Trading Book Reviews

Book Review: Reading Minds and Markets

[easyazon-link asin=”0132354977″][/easyazon-link]I’ve recently been reading a book titled [easyazon-link asin=”0132354977″]Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace[/easyazon-link] by Jack Ablin. Ablin is a long-time money manager with experience in both the fixed income and equity markets. While at first glance I think a lot of folks would probably say this book isn’t really something traders would be interested in, I think there are some nuggets to be had for those with a fundamental approach to the market and those who like to have a big picture view of things.

I don’t know how well the title actually sets up the book. Clearly it was crafted to hit the hot button concepts. The book is primarily about asset allocation – picking the best place(s) to put money to work.  Ablin provides what he considers the five ways one can look a the markets (speaking mainly of stocks and bonds here, but thinking on a global scale) to evaluate areas of potential opportunity. For each of those ways he provides some ideas for metrics which can be used to provide the necessary relative analysis.

The discussion of different potential metrics I found quite useful. It stimulated some ideas for me in the things that I do, and I’m sure it would do the same for other readers as well. These are, of course, more macro measures looking at broader themes, but that’s the basic point. Ablin pounds the table quite frequently about the value of looking at things top-down.

High level portfolio allocation type books can sometimes be very dry and boring. This one is actually quite approachable. The author includes quite a few personal anecdotes from his experience managing funds, showing both his triumphs and the short-falls which motivated him to improve is knowledge and methods. My one gripe was that the book was written to a bit too low a level of reader. Obviously, that makes it accessible to a wider audience, but I personally found some of the written annoyingly basic.

That drawback aside, for those who are interested in top level asset allocation type decisions, or who want a set a tools they can use for macro level analysis, I think this is a book which can offer up a lot of useful tips and ideas.

Reader Questions Answered Trading Tips

Scalping Individual Stocks

What is the best way to approach trading only 1 stock over and over during the trading day? I know scalpers that take up to 100 trades a day and trade only 1 stock

I got that question the other day. This is one of those times where I have to admit I have no idea. I don’t scalp, have never scalped, and have no plans on scalping individual stocks. I have no desire to be that fixated on the price action day-in and day-out. I’d probably go crazy.

That’s just me, though. I know there are folks out there who scalp and do it successfully. For the sake of the asker of the question above, I encourage any reader who has experience in that area to share their thoughts on the matter.

Reader Questions Answered

Minimum Amount Required for Option Trading

How much capital is required to trade is a question which crosses just about every trader’s mind somewhere along the way. It certainly comes up in questions on trading forum sites frequently. I actually got a fairly specific version of the minimum funding questions yesterday by and emailer.

How much is needed to start trading options? What things should I be considering before going ahead?

There are a few general things which come in to play here:

  • How many positions will you have open at a time?
  • What is the price level of the underlying market?
  • Are you trading in, out, or at the money options?
  • Are you doing outright long/short positions, or spreads?

Obviously, the fewer positions you have open the less capital you need. Likewise, if you’re trading options on lower priced underlying markets the price of the options will tend to be lower. For example, an option on a $100 stock is going to be markedly more expensive than one on a $10 stock.

Similarly, there’s a difference in cost, and thus capital needs, depending on whethere you are trading options that are in-the-money (ITM), out-of-the money (OTM), or at-the-money (ATM). ITM options will be the most expensive and OTMs will be the cheapest, and the further away from ATM you get the greater the price differentials.

Finally, if you are doing outright long or short positions your capital needs will probably be greater than if you are spread trading. This isn’t a guaranteed thing, though, as in some cases spread trades can require just as much capital as going straight long or short. It depends on the strategy in question.

Consider the strategy as well
Beyond those basics, there is the need to look as your method of trading and what it means to things like exposure and potential drawdowns. More frequent trading probably, but not necessarily, means a higher capital requirement. That likely depends mostly on how many overlapping positions you’d have, but also takes into consideration transaction costs. They can really chew up an overly small account.

What kind of losses you may take on individual trades makes a difference as well. If you are figuring that you will lose all or most of the money you put into a trade (or potentially more if you’re shorting) then you’ll need more capital than if you normally would only take fractional losses on the options when trades go against you.

You also need to consider your risk of ruin, in a manner of speaking. Basically, that’s a look at the potential drawdowns you could suffer. You have to make sure you’ll never lose enough to keep you from being able to trade any more. That means having enough staring capital to make sure any drawdown that may come about will not cause too much trouble.

Bottom Line
If you’re just getting started in options, stick to one position at a time and one contract in size, and focus on lower priced underlying stocks you could probably begin with $1000 and be assured of at least a few trades to get your feet wet. Once you’re beyond that stage and are set to really make a go at trading options with a decent chance of success you’ll probably want to be working with something

Trading Tips

Adding to Your Winning Trades

At some point just about every trader starts pondering the question of if, when, and how to add to winning positions. After all, part of trading success is getting the most out of your winners, while of course also minimizing the impact of your losers. Let’s look at the two primary strategies for doing so.

Start Small & Build
One approach some trading take is to start with an undersized position when first entering a new trade. For example, if they would normally look to risk 3% on their trades they might start off with only 1% exposed. The idea here is that any given trade could be profitable, and they don’t want to miss out all together, but that they want to see some kind of confirming move from the market before moving up to a full-sized position, or expect to see a counter move that could be used to get a better price.

This approach is often referred to as scaling in. Traders who find themselves often getting in too early on a market turn (like a change in trend) can benefit by this approach because it makes sure they are in should the entry not be too early after all (ensuring some profit), but allows them to move the remainder of the position in at potentially an even more attractive entry point.

This approach generally isn’t great for a strategy where trades tend to be immediate winner or loser types, meaning the market either takes off in favor of the trade or it moves directly against it to get stopped out. It can, however, be very good where there’s some kind of secondary confirmation that the trade is likely to be a winning one. For a chart based trader that could be something like seeing a higher low when in a long position.

Doubling Up, etc.
The other way traders look to add to positions is to use the profits from a winning trade to expand their position. This is particularly the case in markets like futures and forex where gains from open positions are immediately available to be used as margin for new trades. For example, if a trader is long an S&P 500 e-mini contract and the market rises 20 points, they have an extra $1000 in available margin money in their account. That may let them expand their position by doubling up (depending on how much they had in the account in the first place).

Needless to say, adding to winners should be based on a well-defined methodology and not just done willy-nilly.

Your Position Adding Mindset
Doubling up or otherwise adding to positions that are already what would be considered “full-sized” requires a clear mindset when thinking about what it does to your risk. Basically, it comes down to whether you are going to think in terms of risk on your original equity, or risk on your running equity (original plus open position gains).

Generally speaking, if you take the former view you are going to be willing to be more aggressive when it comes to adding to positions because you will in essence see it as playing with house money. That is all well and good as it can definitely make for some really big winners. Be aware, though, that it can lead to major equity swings as the over sized positions moved up and down (a position of 2x is going to move twice as fast as one of 1x). In some cases big gains are going to be wiped out very quickly because of a price reversal. That can be extremely deflating, so the trader needs to balance things out to have the drawdowns at psychologically (and bottom line profitability) acceptable levels.

Traders who look to running equity as the basis for risk assessments will be taking a much more conservative approach. They will be much less likely to add to trades in large chunks because it would generally exceed their risk parameters. For example, if a traders uses 2% as their risk threshold, they start with $10,000, and have $1,000 in position profits their permissible risk on the trade will be $220. That’s only 10% higher than what it was at the start of the trade. Is that enough to be able to add to the position? Probably not.

While it might sound like the “playing with house money” mindset is likely to be the more profitable, it doesn’t make it the right or better one. It’s a much more volatile approach and as such one not suited for many traders. The first time you see a big gain wiped out in a blink because of the bigger size you will know what I’m talking about.

Test, test, test
Adding to positions isn’t something that should be done randomly. You should have a strategy for doing so, both in general terms and on a trade-by-trade basis. Know what your strategy is go in. Test the strategy out with different variations so you know what will work for you and what won’t. That way, when the time comes to add that extra contract or lot or whatever, you’ll be comfortable in doing so with the knowledge of what to expect.

Reader Questions Answered

A Reader’s Story About a Stop Getting Hit

A reader named Susan left this comment recently on the Some Not-So-Great Tips for Using Stop Orders post I wrote a while back. I think it does a great job of highlighting a situation – or at least a type of situation – which new traders find themselves in where stops are concerned.

I have a question, as a newbie to trading, and using things like stops, etc. We had purchased a stock that started to go up… after it was in profit, we placed a stop order, for about .15 below the current trading price. Until our stop order, the stock was steadily (fairly quickly) headed upwards… but just in case we were not at the screen, we thought we would try a stop order.

I can’t figure out if we did something wrong, or what happened. But this is my perception of what happened -… within seconds of my placed stop order, the stock price steadily dropped to my exact stop price, my shares sold, and then headed right back up to the previous high, to go on higher. All within 5 mins or less.

I am aware stock prices fluctuate, but to my eyes, it seemed my lower “steal of a sale price” was noticed, somehow snatched up, and thing continued on upwards.

Prices can fluctuate, and I guess coincidences can happen. Or the more obvious answer may be that I didn’t place the order correctly, or understand what was to happen once I did.

My understanding was that this price was to execute only if the stock (naturally) dropped.. not to sell at this price immediately (which would otherwise seem kinda MARKET….).

I know this isn’t the case, but it seemed as if someone could read our price, got the stock prices to go down, grabbed ours at a “deal/steal” and then got the stocks to start moving up again. But I can’t grasp what did happen, likely because I have no experience, so likely a misunderstanding of stops altogether, or movement of stocks, in the least.

Any help in understanding this? Thanks so much for your time.

OK. We don’t know what stock Susan is talking about here, so we don’t have a proper frame of reference for the price movements likely to be seen. That said, when I read that she was using a stop 0.15 below the market I just about fell over. I think most experienced stock traders would agree that this is probably way too close. A move like that for most stocks is little more than statistical noise. You’re almost guaranteed that it will get hit just as a result of normal price volatility created by the interaction of buy and sell orders hitting the market – or by news induced price swings.

Tightness of the stop aside, anyone who’s been in the markets for any length of time has seen at least one instance of their stop getting hit and the market basically turning right back around. It’s very annoying, of course, but if you need to expect it. All you can do is review the analysis you did in placing your stop there and see if that was the right decision given what you knew at the time.

There are, of course, situations where stops and other standing orders do get “run” by the market, where large players attempt to create price movement to trigger the execution of those orders. That really only happens when there are large numbers of stops all in a very obvious location, though. Chances are if you’re stop is hit it probably wasn’t any conscious act.

Reader Questions Answered Trading Tips

Shifting from Trade Signal Follower to Trader

Trader Rob from north of the border in Canada (at least that’s north of the border for me) has submitted a question that actually feeds into something I plan on working on in the not too distant future. He wants to know how to shift from trading under the direction of someone else’s methodology to trading on his own.

Hello John and Thank-You for the opportunity to ask a question that I have been working on !

I am currently new to day trading and am going to do everything possible to make this my new career. I am spending lots of time reviewing, learning and actually trading. My trades are based on a buy/sell list provided to me for a fee combined with what I have learned so far. Currently getting better all the time but still a lot to learn.

My question is this in the hopes of including it in my studies.

If I am going to make this my career I will have to pick my own shares to trade, where should a great portion of my studies focus to help get to this point quicker ??


Rob in Canada

Rob is facing the issue new traders almost always face when they base their trading on someone else’s signals. Eventually, they are going to want to (in most cases) break away and make their own decisions. The path they will take is generally going to be one of two main choices. 

The first possible path is continuing to employ the same main strategy as the person providing the signals they’ve been using, obviously with them becoming the one identifying the trading opportunities and devising the trading strategy. This path is possible if the signal provide is one which does more than just says “Buy here. Sell there.” The provider must be taking the trader through a process which has previously been outlined and repeated so that the trader can see it in action, then try to get their own work to produce matching – or at least comparable – results.

The second possible path is for the trader to venture off on their own, either because the signal provider doesn’t provide the system education required or because the trader wants to go in a different direction with their trading. In this case, the trader should take whatever they learned from following someone else’s trades and apply it to figuring out where they should go. That’s things like trading timeframes, markets, methods, the type of risk and volatility that they can tolerate, and all those things that go in to developing a good overall trading plan. With that in hand the trader can narrow in on what would likely work for them and begin the requisite study.

What should Rob do?
Rob seems to be happy with the trades he’s doing based on the recommendations he’s getting. In that case I would work on trying to match up the results of his own research with that of what he’s being sent, at least as the first step (he can look to improve later). One way for Rob to do this could be to run a parallel demo or paper trading operation based on his own work.  When he’s comfortable with being able to mostly match up with what he’s being sent then he can make the leap into doing the live trade identifying and strategizing entirely on his own. Along the way, if he has the funds, Rob could split is capital and trade part based on the signals he’s receiving and part based on his own work – slowing shifting the balance toward his own strategies as they become on target.

Now, if Rob wants to go in a different direction then he needs to figure out what kind of trades he’s after. Day trading is the expressed focus, so he’ll need to figure out the characteristics of the types of stocks he’s going to want to trade and come up with a way to find them. Of course knowing what kind of trading he wants to do first, in terms of type of moves he’s going after and the system or method to find those trades, would help him better know what kind of stocks to seek. Chances are this is going to mean some testing.

Thoughts on Using Trading Signals
I have said many times that I am not a big fan of people trading off of signals they get from someone or something (blackbox) else, especially new traders. Experienced traders who know what they are getting into can perhaps work with other people’s signals, but a new trader generally speaking is going to struggle to stick with them.

The simple facts are that most trading systems don’t work for most people and that is mainly because they aren’t the right fit. An experienced trader can look at systems and methods, see how they trade, and know if it could work for them. New traders don’t have that ability to make those judgements yet, and end up getting caught up in the profitability figures without thinking about all the other stuff involved. New traders are much better off doing a lot of system and method research and testing so they can learn the markets, learn the methods, and learn about themselves as traders than trying to let someone or something else tell them what to do.

Please do note that I am differentiating here between a trader who actually executes the trades of their own volition and a money allocator who is simply looking to let someone/something else make all the decisions.

Unless you can look over their shoulder
Having said all this, the exception I would make in the no signal taking suggestion is the case where the trader can learn from someone along the way. By this I mean the signal provider is walking the recipient through the trade selection methodology, analysis, screening, or whatever goes into the trade identying, strategizing, and managing process. In that case the trader can learn by watching and doing, which in the long run has potentially considerably more value than just being told where to go long and put your stop.

This sort of thing is actually something I am planning on getting going myself. I’m going to set something up where traders can follow along the analysis that I do so they can learn to apply the same techniques themselves. Look for more on that in the not too distant future.

Trading Tips

Happy Accidents are Rare in Trading

Brian Shannon at AlphaTrends recently wrote the post Bad Trade Gone Good (with some luck). In it he describes a recent situation where he found himself on the wrong side of a major trading mistake. Actually, it was a couple of them.

On the one hand, Brian hadn’t set a stop as he normally does when placing trades. He’d been distracted. On the other hand, he entered an order 10 times the size he intended! 😮

I think it’s probably a safe guess that the same distraction which cause not putting in the stop also caused the error in position size entry. Right there is a good lesson for traders – especially those who are thinking about trading in a timeframe where they can’t assure good focus (like trying to day trade during work).

If you can’t be locked in as you should be, then it’s probably best not to be trading that particular time.

There’s another side of Brian’s story, though. He got lucky because the market actually turned back around and put him in the green on a position that would otherwise have been a major loser. He really should have taken a sizeable loss.

In this particular case, the fact that Brian took the time to look at the chart to see what the situation was allowed the market enough time to make the turn. As Brian noted, though, this is pure luck. It’s not something you should ever expect (or pray) to happen if you get caught on the wrong side of a hit like that.

Actually, I’m not all that keen on the idea of doing a re-analysis as Brian was starting to do. There is a huge risk of developing a skewed view of things, one that ends up being biased toward what you hope to happen. It comes from the old trap of weighing positive evidence too heavily and negative evidence too weakly.

That’s why you should do all the analysis and strategize before you get in to a position. If you know what the plan of action is for the different scenarios which could unfold (both positive and negative) you can avoid the need to re-analyze the market mid-trade. This will prevent both over-analysis and skewed perspective analysis.