3/27/2008

Probabilities

We have paraphrased some of Mark Douglas's work here but the ideas are all his. The subject of probabilities must be understood along side expectancy as Chuck Branscomb aptly states.

“At the heart of all trading is the simplest of all concepts—that the bottom-line results must show a positive mathematical expectation in order for the trading method to be profitable.”

Once you have demonstrated your system has a positive expectancy (your edge) you then must allow the probabilities play out with out any deviance from the trade plan.

“What casino owners and the best traders understand that the typical trader finds difficult to grasp is: Events that have probable outcomes can produce consistent results if you get the odds in your favor and there is a large enough sample size.”

“The successful trader understands that each individual trade is independent of every other trade; each trade is a unique event where the outcome is random. If you focus on each trade individually there will be a random unpredictable distribution between wining and losing trades. However on a collective basis the exact opposite is true. If a large enough number of trades are tracked patterns will emerge that produce a consistent, predictable and statistically reliable outcome.”

“A casino owner knows that they have a 4.5% edge over the player in the game of blackjack. They know this based on a sample size of games played in the hundreds of millions. This means that the casino will generate 4.5 cents profit on every dollar wagered on the game. This average of 4.5 cents includes all the big winners, all the big losers, and all the people in-between. The casino owner does not get upset if someone wins a lot of money in one game (random micro event) as they know that over the long run (macro event) based on their statistical data base the probabilities are in their favor and they will be profitable.”
“When you’ve trained your mind to think in probabilities it means you have fully accepted all the possibilities with no internal resistance or conflict. Thinking this way is virtually impossible unless you’ve done the mental work necessary to “let go” of the need to know what is going to happen next or the need to be right on each trade. In fact the degree by which you think you know, assume you know, or in any way need to know what is going to happen next, is equal to the degree to which you will fail as a trader”.

Mark Douglas, Trading in the Zone

The successful trader must not allow themselves to live and die with each individual trade, day, or week. Your own trading database is your macro edge and that is the only statistic that you should focus on throughout the weeks and months of the current trading year. It is difficult not to live in the moment of each trade or each day and if the trader cannot remove themselves from these random micro events they will not be able to stick to the trading plan in order to see if it truly does provide the edge that the successful trader requires.

If a casino owner loses a large amount of money to one blackjack player they do not suddenly change the rules of the game in hope of doing better against the next player.

The trader must remind themselves at all times that they are running a business and it should always be treated as such.

3/26/2008

Floor Trading

The evolution of commodity trading is moving from the organized kaos of the open outcry system of price discovery to the electronic trading platform that we utilize.

The floor trading is fun to watch though.

Money Management

“The best traders are not right more than they are wrong. They are better at getting right when they are wrong.” Lloyd Blankfein, CEO Goldman Sachs

If there is a “holy grail” in trading it is money management. Most traders spend all their time looking for the holy grail of technical indicators which will magically tell them when to enter trades with profitable results. Such an indicator does not, nor will it ever, exist.
Our trading plan must have a positive expectancy or it will ultimately fail. We track and review expectancy by monitoring our risk reward ratio, average trade result, and the plans expectancy as calculated by the Dr. Van Tharp methodology.

The basic theme of money management for traders is to cut your losers quickly and let your winners run. This is true for intraday, swing, and long term trading. To do this with intraday trading is probably the hardest as the trader is programmed to act quickly. The quick stop loss exit is fine; the quick profit exit is deadly.

So the “holy grail” then is to find the right parameters for exiting the trade, not entering the trade. There are many good systems (indicators) to get you into a position; the hard part is the exit. We have determined 3 possible exits for our trade plan, the hard stop, the break even stop, and the profit stop. The way we handle these 3 exits will determine the profitability of the system. The hard stop must be small enough to cut the loser quickly but large enough to give the trade “room”. The break even stop must save against reversal but also give the trade room to oscillate. The profit stop must allow that same oscillation, not giving back huge MFE while also letting the winner run.

All the exit possibilities run on a fine line that cannot be broken by the trader’s emotional responses. They require thorough statistical analysis in order to find that line and determine when the line moves in order to respond appropriately.

Hard Stop

The hard stop provides the trader with the first half of the money management holy grail; cut your losers quickly.

If you cannot take and accept stop losses you cannot be a trader. Stop losses are best viewed as business expenses rather than money lost. All businesses have expenses and in the trading business this will be your largest expense. Therefore like any business that expense must be managed and constantly evaluated for ways to reduce it. Stop losses have also been described as an inventory purchase, when you take a loss it is like buying inventory (cost of goods) and when you have a winning trade you have then sold that inventory for a profit. These analogies only work if your wins are larger than your losses. You can’t buy widgets for $2.00 and sell them for $1.00 and expect to stay in business.

The hard stop value is set as a % of the range bar we are trading. We are currently using 75% of the range bar as our hard stop. With a 16 tick range bar our hard stop would be 12 ticks. This allows some heat in the trade but as we are trading momentum we expect the trade to move our way quickly. If it is not moving our way we do not want to be in the position and the hard stop will take us out. This stop is set with our front end and requires no action on our part after the trade has been entered.

We never increase this stop once the trade is in place and will tighten the stop with 1 bar completed after entry to 1 tick below / above the low / high of the move after entry.

Break Even Stop

This stop is in place as a precaution against the momentum working for us for a short period and then reversing against us. As we do not know which trades will ultimately work for us we have to enter all that meet our parameters and we know a % of these will move our way and then reverse on us. The break even stop protects capital against a reversal in the trade.

The BE stop also provides us “emotional capital” to help us stay in a winning trade longer as we know that after we move the stop to BE we can no longer lose money on this trade. We move our stop to BE + 1 (the 1 tick pays the commission) after we have had the equivalent of the range bar being traded in positive ticks in the trade. For example with a 16 tick range bar we move to BE + 1 after 16 MFE (maximum favorable excursion) in the
trade. This stop is set with our front end and requires no action on our part.

Profit Stop

The profit stop provides the trader with the second half of the money management holy grail; let your winners run.

Only in trading could a profit make you feel bad. Even with money in the bank the trader will look back on the trade and ask could he have made more money if he had held longer or exited quicker. In our experience the profit stop is the most difficult and perhaps the most important decision in the business. We have tested several different profit exits and continually track different exit potentials. We have found that a technical indicator exit will provide the most positive ticks in the long run. Other traders utilize targets for exits and this can provide better results over a short time period. The problem with a target is it will miss the “whale”, the one trade that runs $1000 or more. These big winning trades don’t occur that often but provide the trader with the bulk of their profits in the long run.

We do believe that a multi contract system with one contract coming off at a target and the other allowed to run to a technical exit is probably the best of both worlds.

The best results we have seen to date is the ADX momentum reversal exit. We also begin trailing the profit stop at 50 MFE and this is done automatically by the front end.

Strategic Concepts & Beliefs

Capital is scarce.
Don’t fight the tape.
The trend is your friend.
Trade what you see not what you think.
Stops are not losses, they are business expenses.
A person’s beliefs are always revealed by their actions.

We believe that markets move in waves based on fear and greed. We cannot anticipate these waves and will not try to. We will instead recognize when one of these waves has begun and join in as the wave moves up or down. This type of trading is known as trend following.

We believe that markets form patterns that can be identified on a historical basis and this information can be projected onto the right hand side of the chart to provide an indication of the strength in the trend and the speed at which it is occurring.

We believe that money management not technical analysis is the key to success in the trading business. By researching, building, and tracking a trading program we can overcome the human emotions that derail most traders. This data base of statistics will have to prove the system from a numerical basis in order to provide us the emotional intelligence required to stay in this business.

Human emotions in this business are derived from the very core fight or flight instincts that are programmed into us all. We must control these emotions in order to rise above the trading herd that is heading down the path to financial ruin.

Again, our trading plan backed up by our statistical database provides us the emotional capital required to allow us to preserve and grow our financial capital.

“Truth will be truth, regardless of a closed mind, ignorance, or the refusal to believe.”

Napoleon Hill, Think and Grow Rich

3/24/2008

Trader Psychology

Some thoughts from our business plan on the psychology of trading.

I highly recommend Trading in the Zone by Mark Douglas and Enhancing Trader Performance by Brett Steenbarger.

“We’re trading mob psychology. We’re not trading corn, soybeans, or S & Ps. We’re trading numbers.” Tom Willis

“To follow the good principals and not let fear, greed, and hope interfere with your trading is tough. You’re swimming upstream against human nature.” Richard Dennis

“A trader who trades differentially because of swings in confidence is focusing on his or her own past rather than on current realities.” William Eckhardt

The human brain is a complex instrument with many years of programming implemented well before any security trading takes place. This programming is typically not wired for trading success. We humans wish to avoid pain at all costs and take pleasure whenever we see it. We therefore naturally avoid the “pain” of losses by ignoring them or hoping they reverse and become profit. This leads to disaster quickly. We also seek the pleasure of profit by grabbing it the minute we see any positive results. Delaying gratification is not a natural human instinct and has to be a learned attribute.

These natural impulses must be addressed in order to meet the minimum requirements for successful trading which are, cutting your losses immediately and letting your profits run.

In order to achieve the desired trading results we must use the knowledge we gain from other successful traders, our own good and bad trading experiences, and then build a system that will override our pre programmed money psychology and allow us to trade successfully. With that system in place prior to trading we then have to insure while trading no deviation occurs from the plan. In other words use our brain in the pre trading calm to develop a trading system that we can rely on when we put money at risk and our emotions come into play.

This is the essence of the trading business and our ability to develop and follow such a plan will be the determining factor in the success or failure of the business.

Understanding how we handle stress and our ability to manage the emotions that occur in trading is critical to succeed. Attitude plays an important role in trading as a negative bias will manifest itself in negative results. We must be able to recognize our current state of mind and if unable to “repair” it during the trading day, trading for that day should stop.

“Good moods, while they last, enhance the ability to think flexibly and with more complexity, thus making it easier to find solutions to problems, whether intellectual or interpersonal. This suggests that one way to help someone think through a problem is to tell them a joke. Laughing, like elation, seems to help people think more broadly and associate more freely, noticing relationships that might have eluded them otherwise – a mental skill important not just in creativity, but in recognizing complex relationships and foreseeing the consequences of a given decision”.

Daniel Goleman, Emotional Intelligence