Routines and Habits: A Detour

I was going to write on trading plans, a subject that will probably take a couple of posts. But Ms A. Wang sent me a blog by Dr. Brett Steenbarger, Virtual Trading Groups: Getting to the Next Level, which contained a topic I thought more appropriate to end 2007.

In that blog, Brett writes that traders would benefit by interacting with their peers provided the group consisted of members “sufficiently experienced to offer value to others, ones sufficiently committed to putting time and effort into learning, and–perhaps most of all–ones sufficiently secure to maintain an open kimono and share all the successes, failures, lessons, and letdowns”

The question I’d ask is: who would join and are they the ones that would most benefit from such interaction?

My experience with groups is: those most willing to join the groups are the ones that need it least. Who would join? Usually the classes NLP practitioners call ‘unconsciously competent (the experts) and the consciously, unconsciously competent (the master teachers)’.

What class of traders would benefit most? Two classes:

  1. Those NLP practitioner’s call ‘consciously incompetent’ (those that know they don’t know and want to do something about it) and
  2. The ‘consciously competent’ (those that have yet to internalize the habits of success).

But yet it is precisely groups (1) and (2) that either fail to join or fail to persevere with the group.

At least that has been my experience.

There are major benefits from joining such a group – not the tips, you learn little from tips; it’s in the exponential growth of the learning curve that we most benefit. For the novice the benefits lie in:

  • The exposure to a probability mindset and the different ways that mindset finds its voice.
  • In the fact that there are many ways to make money;
  • In the fact that the successful traders will lose money in many trades; but
  • Most of all, the novice learns that success lies in keeping a gulf between the Avg$win and Avg$loss.

For the successful trader, the group forces him to challenge his assumptions and heuristics – a challenge that may go unheeded when trading alone. In a sense, the successful trader will benefit less than the novice but he will be the one more likely to join and stay.

In 2008, I’d like to see the idea of virtual trading groups take hold and proliferate. I’d like to see consigned to the rubbish bin (where it belongs), the idea that trading/investing is a profession that has a license to print money. In this part of the world, we have ad after ad telling us how to ‘turn $10k into $1M in 12 months for just 15 minutes a day!’ This unrealistic expectation is probably the most important reason for the dismal rate of success among newbies. Finally, I’d like to see the percentage of successful newbies rise from the current 10% to 20% to 40% and more.

When I started trading over 30 years ago, we did not have the assistance newbies have today -unless you were a local in the pits, you learned by trial and error. Now, it’s very different – today, we traders live in a privileged world where success is there for the taking – we only have to do whatever it takes to succeed. Our success lies entirely in our hands; let’s make 2008 the best year ever!

Happy New Year!

Routines and Habits III: The Disaster Plan

In these plans, I look to prepare for Murphy’s Law: “if there’s anything that can go wrong it will’ (BTW did you know there is a whole web site dedicated to Murphy’s Law? www.murphys-laws.com).

The important point here is to prepare for these contingencies before they happen.

Let’s take the most difficult problem first.

  • What happens if your internet connection goes down? Now that may be from a baby inconvenience from ‘my modem’ has stopped working to a granddaddy of a disaster where ‘your whole country’s ISP service goes down’. Don’t say that can’t happen – it happened to me when an undersea earthquake brought down all of Hong Kong’s connections. In my case, my contingency plans swung into action. I told a colleague of the problem and he placed interim stops and profit targets and the next day I was in Singapore where there was no problem.
  • In the same vein, let me ask you if your broker takes phone orders? If he does, what types of orders will he accept? IB, for example, will take only market orders.
  • This brings me to the next major problem: what happens if your broker’s platform goes down? Or worse still if his access to the exchange goes down. Allied to this is the problem of what will you do, if the exchange on which you are trading goes down (e.g. as a result of a terrorist attack)?

Think about this. It may be your account size does not warrant precautions, but then again it might.

The three ‘disasters’ above head my list because to a large extent, the ability to protect yourself depends on others: a friend, having other accounts, hedging on a different exchange etc. The next two on my list are more within our control to remedy but are no less stressful:

  1. Having the market gap against you, big-time! I am not talking about say a 2% gap on the ES but something extraordinary like Oct 1987. If you have a 10% gap against you, what will you do?
  2. The last one: you find you have an open position, an open position you were unaware of and it’s against you by 5%, 10% or more, what do you do in the circumstance?

My solution to both problems is to cut the position. This leaves me free to decide on my next course of action.

By the way, problem (2) did happen to me. I forgot to cancel a GTC stop order when I went on a holiday. Though I have someone who checks my positions daily, he, unfortunately, was having marital problems and failed to check the open positions during the break. I came home and found I was short the Hang Seng in raging bull market and down 10%. I cut the position and I was thankful I did: it finished lower the day I cut it and again the next day. But three days later, I’d have been down close to 13% and the loss would have increased the longer I held it.

The solution to major and minor disasters is preparation. Think them through and then rehearse them in your mind so that your responses are automatic. In the long run the preparation you put in may save your life.

Tomorrow I’ll start the posts on trading plans.

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

S&P and Context

I suggested a trading strategy on Friday before the market opened: buy a breakout of the 90 minute range if the open-gap failed to close in the first 90 minutes. What I’d like to consider today is why I’d sell the open-gap on Thursday and look to buy Friday’s.

The short answer is context.

Assessing context is a critical skill for a discretionary trader. In my view, it is a skill that is being lost. The fading of a gap-open is a well-known strategy for the S&P; but the question always is: is this the correct strategy to apply in this context?

On Thursday we gapped up 10 points from the Wednesday close at 4:00 PM EST. Note that the Thursday open was contained by the boundaries of congestion that had been established in the preceeding few days. Note also that as soon as the market opened on Thursday, we saw selling volume come in. 

The volume profile showed that the attempt to move higher from the open of 1474 on Thursday took place on non-existent volume and indeed, we saw no buying volume come in until 1471. This suggested that the market would extend the range of the initial balance to the downside – with a minimum target being the previous day’s volume value area at 1461.5 and the probable target being the previous days’ second standard deviation at 1458 to 1456.

On Friday. the market gapped 17 points from the 4:00 PM close. Such a strong open ought to have been met by strong responsive selling. Instead we had the reverse of Thursday. The initial down move in the “A” period (9:30 to 10:00 am) was on relatively light volume and this story repeated itself until the ‘J” period.  There was a distinct lack of selling enthusiasm.

The key differences between Thursday and Friday were:

  1. The location within the sidways structure that the market gapped into. On Thursday, the market gapped within the sideways structure and into the sell zone. On Friday, the market gapped above the sideways structure.
  2. The response as evidenced by the buying/selling volume on Delta. On Thursday, the responsive seller came in quickly; but there was no sign of the seller on Friday.

It’s important to note that there were important similarities on the two days: similarities that may be distiguishing differences next time:

  • The market was coming off a rejection low of the Primary Buy Zone
  • There short term behavioural parameters were giving buy signals
  • The Ray Wave was looking for a new high
  • The seasonal tendencies favoured a year-end rally.

Identification of an edge is important; but even more important for a discretionary trader is identifying the context that increases or decreases that edge.

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.

Whither S&P?

I take the view that the S&P (ES H8) is on the cusp.

In “The US$ and the Stock Market”, I outlined my view of the fundamental context for the US stock market.

Technically: 

The 12-month swing shows that a close below 1455 would signal an Upthrust Change in Trend Sell Signal. See Figure 1.

 12m.jpg

FIGURE 1 12-M S&P Cash

The 13-week swing and Ray Wave show that the market is either in the process of forming a wave:4 Irregular.

Or it shows that the market has already triggered an Upthrust CIT pattern, and we need only see a Whole Point Count (WPC) to confirm (see Nature of Trends).  I have taken the former view and I am looking for one more high to complete the 5-wave structure. In this interpretation, I am influenced by the fundamental context.

Should the market break below 1370 (basis cash) and form a 13-w WPC, then I’d change my view.

Since the longer-term charts favour a continuation of the uptrend, I have been playing the S&Ps from the long side. On Nov 27th I went long and exited 1/3 positions on  Dec 10th. I brought my stops on 1/3 of the position under 1427.6 and 1/3 to breakeven. I based the stops on Market Profile theory:

  • The 1/3 exit was at the top of the Value Area (Zone 1 high).
  • The second 1/3 stop is under the Value Area(Zone 1 low);
  • The last 1/3’s stop at breakeven is to protect a position against loss where the environment for the long is deteriorating. Figure 3 shows the profile.

 18d-mkt-profile.jpg

FIGURE 3 18-d & Market Profile

This is where the market stands for me. I am not keen to add to my positions given my view that this is the last leg up and that there are doubts about the continuation of the uptrend.

But if I did want to take a position what would I look for?

  • The market is in a Sideways Market Zone (78.6% retracement) Figure 4

 18d-sw-zone.jpg

FIGURE 4 Sideways Zones

  • There was a cycle low on December 18th
  • Sentiment indicators (COT) is bullish (see below)
  • There are three statistical edges suggesting the low is in (see below for an example)
  • We had a Market Profile Test Day (read possible change of direction day). To confirm the test day, we need to see strong buying today.

Sentiment indicators and statistical data all suggest a rally from here. I use Floyd Upperman’s data for COT (https://www.upperman.com).

An example of statistical setup that is present answers this question: “How often would I be profitable if I bought on the close Monday (Dec 17) of option expiration week if the on that day the S&P hit at least a 2-week low and I held the position for one week”?

The answer is since 1950 we have had 6 winners from 7 trades. The average drawdown is -0.6% compared to an average gain of +2.2%. 

Statistical setups I gather from various sources: the one above from www.sentiment trader.com; others include, http://traderfeed.blogspot.com/ and http://www.stocktradersalmanac.com

So I have a zone and setups. What I need is a trigger and initial stop. But before considering that, I need to consider one possible bearish event.

The market came off the top of the Value Area (Zone 1 high); if it breaks the low of the Value Area (Zone 1 low) without first going to the Primary Sell Zone (Zone 2 high to 1576.10 basis cash), the market is telling us that the high probability event is a change in trend from up to down is happening. That assumption will be confirmed with a WPC below 1370.6 basis cash.

So,  if I were to take a position tonight, I’d be looking for signs that the market will rally. We had a ‘test’ day yesterday on the Profile: Neutral Day closing in the middle quadrant. (See Figure 5). So, what we need to see is evidence of strong buying.

 mkt-profile.jpg

FIGURE 5 Market Profile 

Today’s open will be important.

Ideally, we’ll see a Drive or Test Open (see Mind Over Markets) to the upside. This will suggest a rotational day giving traders time to get set at or below today’s developing value area. If we get a test or drive open, we can set the initial stop for the day below the low of today or yesterday. The safest stop would be below the 18-d Value Area. (See Figure 3).

Well there you have it. A Ben Hur of a blog (i.e. a very long blog). All the best and take care out there.