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Trading Tips

Five Observations from Successful Traders

Tim Bourquin has an article at TradingMarkets in which he discusses what he calls 5 Uncommon Rules of Wealthy Traders. The rules were commented upon by zentrader.ca in his 5 Unique Rules of Trading post, and I thought I’d toss in my own two bits to the discussion. Here are the rules as Tim outlined them.

1. They plan every single trade. EVERY SINGLE ONE.

2. They stopped trying to pick tops and bottoms years ago

3. They are patient with winners – and ridiculously impatient with losers.

4. They trade one market. ONE

5. Their benchmark for success is anything but money

The first observation is a very simple restatement of “plan your trade and trade your plan”. If you don’t have a specific plan going into a trade you are gambling. We traders are not in the business of gambling. We are attempting to apply a methodology with a statistical edge over a large number of trades to allow that edge to create a positive return. That takes planning and consistency.

Tim’s second observation is a reflection of the fact that no one can know what the market is going to do for sure. Even if you are right about the market making a turn, shifting out of one trend and into another, the chances are you won’t get the timing exactly right. You have to realize that and account for it in your risk management.

The third item is basically “cut your losses and let your winners run” stated in another way. I definitely won’t argue the cutting of losses quickly side of things. If the market doesn’t act like you anticipated and you don’t get out of the trade, then you’re hoping it turns around. Hope is not something you want involved in your trading at all. Remember, you can always get back in. As for the letting the winners run, that depends on your system. Some systems have specific profit targets and not abiding by them could be problematic.

I’m not sure I can totally agree with the fourth item, trading only one market. If you are a short-term trader, then that certainly makes a lot of sense. As you get out the time span curve, though, adding in additional markets may make sense. For example, the Turtles traded numerous markets because that was the only way they could ensure a sufficient number of trades to make their system worthwhile. That’s really the key – the number of trading opportunities. You need them to be sufficiently large in quantity to allow the probabilities to work in your favor.

As for the final observations, I agree wholeheartedly. The money focus trap is a big one for new, low-capitalization traders especially. It leads them to take on more risk than they should. After all, when you only have $1000 in your account your gains or losses are only going to be so big in nominal terms. It’s hard to get excited about a $100 gain, maybe. If you focus on other metrics, such as % return, however, things become much more meaningful. That $100 gain becomes a 10% gain, which tells you something much more important. Also, a $10,000 gain is much less impressive on a $1,000,000 account, for example, than on a $25,000 account.

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Trading Tips

Some of the worst market analysis ever!

I came across an article the other day which got my blood boiling a bit. It basically talks about trading the “spread” between the S&P 500 and EUR/JPY forex cross rate. The author was quite happy with himself for calling the spread being exceedingly wide and recommending a spread narrowing trade. He went so far as to say “Selling ES and going long EURJPY is now pretty much risk free.” I don’t know what anyone else’s definition of “risk free” is, but this trade certainly isn’t mine.

I don’t have any problem with the general idea underlying the trade that stocks and the EUR/JPY rate tend to trade in tandem. It’s been the case for quite a while now that when the market’s are feeling good and buying stocks EUR/JPY (and really all the JPY pairs) will rally, but when the markets are nervous and shifting into a risk aversion mode both the exchange rate and the stock market falls.

My issue with this analysis is this. The author is using a dual-axis plot of the S&P and EUR/JPY (meaning two price plots with different y-axis) to determine the “spread”. When there’s a gap between the lines there’s a spread. When there isn’t, the spread is zero. That would all be just fine if the S&P 500 and EUR/JPY were even close in price, which they aren’t.  At this writing the mini S&P contract is at about 1066 while EUR/JPY is right around 110. Notice how they are not anywhere close to zero?

This has got to be some of the worst analysis I’ve ever seen. Please, please, please don’t every employ this methodology – if you can even call it that.

And calling or implying this trade is some kind of arbitrage is even worse. There is absolutely no mathematical or other direct linkage between the S&P and EUR/JPY. That means no arbitrage, just a coincident relationship. It just so happens that in this market cycle they are trading based on the same main drivers. That could change at any time. That means you most definitely have risk.

Again, I’m not necessarily arguing against the idea of the trade (stocks and cross get back in line). I’m just saying the analysis used to get there is severely flawed and dangerous.

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Reader Questions Answered

Entering Trading Positions Around News

Last week I took part in a Currensee panel discussion titled Scalper, Swinger, or Holder. The main discussion, as the name implies, was about trading time frames. Fellow panelists Mike Baghdady, Shaun Downey and I took several questions at the end. Here’s one we couldn’t get to during the allotted time, but I think is definitely worth a blog post here.

Would you prefer to enter into a trade “before” or “after” a NEWS event. Would it depend on how big of an impact that the news has on the market?

If you are a short-term trader, putting a trade on right before a significant news item is essentially the same as gambling. You’re putting your account at risk on what’s basically a coin toss. Traders are not in the business of taking blind risks. They look to repeatedly apply an edge to make money in the long run. For that reason, I’m in favor of waiting until the dust settles after the event.

As to whether it depends on the impact of the event or news item on the market, I would suggest being very careful here. We can certainly point out the major calendar items which will have the market focused on them (payrolls, central bank rate statements, etc.). There are a whole lot of others at the second level, though, that during any given period of time can either be very important or totally ignored. You need to be very well plugged into the market to know which are likely to create volatility on a given day and which probably won’t. And of course even a high profile release or news item might prove a complete dud. You just never know.

Now, if you are a longer-term trader then trading before a data release or news event probably isn’t going to matter much. It’s just a question of how much a potential adverse market move in reaction would impact your position. Of course, if you are a fundamentally driven trader, and the news event in question could alter your view, then you may want to wait to see the result.

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Trading Tips

Why You Shouldn’t Fixate on Winning Percentage in Your Trading

I’ve been reading Curtis Faith’s new book Trading From Your Gut, a review of which will follow shortly when I finish. The part I was going through this morning on my commute into work, though, inspired me to address the subject of win rate and good trading. Faith hits hard on the subject, which is one I’ve addressed on a few occasions myself.

Here’s the deal. Traders, especially newer ones, get way too hung up on being right and having a high win %. This comes from two underlying causes. One is the fear of being wrong. The other is the belief that one needs to have more winning trades than losing ones to be successful in the markets. Both are problematic and will cause trouble.

The need to be right is something which kills traders. As Faith puts it, the whole being right thing is for forecasters and prognosticators. Traders who get fixated on being right make very, very bad decisions sometimes – ones that potentially can blow up their account. They are the traders who hold on to losing positions way too long in hopes they come back because they can’t handle the idea that they were wrong and will have to take a loss. Of course that often leads them to eventually panic at some point and bail on a trade at exactly the worst possible time (as many stock traders did in March 2009).

The need to have a high win rate also encourages such silly trading behavior as “hedging” in the forex market. I’ve heard many a trader justify their taking an opposing position in the pair that is trading against them as letting them stay in the trade so it can eventually turn back in their favor. They seem to be ignoring the fact that all they’ve done when putting on a “hedge” like that is to lock in their loss. Like I said, poor decisions – ones based on emotion.

Then there are those who think that in order be a profitable trader you must have more winners than losers. Of course this is true if your winning trades are the same size as your losers. If, for example, each trade will either be a $100 gain or a $100 loss, then you need to win more than 50% of the time to expect to come out ahead in the long run. It’s a straight forward mathematical relationship. If you win 51% of the time then the expectancy for your trades is $2 ($100 x .51 – $100 x .49), meaning that on average you would expect to make $2 for each trade you do.

We can use the same math to demonstrate how you can also be profitable in the long run with a much lower win rate. Let’s use 25% as an example.

Keeping the same $100 gain/loss as above, we come up with a -$75 expectancy ($100 x .25 – $100 x .75). Not good. No big surprise there.

What if we change from a 1:1 winner-to-loser ratio to a 5:1 ratio, though? Let’s call that $500 for the winning trades and $100 for the losers. Running the figures we get an expectancy of $50 ($500 x .25 – $100 x .75). Not bad at all.

In general terms trend trading methodologies are the ones that tend of have low win % but high winner/loser ratios because they have a lot of small losses thanks to whippy, trendless markets but relatively large winners. Other systems go the other way, with lots of small winners and only occasionally a loser, but a big one.

Even for those with no real issue with being “wrong”, low win rate systems can be a challenge. They tend to be subject to lots of big equity swings because the high number of losers creates lengthy drawdowns. Those can be very hard to ride out, especially for someone who hasn’t developed confidence in their system.

The bottom line is that you should be focusing on making good trades not on making winning trades. Good trades sometimes lose money, but if you keep making them within the scope of a positive expectancy system or methodology you’ll end up ahead in the long run. Getting caught up in trying to make winning trades will almost certainly end up leading to disaster.

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Trader Resources

Alternative Ways to Play Interest Rate Moves

I’ve written in the past about ways to play moves interest rates. Among the ETFs I’ve mentioned are:

  • TBT – UltraShort 20+ Year Treasury ProShares
  • LQD – iShares iBoxx $ Invest Grade Corp Bond
  • HYG – iShares iBoxx $ High Yield Corporate Bond

The first one is a leveraged short play on long-term US government interest rates. The other two are standard plays on investment and high yield (junk) corporate bonds. Many of those in the latter two ETFs are probably holding them as income investments, but they can also be used in spread trade strategies with a view toward the relationship between different grades of corporate debt, or corporate debt vs. Treasuries.

The TBT, of course, is a flat out play on falling T-Note/Bond prices. Unfortunately, it is a leveraged play (2x) so it isn’t idea for a long-term play on rising interest rates.

Doing a bit of digging, though, I found the Rydex Inverse Government Long Bond Strategy (RYJUX). To quote the fund description:

The investment seeks total return, before expenses and costs, that inversely correlates to the price movements of Long Treasury bond. The fund employs as its investment strategy a program of engaging in short sales and investing to a significant extent in derivative instruments, which primarily consist of futures contracts, interest rate swaps, and options on securities and futures contracts. It invests at least 80% of net assets in financial instruments with economic characteristics that should perform opposite to fixed-income securities issued by the U.S. government. The fund is nondiversified.

This, of course, is a mutual fund rather than an ETF. That means you can’t trade it the same way you could TBT or the others. But that’s kind of the point in this particular case. If you’re looking to play a long-run rise in US interest rates, as is likely to be seen when the Fed begins unwinding its liquidity programs and raising interest rates, you don’t want something you’ll be trading in and out of on a short-term basis. This is probably something you’d look to play in a retirement (IRA, etc.) account.

Of course you could also play the futures and options markets to take a short position in Treasuries, but they have some short-coming when it comes to rolling positions forward in a long-term play.

The wider point I’d like to make here is that there are almost always ways to make a play on your expectations for the market. If you keep yourself educated about what’s available to you in terms of markets and instruments you’ll have the opportunity to be creative with your strategies, and potentially to find a better way to play for a given market move (or lack thereof).

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Reader Questions Answered Trading Tips

I don’t use stops. What do you think?

I got the question in the title of this post from a “fan” of The Essentials of Trading Facebook page. If you’ve followed this blog for any length of time you know that the topic of stops and how to use them is a frequent concern among new and developing traders (for example Where should I put my stop and take profit orders?). Let me approach this from a couple different angles.

The market will come back
If you are not using stops because you “know” the market will eventually come back you need a history lesson. Sometimes the market never comes back, or if it does it’s after such long period of time or such a big drawdown that you can’t hold on for the duration. Take a look at this S&P 500 weekly chart.

SP500W102009

Imagine if you had bought the market back in the fall of 2007 when the S&P was trading at 1500+. If you had not had some kind of protective downside exit plan you would have seen a loss of more than 50% on that position (not accounting for any leverage, which if employed would have wiped you out). That’s a hard thing to sit through, as many people who attempted to do it can tell you. The market has come back up quite a bit but is still more than 400 points below where it was. How long is it going to take to get back to those 2007 levels? Who knows. It could be years – years to get back to break even, meaning no gains for all that time in the market and your money tied up preventing you from trading anything else.

If you’re thinking “well that’s too long a time frame, I trade shorter-term” then look at charts in your time frame. I guarantee you’ll find examples of formerly choppy markets that would always come back becoming very unidirectional. You play that game long enough you are going to get burned badly.

Want an example? How about what GBP/USD did in a week.

GBPUSDH102009

The market rallied 700 pips between October 13 and 20. That’s a big hit if you were short. If you were trading with a modest 10:1 leverage ratio you might have survived the hit (at least so far), but it wouldn’t take a much higher leverage ratio to have seen a margin call triggered. Poof! Account wiped out. 🙁

My trading systems doesn’t use stops
This is a legitimate reason not to use stops, and is the reason why you cannot accept the blanket statement that all traders must use stops. If you do as much system testing as I have done over the years you will observe that there are types of systems which do not show improved performance when stops are introduced, expect perhaps in the most loose of fashion. These tend to be trend trading oriented systems, particularly those which are always in and/or use close and reverse type approaches.

Be warned, however. Some systems do leave you exposed to potentially large losses because of the timing of when positions are exited and/or reversed. You should be aware of these potential holes and make sure you have some kind of protection plan to guard against extreme moves. That might mean a very loose stop loss order or perhaps an out of the money option.

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Reader Questions Answered

Avoiding a Covered Call Being Called

A former classmate of mine from my undergraduate days (he and I were officers for the Finance Club once upon a time) sent me a question about option trading.

I want to get your thoughts on something – A covered call option that I wrote is now at the money with expiration in Jan. I planned to sell it in the new year so this is fine. Logically, it shouldn’t be exercised early but I’m not sure it will hold in practice? So, if the option is exercised early will I have a chance to settle for cash? or buy an offsetting option or the shares? It’s a big gain and selling the shares now means a big tax bill in 2010, that I’d prefer to hold off another year.

Now, I’m sure our derivatives professor will be disappointed that he doesn’t remember all the stuff he learned, but that was nearly 20 years ago, so I think some slack can be cut at this point. 🙂

Just for quick clarification for those not in the know, a covered call strategy is one in which a person holding stock (or futures, etc.) writes/sells a call option against their position. It’s a type of yield enhancement strategy in that selling the option provides a bit of income. Of course there are limitations and caveats. I won’t go too far into them here, though.

The concern of my classmate is about the stock being called from him prior to year-end. The option strike is clearly above his purchase price, meaning were he forced to sell it to the holder of the option he would have a gain to be booked, and thus a tax liability. He’d rather avoid that happening until into 2010.

Now options are very rarely excercised early because it generally doesn’t make sense to do so. The only time early exercise pays off is if there is no time value left on the option, implying the option is trading at or below intrinsic value. That basically never happens.

Of course you cannot be 100% sure an option won’t be exercised, which is my classmate’s concern. The problem, however, is that you can’t cancel out exercise risk all together without buying back that option. He could reduce the prospects for an unwanted exercise by rolling to a further out option and/or to a further out of the money strike, but any alternate strategy would still require buying back the original option in order for the exercise risk to be reduced.

But this does bring up an important point. As traders we often don’t give a lot of thought to the tax consquences of what we do, focusing instead mainly on attempting to generate profits (can’t tax what you don’t make). Sometimes, though, it makes sense to take a look at the tax implications of things.