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Three Reasons Why Most Trading Strategies Fail

MAIL BOXI wonder how would you rank order market selection, setup/entry timing, protective stop, trailing stops/exit and position sizing in terms of overall importance to the success of a trading system?

A:  Each are important, but in analyzing numerous strategies I have not seen a tried-and-true ranking system that fits everything.

The reason I think (and my research proves out) that why strategies fail are directly related to three main things: 1) user error (i.e. failure to act on the signals provided by your system in a consistent manner without trying to outsmart the system, 2) over optimization and use of extensive leverage, and 3) the most important of all – little to no risk management through proper position sizing and stops. All in all, if you really are focused on improving yourself in 2010, the first place to look is risk management as it has more of an impact over your eventual success or failure than anything else.

11 Steps for Successful Trading

 

  1. You must have a Mission Statement.  What’s your real motivation behind your trading?
  2. You must spell out your trading/investing Goals and Objectives.  You cannot get from A to Bvery easily unless you truly know where B is.
  3.  You must spell out your Trading/Investing Beliefs and Market Beliefs.  Please remember this very important statement, “You cannot trade the market.  You can only trade your beliefs about the market.”  Therefore, it’s a very good idea to identify your beliefs about the market first. 
  4.  Spell out your exact Trading Strategies.  How do you go about analyzing the market and what are the key things you look at in your market analysis?  What trade set-ups do you use before entry? What are your timing signals for market entry?  What is your catastrophe stop loss?  Where and when will you take profits?  Will you use a trailing stop?  Will you scale into the market?  What exactly is your trade management system once you’re into the trade?    
  5.  What are your Position Sizing Strategies?  This is part of money management and is very important in reaching your trading goals and objectives in terms of profitability. 
  6. What are your typical Psychological Problems in following your trading plan?  What is your plan for psychological management for dealing with these problems?
  7. What are your Daily Trading Procedures?  What should you be doing on a daily basis, not only to become organized, but to become methodical in everything you do as a trader, on a day-to-day basis.
  8. Do you have an Education Plan to Help Improve Yourself on a continuing basis?  If not, you should have one.  Like anything else in life, you need to be continually working on yourself to become better and better.
  9. What is your Disaster Plan?  What can go wrong, and how will you deal with each item?
  10. What is your Planned Income and Budget for Trading Expenses?  This is pretty simple and straightforward; write down everything you can think of and try to be as realistic as possible.
  11.  How do you Prevent Trading Mistakes and Avoid Repeating Them… if they occur?  Really sit back and think about this and write down any and all mistakes that you might make during your trading.  Once you do that, come up with a solution to each potential mistake that you might make so you don’t allow that to happen.

The Wisdom of Paul Tudor Jones

Here are some noteworthy quotes from the 80′s (yes 80′s) PBS special “Trader“, highlighting Paul Tudor Jones and his partner Peter Borish’s trading strategies. I’d like to thank Rodrigo for sending me this special, as I wasn’t familiar with Jone’s career. Even after a decade in the business you can still keep learning from successful traders in the hopes of fine tuning one’s craft.

What I found refreshing about Jones is his commitment to helping underprivileged high school students and his pledge to pay for their college education as long as they complete high school. And more importantly, the giving of his time each and every week to intervene in their lives.

“If life ever ceases to be an educational experience, I probably wouldn’t get out of bed.”

When the headlines are extremely negative day after day and the market refuses to go down, it’s “telling a different story than what the headlines are.” When the markets sell off in the morning and are bought up in the afternoon, it’s a sign of quite accumulation.

“After awhile size means nothing. It gets back to whether you’re making 100% rate of return on 10k or 100 million dollars. It doesn’t make any difference.”

“Trading requires an energy level, and it’s very difficult to sustain it 24 hrs a day, which is what this requires. To do the job right requires such an enormous amount of concentration that you’ve got to be able to…it’s physical and emotionally mandatory to find some time to relax, and you’ve got to be able to turn it off like that.”

“The whole world is simply nothing more than a flow chart for capital.” (more…)

11 Rules For Better Trading

Trading in the markets is a process, and there is always room for self improvement. So as we start the new year, here are my 11 rules that help me navigate the markets. By no means is this list exhaustive or exclusive.

Rule #1
Be data centric in your approach.
Take the time and make the effort to understand what works and what doesn’t. Trading decisions should be objective and based upon the data.

Rule #2
Be disciplined.
The data should guide you in your decisions. This is the only way to navigate a potentially hostile and fearful environment.

Rule #3
Be flexible.
At first glance this would seem to contradict Rule #2; however, I recognize that markets change and that trading strategies cannot account for every conceivable factor. Giving yourself some wiggle room or discretion is ok, but I would not stray too far from the data or your strategies.

Rule #4
Always question the prevailing dogma.
The markets love dogma. “Prices are above the 50 day moving average”, “prices are breaking out”, and “don’t fight the Fed” are some of the most often heard sayings. But what do they really mean for prices? Make your own observations and define your own rules. See Rule #1.

Rule #5
Understand your market edge.
My edge is my ability to use my computer to define the price action. I level the playing field by trading markets and not companies.

Rule #6
Money management.
Money management. Money management. It is so important that it is worth saying three times. There are so few factors you can control in the markets, but this is one of them. Learn to exploit it.

Rule #7
Time frame.
Know the time frame you are operating on. Don’t let a trade turn into an investment and don’t trade yourself out of an investment. (more…)

Zubulake and Lee, The High Frequency Game Changer

The High Frequency Game Changer: How Automated Trading Strategies Have Revolutionized the Markets by Paul Zubulake and Sang Lee (Wiley, 2011) is not an engaging book. It was definitely not written for the retail investor. Instead, it reads like a series of mini-reports from a consulting firm. It should therefore come as no surprise that the co-authors are a senior analyst and the managing partner at Aite Group, “an independent research and advisory firm focused on business, technology, and regulatory issues and their impact on the financial services industry.”

Rather than write a standard review, I’ll pick out two data points from the book that I think might be of general interest.

The number of electronic trade messages quadrupled between December 2006 and 2010. “If U.S. equities continue their pace, Aite Group expects message volumes to average 1.2 billion messages per day by 2011. The market already saw peak days approaching this number in late 2008. … Options pricing is exponentially worse than equities market data volumes. Current … OPRA data peaks exceed 1 million messages per second. Aite Group expects OPRA will generate peaks exceeding 2.2 million messages per second by the end of 2010.” (p. 47) I don’t know whether this projection came to pass, but the infrastructure demands are evident. No wonder some brokers charge for cancelled options orders.

I wrote about the importance of high performance databases in an earlier review. Zubulake and Lee confirm this: “Speed is essential for firms running strategies that feature both real-time and historical data. Aite Group estimates that 90% of quantitative trading firms currently maintain or are developing at least one trading strategy that requires playing back historical data in conjunction with real-time data.” (p. 113) Sure beats trying to keep all that history in your head!

11 Rules for Better Trading

11rulesbettertrading

Trading in the markets is a process, and there is always room for self improvement. So as we start the new year, here are my 11 rules that help me navigate the markets. By no means is this list exhaustive or exclusive.

Rule #1 Be data centric in your approach : Take the time and make the effort to understand what works and what doesn’t. Trading decisions should be objective and based upon the data.
Rule #2 Be disciplined : The data should guide you in your decisions. This is the only way to navigate a potentially hostile and fearful environment. (more…)

A Few Notes From Adam Grimes

Adam Grimes (Chief Investment Officer of Waverly Advisors) prefaces his 2012 book, The Art and Science of Technical Analysis: Market Structure, Price Action, and Trading Strategies, by stating: “This book…offers a comprehensive approach to the problems of technically motivated, directional trading. …Trading is hard. Markets are extremely competitive. They are usually very close to efficient and most observed price movements are random. It is therefore exceedingly difficult to derive a method that makes superior risk-adjusted returns, and it is even more difficult to successfully apply such a method in actual practice. Last, it is essential to have a verifiable edge in the markets–otherwise no consistent profits are possible. This approach sets this work apart from the majority of trading books published, which suggest that simple patterns and proper psychology can lead a trader to impressive profits. Perhaps this is possible, but I have never seen it work in actual practice. …The self-directed trader will find many sections specifically addressed to the struggles he or she faces, and to the errors he or she is likely to make along the way. …[Institutional] traders will also find new perspectives on risk management, position sizing, and pattern analysis that may be able to inform their work in different areas.” Using example charts for many assets from different times over different time frames and from different markets, he concludes that:

From Chapter 1, “The Trader’s Edge” (Page 7): “Every edge we have, as technical traders, comes from an imbalance of buying and selling pressure. …we do not trade patterns in the market–we trade the underlying imbalances that create those patterns.”

From Chapter 2, “The Market Cycle and the Four Trades” (Page 45): “When buying pressure seems to be strongest, the end of the uptrend is often near. When the sellers seem to be decisively winning the battle, the stage is set for a reversal into an uptrend. This is why it is so important for traders to learn to stand apart from the crowd, and the only way to do this is to understand the actions and emotions of that market crowd.”

From Chapter 3, “On Trends” (Page 95): “…many outstanding trades come in trending environments. Market structure in trends is often driven by a strong imbalance of buying and selling pressure, it is often easy to define risk points for trades, and some of the cleanest, easiest trades come from trends. However, markets do not always trend.” (more…)

How does the mind of a trader work?

MindpowerIn order to understand behavioral finance and crowd behavior on the capital market, first of all we need to understand the factors that influence the trader mindset. Traders are “misled” by many things. Let us put these factors in two main categories, depending simply on their source, external or internal.

The most important external factor is “everyone else”, the trading crowd, the general opinion. We form an opinion about the others. We believe them to be either smart or stupid, either right or wrong, then choose one of the two main psychological trading strategies: “go along to get along” or be a contrarian. Then we have other external factors like payoffs, scale, psychological and academic background, social structure, external advisory and resources. (more…)