The Education of a Trader (3)

BarroMetrics Views: The Education of a Trader (3)

So far I have been  considering the ‘how’; I am answering the question, ‘how I acquire the knowledge I need’? In this blog, I want to turn to the ‘what’?.

Most of us have heard and read that success depends on acquiring the know-how to construct a set of rules that form the base of our trading strategy and risk management. We have also heard that we need ‘winning psychology’.

I define winning psychology as a set of tools and concepts that facilitate consistent execution of our rules. That said, you can immediately discern that it would be  intensely personal to craft the tools and concepts. Some areas you may want to consider are:

  1. What will I need so I can improve ?At the very least, we’d need a journal that records our emotional responses and observations about the market. We also need to keep a record of our trades. The latter will form the basis for analyzing our performance.
  2. How to integrate your emotions and your reason. It is now known that the best decisions are the ones that come about when both are in sync.
  3. What are the habits and routines that I want to establish that will help my trading success.

On risk management, you need a strategy on how to manage winning positions – what I call trade management and a set of tools to manage position sizing and risk control.  Here I’d start by focusing on determining what constitutes a ‘normal’ position size. True, you would need a set of stats that many of us don’t keep.

If you fall into this category,  the Turtle position-sizing formula is as good as any.

(% of capital to risk x Capital)/(Dollar Value of 10-day ATR).

What the formula lacks is the trader’s variables: his average dollar win, average dollar loss, win and loss ratio. There are better position-sizing formulas around but all require the trader’s personal input.

In this area, you also need to consider:

  1. maximum portfolio risk (when you are trading more than one instrument)
  2. when to allocate winnings to the trading capital base and when to deduct losses from the base.
  3. when not to trade.  What number of consecutive losses are you prepared to bear before calling a break? What maximum loss will suggest you need a sabbatical from trading?

I’ll conclude the series in the next blog.

How Do I Set Stop Levels? (3)

BarroMetrics Views: How Do I Set Stop Levels? (3)

This blog looks at the way I manage a trade. As you may expect, my approach is based on firstly protecting my capital base and only then looking at protecting profits. To do this, I use the Rule of 3 and the Expectancy Return Formula.

The Rule of 3 in strongly trending markets will result in a diminution of returns; on the other hand, in choppy markets, it will decrease the losses. In effect I am surrendering maximization of returns in some periods for a smoother equity curve.

The Rule of 3 provides:

  • Exit first 1/3 at a level where the return is twice the initial stop. The initial stop is unchanged.
  • Exit the second 1/3 at a logical target. The initial stop is brought to break even.
  • Exit the last 1/3 when the trader’s timeframe trend changes or when the trailing stop is hit.

The Expectancy Return is the benchmark by which I test my ideas.

I tell my friends and students that so far as a trading plan is concerned,  start your trading career with any plan that has an edge. It need not be the one that will bring you the greatest return – having the best doesn’t really matter until you have some competency in consistency of execution of your risk management and trading rules.

Think of it this way, the type of equipment will make little difference, if any, to a golfing duffer. But to Tiger Woods, the best equipment can be a match-winning  difference. So too with a trading newbie, in the beginning all that matters is we have a plan with a positive expectancy so we can learn to execute consistently the trading plan and risk management rules. Once we develop some mastery of consistent execution, we can go about developing our trading plan.

What usually happens is our mastery of execution and plan development go hand-in-hand. This I think is a more difficult route to consistent success but seems to be the way success occurs among those I have helped.

Once our plan has positive Expectancy Return, the  stats it provides tell us when a profit is a profit and when an open position plus is merely noise.

For example if our trading system has a 30% win rate, we know that to breakeven our average trade needs to return $2.33. Hence, any open profit that is below $2.33, is ‘noise’. So, unless we see some sign that the trade is not behaving like it should, we wouldn’t consider any open profit below $2.33 as being ‘profit’ we have to protect.

Well those our my idea. I hope this has helped those looking for ideas on risk and trade management.

How Do I Set Stop Levels? (2)

BarroMetrics Views: How Do I Set Stop Levels? (2)

Ranadagger asked: “could u please also guide as to when do u put ur stop to breakeven and how do u start trailing the same. how much of paper profits do u protect, when do u decide to take partial profits and when do u take complete profits and run.”

I could write a book on the excellent questions you have posed. Let me try to answer them as succinctly as possible.

Firstly, the answers to the questions are founded on my trading philosophy:

  1. The key principle is the protection of capital through
  2. Consistent execution of my trading strategy and risk management rules. Once that is achieved
  3. Pursuit of superior returns.

I implement the philiosophy from the initial stop. Yesterday I introduced the idea of technical stops with filters. This tool is augmented with:

  • The stats derived from Maximum Adverse Excursion studies
  • The stats derived from the Expectancy Return data and
  • The Rule of 3.

I’ll look at Maximum Adverse Excursion today and the rest in subsequent blogs.

I took the idea of MAE from John Sweeeney but I apply differently.  From memory (I read the book eons ago), John uses the maximum loss. I don’t like since the maximum loss since it may represent a Black Swan event. Instead I use mean and standard deviation.

The idea is a simple one. What we want to know is: what is likely maximum loss I have to endure before the trade subsequently  proves to be a winner?

But rather than define the Maximum Loss in terms of a single loss, I define Maximum Loss as “mean +2 standard deviations” (i.e a theorectical probablility of a 95% occurrence).

This means I need to keep the necessary stats to produce the numbers. But I believe it worthwhile. The stats allow me to finess my stop levels:

  1. If the technical stop is too close, I increase the stop to just beyond the MAE.
  2. If the technical stop is much farther than the MAE, as soon as possible, I look for an opportunity to move my stops to just outside the MAE.

More on this next week……

Risk Management

BarroMetrics Views: Risk Management

What is risk management? For me it’s a set of tools that balance maximization of profitability with minimization of risk of ruin. It’s made up of two categories:

  1. Trade Management: the strategics and tactics to manage an initial exit (when we first place a trade) and the strategics and tactics to manage our position once a trade starts to move in our favour.
  2. Money Management: the strategies and tactics to answer four questions:
  • How much to risk of this trade?
  • How large a position size for this trade?
  • The maximum portfolio risk at any one time?
  • When to decrease and when to increase our trading capital i.e. at what point of the loss/profit cycle? For example: the simplest method is to increase or decrease after each trade.

But behind the strategies and tactics, a trader needs a certain mindset leading to certain habits and routines; this is what I’d like to talk about today.

When we first start to trade, we may get unlucky:

  • we either get stopped out repeatedly only to have the market move in our favour and/or
  • hold to losing trades and be rewarded with eventual profits
  • taking positions too large for the capital and be rewarded with profits

As a result, we decide that no exit strategies are the way to go. Eventually of course, the market catches up with us: we learn that we need to cut our losses or we’ll blow our account; if we fail to learn this lesson,  we eventually have to stop trading.

If we learn to cut our losses, our main tool, at least in the beginning, is the stop-loss order.  Some of us never move beyond this tool. Others learn that preparation and defining the circumstances we will exit a position and under what circumstances we will remain takes precedence over the ‘stop-loss’ order.

This is easier said than done. As behavioural psychologists have observed, humans have a status quo bias.  This means that once we are in a trade, we tend to look for reasons to remain in the trade. Add to this bias, the fear that if we exit a trade, it may go our way and you have powerful reasons why early exit is difficult.

But if you think about it, there is no reason why an ‘early exit’ (i.e. exit before the stop-loss order is elected) should not form part of our exit strategies. If we know why we take a trade and understand the assumptions behind it, then once the assumptions are invalidated – ‘if correct then the market will generally not behave this way’- we should exit.

In my case, I found keeping a journal an invaluable aid to train me to accept early exit.  By keeping track of what did happen after an early exit,  I proved to myself that my profitability increased. Yes my loss rate went up but the decrease in ‘average dollar loss’ more than made up for the higher loss rate.

So now, I prepare for a trade by defining what I expect to occur if my analysis is correct and what has to occur for me to consider early exit.

Subjective Risk Management

BarroMetrics Views: Subjective Risk Management

In preparing for my talk on Risk Management sponsored by CMC Markets (see attachment: Art of Trading.pdf), it struck how important a role the subjective aspects are for Risk Management.

Our Vision and Goals set the scene for the driver of our Trading Rules (of which Trade Management forms a part; Trade Management is one aspect of Risk Management) and Money Management Rules. In the latter case, our subjective risk profile defines our trading philosophy; in turn our risk profile dictates the type of Money Management Rules we apply.

In my case for example, I first seek to preserve my capital through the consistent execution of my Trading rules and Risk Management Rules. Only when that safety is secured will I seek superior returns.

This means that sometimes I will forego what appears to be a superior reward to risk because I assess that the probability of success is too low; other times, I’ll exit a trade at break-even or a small loss only to re-enter at a worse off price – because at the time of the exit, I assessed that the probability of success was no longer in my favour.

The approach may not work for every one, but it works well enough for me.

 artoftrading_rb.pdf

Area of Competence

BarroMetrics Views: Area of Competence

The other day I was on Bloomberg’s ‘Asia Confidential with Bernie Low’. As is the normal pattern with this type of shows, viewers are invited to ask questions of the guest commentator. Here you take pot luck with the questions: the viewers will tend to ask questions from their own mindset and experience  – a context that may well be outside one’s area of expertise.

Well I had one of those shows – all viewers who had questions based on technical analysis must have switched off for the day. I kept getting  questions like: “I can’t buy your call that the S&P will rise to 1500 in 18 months to 2 years. We are de-leveraging; where is the leverage going to come from?”

My answer: “I wouldn’t have a clue. I don’t think in that manner”.

If it weren’t for the other guest, it would have been a long 15-minutes for me. At least he was able to give what sounded like well thought out answers.

The point I am making is the markets are like the shows. There are times when conditions suit one’s knowledge and area of competence; and at other times behave in a manner that leaves one flummoxed. Take the two attached charts, one of the Shanghai Index and the other of the S&P. Both had similar underlying conditions:

  • The 13-week line up (quarterly trend) was statistically stretched and
  • The 5-d had possible topping patterns.

But the Shanghai Index (with the less reliable pattern on my stats) gave a 600 point profit (ATR of mean + 19 stdev) before a rally warning; the S&P gave a maximum of 20 points (ATR mean +1 stdev); and  to make the 20 points, you would have had to sell the high of the signal day and buy the low of the day before the rally warning. Clearly a massive difference between profit potential of the two signals.

In my early days as a trader, I’d spend much time looking for distinctions that would identify when a pattern would and when it would not work. While that is still a worthwhile endeavour (new robust distinctions are always useful), I spend more time looking for ways to manage my risk.

The fact is by being aware of when one should increase position size and when one should reduce will make a huge difference to the bottom line. And the way to identify those situations is by being aware of the metric patterns relevant to one’s situation. The best guides for newbies are the patterns derived from the Expectancy Reward formula:

(Avg$Win x WinRate) – (Avg$Loss x Loss Rate).

I found that generally the components will provide patterns to guide and advise us.

It’s Your Money, Husband It!

BarroMetrics Views: It’s Your Money, Husband It!

This blog focuses on highlighting the risks traders face when choosing brokers.

A little context: I view brokers as being in a fiduciary relationship and as owing a fiduciary duty to their clients. Ray, what in heavens name do you mean? It sounds like legal-eagle double talk!

Think of it in the same terms as the client-lawyer relationship. Clients place their funds in a solicitor’s trust account. The amount is security for payment of fees and disbursements. Because the funds are held in trust pending completion of a matter, they are kept in a separate bank account called a ‘trust account’. The trust account is not available to creditors of the legal firm should the firm become bankrupt. If a lawyer does the wrong thing and mixes the trust fund with his own or absconds with the trust monies, a Law Fidelity Fund will reimburse the client.

I see the trader in exactly the same position as a lawyer’s client.  But in many parts of the world, while some protection is given to stock traders and futures traders, there is no protection given to FX traders. It is your job as a FX trader to make the necessary enquiries that will  protect your capital.

Recently, this was  brought home to me.

Currently I am using one broker for both FX and Futures. By funding my FX account from the futures account, I obtain the protection of the futures legislation. The country in question provides for segregation of client funds for all accounts but does not provide for compensation for FX funds where the broker breaches the act. By funding FX from the Futures account, I protect most of my funds.

Unfortunately the Futures arm of the current broker is having problems:

  1. their platform is not working
  2. to execute trades we need to call in the orders;
  3. in addition, the dealing desk refuses to work any orders for exchanges that won’t take ‘stop’ orders.
  • Now, imagine the situation where your levels are hit and you want to exit; imagine the time it takes and what the market can do in the time you call in, wait for the phone to be answered etc …. ! I’ll leave the slippage to your imagination.

Needless to say, I have opened a new Futures account for trading purposes with a broker whose trading platform is operational. I should begin with it later this week- as soon as the funds are deposited in my account.

While I was in the process of change, I received an offer for trading with a FX broker who was offering less than 2 pip spread with the majors: EURUSD, GBPUSD etc and 3 – 5 pip spreads for the others. The spreads are fabulous and I was impressed with the salesperson; so while I had not contemplated changing FX brokers, I was now tempted. But later enquiries decided me against trading with this broker…….

Interested why? More tomorrow………

A Secret to Trading Success

If there is a key concept that leads to trading success, it’s the understanding, integration and application of the Expectancy Return:

(Average Dollar Win x Win Rate) – (Average Dollar LosS x Loss rate)

Where:

  • A$Win = the average of the dollars won in our winning trades
  • Win Rate = the total number of winning trades/sum total of all trades
  • A$Loss= the average of the dollars lost in our losing trades
  • Loss Rate = the total number of losing trades/sum total of all trades

The reason why the formula is important is because trading is a probability game. We don’t know what will happen; we make best guesses and create scenarios that are neutral, scenarios that favour our trade and scenarios that are unfavourable. Even then, the fact that a scenario is favourable in any particular trade does not mean that for that trade we will be successful. If we have an edge, it will mean that over a large sample size, we will have a positive return.

That edge is expressed in the Expectancy Return.

There are certain key elements we need to bear in mind:

  1. The Win Rate alone means little. A trader can have a Win Rate of 90% and still produce a negative expectancy. Let’s say a trader has a 90% Win Rate, and an average dollar win of $10; and he has an average dollar loss of $100. Given these numbers, the trader will lose over time.
  2. The important relationship is the relationship of the two sides of the equation. The greater the difference between the average dollar win over the average dollar loss, the lower the Win Rate can be over the Loss Rate.
  3. Generally, the shorter the time frame, the higher the Win Rate, and the lower the average dollar win. Successful scalpers, for example, produce a high win rate with a lower dollar win punctuated by some very large losses that happen infrequently.
  4. Since we are unsure of what the future will bring, the standard by which to judge when to take profits is governed by our stop loss, our expectancy return and our Maximum Adverse Excursion.

This brings me to my final point. It’s important to keep records and statistics of our trading. Without them it would be impossible to maximise our return. For example, let’s say you consistently use 40 points stops and take 17 points profits; and let’s say that while you have not lost your shirt, you are exactly making a fortune.

To work out what you need to change means you need data. You need to know the frequency distribution of your profits and losses and of course the win and loss rates. Armed with this information, you will be able to judge whether you would be better off taking fewer profits i.e. letting the profits run and have fewer winners and more frequent losses; or reduce the size of the stops, have more frequent but smaller losers etc. The point is we need information in the form of records to make an informed decision.

Taking Calculated Risks

One of the things that I learned from Pete Steidlmayer was to take calculated risks. Not that I am risk averse – that too was something I had to learn: the times when risk taking is unjustified.

What I learnt from Pete was that to succeed I had to take calculated risks and not to just take risks. There is a world of difference between the two ideas.

Just taking risk is akin to gambling, at least in my book. We take a trade not knowing if the probabilities favour our methodology, not having any idea about managing a trade, not having any idea of the risk of ruin the position size brings or whether the position size is  worth the risk. When we take a trade in this state, we enter and hope for the best.

So what are the differences when we take a calculated risk? The differences, in two words, are knowledge and consequence.

Knowledge means that we know within the boundaries of our perception and methodology that over a large sample size, our $1.00 investment will return on average ‘$X’ (and an amount that is positive). Consequence means we have worked out the worst case scenario and have accepted those  results BEFORE we take a trade.

In my own trading, I use a spreadsheet that:

  1. Asks me to consider the Risk. The $ at risk for the position size must be within my money management
  2. Then it considers the Reward:Risk. The ratio must fall into my Normal Expectancy Ratio Range. What I did here was to tabulate the results of all my winning trades and work out the mean and standard deviation of the Ratio. That gave me my ratio’s normal range: 1.89 to 2.4.

Consequently if a potential trade falls much below 1.89 I am unlikely to take it; and if it is above 2.4, I would first re-examine the trade and if the ratio holds true, I consider increasing my position size.In this way, I take calculated risks.

Being Right

After my presentation at the Share Investor Expo on December 6, I spent some time speaking about the fallacy of wanting a high win rate. I know that some ‘did not get the point’ – this blog is for you.

The key to investing/trading success lies with the Expectancy Return Formula:

(Avg$Win x Win Rate) – (Avg$Loss x Loss Rate) = Positive result.

The formula makes it clear that the first product MUST be larger than the second. So, how do we do this i.e. in periods of uncertainty?  How do we as traders increase our profit potential while limiting the risk?

Figure 1 shows the way.

Entry at the mode zone (two vertical lines labeled RISK) will mean we take a trade when the probability of loss is at its trough and the probability of profit at its zenith. In addition, we take trades when the benchmarks are clearly defined e.g. we can say that if ‘XYZ’ happens we’ll stay in; if ‘ABC’ happens we’ll exit; and we can say that as for the rest, we’ll hold for another day provided we don’t get stopped out.

Figure 1 shows that when we take the trade at the mode of probability of success, our reward:risk ratio is at its optimum.

risk.JPG

FIGURE 1: Optimum Profitability

That’s the theoretical picture. To attain this ideal in day-to-day trading, I take a trade when I feel I have 5 items in my favour. As an example let’s have a look at Figure 2, the 12-Month swing (yearly trend) on the S&P

1) The structure of the market: In the S&P, we have a potential 313 Outside Buy Signal (See Figure 1 and The Nature of Trends). I would view such a buy signal as to the left of the Mode of Probability. The context suggests that a failure at the Failure Zone has at least an equal probability of success as the 313 Outside Buy. Unless I could take a buy trade with a relatively low dollar risk i.e. within no more than one ATR 741, I’d bypass the buy trade for the moment.

2) A Price Zone to take a trade

3) The Price/Volume relationship:

The benchmarks I’d use is the average volume per bar as the market rallies to the Failure Zone (the preferred zone is the 66.67% and 50% provided that zone is confirmed by other zone projections):

  • If the Avg Volume is at or less than 931,236, then the probability is there will be a Failure. In this case, I’d be looking to sell at the Failure Zone.
  • If the Avg Volume is 1,724, 603 or greater, the market will probably reach the Primary Sell Zone at 1553 to 1452. In this case, I’d be willing to buy on a pull back provided the Reward:Risk Ratio is satisfactory.

4) Time: I use statistical estimates to provide a time and price window for the conclusion of a move. I also use some time ratios.

5) Momentum: I’d use Ray’s Clock (see The Nature of Trends)

Once in the trade, I’d use time, structural and price stops to keep the trade within the Optimum Risk Zone (the vertical parallel lines).

313o-buy.jpg

FIGURE 2 12-M S&P Cash