The Quality of Our Decisions Part 2

In ‘Think Better’, author Tim Hurson suggests a business decision-making model that evolves my process. Firstly he suggests that we alternate between right-brain and left-brain activity; secondly within his seven step model, he has some very useful tools. Whenever I brainstorm I use Mind Mapping software called Mind Manager. A free version of a mind mapping software can be found at:

Let’s consider an example and let’s say we are looking at yesterday’s ESZ7 12-m (yearly trend). We’d start with his first step, the one he calls: “What’s Going On”? Here he aims to use the right-brain to identify the critical factors. In our case we’d be brainstorming to probe for the factors that will affect the probabilities of our trade. A couple of useful questions he uses are:

  1. What’s the Itch? And
  2. What’s the Impact of the Itch?

Once we have a list, he suggests we verify our ideas by asking: “What the Information?” and drawing a distinction between what we know and we interpret. This is a useful distinction. For example:

Yesterday in the ES we had a directional day on lower than mean volume; the Profile showed a 3-i day down. That’s what we know. I’d interpret that by saying that the directional day favoured more downside to come; the lower than mean volume suggested the down move was coming to an end and the 3-i day suggested that in the 1st 90 minutes of trading, if we sold above the value area, we should be able to at least scratch the trade.

One of the questions that immediately arise is: “What does it mean if today we don’t get free exposure?” Another question would be: “What does it mean if today, we fail to make a lower low?” etc. In drawing a distinction between what we know and what we postulate, we are more likely to trade with an open mind: the process stimulates our ideas and reduces the risk of myopia – seeing only what fits our pre-conceptions.

Once we have a list of possibilities, we fine down to one or more critical questions that the Trader’s Timeframe will need to answer (in yesterday’s post the 18-d). The questions are answered by creating scenarios and assigning probabilities. We’d then use Decision Tree software to arrive at a solution. When using the software I like to see the conclusions hold over a range of values. If the Decision Tree software changes its decision over a narrow range, I consider it too close to call.

The attachment is the example I use on the video on the Decision Making Process. In that Tree, a change in the probability of success from 12.5% to 21.4% altered the decision. I would consider that too close to call and would stand aside.

Decision Tree


For a free Decision Tree Software go to:

Tim Hurson’s book is a great read and one I think you’ll find useful – but you will need to adapt some of the ideas to trading.

The Quality of Our Decisions Part 1

As traders, we spend much time in seeking more knowledge on the markets, knowledge that will provide us a distinction, a distinction that will lead to a greater edge.

But there is an area that most of us tend to overlook when looking for that edge; indeed usually when I introduce it in my public talks, I can see the audience glaze over and can almost hear the audience think: “Get over this quickly! I want the good stuff!” Well folks, “this is the good stuff”.

And the topic (drum roll please..): A Better Decision-making Process.

If you reflect on this, you’ll see why this is so important to trading, and to life. The quality of our trading, and life, ultimately depends on our actions and our actions are a by-product of our decisions.

So on what does a more robust decision-making process rest? Behavioural Finance? Logic? Creative Thinking?

None of the above. We need to go beyond Behavioural Finance; it does a great job for identifying the blocks to better decisions but some have taken a view that because we can never totally eliminate our blocks, we are doomed to poor decisions. The question is ‘poor’ compared to what? It’s like saying because we are not champion ‘traders’ we are doomed to being merely ‘good’ traders. So?

I consider myself not particularly talented in the trading arena – not a champion by any means; but that has not stopped me from making a better living than I probably could have made from any other profession and certainly better than one I would have earned from the law.

Similarly even if we never totally eliminate the psychological barriers to robust decision-making, this does not mean we should not try to make the best decision we can in the circumstances. And this implies seeking ways to improve the process.

Luckily for us, in recent years new discoveries have been made that lead us to think better. One discovery: the better decisions come from a synthesis of the right and left brain. Recently a discovery was made that an even process is to alternate between right and left brain activity. Since I read about the theory, I amended my decision-making process to incorporate this idea. It’s too early to report if there has been a bottom-line impact but it certainly feels more comfortable.

My previous decision-making process began with the right brain ‘stream of consciousness’ thinking. I would start with the 12-period monthly swing chart (yearly trend, 12-M) and work down to the 18-period daily swing chart (monthly trend, 18-d). The purpose of this step was to seek the critical question/questions relating to an instrument. For example in the S&P, on Monday November 19, the critical questions for me are:

  1. Whether the low at 1438.53 marks the termination of the correction.
  2. If not whether the end of the Zone marks the end of the correction (For those that have read the Nature of Trends this is the Primary Buy Zone marked by 1555.9 and 1370.6).
  3. Whether the high at 1576.1 identified a 13-w Upthrust Change in Trend Pattern or an Irregular Correction.

Using the various tools at my disposal, I would seek the answers using my Left-brain. The result of this process would be a strategy (buy/sell) and tactics (zone, entry and exit strategies). The final step would be to review the decision against my Behavioual Finance checklist to ensure I was not making some simple error in thinking e.g. anchoring an exit price.

I have just described the previous process. Recently I read “Think Better” by Tim Hurson and have adopted his model. I believe it is superior to the one I am using. I’ll deal with this in tomorrow’s post.

Market Profile and Context

The courses taught today on the traditional Market Profile focus on the bell curve, ‘the Profile’, with little comment on the other aspects.

Peter Steidlmayer taught that there were 5 elements to his traditional approach:

  • Long-term Perspective,
  • Long Term Activity Charts (LTAC),
  • Market Structure,
  • Market Timing and
  • Trade Location.

Each element played its part bringing a trade to a successful conclusion. And although this was not expressly taught, I took the view that Long-Term Perspective and LTAC provided ‘the context’ to Peter’s approach. Nowadays ‘context’ in the Market Profile is provided by the longer-term distributions; but I still find Peter’s way of classifying fundamental events useful.

There are three types of events:

a) Expected events when fundamentals are correctly perceived by the market and as a result, we have range bound markets. In range bound markets we buy the low end of the range (what I call the Primary Buy Zone) and sell the upper end (the Primary Sell Zone)

b) A surprise event which are an ‘act of God’, an event totally unexpected by the market. In such as situation, price moves away from value and then returns to value. Chernobyl (April 26 1986) was such an example. Following a muted response to the disaster on April 28, the S&P fell from 243.55 to 232.25 over 13 trading days. Six days after the low, the S&Ps were trading at 244.75. In such a situation, the strategy is to take a position on the basis that price will return to their original levels.

c) An ‘unexpected event’ where the market fails to recognize a shift in the fundamentals; a shift that signals a move by value away from price. In short, an event that will change the longer-term trend of the market. (In my jargon a change of trend of at least quarterly trend proportions).

I believe that an ‘unexpected’ event occurred in August 2007 when the major Western Central Banks poured liquidity into their respective economies’. We are talking billions of dollars over a very short time. Usually we’ll begin to see reflected in the economy, the effects of excess money reflected within six to nine months time: in this case, say from March 2008 onwards. In other words, inflation figures will start rise. The FEDS will then find themselves between a rock and a hard place (of their own making). The Weekly Leading Indicator published by the Economic Research Institute ( shows that the US economy is set to slow down in the months ahead.

So the FEDS will have a climbing inflation with a weak economy and Bernanke is reported to shifting towards an inflation targeting system. Given their charter and stated policy, the probability is the FEDS will have to raise rates. In turn this will have an adverse effect on the US economy and US Stock Market.

Now let’s add another spark to the potential firestorm.

China‘s inflation is said to be running at the highest level in a decade (Financial Times 11-16-2007). So far the half-hearted attempts to stem the rise have done little to alleviate the problem. When the Government starts to take strong measures their stock market will turn down. In addition a slowing US economy will have a severe impact on the Chinese. ‘China‘ central bank estimates that every 1% drop in the US economic growth translates into a 6% fall in Chinese exports (FT 11-16-2007)’. Exports now account for 33% of the Chinese economic growth. So a slump in the US economy will impact the Chinese, and a slowdown in both countries, the rest of S-E Asia.

I see these facts as painting an ‘unexpected event’ portrait for a US stock market downturn. The probability is set to begin from the time the US inflation figures start to rise – this clear and present danger to be present from March 2008 onwards.

Now don’t get me wrong. I am a technical trader and the timing of short entries (if any) will be based on my chart patterns. But my best trades have been when I identified a story not yet heard by other traders e.g. at the ADUS secondary bottom in about September/October 2001.

If this scenario proves correct, we’ll have the usual seasonal strength in 2007 with new highs into March 2008 onwards. From that month onwards, I’ll be looking for evidence of the onset of a downtrend of at least 13-w proportions (i.e. trends in the quarterly time frame).

Managing A Trade

I am going to depart from planned content. I was going to comment on ‘Context and the Market Profile’. Instead I’ll continue with the current thread and write on managing the ES trade.

In The Expectancy of a Trade and Your Trading PIan I argued that the we had total control only over our entries and exits. In the Role of Intuition and Barros Swings – How to Use Them, we saw how the comment applied to the ES’s entry. I determine the size of my position both on the number of contracts I take and the amount of capital I am willing to risk. These are determined by a subjective assessment of the probability of exiting without loss. The risk I am willing to take ranged from 0.5% to 4%. In this case I was willing to risk 1% and take say, 6 contracts (the amount of contracts is for illustrative purposed only)

I found that because of the large stop (below 1535), 6 contracts would have cost me 2%. So I took only 3 at 1539.25. I wanted to add another 3 contracts on a breakout that conformed to my ideal breakout pattern. I treated this as a new pyramid trade. I could have added 6 and risked another 1% because I treat each entry as a separate trade. To prevent overtrading, I do have a maximum portfolio risk.

Although I could have added more than 6 contracts on the breakout – the breakout setup raised the probability of success and hence increased the risk and number of contracts – in this context I had decided to keep to 3. I had 1st resistance at 1496 and last night when the market stalled after reaching 1496, I had a dilemma. If I used the Rule of 3 and exited one third of my position size, I would not break even on the remaining open positions.

If I exited half my position size (the ones taken at 1469), then my risk per contract dropped to 10 points. So I exited half at 1488.5 and held half with stops below 1538.

Today with the CPI due, I decided to raise my stops on half my remaining positions to 1544 and keep the rest below 1538. I then had to work out if I should exit the remaining positions or let the stop take me out.

The inputs were:

a) I had no feel for the CPI figures so I rated the bear and bull response at 50%

b) If bearish, there was a 10% chance of no stops being hit, a 90% of the first stop at 1544 being hit and a 40% chance of the stops below 1538 being hit.

I then worked out the results in points for each secnario and placed the information in a Decision Tree Spreadsheet. Figure 1 shows the results. In this case, given the inputed data, the probabilities favoured letting the stops be hit.

Decision Tree

FIGURE 1 Decision Tree

As an aside, even if I moved all my stops to 1544 (90% of being hit), the matrix still favoured holding the position into the CPI. If I moved them all to below 1538, the matrix still favoured holding the position into the CPI. Based on this, I have reveresed my earlier decision and now my stops are below 1538.

TheMatrix worked out that only probabilities of 96% and above would favour exiting immediately. This would be true even I exited no higher than 1454. I have assessed that for that to happen we would need a headline rate of greater than 4% and a core rate greater than 2%. If the CPI numbers are that bearish, I’ll exit immediately.

The Decision Tree I use is sold by Palisade Tools. You can download a free copy of a Decision Tree matrix from If all you are after is a decision tree software, then use this. The only drawback with the permanent evaluation copy is you cannot save your work. To overcome this, all you need do is grab a snapshot before exiting.

So let’s stop back and suumarise this post:

a) We adjusted position size to allow for the larger than normal stop.

b) We took addtional positions based on new information,

c) We exited part positions when the market stalled at first resistance

d) We performed a Decision Tree analysis ahead of the CPI and

e) That Decision Tree analysis included a scenario where the CPI exceeded the upper boundaries of the expected range for tonight (bearish scenario).

By the way, the Decision Tree analysis did not stop there. I also did an analysis of what I would do if the lower boundaries (bullish scenario) are exceeded.

The Relative Importance of Your Trading Tools

I was referred to Brett Steenbarger’s blog of Nov 14 ( . As I read, it struck me that the tools we use in our trading plans are of less importance than having a plan.

Brett’s approach to the markets is very different to mine. He is a short-term trader and to gain his edge, he uses internals backed by statistical testing. I have had the honour and pleasure of meeting Brett and would say that his tools suit his personality.

I too use statistical testing but because I process sensory information visually {and to a much lesser extent kinesthetically (through feelings)}, I use tools that suit my personality: Barros Swings, the Ray Wave and the Market Profile are all used as visual mediums.

A fab example of this difference was Brett’s use of the volume at the bid (as the market moved down) as a target for identifying the end of the move up. I never thought of using volume that way. Incidentally, I also subscribe to Market Delta but what I find important is the shape of the profile at support and resistance areas.

Again last night provided an interesting example.

As you know from my blog, I went long early with a position that was half normal size. I then decided to use the breakout of the 1st hour’s opening range to enter the market for my remaining positions. But, the 30 minute volume profile on the 1st breakout (at 11:30) took the form of a bell curve. This suggested that the market would rotate back into the range and it did, all the way back from 1466 to 1459.

At 13:30 the market took out 1466 but this time the volume profile for the period took the form of a one-timeframe (trending) market. Sure I got filled 3 points worse off, 1469 rather than 1466 but I had an easy exit strategy if I was wrong about the breakout. A failed breakout with one-timeframe characteristics is likely to attempt a move in the opposite direction. This meant I could place my stops at 1457 under the start of the distribution (1459). This exit strategy was unavailable to me if the breakout took the form of a bell curve since that shape said that the probabilities favoured a rotation back into the opening range.

Score another important lesson for Pete Steidlmayer: it’s not the breakout price that is important. What is critical is how the market reaches the price (e.g. the form the breakout takes) and what the market does after reaching the price.

So, you’re probably asking what’s the central point of this posting.

It’s a simple one.

Newbies worry about some secret whiz bang, never fail, tool that will bring them untold riches. But such a tool does not exist. What is more important than the non-existent, never fail tool, is to find a tool or tools that match our personality. Unless we do that, we are likely to second guess our signals; such second guessing will lead to the slippery road of breach of discipline. So, rather than engage in a fruitless search for a non-existent super tool, focus instead on understanding your personality and find the tools that mesh with it.

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.

Barros Swings – How to Use Them?

I have received mail from purchasers of Nature of Trends (Wiley Edition) asking how to use Barros Swings. In fact a large section of the book deals with that topic. In addition, the Appendix shows you how to construct the swings. So, in this post, I’ll only briefly summarise the uses for the Swings

But first let’s outline the problem.

Figure 1 shows a downtrend….Are you sure?

Figure 1 Uses of Barros Swings

FIGURE 1 Uses of Barros Swings

Let’s take a look at Figure 2. Notice that we have at “A” and at “B” higher highs and higher lows.

Aren’t downtrends supposed to have lower lows and lower highs? But since we have higher highs and higher lows, don’t we have  an uptrend? Yet we intuitively say we have a downtrend, don’t we?

FIGURE 2 Possible Uptrend

FIGURE 2: Is this an Uptrend?

This then leads to the first use of the Barros Swing: to identify the trend of a timeframe. Let’s turn to Figure 3 and the solution to the above problem.

Figure 3 shows that each time the 13-w corrects, the 4-week trends up i.e. forms at least a higher high and higher low. In other words, whenever a timeframe corrects, we can usually expect the First Lower Timeframe to try to change its trend. (In this blog, I am using the 4-week as a substitute for the 18-day).

Identifying the Trend of a Timefram using Barros Swings 

FIGURE 3: 13-w and 4-w swings

In addition to identifying the trend, Barros Swings identify the support and resistance areas of a time frame. In Figure (3), for example,  the highs and lows of the blue swings are the 13-w critical support and resistance points; the red swings are the equivalent of the monthly trend and its swing highs and lows identify the monthly support and resistance levels.

The final function of the swings is to identify the patterns that warn of a change in trend.

Yesterday, for example, we spoke about an Upthrust, a pattern that identifies changes of trend from up to down. The swings not only disclose the pattern, they also identify the time frame that is changing its trend.

By knowing that a swing size is changing its trend, we know that the first higher timeframe will probably have a change of line direction.

In Figure 4, we have the monthly S&P (cash). If the Green Line is going to turn down,  its minimum target is 1340.45, the price at which the green line will turn down; of course the 12-m may be making a double-top in which case we can expect a retest of the 800 area.

S&P Cash 12M

FIGURE 4: Double Top?

Well folks, that about covers it: in this post I have covered a short summary of the uses of Barros Swings.

Context – How It Improves Profits

Two important ideas I learned from Peter Steidlmayer:

  1. The use of different timeframes in my trading and
  2. The idea of ‘context’.

As a discretionary trader using technical analysis, ‘context’ has made a great difference to my bottom line. Before I explain what I mean, let me first define some critical terms:

  • By discretionary I mean I have a set of rules that I usually follow; but I also have a rule that says “I don’t have to follow my rules”. I have this rule so I have room for my intuition to come into play – especially when exiting. Thirty (30) years of trading means my subconscious sees patterns that my conscious mind fails to see. The trick is to know when intuition rather than my ‘rat brain’ is in control.
  • By Technical Analysis I mean the use of charts to identify who is in control of the markets, the bulls or the bears, and whether that control likely to continue or end.

I place great store in ‘context’; it’s the filter by which I judge my setups – the patterns that tell me when the probabilities favour a trade. I do test and validate my setups through computer backtesting. I start with the raw idea and if that proves statistically that the setup is robust, I test it real-time with small size. If that proves successful, then I test it within a context. Only when the setup passes that gate do I employ it in my plan.

Let me show you what I mean by reference to the current cash S&P.

I use a pattern called a Change in Trend called an Upthrust (see Nature of Trends, page 38). It is one of my favourites and one of the patterns that has a $win expectancy ($2.87). When you consider that the average historical upper end of expectancy is 2.33:1, you see how profitable the pattern is for me.

The 13w chart below shows a classical Upthrust. Normally I would have sold double size and would have been looking for a move to at least the area bounded by the Blue Horizontal Lines and probably a breach of B followed by a subsequent trend down. I’d also normally have followed the trade management process I call the Rule of 3: I would have covered only two-thirds of my open positions after the market reached the blue lines. One-third of my position size I’d have left open because it would be the start of the positions I start to pyramid in anticipation of the expected downtrend.

Upthrust 13w S&P

13-Week S&P

But in this case, I sold ‘normal size’ and have covered half my size at first support reached on Friday. I also plan to cover the rest either at the zone bounded by the blue lines in the chart above or on a buy signal generated around Friday’s zone.

The reason for this is the ‘context’ that is partially provided by the Ray Wave: because of the nature of Wave [2], I was looking for a one of 2 patterns for Wave [4]: Running or Sideways. The market accepted below the maximum Running Zone on Friday Nov 9; that being the case, I would expect the market to go to the zone bounded by the blue lines. If the market breaches B, then we have the first sign that the current bull market is in difficulties and if we get acceptance below ‘B”, this would confirm the 13w Change in Trend Upthrust signal.

13w Ray Wave Count

13-week Ray Wave Count

(By the way, a Ray Wave count is not an Elliott count although I have borrowed some of Elliott’s ideas).

Context then in this case, caused me to hold a smaller than normal size and has me looking for a buy around the 1400 – 1370 area. Can I be wrong about the context? Sure, but my results say I can also be right and I am happy to give context its due.

Nature of Trends Wiley Edition – A Review

Today I have posted a review by a student and friend on my book Nature of Trends, Wiley Edition. By the way, my self-published edition has been withdrawn from sale. The Wiley edition is available from Amazon.



As an STCer of Ray Barros, I could finish reading the new book within 24 hours and comprehend well what was written initially for his mentor students in 2004.
THE NATURE OF TRENDS – Trading Success 1- Ramon Barros 2004, has 6 chapters and a smaller book volume.

THE NATURE OF TRENDS –Strategies and Concepts for successful investing and trading – Ray Barros (Wiley 2008), has 7 chapters, of which two new chapters on Entry & Trade Management and Effective Money Management & Winning Psychology were added while Formulas for Constructing chapter was omitted.

I have found the new book revised to cater to easier reading and comprehension for the general traders as well as newbies who are not familiar with BarroMetrics or some understanding of Ray Wave. Still, it is not easy reading as it is full of traders jargon and technical analysis. However, for those who aspire to trade well, reading widely and attending trading courses will eventually help in understanding most of what was written.

Ray has been studying since the day he started trading , but he found an edge in his trading seven years later on under the pupilage of Pete Steidlmayer (the father of Market Profile) who has a great influence in his trading analysis . To this day, after almost 3 decades of trading, Ray is still learning, reading widely all the trading books he can find/buy. For your information, he is the only person I know who has to rent a place to store and catalogue his books as in a library, in HK.

However, to trade with an edge and to adopt all the tools of analysis used by Ray would require an in-depth study over a course/courses of study under him.

As his students are aware, it is not just for any one who can afford his mentorship fees who will be accepted. He selects 5 mentor students per annum after a careful screening of the students’ attitudes and sense of commitments to succeed.

It is no wonder there are potential students queuing up to be accepted as his mentor students in spite of his high fees to mentor and hand-hold for 2/3 years each mentor student.

Under the chapter on Effective Money Management & Winning Psychology, I was pleasantly surprised to see in print the results of a joint competition that I persuaded Ray to be my partner when I came across the Daniels Forex Futures competition in June/July 2007 which allowed two joint contestants for entry.

We were placed in top positions many times but on the final day, placed second, losing out by just over 1%. It was not so much about winning the competition as participating to test his methodologies in the real-world of trading. The results shown in the attachment prove that the tools in Ray’s book do produce good results if and when applied properly and free from the ‘rat brain ‘ syndrome.

I would recommend this new book to all traders, especially to students of BarroMetrics and Ray Wave, to buy this book and study it as your bible of trading well.

The first edition by Ray is harder to comprehend and by reading the second edition by Wiley press, I personally find the reading and comprehension go hand in hand after reading both.

Daniels FXFutures Trading Results

Daniels Trading Results

Anna Wang

STC Student

November 11, 2007

The Expectancy of a Trade & Your Trading Plan

The Expectancy Return formula identifies the key area on which we need to focus.

Most newbies focus on the win rate. But the win and loss rate are less under our control than the Avg$win and Avg$Loss. This post will explore the reasons for this.

No matter how good a trader we may be, we will experience drawdown periods – where everything we do is wrong. On the flip side, we have long-term losing traders with periods where all they do turns to gold. I believe the reason for the phenomena lies in the nature of free markets. I liken the market to waves within a limitless circle; and I liken our market knowledge and trading plans as a rectangle within the circle. As long as the waves wash into our rectangle, we enjoy success; the more our rectangle is filled, the more success we enjoy.

But when the waves recede from our rectangle, we experience drawdown periods. In this metaphor, we have little control over our win/loss rate; it depends entirely on whether or not the tide is in our rectangle. Sure we can increase the size of rectangle (i.e. increase our self and market knowledge); but since the circle is limitless, we can never know enough to prevent the drawdown periods.

On the other hand, the Avg$Win and Avg$Loss is totally within our control because they are dependent on our entry and exit. By focusing on expanding the difference between our Avg$Win and Avg$Loss, we create our profitability.

By the way, it’s easier to decrease the loss than to increase the profit. When I take a trade I ask a series of questions whose answers prepare an exit before my stop is hit. One of the questions I ask myself is: “What does the trade have to look like for me to remain in the trade?”. Another question is: “What does the trade have to look like for me to exit?”.

The attached JPG of my personal account shows the difference between a good trading month and a poor one. October was a poor month: my total Win Rate and Loss Rate were almost equal (+17 to -16); but the $Loss was 1.3:1 to 1.0 $Win; and as a result, I lost (3%) for the month. Now have a look at Feb 2006.

In Feb I made only $5000.00 more than October, but my losses were ($38,000) compared to October’s ($114,000.00). As a result, I made a whopping +6.9% ROI!

My results for 2006 to 2007 show we’ll make money if we focus on our entries and exits and thus increase the difference between our profits and losses. The alternative is to focus on improving our Win Rate and that is much harder to achieve.

Monthly Results 2006 - 2007