The 81-bar (405 minutes/5 minutes) ATR over 63 trading days of the June 2007 ES averaged 1.36907 points or 0.091894 percent. I went back and got the numbers from the December 1999 ES contract. ATR averaged 2.241474 points or 0.166217 percent. The range of the ES has contracted by 44.7% while it is down 38.9 percent in terms of points.
Assuming we buy on the offer, sell on the bid, and pay $5.00 round turn commission, if a trade goes our way by 3 bars, the expected range would be 1.36907 x 3 = 4.1091 points. But since bars overlap each other, we take 50% of the expected range and arrive at an estimated maximum profit of 2 points. Deduct two ticks slippage and we’re down to 1.5 points or $75, less $5 commission = $70. And that is only if we get three consecutive bars in our direction.
No wonder making money is harder than it “used to be”. And good reason to increase the intraday time frame to something larger than 5-minutes?
Example 2
Back in the day, at the top of the dot com bubble, this market was so wild that the NQ could move 10 points over a few bars on the one-minute time frame. But no more.
The comparable numbers for NQ were:
NQM07 = 2.237132 points or 0.119495 percent
NQZ99 = 6.894643 points or 0.252113 percent
Range is down 52.6 percent while it is down 67.6 percent in terms of points.
Example 3
The comparable numbers for YM were:
YMM07 = 10.08255 points or 0.077008 percent
DJZ99 = 15.93568 points or 0.14949 percent
Range is down 48.5 percent while it is down 36.7 percent in terms of points.
Conclusion
First, the stock scan experiment could have been better designed. Since this is something that everyone can do for themselves, I will leave you to investigate further. You might check out the work of Charles Kirk since he has been looking at this. O’Neil’s CANSLIM is partly based on momentum.
There are a couple of gadgets found in a typical quant’s toolbox that might have practical application to refining this scan, but I will have to circle back to this in the near future since picking stocks is really not my favorite topic.
Second, there is good reason to monitor and adjust one’s intraday time frame according to the market’s range. Slippage and commssions are fixed costs and represent larger transactions costs in low-range environments.
The profitability of a directional trader is affected greatly by both the choice of trading vehicle and time frame. Trading techniques and systems provide decision and logistical support, but cannot replace sensible security and time frame selection. When in doubt, use a larger time frame and trade smaller size.
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This is one of the top questions found in my mailbox, so the subject is either fascinating or it is a challenge for many readers. This article features my strategies and solutions for intraday trading.
CLICK TO ENLARGE: September 2007 ES, NQ, ER2 and YM from June 6, 2007 (rollover date) to August 3, 2007. P/L for the system is the green line P/L for individual trades is the blue line.
People always ask me to “send a screenshot”, so here it is. This example allocates an equal amount of capital to each of four e-mini futures contracts: ES, NQ, ER2 and YM.
From June 6, 2007 (roll over) to the close on August 3, 2007, net profit was $70,570 (before commission) on starting capital of $200,000, using 4:1 leverage.
The Mission
I’ve traded stock index futures on an intraday basis since 1996. Over the years, not much has changed. What worked then still works now. The basic goal is to:
- Use small discretionary setups to scalp the first half-hour, especially when the market is really emotional. I particularly like small flags and gap plays documented in TrueBlue Trader Course Material.
- Avoid getting killed after the first hour, when the market usually settles down and starts to chop. Stay out.
- Get on board the train if it leaves the station in the afternoon for a trend day into the close.
There really isn’t much more to it although one can make it as difficult as one chooses, I suppose.
Small Movement = Small Profit Potential
Just like swing trading off a daily chart, the trick is to use a time frame where there is enough price range to overcome transaction costs and stay out if the market is chopping. If the definition of trading is to take advantage of fluctuations in price, then one is better served by staying out of a market that is in a well-defined range or if the range itself is small.
While is it tempting to take a position inside a trading range or a congestion pattern, the fact is that they are extremely prone to fakeouts. Extricating oneself from a position against a breakout can be very expensive due to slippage. It is probably much easier to get on board a breakout after it happens.
The Problem with Stops
Even if you do not use InVivo Universal Stops, this issue still applies. Traders discover early on that using stops based on a certain amount of dollars is not effective. After a short while, they move to stops that reflect the volatility of the market.
For example, virtually all trading systems and many indicators incorporate average true range (ATR) into the formula. Stops are calculated as a multiple of the ATR value. The larger the ATR, the larger the stop. Let’s take a look at what happens.
TIME-BASED CHART: 5-minute ER2 chart, with the 21-bar average true range expressed in dollars.
At the end of a huge directional move, a time-based chart will generally feature an extreme ATR reading. Any trading system or indicator that uses ATR will end up having a really big stop at the end of the move, just when we really should be tightening. When swing trading, this does not pose a problem. But in futures trading where leverage is high and time is short, we must do better than this.
TICK-BASED CHART: 2000-tick ER2 chart, with the 21-bar average true range expressed in dollars.
The solution is to use a tick-based chart. Opening gaps can virtually be eliminated by using a 24-hour chart. Expanded range bars (critical to discretionary trading, by the way) are reduced significantly, decreasing instances of extreme ATR readings and producing stops that are more appropriate for the purpose.
I coded up PT.ATR($) to express ATR in dollars. The difference between a time-based chart vs. a tick-based chart is $40. If one uses the usual 3ATR stop, the difference between the 5-minute chart and 2000-tick chart (even though they look nearly identical) would be $120 per contract. That is a lot of money to give away in this tiny time frame.
My Trading Program
Here is how I do it. Let’s go over the elements of my e-mini stock index futures trading program.
- Leverage: Feel free to backtest this, but for me, maximum leverage is 4:1 for intraday stock index futures. As Spock said in Star Trek, “Live long and prosper.”
- First half-hour: focus on discretionary scalping using a small time frame such as the 5-minute chart, particularly if there is an emotional, gap open. 1-2 trades allowed.
- After the first hour: No more discretionary trading. Apply the TrueBlue Trading System to a tick chart with a 21-bar ATR of at least $150. Do not worry if it is larger, since the position size calculator will reduce the number of contracts. 1-2 trades.
The System Settings
The holy grail of intraday trading is to get on board and ride a trend day, but while there are as many opinions about how to identify one as there are traders, it might be best to think about it in a probabilistic way. If we are consistent in our efforts, we will be on board them all, so just stick to the program.
Be sure the computer is set on Eastern time. We are interested in a move that happens in the afternoon that goes into the close. We tell the system to take trades after 2PM Eastern and stop trading at 4PM Eastern.
OwnCapital = 50,000
PercentOwnCapital = 20 (4:1 leverage)
StopFactor = 1
ShortFactor = 1
TimeEnter = 1400
TimeExit = 1600
That’s it, and as usual, the key is in dealing with the logistics of trading: trade small, without excessive use of leverage. Make sure the range is large enough that we know the market is actually moving. If the range expands, the system will reduce size accordingly.
The Power of Compounding
The market is here to help us compound our money. At the beginning, it is slow. $500 here and there seems insignificant, but consider this, from Fortune’s Formula:
On one of his visits to the Shannon’s home, Ed Thorp saw an equation on a blackboard in the study. It read:
211 = 2048 Thorp asked what it meant. Both Claude and Betty turned silent. After a moment’s hesitation, they explained that they had been trading hot new stock issues. They had been doubling their money about every month. They were figuring how much money they would have. Every dollar invested would turn into $2,048 after eleven doublings.
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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 lin