How David Beats Goliath

Trading is the game in which Goliath and David are consistently fighting: On one side we have institutional traders, mostly banks, with all computing power of the world; with best quants on the world; with guys that are paid millions of dollars to make decisions. On the other side, there are small guys, operating in small rooms, armed with one or two PCs and Internet connection.

If you face and ask any of these Goliaths if there is a way for David to beat them consistently and survive in trading game, they would probably simply say that such path doesn’t exist. Is there truth in it? For sure there is! Big institutional traders think that small retail trader cannot make money consistently enough to survive. (I guess, statistics is on their side too.) I kind of agree with such thinking, but I would say that retail traders can’t make money if they are to play the same game that institutional traders are involved with.

History is showing us many examples in which David beats Goliath and one simple recollection from the top of my head is from the world of sports - as small teams do beat big teams often enough. How they do it, and how retail trader can make money in the game where his odds are much smaller than odds of big guys?

I believe that first and most important decision is not to play the game in a very same way institutional traders play it. They move millions or billions in one transaction. Retail traders don’t have that capital, so there is no reason for massive movements to occur. Big guys make decision based, mostly, on fundamental information - small guys don’t have to do that. Big guys must buy newest and best performing PC systems every few months, while small guys don’t have. Big guys must pay massive salaries to all those cleaver guys working for them - small guys don’t have to fork out fat pay-cheques at the end of every month.

Even though big guys have big advantage, they still have more than few disadvantages stacked against them. So, don’t worry what institutional trades are saying and simply go and find a way to attack them when they are the weakest. And then, just take portion of their money.

Many wars were won by smaller and less equipped armies and numerous underdogs won in sporting events when nobody gave them a smallest chance of winning.

It was done, it is done daily and it will be done as long as we are around.

Trade with trend.

Tour de France

You must be thinking this market is making me crazy: What Tour de France, the most prestige bicycle race in the world, has to do with trading?

I shall say: It has much to do with trading. It is very nice business and, for that matter, trading lesson could be learned by watching Tour over last two weeks: It's very difficult to improve your performance on the downhills. 

Yesterday we had one of the stages with many hills, followed by many downhills. Best riders, including Lance Armstrong, were pushing hard uphill, making their time difference grow and then they would just fly downhill being more relaxed and just keeping their advantage intact. Simply, the biggest portion of leaders’ advantage was made on uphills. 

So, we are hitting some sideways market and that’s when system like ours is not to produce stellar results. Not that we are losing money, but net winning number of points dropped substantially when compared to historical average of the system’s performance in various market conditions. Simply, we are in period when trades that were few hundred points in profit are closed flat and trades that were green get closed at the stop loss level. All in all – it is very frustrating period for trend followers.

However, we are on the uphill section of our trading, so we must work, learn and find better ways of trading. Hills are where all work is done - When trend develops, downhill section of our trading will start and that is when maybe 2000 points, maybe more, will be made per month. 

I believe that most of traders spend their days looking forward to those rare moments when everything goes right. Imagine how much leverage one would have if one spends his/hers time maximizing those common periods during which everything is not absolutely smooth and easy.

Trade with trend.

Trading system

I’ve exchanged some emails with readers of this blog, so it looks to me that some information was wrongly interpreted. I would like to use this post to clear things up a bit:

Trading system is one of three important components of one’s trading and I believe that we start our development with trading system which should be foundation of our success. 

Three components of trader’s development:

1. Trading System

2. Money Management

3. Discipline/Psychology

As I stated above - trading system is the first component profitable trader has to have under his/hers belt. Without profitable trading system one will not be able to make it, simply because systems with negative expectancy DO NOT make money.  

Finding proper trading system for each person is difficult task as system that suits me, might not suit somebody else. We all have different personality and it is absolutely OK not to have same interest in life and same trading systems. But, what matters to all of us: System must deliver, as it must have positive expectancy!

Expectancy: 

(Average Win * Winning %) - (Average Loss * Losing %) > 1

or

(Average Win * Winning %) / (Average Loss * Losing %) > 1

As there are thousands of blogs/web pages about trading systems, let’s simplify things a bit: 

Systems are either mechanical or discretional. 

Mechanical systems are driven by strict rule(s) and they trade every time condition(s), defined by rule(s), is (are) met. Some typical mechanical systems are: moving average crossovers, moving average penetrations, price brake outs, etc.

Discretional systems are designed around some of trader’s observations. As an example: Trader notices that if market does not make new high of the day in first hour of trading, then there is good probability for the market to fall. Then, in each and every single situation of this kind, trader might use news, technical or fundamental analysis, etc. to accept or reject assumption that market might fall and with all of that in mind he/she will make his/hers decision.

Systems could be designed around different time frames and some are to be used intraday, while other will hold position overnight. Simply, there are numerous systems - in many time frames, based on many different criteria, but all of them must have one common quality, to even be considered by a trader: Systems must have positive expectancy. 

I shall recommend one thing here: When you design your system, please write down all criteria for execution of trades. If you don’t have a system on paper with everything stated nice and clear - you simply don’t have system, as what you have are just words that might-work-or-might-not when money is on the line.

Trade with trend!

Taking a loss

Why many people are not making it in game of trading?

My guess is good as yours about this, but I would like to point that I personally know few traders and investors who are very uncomfortable with taking a loss.

Losing traders often bring a measure of perfectionism to their work, as these trades create some extra pressure. They equate a good trading day with a profitable day. No, no, no! A good trading day is one in which you have followed your well-researched plan with focus and discipline. Good trading days, over time, will generate profits if your trading plan and risk & money management make sense. But, the uncertainty of the markets means that even the best laid trading plans can go awry. 

In the short-run, you cannot control your profitability.

You can control whether or not you have good trading days, which will generate profits over the long haul—if you have adequately researched your strategies.

The perfectionist trader equates taking a loss with experiencing failure. The loss thus sets up a rash of negative internal dialogues and subsequent trades born of frustration. A more realistic trader realizes that there is a degree of uncertainty built into the market and that losses are simply a cost of doing business. The goal is to limit these losses as effectively as possible, not exclude them or become preoccupied with them.

System which is used here by us to trade ALSI is always in the market: It will stop your position and, at the same time, it will give entry for position in opposite direction. So, we should not worry much about stop losses, as price levels and chart structure are there to act as stop loss for every trade we take.

If you are using different system, you can base your stop losses on:

1) Price – when certain price level is broken (to upside or downside) you close your position;

2) Time – this one is for intraday traders who are closing their trades at the end of the day w/o any consideration;

3) Indicator – if your indicator clearly suggests that your position is not correct. 

Once stops are set, they should be mentally rehearsed while the trade is on, as a way of ensuring that they will be honored. A good loss is a planned one; the only true market failures are the ones that are unintended.

Discipline is at the heart of exemplary trading: When you set, rehearse, and honor stops, you are building that discipline and using your losses to reinforce the qualities needed for success.

Successful traders plan for “failure”; unsuccessful ones fail to plan.

Trade with trend!

This blog post is dedicated to work of Dr. Brett Steenbarger.

Realistic goals

I believe that almost all of inexperienced traders came to trading field with very nice and defined goal: TO MAKE MONEY.  

Is goal of making money in markets realistic or not?

If one just has started with trading, then this is not even remotely realistic goal. Same would be to ask first year medicine student to perform open heart surgery or to ask somebody who just started going for music lessons to play some complex piece by Mozart or Beethoven. 

What would be realistic goal for beginners?

Short answer: Their goal should be to survive for as long as possible.

Long answer: To be around in 10 years time.

Above is table that shows how one could progress as trader. Assumption is made with ALSI trading example in mind and in this scenario there is enough start-capital to trade one contract. (Just a reminder: That start-capital should be, at least, equal to two times margin requirement.) Let’s assume that during first year of trading one makes no profit or loss. After 12 months one improves and learns something about trading, so for the following 6 months he/she makes on average 100 points per month. Time is passing and our novice trader manages to survive for 30 months since first trade was placed and he/she now knows how to trade and he/she is making 1000 points per month on average. This is what the table below is showing us - how the money, despite we are looking into very conservative scenario, is growing exponentially and why is important to consider this as marathon run, as trading is definitely not a sprint. 

Numerous novice traders come to trading and dream about millions they are going to make after first few trades. Sometimes, one could be lucky and make it in a very short period of time and with little effort, but same goes for lotto. 

This is not game of luck - it is game of probabilities. 

* Required capital – As of July 9th, 2009 margin amount equals to R 15,500.00.

If you need an Excel file that you can play with, please contact me by mail or post a comment here on blog.

How to find trading system

How to a find trading system is a question that I’m asked very often.

There is an ever going quest to find a good trading system and once you have one that is making money, you will probably try to get an even better one - by trying to improve existing one and by squeezing even more points out of it.
Web is full of trading systems, sold for $99.95 or so, with promises of making you million or three over next month or so. I would like to ask - If it is so profitable, why the owner would sell it for that amount, when he/she could trade it and retire after few months.

Finding a trading system is a time consuming process. One should have reliable data for market that one plans to trade and software with back testing capabilities. I use Metastock for back testing (same software is used for charts) while for ALSI data feed I am subscribed to local data provider - Hisat.

Metastock has very nice back testing capabilities and it comes with approximately 40 trading systems, ranging from simple to very complex. All systems are explained and focus is on what they are using as signal and what is being done with optimization parametars, with possibility to test across array of numerous time-frames, stop-losses, etc. So, it is possible to input any parameter that you can think off and see what the outcome would be.

There is somewhere on the web a trading idea to optimize some trading system by going only long after winning trade and short after a loss. So, absolutely anything is testable and tradable.

When it comes to data that is to be used for back test, one should choose market and time frame first. Also, one should have idea what one wants to trade - ALSI futures or white maize maybe; maybe gold; pork bellies or government bonds. There are hundreds of markets out there, so one should be wise when choosing one. There is no need and urgency to go for main-stream markets, but for one that is liquid and relatively easy to trade. Time frame could be changed, as back test will allow you to look into all time frames you like - from 1min to weekly chart.

I would recommend starting with some trend following system, i.e. moving average penetration or crossover. After one finds system that has positive expectancy, next step is to paper trade it in live market conditions. One should record all trades - every winner and every loser and I would recommend for that trial phase to last for at least six months. System must prove itself over as many trades as possible, with some bare minimum of 400 trades. Only after all these steps are completed, I would recommend that one should go in with real money.

This is just for starters. From there on, one should develop as a trader. System is only 10-20% of success, as there are many other factors one should work on after system with positive expectancy is in place.

Trade with trend.

NOTE: Positive Expectancy = (Average Winning trade x Winning %) / (Average Losing trade x Losing %) > 1

Where to start from when it comes to trading

I often get a question from various people about list of books they should read before they start with trading. My short answer is always the same - As many as possible! 

Here is a list of several books that I like a lot. 

Psychology of trading:

(Dr. Brett Steenbarger is a must – With all three books written by him.)

The Psychology of Trading

Enhancing Trader Performance

The Daily Trading Coach

Trading in the Zone by Mark Douglas

-------------------------------------

Technical Analysis:

Technical Analysis Explained by Martin Pring is a must

The Candlestick course by Steve Nison
-------------------------------------

Other: 

Reminiscences of a Stock Operator by Edwin Lefèvre

Market Wizards by Jack Schwager

Trading for living by Dr Alexander Elder

Come into my trading room by Dr Alexander Elder

These books are just to start with. When you are done, there are many other more sophisticated books discussing different trading topics.

Trading is a performance field in which one must learn every day. Even after almost six years of successful trading I’m still buying books and looking for new ideas. If one wants to be successful in trading, then that one must love and appreciate trading as endeavour - Just because of that love and appreciation one should consistently try to enhance his/her knowledge and skill. 

Isn’t that case with anything you do in your life?

Trade with trend.