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.

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.

The Rule of 3

I use the Rule of 3 to smooth out my equity curve and to pyramid safely.

In this post, I’ll explain the first use. It’s important to understand that the Rule of 3 will reduce my bottom line in strongly trending markets. But in markets such as I have been trading recently, it prevents heavy losses and often allows me to exit positions at breakeven or with a small loss.

The Rule as set out in this post is not set in stone. I’ll vary the process to suit my perception of the trade’s risk.

My trader’s timeframe is the 18-day swing (monthly trend). My favourite entry is Negative Development on the First Lower Timeframe i.e. on the 5-d. Figure 1 shows the ideal pattern with a small variation – the trader’s timeframe is the 12-month and the First Lower Timeframe the 13-week.

crude-oil-12-m.jpg

Figure 1 Crude Oil 12-M

Entry is with 3 contracts or multiples thereof. Let’s assume we bought at 60 and had a stop at 52. We exit the first 1/3 as soon as we cover the stop on the remaining 2 contracts. Since our stop is 8 points per contract and we have 2 contracts, we need 16 points. 16 + 60 = 76. We exit the 2nd contract at the Primary Zones, in this case the Primary Sell Zone.

The Primary Sell Zone ranges from 79.35 to 76.54. So I’d exit the contract somewhere in that area. When I exit the second contract, I raise the stop on the third contract to breakeven.

The third contract I hold. This is the contract that gives me a position in case the market breaks out. Most times I’ll get stopped out but the occasions I don’t get stopped out more than makes up for the loss of the profits when I do. Figure 2 shows what happened when the market broke out: at that stage, I have pocketed profits on 2 contracts, holding a third and looking for a retracement to re-enter with 3 contracts and start the process all over again.

crude-oil-12-m-2.jpg

Figure 2 Crude Oil 12-M

I’ll exit the third contract when my trailing stop is hit or there is a change in trend pattern.

What I have described is the optimal Rule of 3. But as I said, I vary the process based on my estimate of the risk of the trade.

In the current ES trade for example, I believed that while an upside breakout was likely, it would not result in a sustained trend. In that situation, I looked to take profits on one contract much earlier. I’d do this by looking for an opportunity to bring the stop on one contract to breakeven. In this way, the second contract need only cover the costs of one stop. I would also take profits on the second contract much earlier and exit the third at the Primary Sell Zone.

Pete Steidlmayer used to have a phrase ‘behavioural parameters: patterns that we can rely on in our trading. Pete taught some behavioural parameters in sideways markets that I find extremely helpful to the Rule of 3…..but that’s a story for another day.

Exit Strategies

A little early today. With CPI due out and the volatility up, I may not get a chance later.

Today I want to talk about exit strategies. Now every newbie will tell you (he may not do it, but you can bet, he’s heard it) that every entry needs to be accompanied by a stop loss. Like most things in trading this is not all it seems to be. Indeed, some fund managers, Ken Fisher, for example, argue against it.

So what is the truth?

One thing is certain, every successful trader/investor I know, and know off, has an exit strategy. If your exit strategy is based on what you can lose, then, you probably won’t be taken out of the game by one loss but you will probably bleed to death. The fact is the market doesn’t care what you can or cannot afford to lose. And as far as stop placement is concerned, neither should you.

First determine what the market has to look like for your trade to be wrong and then work out if you can afford the loss. If you can’t afford the loss, cut down your size. If that still doesn’t do it, by-pass the trade. Willy-nilly placing a stop loss, is just asking the market to take your money.

My exit strategies involve:

  • Price stops: at this price my trade is wrong and it’s a price beyond which I won’t hold a position no matter what.
  • Contextual (strategic stops) exits: what does the market have to look like for me to exit a trade? What does it have to look like for me to remain in the trade? The answers are dependent on the type of setup that got me into the trade. If it’s a Negative Development setup, the market has to prove the trade right after a set time after entry.  I seldom extend the time to exit – though I often exit ahead of time. If it’s a Contraction setup, I am more forgiving as far as holding onto a position that is not moving.
  • Time stops: both Negative Development and Contraction have a time stop.

On Monday, I’ll look at strategies for taking profits.

Trading and Making Money

Two trades in Crude Oil illustrate my approach to making money in the trading game. If there is a Holy Grail in trading, it’s reflected in the formula:

(Avg$Win x WinRate) – (Avg$Loss x Loss Rate) = > $0

In other words, what is important ( taking the win rate into consideration) is for our $ win to be greater than our $ loss.

To maximise the difference, I seek to exit a position BEFORE my stop is hit. So when I say that my trade has an 80% of success, this does not mean that I have an 80% probability of making money. Given that my win rate fluctuates between 47% and 55%, the comment “80% probability of making money” would be sheer nonsense. What the statement means for me: if I exit before my stop is hit, I have an 80% chance of being right. This means that in 80% of the time, if I had not elected for early exit, my stop would have been hit.

Figure 1 shows my results for 2006, my trading year is from September 1 to August 31. My aim is to make around 25% per annum. In 2006 I had a better than average result even though my win rate was slightly below 50%.

2006-results.jpg

Figure 1 2006Results

But early exit comes at a price: there will be times that when exiting a position means I’ll re-enter at a more adverse price. This is what happened with the most recent Crude Oil trades.

Figure 2 shows a classical “Negative Development” buy setup and entry (For Negative Development see previous posts and Nature of Trends). Note that I use CSI’s Perpetual contract for analysis and the appropriate nearest futures month for stops and entry levels.

crude-oil-perpetual.jpg

FIGURE 2 Negative Development

What I expect following Negative Development setup is strong continuation. Instead, we had two inside days. So, on Dec 11, I exited the position with a 0.36% loss. I exited not because the trade had done anything wrong, but because it wasn’t doing what I expected.

I did plan a re-entry on a breakout and this was triggered last night. This second trade can’t lose because I exited 1/3 at last night’s close, moved my stop to breakeven on the second 1/3 and left unchanged the initial stop on the last 1/3.

The early exit cost 0.36%. When you consider the difference between my initial exit and breakout entry, my loss on the trade was 0.42%. But I am happy to wear the loss which with hindsight need not have occurred. But that’s the point: only precognition of last night’s breakout would have kept me in the trade. And since I don’t have that skill, I was happy to bail and happy with the way I managed the trade.