Routine and Habits II: The Business Plan

My starting point each September 1 (my year runs Sept 1 to Aug 31) is my business plan.  Since I treat trading as a business and we all know most, if not all successful businesses, have a business plan, I thought this the appropriate place to begin Success Routines and Habits.

I prepare my Business Plan in the first two weeks of September and I give priority to the task.  Below are my headings; they are far from being cast in stone and the same can be said for the plan. It’s reviewed and revised quarterly. The plan serves as a guide only. In the recent past, I can’t remember when I did not make some mid-stream correction.

HEADINGS:

  • Vision & Mission Statement. To me this is the crux of the document. What we want to become and why must align with our values otherwise all the plan will be is wallpaper and will be as much use.
  • Goals
  • Expenses
  • Projected Income
  • Trading Plan
  •    Rules
  •    Trading Timeframe
  •    Markets
  •    How do I know when plan is not working?
  •   When will I take an enforced break?
  • Risk Management Plan
  •    Position Sizing per trade
  •   Position Sizing Portfolio
  •   Initial Risk Exposure per trade
  •   Initial Risk Exposure Portfolio
  •   When and how to Pyramid.
  •   When and How to make Profits available to trading capital.
  •    Maximum Loss per trade
  • Ongoing education in Plan, Risk Management and Psychology
  •    Time Allocation
  •    Dollar Budget
  •    Areas to Focus on within each area (Plan, RM and Psy)
  • Focus and Review Plans
  •    Especially if there are important life-style changes e.g. changing jobs, having a child etc
  • Disaster and Contingency Plans

A few years ago I attended a seminar by Van Tharp (www.iitm.com; also his blog at: www.smarttraderblog.com) on Business Plans. At the end of the seminar, we all had to do a business plan. I have attached this as one of the better ones submitted to give you an idea of the form the plan can take.

businessplan.doc

Routines and Habits for Success I

I trust you all had a great Xmas!

Over the next few blogs, I’ll be considering the routines and habits we need for trading/investing success. In this post, I’ll be examining the pre-conditions that are necessary.

Routines and habits are actions. There are 5 pre-conditions to effective action:

  1. The quality of our preparation and planning
  2. The will to execute our plan
  3. Our willingness to act beyond our comfort zone
  4. The effectiveness of the review of our results: we seek to improve the results that lead to our goals; and we seek to change or replace the actions whose consequences lead away from our goals.

But effective action is only one half of the power equation. Actions are the direct result of the decisions we make. Our decisions are dependent on:

  • Our internal landscape: our experience, intelligence, attitudes, beliefs, and values.
  • Possessing certain values that are critical: honesty, integrity and accountability.
  • Our willingness to look behind our closed doors. We all have areas of our past that we’d rather not examine. But here’s the conundrum, to the extent that they remain hidden from our conscious minds will be the extent to which they control actions, usually with adverse consequences. So by having the courage and fortitude to endure the emotional pain that comes from such an exploration, we’ll achieve a self-awareness that leads to more effective action.

Armed with the pre-conditions, we’ll examine routines and habits from the 3 perspectives: Intellectual, Emotional/Psychological and Physical.

First in this series begins tomorrow when I look at one aspect in the Intellectual camp: the Business Plan

Richard Wyckoff III

I don’t usually post on weekends. But it’s Xmas so think of this as my Christmas present to you for your support. Merry Christmas and Thanks!

In this post I’ll conclude the Wyckoff series and suggest source materials in case you’d like to take your studies to another level.

Like Steidlmayer, Wyckoff’s work evolved over time – from his early days as a tape reader to the technical trader by the time of his death. Throughout his career there was one constant: principles mattered over patterns. Understand the principle, and you can adjust the pattern. As they say, history repeats itself but…never repeats in exactly the same way.

By the end of his career, Wyckoff had three main principles:

  • The Law of Supply & Demand
  • The Law of Cause & Effect
  • The Law of Effort and Result

Rather than have my take on what Wyckoff meant, read the information straight from the horse’s mouth. You can download the first 5 pages of the “Introduction to the Wyckoff Method of Stock Market Analysis” (published by the Stock Market Institute and including the charts) at http://www.tradingsuccess.com/pdf-pub/wyckoff.zip. ((For this, you need to thank my techie, O K Lee (real name) who was kind enough to work on a Sunday).

Principles are crucial to success. But to learn to apply the principles, we need a model of application.  So, by the time of his death, Wyckoff had also developed a model for trading changes in trend and trading continuation trades.

The best source of this model is the Stock Market Insitute in Arizona. The good news is they finally have a web site: http://wyckoffstockmarketinstitute.com/. The bad news is they no longer seem to carry the ‘Introduction to the Wyckoff Method of Stock Market Analysis’. Futures and FX traders needed only the Introduction; stock traders/investors would find the full course useful. It would certainly pay futures and FX traders to ask SMI if they still have the “Introduction….” for sale. If you do learn the model, always keep in mind Wyckoff’s comments about the importance of principles. Without understanding them, the model cannot be adapted when the trading environment changes.

Other sources:

  1. There is an excellent but incomplete summary in: The Three Skills of Top Trading: Behavioral Systems Building, Pattern Recognition, and Mental State Management (Wiley Trading) by Hank Pruden
  2. This book contains no theoretical explanations but contains some great practical applications: Timing the Trade: How Price and Volume Move Markets! by Tom O’Brien
  3. Stocks and Commodities has a series of articles by different authors. Go to the bookstore and search for Wyckoff: http://traders.com/

Tomorrow I’ll review the S&P recommendation I made on Friday.

Richard Wyckoff II

Yesterday I posed 3 problems that those using Wykcoff had to overcome:

  1. How do we define market direction?
  2. How do we determine whether volume for any given period is net selling or net buying?
  3. How do we overcome volume cyclical patterns (e.g the pattern in financial futures) or sessional patterns (e.g. the pattern found in intra-day ES data)?

The answers to the first two questions can be answered using Market Delta; the answer to the third question lies in normalized volume.

To answer the question how do we best determine market direction, we need to first consider what is the best indicator of acceptance of a given price? Remember there are no issues where the market makes a higher high, higher low and higher close. In this case, the market’s direction is ‘up’. It is where there is a discrepancy between the extremes and the close that problems arise e.g. a lower close with  higher highs and higher lows or where you have an outside day.

Our work confirms that the best indicator of direction is the Market Profile’s Point of Control. This is the mode of a day’s profile and represents the price where 70% of the trading has taken place. Figure 1 shows the idea for a 30 minute chart – you can use this idea for any timeframe.

blog-12-20-2007-poc.jpg

FIGURE 1 POC

Market Delta’s Delta Module will tell us if a time period’s volume is net buying or net selling. In Figure 2, the Figure below each time period’s range shows the difference between buying and selling volume.

blog-12-20-2007-md.jpg

FIGURE 2 Net Volume

To see how this works, take a look at the 3:00 PM bar. We made a higher high and higher low (lower close see FIGURE 3) on reduced net buying. The POC was slightly higher.  So the higher high was a fakeout and a sell signal – market direction up on low volume. Looking at the normalized volume chart we see a DOJI bar with normalized volume that was at least normal. The normalized volume is the grey coloured histogram. The green and red colours on the histogram represent the Delta relationships.

So the normalized volume chart shows the market moving higher on at least normal volume and smaller range – this is a signal of a possible reversal.

Wyckoff’s volume ideas are now mainstream technical analysis, for example:

  1. New highs or lows should be accompanied by normal to moderately higher volume.
  2. Excessive volume on new highs suggests a possible climax.
  3. Less than normal volume suggests a false breakout (fake out).

I define normal as being within 70% of the mode; moderately higher as being above the mode (effectively 70% + 12.5%) and excessively high as the rest of the volume above the mode. I use the same process as Steidlmayer when he calculates the Value Area.

One question I am always asked is: how do you calculate normalized volume?

It’s a bit of a pain. If you trade only the S&P, it’s much easier to subscribe to www.marketvolume.com. For other instruments, I work out a sample every 12 months for the next 12 months. The process for daily data:

  1. Start 2 weeks into the roll-over month and end on the last trading day before the roll-over month. For example, for March 08 active month, start in Jan 08 and end Feb 2008.
  2. Work out the average volume for every corresponding day of week e.g. all Monday’s in 2007 that meet condition 1.
  3. The averages represent your normalized volume for Monday, Tuesday etc.
  4. Make sure you align and average the major news event releases.

As I said, the calculation is a pain – which is the reason I outsource the work.

When I turned to analysing volume with market direction and range, I find that my bottom was considerably improved.

Outlook for ES Dec 21: Normalized Volume shows normal volume with a DOJI bar. If this occurred at an extreme, I’d look for a change of direction; but where it occurred yesterday, I would place little value on the DOJI. Market Delta shows normal BUYING volume with a lower POC. I interpret this as a poor attempt to head South. Hence I’d be looking for higher prices tonight.

Futures are calling ES 9 points higher. As long as the open-gap is no less than 4 points, the ideal buy scenario is a failure to close the gap in the 1st 90 mins. One buy setup would be to buy the breakout of the 90 minute range provided the 90 min range is not more than 15 points. The stop would be below the Volume POC (1465). This is the easiest scenario when writing because the parameters are so clear.

It’s not the one I’d prefer. My preferred buy setup is to look for a pullback into 50% of the gap and provided the volume at the 50% or so is below normal, I’d look to buy on a 5-min setup that takes place between the hour and 90 minutes.

Richard Wyckoff

In this post, I introduce Richard Wyckoff. Here’s how Wikipedia describes him (http://en.wikipedia.org/wiki/Richard_Wyckoff)

“Richard Demille Wyckoff (born November 2, 1873; died March 19, 1934) was a stock market authority, founder and onetime editor of the Magazine of Wall Street (founding it in 1907), and editor of Stock Market Technique……..”

But the write-up does little justice to a man who established a school of thought. Richard Wyckoff believed that understanding the context and principles of market movement was the path to success. His approach struck a responsive chord within me, fanning a spark that had been lit by Market Profile Theory. It’s strange how things work out – I came across Steidlmayer in 1980 and only later to Wyckoff’s (whose hey day was in the 1920’s). Yet the two works fit together like a seemless whole.

Many modern traders are unaware that Wyckoff”s approach was diametrically opposite to Richard Schabacker’s, the uncle of Robert Edwards (Edwards and Magee fame). Schabacker believed in the classification of patterns – the ‘why’ was less important than the ‘form’. I see Schabacker’s approach mirrored in many modern works. (For a write-up on Schabacker, see http://www.marketmasters.com.au/82.0.html)

Wyckoff opened my eyes to the relationship of:

  • Direction – which way is the market seeking to go?
  • Volume and range – how good a job is the market doing in moving in its desired direction.

Steidlmayer was later to call these factors ‘trade facilitation’.

Wyckoff’s idea behind ‘trade facilitation’ was simple: the effect (range) ought to mirror the cause (volume). If it failed to do this, the market was telling us that a new game was afoot. So, if we had above normal volume and below normal range, this was a warning of a possible change of direction.

While Wyckoff’s principles are easy enough to state, applying them (at least till now) was another matter. There were at least two troublesome questions:

  1. How do we determine the market’s attempted direction?
  2. How do we determine whether volume is net selling or buying for any given period?

Traditionally:

The answer to (1) is to relationship between the close of today and that of yesterday: e.g. a plus close was interpreted as an attempt by the market to move higher. But what happens when you have a day with higher highs and higher lows and a down close? I always found it diffcult in these circumstances to say that the market was looking to head South.

The answer to (2) was to treat a whole period’s volume (e.g. the day’s volume, the 30 mins volume etc) by referencing (1). If we had a down close, we’d treat the whole period’s volume as selling volume. You don’t need me to point out the logical flaws to this.

Once we had intra-day volume another problem arose. The issue is well-illustrated by the volume during an ES trading session. The greatest volume tends to take place in the first two hours. The volume then tapers off till the last two hours of trading when volume again increases – usually the volume for these last two hours is less than the first two hours. Figure 1 shows what I mean. The yellow rectangle shows one day’s trading. So, given this tendency, merely comparing one period’s volume with the previous one, was inadequate – we aren’t comparing apples with apples.

blog-12-20-2007-uv.jpg

FIGURE 1 ES 30 Mins Bars

Those were the problems. Tomorrow I’ll present the solutions.

Thanks to Dr Brett Steenbarger

My father was a charismatic character: a champion sportsman who landed in HK to start a job as a lowly accountant and by the time he died, had risen to become the Managing Director with an equity share. He was a well-liked, charismatic character who taught me much: the value of keeping your word, integrity and fair dealing. Among other lessons were his sayings. One of them was:

“The highest praise you can receive is genuine praise from someone you admire and the praise’s content and its form is one you want to be praised for”.

In Brett’s blog (http://traderfeed.blogspot.com/)  yesterday, I felt truly praised:

  • It came from someone I respect and admire.
  • It’s clear that Brett took the trouble to read Nature of Trends. Given that I see Brett as a digital-kinesthetic-auditory personality and that I am a visual-kinesthetic-digital, I suspect the reading was no  easy task. The fact that he did read it is something I deeply appreciate.

So thank you, Brett,  for taking the trouble to read the book and for all the trouble you took to write the review. I am very grateful for what you did.

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S&P

Tomorrow I’ll be posting the blog early. I want to cover a full analyis of the S&P and in the process show how Barros Swings, Ray Wave and Market Profile come together to provide a roadmap for a trade.

FOMC Rate Decision

There are two services I subscribe to that I find invaluable for the assessment of fundamental data:

  • Shadow Stats: www.shadowstats.com
  • ECRI Light: www.businesscycle.com

Shadow Stats provides an alternative data source to official US statistics and ECRI Light provides reliable leading indicators on the state of the US economic growth and inflation. The two together provide data on whether or not my ideas about ‘long-term’ perspective are being reflected in the economy.

I tend to rely more on the ECRI report than Shadow Stats and will lean to the former if there is a conflict. But right now they both agree: the US economy sucks. Despite the rosy picture provided by Non-Farm payrolls, the latest Shadow Stats demonstrates why the official figures are an illusion.

The ECRI published Friday Dec 7 2007 for the week ending Nov 30, shows US economic growth at a 5-year low and inflation down a tad. The ECRI indicators have about a 3-months lead time. So, I’ll know if my idea – that the massive increase in the money supply in August through to November 2007 will lead to a rise in inflation despite the weak economy – will be correct about 3-months before there is pressure on the FEDS to raise rates. But that’s for the future.

For today, the true state of the economy is the focus. Tuesday 2:00 PM EST, the FEDS will announce their decision. The worry for me is I am in the majority camp – I think there is little chance there will not be a .25 cut in the Fed Fund Rate and in the Discount Rate. But given the state of the economy, the sub-prime liquidity crunch, and Bernanke’s ideas of the causes of the 1929 Depression, I rate the probability of a hike above .25 around 67%.

If it were just the matter of the economy, I’d rate the probability much higher. However in the near term, the FEDS have the US$ to worry about. I would hesitate a guess that despite the jaw-boning, they would not be averse to a sliding US$ as a measure against recession. However, what they don’t want to see is a US$ rout. And that is what they are likely to get if they decreased rates in the Fed Fund Rate and the Discount rate by 0.50. In addition, the decrease in rates in the Fed Fund Rate has done little to assuage the liquidity problem.

So, for all these reasons, I rate the probability of about 67% for a decrease of .50 in the Discount Rate and a .25 cut in the Fed Fund Rate. Such a move at least provides some chance the US$ decline will not turn into a bearish stampede.

What do I see happening if such an eventuality occurs? Well, I’d expect the ES to rally strongly and take out the current highs before year-end. We’re only 70 points or so away, so that’s not hard to imagine.

I’d expect the US$ to drop strongly over the next week but do expect to see some buying come in. December is seasonally a strong month for the US$ and so far it has held up well.

As always, whatever your position (long or short), in whatever instrument (Gold, Interest Rates, Stocks and Stock Indices etc), I recommend you create some worse case scenarios in case the FEDS do something unexpected and/or the market reacts in a way contrary to your expectations. Preparation is my key to preventing the ‘rat brain’ seizing control and thus turning a well-planned loss into a catastrophic one.

The Anatomy of a Bubble

I have just completed reading a good book by James Montier, “Behavioural Investing, a practitioner’s guide to applying behavioural finance”

One of the more interest chapters was ‘The Anatomy of a Bubble’. James postulates that bubbles tend to move through 5 stages:

  1. displacement
  2. credit creation
  3. euphoria
  4. financial distress
  5. revulsion

The author suggests that displacement is usually an external event that creates opportunities in one sector that are greater than the opportunities lost by the event. In the US, the most recent bubble was caused by the internet.

The boom thus produced is given a mighty boost by monetary expansion. This idea is in line with the Austrian economic theory of what causes the business cycle – but more on that another day. James argues that in 1998 because of the LTCM and Y2K crises, the Feds cut the Fed Fund rates to protect the financial system. But the Feds overdid it and as a resultant liquidity surge moved into financial assets.

James defines ‘euphoria’ as the stage when speculation for price increases is added to investment and sales. He takes the view that between 1991 and 2002, the US experience fitted this description.

Financial distress follows an environment he calls the ‘critical stage’; he says the two – critical stage and financial distress tend to move hand in glove. The critical stage is marked by insider selling as was the case in2000/1. James believes that the US passed such a stage between 2000 to 2002.

The final stage of the bubble cycle is the ‘capitulation stage’ – a stage where people are so badly scarred by their experience that they no longer wish to participate in the markets. The US still has to see this stage. Certainly it was not present in 2002 – if two measures that James uses are any guide. Firstly, the strategists remained bullish. Secondly volume remained high. James takes the same view as many technical analysts that market bottoms are usually marked with collapse in volume. This has yet to happen.

What sort of valuation decreases need to occur to mark a possible bottom? The author suggests at the very least a 30% decline from the highs.

Next week the market will be down to what I have been calling the minimum buy zone. If the 13-w (quarterly trend) uptrend is to hold, then the low at 1370.60 basis cash S&P needs to hold. Breach of that low will mean that whatever we have in the 13-w, we no longer have an uptrend (the sequence of higher highs and higher lows will be broken). I have argued that the massive injection of funds by the Feds since August 2007 will keep the bears away until the Feds are forced to raise rates in 2008 – when the liquidity finds its way into the inflation numbers. For this reason I believe that the probabilities favour the 13-w low holding. That is the low risk idea.

But an idea needs to measured against present tense information and so far there has been little sign of slowing downside momentum as the market approaches the buy zone. This is a tell-tale sign that the zone will hold. If momentum continues to build into the core zone, 1393 to 1370, this will be a warning that the zone will give way.

If that occurs, then, we may be seeing the start of the down leg that will culminate in James’ revulsion stage. By the way, a point James makes and one that accords with my experience: in the revulsion stage, the negative correlation between stocks and interest rates will no longer apply.

That’s not the way I would describe it but the result is the same. In my jargon, we are in a phase of the business cycle where once a bear market starts, the Feds will be unable to limit the damage to the economy by lowering rates.

I am looking forward to next week; it should provide interesting opportunities.

Thanksgiving

It’s Thanksgiving in the US. This means I have a holiday and time to reflect. As a trader, I get caught up with the markets (especially with the volatility of late) as well as the other hurley burley events in my life. It’s good to take time out to smell the flowers; to take time out to pause and be grateful for the wonderful people and things in my life.

I have a lot to be grateful for. The markets have been good to me. Oh sure, there have been down years; but overall I have not only achieved my goals but also more than I even dared to dream. It was not always that way: if you had asked me 7 years into my trading career: “Hey Ray! Are you going to make it?”

I’d have answered: “Sure! But you wouldn’t know it from my present results!”

It took me a long time (over 7 years to have the first winning year) and a lot of losses (about A$750,000.00). I succeeded because my wife, Chrisy, stood by me and provided the financial resources to keep going after I had lost our savings. During those tough years, her support was on occasions, the only thing that kept me going.

Chrisy bought me time; Pete Steidlmayer delivered the content that proved the turning point for my trading. He showed me that trading is a probability game and the lessons I learnt in 1980 are still beneficial today.

Those are yesteryear events; events for which I am grateful. Venturing closer to today, I now have friends who provide the bedrock social support and warmth so necessary for life – friends like Stuart Leslie, Anna Wang, Mic Lim and Jeff Tie. Stuart and Ana started off as mentor students and have become close friends. Mic is one of the best traders in Singapore (sorry Mic I know how much you dislike me saying that in public – but mate you are!). Jeff is my first friend in Singapore.

Trading is a tough game. There is no established educational process and the industry is full of hype and empty promises. On the other side of the equation are the newbies whose attitudes are best summarised by the words of an event participant: ” I want a system that is easy, costs no money and time to learn and one that will quickly make me a large fortune from a small starting base” (!!).

For those that know that trading success will take time, effort and money, take heart. Unlike when I first started, today you have access to genuine (and sometimes free) assistance. There are coaches like Brett Steenbarger, Denise Schull, Jim Kane & others…who each in their own ways provide an excellent service to the struggling newbie. So, no matter how you are trading and no matter what challenges you face, take a moment to enjoy the view that life is providing.

Happy Thanksgiving!

The Role of Intuition

As a discretionary, technical trader, I find my intuition plays a strong role in my trading. Today’s price action in the ES was a great example of what I mean.

I subscribe to a few Sentiment Indicators, Floyd Upperman, Whisper Numbers, and Sentiment Trader. All were bearish to some degree, and one was bearish even though the COT figures used in the approach showed a bullish bias. Even though this view was consistent with the system’s rules, it struck me that there was just too much bearishness in the market.

Add to this the fact that many of the technicians I respect were looking for the market to head towards the spike low – the one formed on the S&P on Aug 16, and you’ll appreciate the reason for my discomfort. I prefer to be a lone voice; company, especially company I respect makes me uncomfortable. In short, my intuition was screaming ‘long tonight’. In my view the 18-d (monthly) trend is still up and there is no change in trend pattern in sight. So my strategy is to find spots to go long for this timeframe.

I had my strategy (long); I also had my zone – well sort of. The market was near the upper band of my entry zone (about 25 points away) but it was close enough for me. I had my setup to go long when I found that the market was going to gap up sharply.

Figure 1 shows what Peter Steidlmayer called ‘trapped money’, a form of Negative Development. The Trapped Money Zone is the zone between yesterday’s close and today’s open. Trapped Money needs a spike low and strong open leaving shorts trapped by last night’s price action. If the market holds above that zone tonight, then the probabilities favour a move back to 1532 and probably the 1576 to 1550 zone (basis cash).

Trapped Money

Trapped Money

FIGURE 1 Trapped Money S&P 80 Mins

In addition, on a seasonal basis, Nov 14 is favoured to be a down day. So if the market shows strength today, this is a plus for the bulls. And, after the 14th, seasonal strength kicks in. Figures 2 and 3 show the seasonal charts for November and December. The only seasonal danger is the period December 8 to December 12.

Season Strength November 2007

Season Strength November 2007

FIGURE 2 November Seasonal

Season Strength December 2007Season Strength December 2007

FIGURE 3 December Seasonal

The difficulty with the trade was the large stop: below1438. For this reason I decided to take a half the normal size. Entry was relatively painless. After the initial run up, I bought the third half hour weakness, entering at 1459.25 (basis Dec), stops below 1438.

To stay in the trade, I’d need to see market close in the top 33% of today’s True Range: High of today – Close of yesterday (or low of today whichever is the lower). If the market can extend its current range 1466 to 1454.5 and close in the top 33% of its True Range, so much the better.

If the market fails to close above 50% of its true range, I’ll exit the position. The reason is ‘trapped money’ suggests strength. A failure to close above the 50% mark is a sign of weakness. My initial target will be 1532 basis cash and I will be adding to my longs once I see confirmed signs of strength.