Thinking ‘Three Moves Ahead’ III

In Chapter Four of Three Moves Ahead, Bob Rice deals with the issue of time. He starts with the sentence: “Run out of time, and you lose. It’s the same in business and chess”. He could have added “and in trading”.

Pete Steidlmayer taught me that the greatest enemy to keeping losses small is trade location and time. I’ll consider trade location another day. For now, let’s focus on time.

In the trading world, we are usually taught to buy (or sell) breakouts and to protect the position with a price stop. While I do place a stop at a price beyond which I am not prepared to accept further losses, this is not my main exit tool. I exit using an assessment of the price structure and a time stop based on that time structure. In this way, I keep my losses down. Let me give you an example.

April is proving to be an ebb month – most of what I have done has resulted in a loss. In addition, even the profitable trades have only been marginal i.e. the profits occurred not because the market hit my price targets but because the trade management got me out with a profit. Had I not exited, those trades would have been losers.

So far, including two open positions, I have taken 15 trades for 10 losses. My total loss for the month (if my open trade stops were to be hit would be (2.7%)). If we exclude the open positions, my closed out losses amount to (1.19%). Of the trades closed out, only one trade would not have resulted in a stop being hit i.e. of the 10 losing trades, one would be open and no loss would have resulted.

My normal size stops average 1.5% of capital; but because I decided early that I was in an ebb state, I reduced my position size by 50%. So, in 10 losing trades, I should have lost 7.5% (10 x 1/2 x 1.5%). My profits have been 0.53%. So, without early exit, my CLOSED OUT net losses would have been about 7% (7.5 – 0.53%) – rather than 1.19%.

So early exit has made a big difference.

The key to early exit lies in assessing:

  1. what the market has to look like to stay in the trade
  2. what the market has to look like to exit the trade and
  3. whether the move against you is rotational or one-timeframe. If one timeframe, market exit is the key. If rotationa, the key is to assess an area (usually the point of control) to which the market will return to exit. Note that my entry price is irrelevant. The market neither knows or cares where you entered, it only knows its structure. Too many traders exit positions based on their entry. They should instead be looking at their exit relative to their risk.

Let’s turn to an example.

It looks as though the ES will open at 1403.75 and let’s say tonight I sell the ES leaning against the 60-minute open-gap rule, this setup carries certain setup assumptions and certain follow through ones.

  • My initial stop would be above 1426.75, basis June. (Above the maximum extension of my structure 1397.5 high, 1258 low)
  • In the first 60-minutes, the market should cover the open-gap i.e. if we open at 1403.50, we should see 1397 in the first 60 minutes. Because the market opens above Friday’s value area, there is only a 40% probability of a trend day down. Hence I’d be watching the volume configuration at 1397 to assess the type of market the day is bringing. If it is rotational, I’ll exit part of my positions (1/2) at around 1397 to 1395. I’d bring my stops above the highs of the day or 1406.75 whichever is the higher.
  • If the volume suggests a one-time frame day, I’d hold all my positions and have stops at scale out levels in case the one-time down reverses up.
  • At the end of the day, I need to see a close below 1384. If we close with a bearish candle but above 1384, I’d exit 50% of the position.
  • If the market fails to close the open-gap in the 1st 60 minutes, I’d exit the short position and re-assess. This would include whether to go long.

By asking the 3 questions daily, I find that the initial monitoring phase allows me to exit at a lower cost than the initial stop.

More on time tomorrow.

Thinking ‘Three Moves Ahead’ II

I have to give a presentation tonight so I am posting early.

Yesterday I suggested certain questions we ought to ask ourselves before we take a trade. Today I’d like to take the preparation, ‘the opening move’, one step further.

The questions help the analysis for the trading plan and for the risk management plan. They don’t apply to scalpers and perhaps some of the very short term traders (1 to 3 minute charts) – simply because this group trades predominantly on feel rather than cognitive considerations. For other timeframe traders, the questions satisfy our cognitive requirements prior to a trade. They are asked after determining whether to be long or short and for what instrument.

But that’s only one step of the preparation.

The second step engages our creative/emotional side. I ask my students to visualize:

  • the execution of the entry (including size) and
  • the execution of the exit strategies: initial stop, subsequent management and successful conclusion. By this I mean that we ‘see’ a successful end to the trade – where we exit our core profit at our target. We also see ‘what the trade has to look like to remain in the trade’ etc; we also see the trade proving to be a failure – we ‘see’ the initial stop being hit and we ‘see’ occurring the conditions we ‘need to exit the trade’.

It is important that we accept the profits and losses as planned. I believe the reason why most traders fail to place stop losses in the market is because they subconsciously carry an image of the stop being and only to have the market resume moving in our direction.

But, if we change that image to one where after the stop is hit, the market moves against us big time, we are probably going to ensure the stop is in. Some of you may recall the trauma suffered by the High Probability Trader in the Societe Generale induced meltdown. He kept looking for a rally that never came and had to close the account. If you saw the video, use his image to spur you on ensuring you place a stop – ‘see the market continue to move against you after the stop is hit’.
Let me say this again: it’s that important.

Behind the physical act of placing the stop, is the psychological acceptance of the loss. If you approach position sizing in the same way I suggested in the previous blogs, you’ll automatically include an assessment of the risk for the trade. If you use another approach, I recommend you add a risk:reward assessment to the preparation. Once you know risk, it’s important you accept the risk as a loss. In my own trading, I use Ed Sekoyta’s suggestion to treat the loss as already having been incurred. If you believe this ‘story’, acceptance is a fait accompli since it ‘has already happened’.

Tomorrow we’ll proceed to the role of time in trading decisions.

Thinking ‘Three Moves Ahead’

Before I start today’s blog, I’d like to turn to a question Manish Shah, <manish.shah@centrum.co.in>, asked. By the way, I’d be grateful if questions are posted to the blog – that way, all benefit. Here’s the question:

I want to ask you a small question. I am not an out an out mechanical trader. But I have a few standard setups that I watch consistently. But there is always a discretion that is attached to the analysis. Is it okay to have part mechanical and part discretionary approach or you advocate a pure mechanical approach. Secondly which markets do you trade/track..

A Q1: Ayn Rand (http://www.aynrand.org/site/PageServer?pagename=about_ayn_rand_aynrand_biography) ‘taught’ me an axiom that has served me to great stead: words are capable of precise meanings.

I believe that there is a conceptual error that leads to great confusion – the belief that traders are either mechanical or discretionary. In fact there are three types of traders: mechanical, discretionary and subjective (sometimes also called intuitive).

  1. A mechanical trader is one that ALWAYS follows the trading rules without exception.
  2. A discretionary trader is one that has rules among which is a rule that says: “I need not follow my rules”. This allows a discretionary input.
  3. A subjective trader is one that has no rules and trades purely by feel. Most successful pit traders I have met are/were subjective traders. Nowadays, this group is probably represented by the electronic scalpers. I say probably because to date, I have no direct experience to base this assessment.

So, in your case, I assess you as a discretionary trader and of course it’s OK. On whether or not I advocate being a mechanical trader: I believe the mode you ultimately choose is a function of your personality. I would add this: whatever your personality, in your training period, spending a time (even if it is a short one) as a mechanical trader will teach you discipline.

AQ2: I trade Futures: Stock Index, Interest Rate, Soybeans, Gold and Crude Oil

FX: The majors and AUDUSD, USDCAD, GBPJPY

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Now to tonight’s blog.

I love to read. Often I find ideas that benefit my trading in works from different fields. I have just completed such a volume: “Three Moves Ahead – What Chess Can Teach You About BUSINESS (Even if You’ve Never Played)”, Bob Rice. So for the next series, I’ll adapt some of the chapters and see how they relate to trading.

In one of his early chapters Rice argues that the ‘goal of a chess or business opening is to create a difference you can exploit later in the game’. I believe the same can be said about trading. What are the important first considerations in trading?

  • Probability of Success of the setup?
  • Normal size?
  • Will the Ebb and Flow affect the normal size?
  • At what price does the scenario break down?
  • What has to happen to remain in the trade?
  • What has to happen to exit the trade?

By developing the ideas ahead of a trade, we prepare for it. In this way, we avoid the trials of impulse trading.

Trading and New Experiences

I like to think that I love to try new experiences, especially if it comes to trading. Hence my willingness to try the course by Pride Educators (http://www.tradewithpride.com/) and my testing of Dynamic Trading Bars (http://www.trade2win.com/store/dynamic-trading-bars-p141.html). Sometimes I read a book/books for the sheer joy of viewing an event from a different perspective.

I have to admit, however, that in this field of new experiences, I more than met my match in a student and friend, Ms Ana Wang. She has packed enough experiences to last two lifetimes (www.anatrader.com).

Last year she dragged me kicking and screaming into participating in a trading competition. In my 30-years as a trader, I had never entered a trading competition. Partially because I feel that winning a comp requires different risk management skills to long-term success and partially because…well I was afraid. What if I did poorly in public? Horrors!

Ana would have none of it. She said she needed only a hand with the position sizing – she’d take care of the rest. Well those that know Ana will know just how hard it is to refuse her once she makes up her mind. So in we went and ran second in an exciting competition. She was beaten on the last day by a little under 2% – after having led for much of the second half.

daniels.jpg

Daniels Results

I loved the experience and while it is unlikely I’d do it again, I am more than glad to have taken part.

Last month, Ana was at it again. She started an advisory newsletter on trading. Again this is an area I refuse to venture into. While I think that it’s a legitimate source of assistance, its main drawback is that subscribers tend to heed entry suggestions and ignore position sizing and trade management advices (at least that’s what I did in my losing years).

As usual, Ana will have none of it. She started the newsletter (www.awanginvest.com) and has just ended a 2-week free trial for RSS subscribers.

What does this have to do with trading?

Like Charlie Munger, I believe trading is enhanced by a willingness to expand our horizons beyond our comfort zones. Most times, most of us rationalize our failure to move beyond our comfort limits and then bemoan that our lives are not as rich as we would have liked.

I believe that in trading, as in life, the greater our range of experiences and the more we learn from them, the richer our lives become. Ana would never forgive me if I revealed her age. But her willingness to venture forth, at an age when conservatism is said to be the norm, would put the younger generation to shame.

The Mental State for Scenario Planning

One of the critical mental states for Scenario Planning is the ability to hold competing ideas at the same time without having to resolve the discordance. Among my mentor students, this lesson is one of the hardest to learn. I believe this is because humans are wired with two traits:

  1. Hindsight bias and
  2. The need to resolve apparent conflicts – cognitive dissonance

Hindsight bias leads us to believe that ‘we ought to have seen that coming’ (but often it’s obvious only after it has occurred) and cognitive dissonance leads us to ignore information that is inconsistent with a held view. In a recent book, ‘The Opposable Mind’, Roger Martin argues that the most successful leaders are the ones who practice integrative thinking. He defines this as ‘the ability to hold two opposing ideas at once and then reach a synthesis that contains elements of both but improves on each’.

While the synthesis aspect may not be available to a trader – if we are trading directionally, we’ll be either long or short – by holding opposing ideas and by constantly looking for clues that confirm or deny a scenario, we become better traders and risk managers.

The ability to do this allows me to deal with the issues raised in Derrick’s question: How would I deal with a close above 1416 and a fall to 1253?

If this question were posed by one of my students, I’d say there were certain assumptions she’d have to challenge:

  1. The first is the need for certainty. A trade we take is based on our belief that the probabilities favour a successful result. But any trade we take can move against us. Most times a student needs to deal with the unconscious belief that his model of reality is reality i.e. whatever he believes will happen must happen. The result of this belief is a block against thinking in probabilities.
  2. The second I raised above – the blocking of information (rather than acceptance) that is contrary to the original assessment.

Scenario Planning trading requires just the opposite. We accept the discomfort of holding two opposing ideas; we accept the probability of loss; we accept that we’ll sometimes act in a less disciplined manner (while constantly seeking to improve discipline). Doing this allows us to form a high probability view and then constantly review market information to confirm or deny the views: our original view and an opposing one.

This means that the probability of success is constantly undergoing reassessment. If at any point during a trade, we assess the probability no longer favours, we need to exit the trade or at least tighten our trailing stops. Then, we need to accept the consequences of our actions. Sometimes, we’d have been better off not exiting or tightening our trailing stops. But if we do it right, most times, we’ll be better off taking the action.

So, Derrick, a short answer to your question: I would handle that situation in the same way I handle all trades. Before entering, and during a trade, I ask:

  • What do I have to see to remain in the trade?
  • What do I have to see to exit the trade?

The answers to these questions would involve price points as well as structural benchmarks.

The Paradigm of Success

Nowadays, there is a tendency among trading coaches to diminish areas outside the province of their expertise: those who specialize in psychology will claim this is the most important; those that deal with money management stress its critical role; others focus on the having of a written plan with an edge.

One reason I like Dr. Brett Steenbarger’s material is he stresses that often traders fail because they lack a coherent plan or because they fail to keep metrics of their results (TraderFeed) – and his area of expertise is psychology.

It seems to me that newbies fail to appreciate the nuances of the relationship between psychology, money management and trading plan. In this post, I am seeking to approach the subject from a different angle to describe the essential connections between the three.

Figure 1 is the Paradigm of Success.

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FIGURE 1 Paradigm of Success

Success starts with the centre and the centre gives birth to the rectangle and the circle. The more we radiate away from the centre, the greater importance the factor plays in our trading success; at the same time, the closer we get to the centre, the more primary a role the factor plays.

On this view, the written trading plan plays the foundational role to our success. Unless it has an edge and unless it provides us with robust (i.e. repeatable over instruments and market conditions) entry & exit signals, psychology and money management have no role to play.

The plan gives birth to Risk Management: money management and trade management. Money management decided such issues as risk per trade, position size, portfolio risk, when to make our profits available for trading and when to reduce our capital because of losses. Trade management protects our open profits while allowing room for the market to fluctuate as it moves in our favour. I have suggested that the primary tool of trade management is the initial risk.

Risk management depends on our analysing the metrics of our trading plan. For example, knowing the plan’s Maximum Adverse Excursion; knowing the plan’s Maximum Favourable Excursion; knowing the plan’s Expectancy Return. Once the plan produces the data, Risk Management takes over to balance the maximization of profitability with minimizing Risk of Ruin. You can have the best trading plan in the world but it takes one breach of our risk management to send us bankrupt.

The circle surrounding the Plan and Risk Management is Winning Psychology. In my view, the chief function of Winning Psychology is the consistent execution of our trading plan and our Risk Management. A secondary role is to learn from our successes and failures. No matter how much of an edge our trading plan has and no matter how effectively our risk management rules optimize profitability, unless we execute both consistently they will be unable to produce their promised results.

Why 95% of Traders Lose and What You Must Do

I have just finished Noble Derakoln’s “Winning the Trading Game, Why 95% of Traders LOSE etc”.

I like it in parts – the best was the section describing the path losing traders follow. I’ll start this series by setting the stage using Derakoln’s description (page 70).

Beginning with Happiness: For some reason, most newbie traders I have met start off with a series of winning trades – certainly this was my experience. Nothing feels better! Put a position on and whamo! Profits by the bucket load! Why didn’t I discover this sooner? I must be the world’s greatest trader!

Next Comes Greed: Now we start to overtrade and start to create fantasies of untold wealth. Then, sooner or later, the deck of cards come crashing down. Somehow we get into a trade that was way too big; somehow we failed to take profits (“not worth my while”); or somehow, we failed to exit at breakeven (I knew I should have got out when I had the chance). Now we are praying: “Dear God, please let me just breakeven – I’ll even accept a small loss!

Followed by Fear: Now we really start to fret. We look for news, magazine items, books anything and everything that will provide some solace to the deepening horror of imagined greater losses to come. By imagining future losses, we find the current loss easier to bear. It allows us to ignore the reality of the meaning of the actual losses. We can pretend that soon, very soon, the market will go in our favour and then the pain will stop. But as the losses mount, panic finally sets in and eventually either we run out of margin funds or the pain of losing is so great that we exit.

Which Leads to Sorrow: The loss was an aberration – ‘the method was good, I only have to find a way to avoid losing trades!” “After all ..the market just turned around. It was a shakeout, I just didn’t have the courage of my convictions (my stop was too close)” etc. All I need do is study and find a solution to the pesky problem of losses.

Frustration: The problem is no matter how much we study, the problem of losses remain. We find that in just one trade, we lose months of profits; worse still, we lose all our capital in just one trade. And, we find that this loss of all our capital happens more than once. “It’s not our fault. I returned 1000% my original capital in just one month! I must be a good trader! It’s all the broker’s fault – it’s Ray’s fault (he’s hiding his good stuff) – it’s the market’s fault; it keeps finding Black Swan aberrations! etc etc.

Defeat: We come to feel that we’ll never be winners. The seminar we attended (book we read) was a load of xxxxx. ‘The author makes all his money teaching (writing) – no wonder he said it would take 3 years to be successful’. Then a new ‘get, rich, system (software)’ flyer arrives and the cycle starts again.

Until I read the pages in Drakoln’s book, I couldn’t understand why I had been unable (at least to the extent that I wanted to) to have newbies accept that success comes from:

Winning Psychology (60%) x Effective Money Management (30%) x Written Plan with an Edge = Success

Even though the multiplication sign between each factor meant that we need all three to succeed, most newbies I struck at Expos, ATIC (see http://www.theatic.net/2008/about_atic.php) etc failed to break the Drakolyn’s cycle.

Today, I realized that I needed to present the material differently. So folks, wait for it! Tomorrow, I’ll introduce the Paradigm of Success.

Success Depends on Knowing Your Outcome

The Asian Traders Investment Convention (ATIC) held in Singapore over the weekend drove home to me how important it is to our success that we clearly identify the outcome we want and the reasons for the outcome.

In Singapore, I hold one seminar a year. The aim of the seminar was always to provide an educational service that would allow newbies an avenue to take that first step to trading success.

My experience with the mentor program suggested that providing a free service was not the way to go. Not a single ‘sponsored’ (i.e. free course) student has ever graduated – perhaps one day. So, when I first ran seminars in Singapore, I charged the going rate and taught the areas I had the best knowledge: The Barros Swing, the Market Profile and the Ray Wave. Cost per head ranged from S$2,800 to S$3,500. But because overheads and cost of acquisition were so high, I normally lost a little money on the events.

The loss didn’t worry me; but what did cause concern was the fact that I did not achieve my outcome: the seminar made little difference to most of the attendees. So, they not only wasted my time, they wasted their time and their tuition fees.

So I went back to the drawing board and designed a 2-day course that focused on a quantitative journal keeping approach to identify the impulse trades; a simple position sizing approach and a plan based on Cutler’s use of the RSI – I did make a tweak here and there. Back-testing shows the plan will make a profit of around 10% to 12% with low drawdowns.

The outcome I want from the seminar is to teach the attendees to execute consistently their plan with proper position sizing. Once they attain this, they can expand their knowledge and improve their plan.

Since previously I had lost around S$5k per event, I planned my budget around that and came up with a fee of S$400.00 per attendee. If no one attended, my maximum loss was S$4000.00. All in all, a win-win situation: in my worst-case scenario, I’d lose less and the attendees had an inexpensive leg-in to success.

The trial seminar last year went well – around 63% of the trial class is making a small but consistent return. They are now ready to move on and expand their knowledge of the markets.

This year we launched the seminar at ATIC and I succeeded in niggling everyone around me:

  1. Understandably, I niggled my friends and fellow educators who were promoting their own S$3K seminars.
  2. I also niggled my wife and Ana Wang who work tirelessly on my behalf – they feel that the I am ‘selling’ my services too cheaply.
  3. But surprisingly, I niggled some ATIC attendees who were overheard to remark: ‘so cheap, must be no good!” And “Why does he think he is so good?”

The point is: unless you have a firm idea of the outcome you want, it would be difficult to maintain a sense of purpose. In this case to provide the attendees with a solid platform for future success preferably, at no financial cost to me. Whatever others may think of the idea, this is the vision I have.

What does this have to do with trading?

You need to know why you trade – this is part of the Vision and Goal aspects of the trading plan. And when setting the Vision, it’s not enough to quantify the dollars you want out of trading. Another Dr. George Lianos quip: ‘money is never just about money; sex is never just about sex”. What he meant was we need to look beyond the obvious: what does the dollar return mean to you?

Security, love, appreciation? And so the list continues.

By identifying the emotional premise for trading, we are on our way to identify what Denise Shull calls ‘the echoes of perception’ – the unconscious motivations formed in our youth that govern our lives today. By forming a well-formed outcome, we achieve two things:

  1. A standard by which to measure our behaviour and
  2. By understanding the underlying reasons for our outcomes, we ensure that they align with our values and in the process discover, and thus manage, our unconscious motivations. By uncovering them, we find that consistent execution of our plan becomes more a habit than a chore.

Two Missing Igredients for Success

In today’s blog, I’ll be considering two practices followed by professionals that are usually ignored by retail traders.

The first one is the ability to hold, at the same time, two or more competing ideas on the basis that both are equally valid. In my mentor program’s trading training section. I start with a rule-based approach, as mechanical as the student’s personality will allow. The outcome I seek is to ensure the trader learns ‘to see a trade, take a trade’ and to ‘trade what he sees, rather than what he’d like to see’.

As a trader evolves and becomes a more experienced discretionary trader, he understands that at any given moment, the market can do one of three things: move up, move down or move sideways. He takes all competing information, organises it as best he can and concludes if he will or will not take a trade; if the former, at what price to enter, place a stop etc. He does this without falling into cognitive dissonance.

Cognitive Dissonance theory says that we have a tendency to seek consistency among our beliefs and/or our sensory data or other beliefs. In the case of sensory data, we tend to either change the data to suit our beliefs or change the beliefs to suit the data. In trading, I think a better way is to hold the competing ideas as being equally valid and to then to organise the data as one or more of the possible market behaviours: up, down or sideways. Based on this organization, we come to a trading decision.

Let’s use the current ES as an example. I hold the view that the 18-d (monthly trend) and 13-w (quarterly trend) are in a start of a downtrend; and the 12-M (yearly trend) needs to complete an Upthrust Change in Trend pattern by giving a bearish bar close in February. Now, that’s what I call a bearish mindset!

But, here’s the thing. On Friday, the ES had a bearish setup for the 80-min 5-period swing (1d i.e. Daily trend) – see “A Surprise or Unexpected Event“. The Gann idea I call, ‘the 4th Time Thru’, is a very reliable pattern. If the market is as bearish as I believed, then I’d have expected the ES to breakdown on Friday following the breach of 1337 (basis March). While the ES did move lower, it did so sluggishly. When I went to bed, I was expecting to awaken to see new lows made, with a close near the lows – much like the price action yesterday (except yesterday I was looking for an close).

When on Thursday I analysed the ES, I had to be able to hold two conflicting ideas: the market was bearish, and therefore it should break 1337 and close down. If it was bullish, or at least not as bearish as I believed, then the downside breakout would fail and the market would reverse. In that case, I had to consider if I wanted to be long. I decided I did.

I decided this because if the market reversed then:

  • The minimum target would be 1373 to 1378 and there probably would be a retest of the breakdown zone 1397 to 1400. And
  • If the market did fail on the fourth attempt down, the underlying market trend may be up despite my tools. In other words, the market behaviour and my belief that the trend is down are at odds. In that situation, I am better off deciding on a course of action considering the market’s behaviour rather than closing my mind to the contradictory information.
  • I hold this view despite the fact that I believe the Ambac rescue package will not change the bear trend i.e. the news that pushed prices up on Friday are a ‘surprise event, rather than an ‘unexpected event’ (“A Surprise or Unexpected Event“)

Too often the course taken by traders is to block out the information that fails to support their view; in other words to pursue what I call myopia. Unfortunately for us, many times the market rewards myopia until one day… until the day she decides there a lesson to be taught. On that day, the learning is painful.

A good, and tragic, example of this is the ‘High Probability Trader’s’ experience on ‘Soc Gen Day’.

So that’s one trait. The second trait is the unfailing use by professionals of their monthly (or weekly reports or quarterly reports). Certainly one weekend a month I pore over my psychology and equity stats to look for patterns of behaviour that positively or negatively impact my trading. If I see a large loss, or a series of losses, I look seek to identify the events that contributed to the losses. The same for profits.

Of all the ideas I teach, this one is the most honoured by its breach. I thought that perhaps it was because I asked students to do it manually rather than by Excel macro. So I asked someone to do it on the basis I’d sell it at my speaking engagements. He charged S200 (about US$150). Not what I’d call a fortune. Out of 60-odd members, 2 took up the offer. So doing it manually is not the answer.

I don’t know what the answer is, but I do know that your period’s benchmarks are critical to success.

———-

An aside: On Mar 1 & 2, I’ll be speaking at Singapore’s Asian Traders Investment Convention (ATIC) to be held at Suntec City. See
http://www.theatic.net/mailblast/sg_atic_2008.htm

This is a quality event for a very low price. In fact, you can even avoid the entry fee, S$18.00 (to the convention) by filling in the survey in the link above BEFORE February 28. I’ll be presenting new and unique ideas on managing impulse trades and position sizing. Note that for key note speakers there is a fee of S$30.00.

A Surprise or Unexpected Event

I wrote this piece for the WILKI (a meeting place for student and friends). I thought I’d post it here to illustrate:

a) The market can and will do anything. In my case, I did not stop and reverse. I prefer to see how the market behaves at a price rather than just place a straight stop (for entry or exit). I was tired my Saturday morning and went to bed 45 minutes before the close (4:00 am HK time; 3:00 PM EST). I had taken 1.5 normal size for a risk of around 1.0% with the stop at 1451.75.

I have to admit I also thought I was ‘safe’ on the shorts at 1343 and 1346. The market was trading at 1333 when I hit the sack. I placed stops at 1351 for the 1337 entries and 1357.75 for the others. BTW in the post below I said I missed getting stopped out by 2 points; I should have said 2 tics. I exited my remaining positions my Monday morning at 1457.75

b) Position sizing and risk control is everything in this game. No matter how confident, we’ll keep position sizes that risk minor damage to account should a black swan event occur.

I have made the original post on the ES setup available at: http://tradingsuccess.com/stc/

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Friday’s price action is the reason I am not a ‘pure’ technical trader in the sense of the maxim: ‘the charts tell all’. That’s true with hindsight but hindsight is not of much use when we are seeking to make money from the markets.

Technical traders trade off patterns that over a large sample size repeat; it is this trait that provides us with profitable opportunities. But, as Chaos theory shows, the market is subject to inflection shocks – shocks that can change the market’s dominant direction – what Tubbs, Wyckoff, Livermore etc called the path of least resistance and I call ‘the dominant trend’. Such shocks can ruin the best historical patterns.

Pete Steidlmayer anticipated Chaos theory when he taught that fundamental events can be classified into 3 categories:

a) Expected events: the news is in the market and correctly perceived by the traders. This results in a sideways market. Traders sell whenever the market moves above value and buy when it dips below.

b) Surprise events: essentially acts of God i.e. events that come out of the blue but are events that have no lasting impact. Price moves away from value and when the shock is over, prices return to value. In other words, we see a sharp, sudden correction against the trend; like all corrections, the trend resumes once the correction exhausts itself.
The price activity after Chernobyl is a good example.

c) Unexpected events: events known but their impact appreciated by few traders. The event has changed the dominant trend and value will lead price. For me, the sub-prime impact was such a key event.

(An aside: For those that believe the FED will get the US out of the current mess by lowering rates, the insights provided by Tim Morge should prove insightful: http://www.moneyshow.com/msc/investors/playerCust.asp?v=1388&scode=01080)

This brings me to the last hour of Friday’s price action because of a possible Ambac rescue package. The details have to be worked through and have to be announced . This is expected Monday or Tuesday. The deal may fall through but I doubt it. Unlike the Buffett offer, this deal will be important to all parties, so like the LTCM bailout, I think the parties will strike an arrangement.

Assuming that this eventuates, the question we have to ask ourselves is: is the deal a ‘surprise’ or an ‘unexpected’ event? I believe it is the former. The deal will assist Ambac but will do little to assuage the problems so brilliantly set out by Brussee. (Hence my review the other day). In other words, we can still expect to see a bear market develop.

So if you are short, like I am, ‘so how?’.

I can speak only for myself: On Friday, I sold against a Market Profile Test Opening at 1446, and 1443 for 2/3 size. The remaining 1/3 I sold at 1337. I was stopped out of the 37s by the late rally and I missed being stopped out of 40s by 2 points. So, now what will I do?

A: Exit first thing Monday morning (Singapore time).

Why? The reason for this trade is gone; my views on the Ambac deal are irrelevant for this trade.

If the deal falls through or the market breaks for whatever reason, then I look at a new trade. My job as a trader is to control my losses. I have learnt the hard way that sitting on a losing position (because of some view) is a sure way to the poor house. The loss if I exit on Monday at around 1455 will be about 1.5%, well within my loss parameters. But if I hold the position, who knows what the loss may be?

Sure, there may be no loss but if the rally continues, at what point do I cut and what will that cost me? Certainly more than 1.5%. Sure, I may fail to get back in on this new break. But, there is always another trade at another time in another instrument. I can always recover the 15 or so points per contract lost on this trade.