Creating a trading system IV - The basics

What are the absolute minimum needed to create a trading system?

The answer is:

• Trade management methodology
• Risk management system
• A methodical way to enter the market (even if its a coin toss)

My system of trade management is fairly mechanical. I prefer fixed stops and a fixed scalp exit that is twice the stop size. Some discretion may be applied for any additional contracts. They may be held until a price target is hit such as high or low of today or prior day, or the trend terminates (by breaking a trendline), or a climax bar or simply when the profits are too large to be left on the table. The first step in creating a trading system therefore is to determine an acceptable stop size. If the stop size is too small, you will probably be stopped out before reaching twice the risk. If your stop size is too large, it may never reach twice your risk. Somewhere in between is a band where stop size is acceptable.

Risk management is also pretty simple. I have maximum loss limits per trade (stop size), and per day (maximum number of failed trades) and in case I run into unexpected price action, I will also have amortized loss limits per month. I have posted extensively on risk management and those rules are universal regardless of what you trade.

There is a broad choice of ways to enter the market based on indicators, price action, support and resistance levels and possibly countless others that I haven't even heard of. I have the strongest confidence in price action, having tried many others which resulted in utter failure and bafflement. 

However, for the purposes of stop size determination, I may choose a mix of random entries and price action. Once stop size is determined, I'll only trade price action.

Creating a Trading System III - Price Action Trading

Over the years I have tried nearly every system of trading. Nearly all of them have failed to generate consistent profit (although many did work for a few months). Some of this may be simply because the systems were not suited to my style of thinking but I believe most systems are biased towards a perma-bull market and will fail during any sharp bear move. And most such failures are spectacular.

One of the reasons for this is that newcomers are attracted to trading when they hear success stories from their friends and family. Such success stories, especially dramatic trades usually occur near the top of a bull market. Systems that have recently proven to be working in the past year or two are likely to be biased towards a bull market. This attracts newcomers right before an impending crash.

Systems that cannot work in both bull and bear markets are terrible choices for a trader. The best and largest moves occur in bear markets but bull markets last longer. Any system that cannot trade both is likely to be a poor performer unless you happen to start your trading career in a lucky decade.

After trying out indicators, buy and hold and all manner of fundamental trading, I finally settled on price action trading as a framework for my system. Price action fit well into my understanding of demand and supply and my observation that one cannot consistently predict at what price the market is likely to turn. Trends can be dramatic and sharp and last much longer than anyone can predict.

One of my early discoveries was that anything you may know about any system is probably incomplete. There will always be subtleties that you need to pay and learn over time. There will always be edge cases where a certain setup may not be valid and even after you have detailed experience trading a single setup, a good percentage of the time, the setup will simply fail to reach target before taking out your stop.

Another observation is that some setups are likely to give a large gain if they are successful. For example, the 1st pullback after a trend breakout early in the day is likely to give a large move lasting for at least an hour. Even if the setup here is weak, its often worth taking the risk of a small loss since the win will usually be very large and more than make up for a few losing trades.

There is simply no way around the fact that trading is a system of probabilities and you need to find and press your edge. When the winning probability of a setup is high, you can take the trade even when the expected gain is smaller.

Price action trading provides a general framework where I experiment, learn and build my trading system. Unlike a system that uses indicators which really has no framework but simply magic math that tries to convert a price movement into a binary buy/sell decision, a price action framework can keep you on the right side of the market, enable you to anticipate large moves or chop and act accordingly.

This general framework is a springboard from which you can refine your trading and market reading skills on your journey to be a profitable trader.

Creating a trading system II - Trading versus investing

There is an inherent distinction between traders and investors. Depending on how you think, you may be suited for one versus the other.

An investor likes to think there is an inherent value for an instrument (stock, index, future) and any price below it is cheap and any price above is expensive. The actual value could be determined in a variety of ways.

For example, the simplest way of looking at a stock investment is to look at it as an alternative to buying bonds. Assuming that you could have a stop at 10% below your entry price, a stock that gives a dividend yield of 10% is worth at least breakeven. There are not many stocks that give such a good yield unless they are so cheap due to recent devaluation that owning them is high risk.

In a bull market, a stock expected to perform with the market, i.e. at 7 to 11% annual gain is possibly worth breakeven if it gives a 3% yield with a 10% stop.

When price falls below the current price, the yield and the expected gains increase, and the stock is said to be value for money. Similarly, when the stock makes a large price gain, the expected remainder of the gain and the dividend yield decrease and therefore its expensive.

In reality, no one pays attention to this very common sense way of investing. Most investors buy or sell based on recent strength or weakness or financial advisors or media. Part of the reason is that the best performing stocks often do not pay dividends, but rather reinvest their cash into developing their business.

To account for this situation, there are a variety of fundamental data that investors use to determine value based on PE, earnings growth, revenue to debt ratio, price to sales and so on. The problem with this is that these values are totally disregarded in a strong bull or bear market.

In any case, investment is primarily about determining fair value based on earnings, dividend, growth potential, etc. and buying below and selling above.

A value price may be $10 and there is no sense buying above $10. An investor may want a minimum return of 10% and therefore will only buy at $9 or better. He is likely to sell at $11 since it represents greater than market expectation of gain. He will continue to buy near $9 and sell near $11.

Traders on the other hand, do not think in terms of value but in terms of demand and supply. Fundamentals are but one factor in demand and supply but there are many others such as irrational exuberance and news.

While some traders have successfully married the concept of value in trading using market profile, most traders are better off trading pure demand and supply and disregard all notions of value. Institutional value fluctuations usually do not happen at the minute levels and frequency of day trading. For traders, price is about demand and supply and this is translated to concepts such as support and resistance, trends, legs, etc. In other words, traders trade patterns, investors trade prices.

Creating a trading system I - A new beginning

From January 2013, I'll go through the steps of creating a new trading system to trade CL contract (oil futures.) My goal is to go through the steps of creating the risk management and trade management system for CL and publicly log all my trades, including experimental trades.

Initially, I will work on figuring out ideal stop sizes, scalp and swing targets and the system will run on SIM. As the system picks up consistency, I will start trading the system live.

This will serve as a template or guide for me and my readers to create their own price action trading systems on anything they may wish to trade.

Why CL?

From recent experience, I believe there may be a case for accelerated consistent profitability for new traders in CL compared to ES or any other equities contracts. CL also does not usually suffer from the lunchtime lull and traps that ES traders need to be wary of. CL does have its own dangers, namely slippage and whipsaw during news events. These are part of what makes stop size determination a bit harder on CL.

For the rest of December, I will attempt to describe my overall trading principles and the reason I believe they are universally applicable.

The Trader's Mind X - The transition to success

So now that you understand the differences in psychological makeup of a new trader versus a successful trader, let's see how to transition your mind from the former to the latter.

Replace lust with caution and skepticism
The very first step is to limit the number of trades you take. When traders say that overtrading is a very common trading error, thats only half-correct. Many of the ills of trading poorly show up as overtrading. By limiting the number of trades you can make, you prevent the amount of damage you can do to your account in one sitting. But more important, your mind needs to shift from getting into this move to getting into the biggest move of the day. Since there are only one or two big moves in the first couple of hours and perhaps another in the last hour and half, your approach switches to looking for quality trades and large swing trades.

What this means for your account is that despite a low win rate, you can still be a profitable trader if your wins are at least twice as large as your losses. Your goal as a new trader should be to exclusively focus on large moves. If you are unsure the move is going to be large, its ok not to take the trade. Don't worry if you stand aside and the move ends up being big. That is part of trading. Learn to let it go. Similarly, you will be stopped out a couple of times and the very next move will be large (or not). That's ok. You are in the process of learning to judge exactly where the large move is. With experience it will come naturally (but not without sufficient screen time).

Replace fear with discipline
Once your discrimination and judgement get better, your larger wins and smaller losses will make you a better selector of trades however, your trade management needs to be extremely disciplined. Note that as long as you are trading in a trend (HH and HL or LL and LH) with volatility (decent size swings and bars) and near support (TL/ema/swingpoint), your chances of success should be slightly greater than 50% at the very least. Add good pattern and signal bar and your win rate should be around 60% or even more. Your decision to enter the trade is all the processing your mind needs to make. Once you set a stop and target, do not change them. Your mind is vulnerable when in a trade and susceptible to errors of judgement. You should simply let the math work for you and let the market either fill your target or take your stop out. If your setups are truly 60%, you will accumulate winnings in the long run.

Replace desperation with acceptance
Many professionally successful people who come to trading believe rightly that perseverance is a virtue and its their dogged persistence that made them successful. Realize that in trading, perseverance is inapplicable and desperation is probably what you will slip into. Learn to accept that today is a losing day and stop trading. Take a trading buddy's help if you wish. Disclose your losing trades and let them tell you to stop. Soon, you will be able to stop on your own. Similarly, do not be overconfident on successive wins and end up taking untested setups. Many traders have their large losing days right after their large winning days. If you are susceptible to these, just take a day off or only take one trade the next day after a big winning or losing day, win or lose.

Refine your method continuously
Over time, you can make slight changes to the above rules and fine tune your setups. For example, you should always keep track of the success rate of your individual setups and your average win or loss per setup. That way, passing a lower expectancy setup or taking a good setup with a questionable signal bar become easier. Always keep your trading goals in mind when you refine your methods. For example, you should prefer to refine your system for higher probability than to get a better price since adding a contract to a higher probability trade is a better way to make more money than getting an extra couple of ticks on existing size.

Over time, your approach and mental state will shift to that of a successful trader. However, this is not easy and will be a constant struggle. Even after you have been winning for a while, its possible to have slip ups and lapse into your old habits. You should always be on guard and protect your mind from harmful habits as long as you are a trader.

The Trader's Mind IX - The consistent trader

The consistently profitable trader replaces eagerness and impatience with patience and caution. The simplest thing you can do psychologically for your account is to prevent getting into bad trades in the first place.

Never be eager to trade but when your setup shows up, act without hesitation. This seems counter-intuitive, but this is how many predators work. You may have seen shows on discovery channel where a camouflaged fish stays without moving until a prey comes close enough and then it jumps suddenly and eats it. That's basically what the trader tries to be: patient but alert.  With some exceptions, its usually better to miss a trade than to take a trade and be stopped out.

Once in a trade, a winning trader simply follows fixed trade management rules. For example, price either fills a fixed target or stops the trader out. There should be little discretion here, since your judgement, which was strongest before you got into a trade is now at its weakest. Every tick against a weak trader makes him panic and want to get out for breakeven or tiny profit. Every tick in his favor makes him push the target further out. The consistent trader does neither. Its not that he is any superior, its just that he uses mathematics to ensure that his odds of reaching a profit are higher than his odds of being stopped out and over time, he accumulates winnings regardless of what happens on this individual trade. The individual trade does not matter and losses are part of trading. Do not try to use your judgement now, its at its weakest. Use well tested trade management rules.

After a win, a poor trader is jubilant and will trade larger size and weaker setups (trading the house money). After a losing trade he is in dispair and curiously may do the exact same thing: trade larger and weaker setups to "make the money back." This is a well travelled shortcut to a blown account.

A consistent trader does no such thing. He simply tries to go back to pre-trade mode where he is patient yet alert.

A winning trader also knows when to stop for the day. Its utterly important not to have large losing days and too many losing trades in a day. Your mind cannot after a point control your emotions because you may not even realize you are in a state of desperation. A winning trader stops trading at a well defined daily loss limit.

Eventually, the winning days become larger than the losing days and a trader becomes profitable. For some traders this is a sudden change but for most its gradual and occurs with improvement in their trading skill.

The Trader's mind VIII - The basics of emotions

What exactly are emotions and why do we feel them?
Emotions are a form of self-communication. When our ancestors were primitive creatures facing an uncertain world, the mind would sense imminent danger and opportunity and activate the physical changes need for immediate action.

Obvious examples are when a predator is sensed, the body needs to quickly switch to fight-or-flight mode. Similarly, when food or mating opportunities are sighted, the mind becomes alert and eager.

Practically all your emotions and behavior stem from millions of years of survival adaptation. In the ancient world, reacting to good or bad situations immediately and appropriately meant life instead of death. Modern humans rarely face such challenges and have developed some degree of control over their emotions. Occasionally, the limbic system keeps escalating emotion and may be hard for you to control it.

Emotions are about expectancy and preparedness. Events that you are well aware are likely to happen and are prepared for do not cause strong emotional reaction. For example, if someone close to you dies suddenly, you may feel shock and dispair and cry for days. On the other hand, if they were terminally ill for a couple of years, their death may actually bring you closure and relief instead. Similarly, if you do not win the lottery, you don't really go into an emotional fit because you never expected to win. But when you win, you are delighted.

Events that you are unprepared for can cause your body to go into "just do something" mode. For example, countries where there are fire-prevention drills see systematic evacuation on a fire alarm while those without may see stampedes.

What does this mean to me as a trader?
When you are watching the market, your mind is in a mode similar to the mind looking for mating opportunities. You'll probably hit on every potential trade till one works. Once you are in a trade, you watch anxiously for prey or potential danger. This compels you to exit trades early with no loss than to stand your ground and be stopped out. When you are stopped out, your mind acts like a parent gazelle whose calf has been attacked by wolves.. Your mind goes into "just do something" crisis mode. This is also called classic tilt mode, when a couple of losses force the trader to abandon all risk management and trade management rules and just try to get his money back.


Lets call these three emotions lust, fear and desperation. Of these desperation is the hardest to control. Your mind is in a state where its willing to go to great lengths and take severe risks to get back its precious young. You will do the most damage to your account in this state. Fear prevents you from following through with your trading plan and you will end up with small winners and large losers and you will be a net loser over the long term. Lust traps you into poor trade after poor trade and your account will bleed slowly from a thousand cuts.

So how do I address this in my trading plan?
Once you understand the forces driving you, you can work on managing them. One way to manage this is to try to observe yourself and see how you act. The very act of observation will change the observed (the observer effect).

Desperation: When you are in desperation, you are unlikely to be able to observe yourself and think rationally. Having someone else observe you will often help with a reality check. This could be a mentor or trading buddy. Its important you disclose all your trades to your observer or it wont have the full effect. Your trading buddy can watch out for signs of poor emotional state and support you with feedback. Having a maximum trade count per day and a maximum loss limit will greatly protect your account from an untimely demise.

Fear: More important than entering a trade is what you do after you enter. If the trade was ill-advised and caused by chasing an unexpected large bar, you should probably just exit at the best possible price. If the trade was a legitimate setup, you need to follow your trade management with discipline. Only discipline will help you overcome fear and develop confidence. Making trade management a mechanical affair with fixed stops and targets frees your mind of fear.

Lust: Before you enter a trade and before you have encountered a losing trade for the day, your mind is best prepared to make clear judgements. If you can read the market reasonably well, take every clear setup until you hit your daily loss limit. When starting out, your read of the market will naturally need a lot of improvement and losses are routine. What you do not want to do is to react to unexpected moves. Any trade you took on an expected move is far more likely to be successful than a trade taken on unexpected moves. Tame your desire to be part of the action. Only take well defined setups. Start with one setup and add more with time.

Naturally, these are not the only emotions you face. Greed, which makes you hold well beyond your expected target is another great killer. Hope, which persuades you to loosen your stops prevents you from developing any kind of discipline. All of these need to be understood and addressed.

In summary, realize that your emotions are telling you that an event occurred that you did not expect and were unprepared for. Learn from the event and incorporate it into your trading plan rather than reacting to it immediately by trading. Use understanding, preparation and discipline to tame your emotions.

The Trader's Mind VII - The Chase

So far we have seen inherent character issues of a trader that work very well in the outside world but sets up the trader for failure in the trading world. These are character issues built over years and are hard to shake. However, with careful planning of rules and discipline, a trader can avoid triggering them. For example, entering only on or after the breakout beyond the signal bar, we can prevent a trader's bargain hunting behavior from causing losses.

In this post we look at a complementary part of the trader's mind, his reactivity to the market. When a trader is watching the market and is expecting a big move up, he is disciplined and waits for a good signal or pattern. Bar after bar forms and the trader chooses to pass up since they do not meet his criteria. Suddenly out of the blue a large breakout bar occurs and the trader is caught unprepared, he simply cannot stand idly by as the market apparently is shooting up. He gives in and buys way above where he would have bought if the bar was acceptable. The market promptly stops him out in a deep intra bar pullback and either fails or resumes its march up.

This is a familiar scene many traders have played over and over.  When the market moves in a way you did not expect and you feel forced to act, you are likely to make a mistake. Even if you are not stopped out, if the bar starts pulling back, your confidence will be weak because this is not a trade you have taken many times and is not a natural setup and management for you. Your mind is very vulnerable to making several mistakes at this point. One way to handle this is to realize that a weak breakout will fail and a strong breakout is likely to break into a trend and the first pullback in the trend is a far better entry.

Another classical reactivity is to a prolonged channel. You see a heavily overlapped or other poor setup in a channel and take a trade and are stopped out. You enter again and again, trying to get it right this time and lose several times before you can finally enter it just right. This leads to a phyrric victory, since your gain from the winning trade is unlikely to be larger than the accumulated losses. Traders often "persist" since they know that the direction is right, they just need to figure how to enter the channel correctly. Unless you want to fade counter-trend entry bars and scalp, the only reasonable way to enter a channel is to wait for a an attempted break of the channel or wait for the channel to break into a trend.

Realize that being right about direction is insufficient. Trading chatrooms are full of traders predicting an up or down move accurately, without being able to find a good place to enter with a tight stop. Entering with a wide stop may allow you to enter nearly anywhere but such trading carries the risk of large drawdowns and is unsuitable for new traders. Patience and the willingness to sit out until your setup appears is paramount to consistency.

In the world outside trading, persistence and chasing your dreams may be great characteristics. For trading, patience and discipline are far more important.

The Trader's mind VI - Conviction and doubt

In the world outside trading, persistence and conviction are good traits. A persistent man is likely to solve the problem, get the date with the woman of his choice or get a job. We judge people's conviction in their positions by how well they can defend their own views. A telling example is the characterization of an election candidate as a flip-flopper resulting in their election loss. Holding fast a misinformed opinion is seen as a sign of strong ethos than switching position based on new evidence.

Your conviction or faith in your opinion endears you to your social clique. Conservatives feel comfortable hanging with other conservatives and greens with other greens. This piece of human nature is something we learn very young and use it to adopt various facets of our identity and stick to it lifelong.

I'm a Mets fan. I'm a libertarian. I'm against the death penalty and so on. The adoption of identity facets is an automatic social behavior and its function is primarily social.

When this behavior is carried to the trading world, it works against the trader from the very beginning. Trading is ultimately a non-social function as far as your account is concerned. Your losses are your own and forming an opinion and sticking to it in the face of hell or high water works against you every time.

A trader who is convinced the market has gone up too far may short the market and when it stops him out, try again on the next high and eventually short his way to the top. A seasoned trader often does not have an opinion as to the general strength or weaknesses of the market and follows the principle: "Trade what you see, not what you think."

To develop the ability to abandon a damaging view when you are wrong, adopt a rule where if you are wrong twice, you won't trade in the same direction until the price moves substantially away from the current location. Remember that you are always wrong and the market is always right.

The flip side of conviction is doubt. A trader who has a long series of losses (including consistent winning traders) are subject to losing confidence in their system, their ability to read the market and follow their own system. Such traders are subject to buyer's regret right after entering a trade, being shaken out on even the smallest pullback and tightening stops too early and thereby exiting on a loss just before the market makes a huge move in the direction of their trade.

Even when the market moves in their favor, they are unable to hold for many points. The very first pullback causes them great distress and forces them to exit at a small profit. Imagine seeing an open profit of four points and then panicing and exiting at +1 when the market pulls back. To build confidence and enable yourself to hold through pullbacks, always take a partial profit on the first push in your direction. Especially during the first hour, reversals can be abrupt and take out your stop and change your winning trade to a losing trade, which damages your confidence even more.

The partial profit enables you to hold your runner beyond the first pullback after which it gets easier since your swing stop moves into profit once the next swing point forms. Taking partial profits and sticking to your trade management rules builds confidence.

In general, you need to work on abandoning your precious opinions regarding the economy, news, the government or anything else you think may be impacting the market. These things may impact the market long-term but you have to realize that your opinions and identity relations are worthless for trading the market. You can only rely on what you see, your trade management rules and your discipline.

The Trader's mind V - The anchor

Humans do not actually have any ability to measure intrinsic value of any item. Practically all estimated values are fuzzily calculated from any claims of value the person may have encountered.

For example, if I show an object never seen before and ask what the value could be, people are likely to go blank. When pressed further, they may guess based on its size, weight, shininess and beauty.

You may have grandparents that long for the good old days when coffee was 5 cents a cup. The entire notion of paying $5 at starbucks seems absurd to them. And to actually line up to pay that ridiculous amount is quite insane in their opinion. This because your grandpa's valuation circuitry is stuck in the 1950s. A similar thing happens to all of us on smaller timescales. This is called anchoring.

When you see an item (say a pound of coffee) for sale at $5, you expect it to remain at $5. If suddenly it jumps to $10, you wont buy it right then, you wait for prices to come back down. But if the price remains at $10 for a few months, you are likely to give in and buy it for $10. Your mind is now anchored to the new price.

Anchoring is subtly employed by stores all the time. The 50% sale tells us that the fancy hat at $200 is cheap because its real value is $400. We are so lucky to get it half-off. Why, its like we just earned $200. All we have to do to earn it is to spend $200. The store has subtly anchored the value of the article to $400 in your mind. If there was no sale, you wouldn't buy it because $200 would look expensive. This is why when JC Penny decided to forego sales in favor of everyday low prices, they took a huge loss. Nobody has any reason to buy because nothing looks cheap.

Anchoring is what makes markets stay in trading ranges (coffee should be $5) and trend ($10 is the new normal). Anchoring is also why pullbacks, especially deep pullbacks work very well (50% off sale). In fact, anchoring is why price action works very well in general.

For a trader, this means that he can simply imagine he's either a seller of buyer of a pound of coffee or any other item that he is familiar with and correctly guess the behavior of the crowd most of the time. If the price gets too high or too low suddenly, there will be resistance and the price will pullback. However, if it stays there for a long enough duration, it can become the new normal. Deep and sharp pullbacks are more likely to continue and slow slides are likely to eventually break a trend for this very reason.

Once you can understand how price moves, you will find price action far easier to read and understand.

The Trader's mind IV - The bargain

If the mad rush on black Friday's shopping is any lesson, humans love a bargain. Who doesn't like to get a $100 item for $80? That's 20% off! You can use the $20 to get something else.

Humans like bargains because it maximizes your purchasing power and is an inbuilt efficiency behavior. Efficiency is not limited to shopping. All things being equal, you should obviously choose a toaster that toasts quicker, a commute that is shorter and so on.

A person who can more efficiently spend his resources has higher survival ability and efficient use of our resources is therefore an inbuilt characteristic of humans.

When it comes to trading, a trader's efficient mind makes him want to buy low and sell high. Buying low is a good thing, unless you are in a down trend and the price is going further down. The bargain hunter forces the trader to enter into dangerous trading patterns such as:

• Bottom picking -- It fell to $3 from $10, what a deal! (All kinds of counter-trend trading)
• Adding on to a loser -- At $1 its 3 times cheaper, my profit will be 3x as big when it goes back to $10
• Entering before a signal bar forms -- its going to be a bull bar anyway, may as well buy now to save 3t

I have personally struggled for months to break these habits before I was successful. The key element is to realize that the price is not what's important, its the difference between the entry price and the exit price and the probability that your stop is not hit in between.

Focus on probability and nothing else. Measure probability of success by taking SIM trades before you take action. You need to have a modicum of discipline to do this. Focusing on probability will automatically shift your mind in the right direction.

The Trader's mind III - Eagerness and Dispair

Eventually, the trader settles in and realizes that trading is not easy but he can see patterns much more clearly. This is chop; this is a breakout and so on. However, in the eagerness to trade, the trader enters too early. The market stops out the trader and gives a better entry and resumes the move.

The trader may go into dispair at this point. An emotionally sensitive trader may have also reversed his position, thinking that the failure of a great setup is a very strong signal and may get stopped out a second time. If this happens enough times, the trader will find his confidence shaken and weak.

The good news is that the reason the market goes where you expect it to go is because you are now able to read the market. The bad news is that the human brain is extremely efficient at recognizing patterns and will alert you as soon as it can. This is a survival advantage. The earlier you spot a predator or prey, the better your chances of having a good meal and seeing another sunrise. Because of this, you will see the pattern a lot earlier and you eagerness will force you to act prematurely.

The right mental adjustment you need to do is to separate the pattern recognition from the action. Once a pattern is recognized, take it as directional advice and wait for a definitive signal. Some traders manage by using large stops. While this may work ok for many, I prefer precise entries since it maximizes my reward to risk (R multiple or RX). A larger RX in various kinds of price action is essential for me personally for trading large size with confidence.

Patience and the willingness to pass on a potential large move are essential for consistency. Once you are able to wait patiently and make a rational choice regarding any signal, you may take slightly lower probability trades if the RX is statistically very large such as 1PB in the first hour.

Patience -- the ability to wait for the right setup depends on detachment -- the ability to pass on a trade and miss a large profit. Combined with discipline, the ability to follow your own rules by resisting short-term temptations to meet long term goals is key trading behaviors for success.

The Trader's Mind II - The Rush

When a trader first begins trading, regardless of whether he is successful, he experiences a rush. A trader who has beginner's luck is likely to experience exhilaration of suddenly coming into money that he never imagined. This leads him to think trading is easy and make a conscious or unconscious commitment to trading as a profession.

The rush of trading is similar to the rush of gambling and other addictive behavior. This will lead him to make significant investments when he doesn't really comprehend the kind of risk for each of these investments. Even a cautious investor will risk more and move to riskier investments until failure hits.

This sort of behavior is automatic and part of human nature and most people find this understandable.

What may be unexpected is that intense emotional experiences can cause sustained changes in the person's behavior. The trader will crave the excitement and rush and continue to engage in trading just to feel the rush of trading. This will automatically put a trader on the track to some very bad habits.

For example, most new traders overtrade. A consistent winning trader may take four to ten trades a day while a new trader is likely to take 40. This is because the initial rush is driving the trading behavior. A second common habit is trading out of boredom. The trader's need for excitement and knowledge of what is possible drives him to seek that experience over and over again.

As a result, the trader does not even realize he has overtraded. He may have thought that he has taken 10 trades and be shocked to find that he has taken 40 trades. Once a trader introduces himself to the trading world in such a fashion, he already doomed to overtrade and go on tilt. Many traders blow their accounts in a few days and are shocked when it happens.

If you are in this stage, stop and ask yourself if you really want to trade to escape the drudgery of your life. Getting a motorcycle is far cheaper. Trading has to be a deliberate, carefully considered business decision. You need to think like the casino, not like the gambler.

The Trader's Mind I - The Trading Contradiction

One of the real contradiction traders face is that the forces that attract people to trading are exactly what make them lose in trading.

For most traders, trading is attractive because they can:

• Make a lot of money
• Get rich quickly
• Have the best commute
• Make a good living trading only 2 hrs every day.
• Live anywhere
• No bosses or employees needed
• Be unaffected by economy, political shifts, natural disasters, etc.
• No hard assets, office space, etc needed.

Do you want to have an income in the top 10% working for yourself two hours from your home while you can browse the computer? Well, who wouldn't?

Lets step back a moment and see how someone outside the trading world may evaluate these criteria:

• Make a lot of money - greedy
• Get rich quickly - impatient
• You have the best commute - lazy
• Make a good living trading only 2 hrs every day. - super lazy
• Live anywhere - mercurial
• No bosses or employees needed - poor social skills
• Be unaffected by economy, political shifts, natural disasters, etc. - fearful
• No hard assets, office space, etc needed. - unattached.

As you can see, the worst developed personalities are naturally attracted to trading and its no wonder that 80% of traders lose everything they ever put into trading. To be successful, you need to fight the very qualities that brought you to trading in the first place. This is the contradiction that traders face on the very first day that they begin to trade.

This is how each of the above qualities impacts your trading:

• Greedy - Makes you stay in a winning trade too long until it becomes a loser.
• Impatient - Forces trades, enter too early on poor signals
• Lazy - does not work on improving one's understanding of the market and trading system.
• Mercurial - Emotional trading, revenge trading, chasing price with every turn.
• Poor social skills - Inability to learn from the experiences of other traders
• Fearful - Cant take trades, exit trades too early, unable to hold through a pullback
• Unattached - Jump from trading system to trading system whenever current system gives a bad day

I know of no single trader who started without at least half of these afflictions.

Once you acknowledge that just choosing to be a trader automatically sets you up for failure, you have the opportunity to amend the very qualities that brought you to trading and modify yourself to be the very opposite and thus be successful.

Predicting longer term moves

Its easier to make predictions on long term moves than to be able to successfully capitalize on it. That's not saying much because longer term predictions often are apparent only post-facto.

The above chart is a monthly chart of the ES 12-12 contract and note that the last bar is an incomplete October bar (i.e. we are mid-bar).

From a structural view, we have had a spike or trending channel from around Mar of 2009 to Apr 2010 and then we have a channel phase. The channel lines are shown in blue. At present, we have poked above the channel line on the third push. We should likely get at least two pushes down. Often the lower trend line (blue) is the target. The most pessimistic scenario is that the move will test the start of the channel near Jul 2010.

Given that this is a monthly chart, this could mean a big drop if this happens suddenly or a prolonged horizontal to down move over the next year or so. A bit more optimistic scenario is that the magenta trendline from the start of the move acts as a support (especially on a 2L or 3L approach) and continues to push the market up. Even more optimistic scenario is that the steep purple trendline combined with ema arrests any down move and continues the move up.

The most optimistic scenario is that the upper TCL will fail to contain the move up and give a rally up by an equivalent amount as the last up move. Such failures are extremely rare and only occur after a lot of violent up and down moves.

Given we have three pushes in a channel and there has not been any recent violent up and down move, my guesstimate is that we will dip below the magenta line and probably also test the channel trendline.

The summary here is that there is lot of good trading in store for 2012 Nov and Dec is unlikely to be a dead market.

Long term investors could take puts on their positions unless they want to exit them. The proceeds of these puts can be used to add on to the same stock positions when the market bounces at long term support.

Channel Theory VI - Channels are forever

A channel after a strong spike such as today should be expected to last forever. While its true that often channels end up breaking (such as the move from b66-77 today), the fact of the matter is channels last forever because they constantly attempt to reverse and fail.

The very uncertain nature of channels can trick you into reading all sorts of reversals if you just look at it the right way. For example, is b4-7 a trendline break followed by a test of the low at b11 and a strong reversal bar? Is b30 a 3rd push and TCL OS and therefore a W reversal? is b34-37 a FF and therefore end of the trend? is b66 a DB? Yes, they were all potential reversals and yet the market made new lows well into the close.

You have to realize that every reversal signal in a channel is a trap. Traders who are used to trading counter-trend at bottom of trading ranges will find themselves buying all the way into the hole on a day like this.

The trick to trading a channel such as this is to expect every reversal to fail and take the failure in the direction of the channel. So for example, while b13 would be hard to enter due to overlap, b18,26 were acceptable signals. b46 certainly was a 2L pb to ema. b77 was G2 (deep PB after strong move).

The only time you can actually take a trade opposite to the channel is after a sustained break of the channel and a HL. So if the move down from b77 had given a 2 or 3L HL, you may take it for another leg up. A 1L move should never be taken since it can fail and result in a 2L move very quickly.

If you missed an entry, you can often enter beyond a small trend bar as long as its not too far from the trendline or ema. For example, b19 and b29, b47, b50 are ok entries.

But the best way to trade such a channel is to swing a contract from an early entry and hold it till the end of the day or an obvious reversal.

Channel Theory V - 1st Channel breakouts usually fail

Channels with small trend bodies such as b21-25 obviously constitute a larger trend bar in a higher timeframe and you can often buy above any small bar with a strong close with a stop below that bar. Such channels are called Trend channels (TC) and often are the easiest to trade. In particular, a small trend bar with a strong close that touches a trendline or a micro-trendline is likely to give a large trend bar after it and makes an excellent swing entry (b34).

On the other hand, bars with tails on both ends such as b2-5 and b45-49 should be viewed as sloping barbwire or barb wire channels (BWC). These should be traded just like BW. The first break against the channel is likely to fail and can be taken for a second leg down (b60) unless its against support such as ema or close of prior day (b8).

A second attempt to break is often successful (b15) and a HL after a successful reversal (b18,b68) are often the safest entries.

Channel Theory IV - Tradable Channels

One way to characterize channel activity is to define them in terms of volatility. While normal clean trends have high inter-swing volatility and low inter-bar volatility, channels have the reverse. From a visual perspective, this means that every swing in a channel goes only a few ticks further than the prior swing (b36,40) but the pullbacks are deep enough to possibly stop you out. This means that any arbitrary entry in a channel is at a higher risk to take out a fixed stop even if it respects a bar stop.

The risk of stop out is inversely proportional to the slope of the channel and directly proportional to the bar size and overlap. For example, you are at a higher risk of being stopped out of  a short in the channel down from b33 than in a short in a channel down from b10.

The probability of profit is higher if there were recent large trend bars. Any large trend bars (b12) that follows a channel activity (b7-11) show energy and interest and the chances of a failure of such a trend bar (b17) or a continuation (b18) leading to a trend breakout are high.

Channel activity in the absence of large bars is highly susceptible to random drifts and reversals (b27-79) and chances of a break into a large trend are lower.

In summary, tradable channels are steeper, have recent large trend bars and have smaller bars compared to their swings.

Channel Theory III - Transitions

Once we detect price action has entered a channel, we should be able to follow its transitions just like regular price action. Anything you expect to see in a normal price action, you can also see in a channel.

Channels are often wedges and most channel moves can terminate on 3 pushes. This is not very simple to read since each push could be composed of complex legs and pullbacks. For example, on the chart today, we have a W33,43,72 from b29 where each leg is made of tiny overlapped legs and extended pullbacks such as the one from b43 to b57.

True channel reversals on the first attempt such as the one at b29 are rare except at a significant support or resistance (LOD in case of b29).

Channels are often very tiny trends and like their bigger cousins can terminate without real reversal. For example, the sustained move beyond the TL to b33 broke the channel down and the price moved horizontally waiting to breakout. Channels may attempt to breakout into regular trends (b14-15) and often succeed in exiting channel mode.

Continuation trades in channels are fairly hard and usually not worth the risk:reward. (This is still an area of research at present and we may be able to trade these in the future). Quite a bit of the issue is due to the inability to predict the slope of the channel. A steep slope such as the channel down from b18 may be worth taking the effort but an extremely shallow channel such as the one up from b29 will usually mentally exhaust the trader waiting for profit to be reached.

A much better option is to attempt to predict breakouts. Correctly predicting a breakout at b67 for example, would allow us to enter precisely for the best results and avoid prior attempts. Some breakouts of channels are large and expand the day's range by more than twice the prior range.

Channel Theory II - Origin

Once we have a definition of a channel, we can apply that to detect when price action displays signs of turning into a channel. In general, when the signal and entry bars are poor, i.e. overlapped and taily, I watch for channel formation.

Since in normal trends signal and entry bars are clearly not overlapped (b4,5 or b6,7 or b8,9), any heavy overlap of signal and entry bars should put you on guard. In particular if the entry bar and the next two bars overlap the signal bar, you have certainly entered a channel. Therefore on this day, at b20, you have already detected a channel.

Detecting channels is not complete until channel direction is also determined. This is trickier to do in real-time since what looks like a channel down simply completes a structural requirement of say three legs and then changes direction.

A channel direction is canonically determined when you can draw a channel trendline.  The earliest direction estimate comes from two LL and a LH or two HH and a HL. Therefore today you would confirm a downward channel at b24. Sometimes what looks like a channel can quickly turn into a triangle or expanding triangle and trap you if you enter too early.

Conflicting channel trendlines (shown above) are common during the nacent phase of the channel. This is a common cause of stop-outs and finding oneself on the wrong side of the market. While the trendline from the start of the move (b13) is usually the best trendline for big picture, channels often test the trendline from channel start (b19).

Never get trapped into thinking that a channel has reversed on the first attempt and trade the newly turned trendline (b33-41). These succeed rarely.

Once you are in a channel, you need to switch your trading to channel mode. Practices that are poor in normal trading such as fading bars become viable in channels and practices that are good in normal trading such as fixed stops and entering on signal bar breakouts lose their strength in a channel.

You could simply wait for price action to break out of channel mode and then look for an entry. When a pullback no longer overlaps the signal bar (b47) you can safely take with trend entries without fear of being stopped out (b59 s, b64s).

Channel Theory I - Defining channels

Channels are heavily overlapped regions of price action that drift up or down in a chart. If the region did not drift, it would simply be BW. Channels are important because unlike BW which can only be scalped for a few ticks or a couple of points, channels do trend and can be traded for enough points to justify the risks of entering a trade. The goal is to trade channels with a fixed size stop such that the potential profit is larger than the risk taken with a high probability of success.

Channels generally have the following characteristics:

Multi-bar overlap: It is common for a bar to be overlapped by many following bars. For example, on the day on the right, b7 was overlapped by every bar except b1 and b19 until it finally broke out of the channel.

Tails: You are likely to encounter bars with tails on both sides, regardless of color. These tails look like a trend is just about to break when watched mid-bar and then the bar will close with the opposing color, leading to poor mid-bar decisions. Never make mid-bar decisions, especially in a channel.

Alternating bar colors: True channels have alternating colored bars with some dojis thrown in. Channels without opposing colored bars are Trend Channels (TC) and are actually simply trends. You can trade with-trend on the close of any small bar in TC but in a true channel you are likely to be stopped out if you use a fixed size stop. True channels that form a leg are leg channels (LC). Sometimes  a channel is so wide that it looks like a sloping trading range. These are trading range channels (TRC).

Unpredictable behavior: Channels may reverse (b19), break out (b30), may turn into any other type price action and are generally hard to predict.

The primary goal of trading channels is to determine the following:

1. Origin: Detect PA turning into a channel and determine direction.
2. Reversal: Channel may reverse direction while remaining a channel.
3. Breakout: Channel breaks into a steep trend move. This is the most important.

While even simple detection of a channel is valuable because it enables you to avoid getting chopped up, detecting breakouts and sharp moves intra-channel allow you to maximize your profits if you wish to trade channels. In the coming days, we shall see how each of these may be achieved.

Components of a successful trade

A trader needs to determine 4 important attributes for a successful trade:

• Direction
• Probability
• Room for profit
• Stop

Direction is obvious. If you are on the wrong side of the market, your chances of a scalp trade are smaller and chances of a swing trade are nil. A simple way to determine direction is to draw a trendline and trade only when the price tests the trendline. Trendlines should be drawn from the start of the move. Most days, this would be from the LOD or HOD but some days such as today, the beginning of the move could be a different bar such as b24. Experienced traders can also detect a reversal such as the three push reversal at b9 and trade the reversal of a trend. New traders should skip reversals and take the first reasonable pullback after the successful reversal (b24).

Probability of success takes slightly more experience to judge. On most days, after determining the market is in a trend, you can take every two legged pullback such as b44 until the trend breaks (a sustained move beyond the trendline). On hard trend days, you can take any pullback and any small signal bar in the direction of the trend as long as the entry side of the signal bar does not have a large tail.

Room for profit takes quite a bit of experience to judge. In a normal trend, a pullback can be expected to at least take out the prior extreme by one tick and therefore a deep pullback is likely to give sufficient profit. However in hard trends and large gap opens, even a couple of ticks may give a decent profit. High volatility and clean patterns are friends when it comes to profit targets. Barbwire and tiny bars are terrible enemies and greatly interfere with profit target estimation.

Stop size is possibly the hardest to correctly determine. Signal bar stops often work but could be too large from a risk:reward perspective. A fixed stop is easy to use for clear patterns and strong bars but very hard for channels and overlapped bars. For example, despite correctly reading the low of the day today, my stop was short by 1t resulting in a losing trade and missing out on a great swing setup.

Taking a fixed stop and continuously keeping track of market direction using the nine transitions means you only look for probability and profit target when entering a trade. Passing up shallow pullbacks means you only need to focus on probability, which boils down to looking for a clear set of patterns and strong signal bars.

The fewer parameters involved in your decision making, the more confident you will be in your decisions and help you become a successful trader.

The road ahead

My frequency of posting has reduced in the past few months but rest assured, with the generous help from my small research team, I'm actively working on bringing several important facets of trading to light.

A small selection of currently active research areas are listed below:

Trading Channels:
One of the most important problems in price action trading is to trade channels using a small fixed stop without resorting to scaling-in or other poor habits. Since channels are common, this is a top research priority.

Predict tight days that aren't worth trading: Some days are extremely tight and on a day with a four point range with choppy overlapped price action, trading is dangerous. Predicting such a day early enables us to stay out and skip trading.

Predict choppy opens that are likely to result in stopped out trades:

Opens that otherwise look like potential setups may never generate a profit and may stop you out or enter a chop zone. Correctly detecting this enables you to skip trading until price action becomes more amenable to trading. This chart is the AM of the FOMC day that eventually led to a huge rally.

Predicting Breakouts:
One of the hardest problems in price action is predicting which bar would lead to a successful break-out. For example in this chart, b57 short led to a breakout while every other signal prior to it failed. A high probability prediction of a breakout enables us to judiciously enter a profitable swing trade.



And more: I'm also working on exiting losing trades for breakeven or a few ticks loss by detecting trade failure early. The setups 1Rev and 1PB have been further broken down into a small set of distinct setups that enable the trader to anticipate and trade them bar-by-bar. As soon as these setups complete the requirements of rigorous testing, they will be published here in a series of blog posts.

The hard road to consistency X - The elusiveness of discipline

One of the great surprises in trading is that knowing what to do and the ability to do it are two unrelated things. Knowing what to do is knowledge, the ability to do it is skill. Its fairly easy to describe price action post-facto. Its simple to know to hold through a pullback or to exit on the next push if you aren't under pressure from holding a position.

Traders need to work on improving their trading to be close to the ideal post-facto decision as much as possible. For the most part, this is a constant struggle. Information is always imperfect and decisions are often hard to make correctly. The process of working on yourself to make the best possible decision given the information you have is what traders do constantly and may be simply called building discipline.

Discipline is more than just following your rules. Its also the ability to make correct decisions in the face of recent failures. Even the most seasoned traders would be impacted by successive failures or missed opportunities.

For example, a trader who was stopped out on a 1CBO buy above b14 may be hesitant to buy b19. A trader who missed the reversal at b13 may enter a larger size on b27, which he may see as a deep 2L PB. Every loss and missed opportunity are likely to cause some distress in the mind of even the most experienced traders eventually forcing more and more mistakes. Similarly, a well executed trade may give a heightened sense of confidence and invincibility, forcing rash behavior.

The resistance to such pressure is something that needs to be worked on and can only be developed with practice. The ability to see a trade setup independently of recent price action and your bout with the market is something you need to focus on constantly.

The guide to doing this is to evaluate the market movements as information and disregard trading as something you need to do. "I need to make 2 points today" or "I better take one more trade so I can end the day without a loss" are terrible advices.

Focus on the information you get from the market. Constantly work on keeping your evaluation as objective as possible. Ignore statements about the economy, foreign crises or anything else that other traders and the news are discussing. They have absolutely no weight compared to what the market tells you.

Building discipline is like quitting smoking. Easy for those who don't have to do it but extremely hard for those who do need to do so. Constant slips of discipline and breaking your own rules are to be expected. Look at the few examples of success around you for inspiration and keep working at it. Know that even fractional improvements in discipline add up and build you up as a trader.

The hard road to consistency IX -- The need to re-learn lessons over and over

A trader should be expected to constantly having to learn and re-learn lessons and this is just part of learning to trade. Some of this is due to being emotionally reactive. A trader who sees a huge bar like b8 may be tempted to sell below it and is likely to be stopped out. Similarly, a trader may short a bull trend all the way to the top and blow up an account.

The first step is to understand what made you fail. Did you enter on fear of being left out instead of waiting for a setup? Are you deficient in some price action principles? (shorting all the way to the top = does not understand trends can go on indefinitely). Are your stops too tight? Are your targets too lofty? Do you enter too early? Do you love to pick tops and bottoms? Do you enter before a signal bar closes only to find that the good looking bull bar 30 seconds before bar close is now a bear bar? Do you enter on limit banking on your ability to predict reversals to the tick? Do you misread overlaps and chop as patterns?

Whatever your errors may be, you need to first identify them. The next step is to figure out the right way to trade those situations. Ignoring actual reversals and taking the 1st pullback after the successful reversal alone eliminates over half the errors above. Using proper trade management eliminates most of the others. If you can get here, you should be breakeven to slightly profitable on most days. But to get here, you need to practice over and over and only sustained effort can break your bad habits.

Days where price action exposes a large gap in your experience (counter-trend trading on trend days) are likely to still create large losing days and therefore, you should switch to SIM to collect data on these days. Identifying market structure responsible for huge losses and acting on them is a much harder task, but the fact that you switched to SIM after two losing trades enables you to stay in the game and figure out ways to identify and trade such exceptional days.

Even so, there would be rare days such as the flash-crash that could still give you some trouble. But you would be far more confident in your trading and welcome the opportunity to learn from exceptional events.

The hard road to consistency VIII - The tyranny of psychology

Many traders and other professionals in the trading world tell us that poor trading is mostly a psychological issue. While there's some truth in this statement, its incomplete and inaccurate. Otherwise, all psychologists should be fantastic traders.

The reality of trading is a bit more complicated. Obviously, you first need a system and understanding of the mechanics of trading. You need good risk management and trade management practices because having the best psychological state of mind is no substitute for stops.

I have searched far and wide for psychological articles regarding trading and found many books, articles and webinars, some with deep insight. However, most psychologists are not traders and their treatment of psychological issues is academic. Most of the material is generalized rather than actionable. For example: "Its more important to enhance well being than to reduce stress while trading" or "ask yourself before taking any action, am I doing whats in my best interest?"

Most of these observations are not actionable or otherwise useful. Benefits of prescriptions not related to actual trading such as marking off your trading area, feng shui, etc. may provide marginal benefits but should be viewed as borderline superstitions.

The entire development of a trader is two stages:

1. Develop or learn a proven winning system
2. Strengthen the discipline to follow it

Developing a winning system is complicated, tedious and time consuming. You are usually better off finding a mentor and learn a proven system and adjust it to fit your personality.

Once you have a system, discipline is what enables you to follow it closely. What is discipline? Discipline is simply the ability to resist short-term temptations in favor of long-term goals. Discipline is actionable. Just follow your system's rules and nothing else!

Its most important to note that many systems work only during specific kinds of price action and you should not trade if preconditions are not met. For example, my system works very well on trending and large range days and works poorly on small range days.  Fading systems work very well on trading range days and fail on trending days. Tick and bar scalpers can trade almost any price action but their win / trade is low and therefore they would need to lease a seat on the exchange to be profitable.

The ability to sit out during price action not fit for your system is discipline. The ability to stick to your stops and your daily stop loss is discipline. The ability to resist poor behavior (chasing trades, adding to losers, shorting all the way to the top, etc) are discipline.

When you chase a trade for example, you have overruled your judgement regarding passing up the preceding signal. You can never develop confidence in your market reading if you are easily swayed by a single bar. Accept that your system cannot detect every setup and at best you can catch a high percentage of moves. For example, do not buy b22 if you passed up b21 as a poor signal. Instead, add the observation to your list of things to investigate. Given enough samples, you will be able to pick on such moves eventually. You should have always anticipated a move, not react to it in urgency.

Over time, these observations will add to your system and make it richer and you will grow as a trader.

The hard road to consistency VII – No good signal bars

One of the most frustrating things for a trader is the lack of a good signal bar in a trend. A good signal bar is any signal bar with a shaved or 1t tail on the entry side and at least a 2t body. Ideally, the signal bar is neither too small or too large compared to recent bars.

I always recommend entering on good signal bars for a couple of reasons. When the market is not ready to trend your way, a strong signal bar is unlikely to trigger (b12, b66). This will protect you from many poor trades. A second important feature of good signal bars is that they are likely to respect a fixed stop (5t/6t for ES) for any given instrument.

However, on some days, there simply is no good signal bar in the direction of the trend (b10,16,20,38,50,73) but the reverse direction will often give great looking signal bars (b12,27,30,44,53,66,76).

This is typical of channel type price action. A trader who insists on great signal bars is likely to take very few trades on a channel day – which is not necessarily a bad thing, since channels are very hard to trade for most traders.

One way around this is to valuate the strengths of a signal by 3 criteria: location, pattern and signal bar. If location and pattern are strong, take a poor signal bar with-trend. For our purposes, location is a support such as HLC of prior day, ema, trendline, breakout point (as in BT) etc. Pattern is any two or three legged pullback.

Therefore, take any two or three legged pullback to a support even on a weak bar. This enables us to take b50, b56 long for example. Note that this can only be done if the signal bar is small and you can use a price action stop (beyond signal bar) rather than a fixed stop.

The hard road to consistency VI - Your equity curve as a price chart.

If you plot your winning days as green bars and losing days as red bars, you get a chart of your account size that looks similar to the price chart such as the one shown above. What makes a price chart go up and down also makes your trading account balance go up and down. When your trading is in an uptrend, you have mostly winning days with occasional losing days. The fewer and smaller your losing days, the faster your account grows.

Therefore a winning trader's account shows a cumulative graph like that of b1-17. A breakeven trader is likely to have alternating winning and losing days, todays gains lost the next day such as the range between b45-59. A losing trader is likely to lose a few times (b18-25) and go on tilt (b26-29) and then stop trading or change his style.

Its obvious that for your account to grow, you need to have fewer and smaller losing days and larger and greater number of winning days. While you may not be able to control the number of winning days versus losing days in the beginning, you certainly have the power to control how large a losing day is. Limiting your maximum loss per day prevents days where you go on tilt, effectively reducing days that look like b27 to a small bear bar, meaning much faster recovery on days where price action is more suited to your style and skill level of trading.

The first thing a big losing trader needs to do is be a smaller losing trader and then change to a breakeven trader. If you take trades where your wins are twice as large as your losses, there are very few ways you can be a losing trader, for example by going on tilt and taking questionable trades. At worst you should be a breakeven trader with alternating winning and losing days.

Once you are a breakeven trader, you can stay in the game indefinitely and hone your trading skills until you slowly start seeing profit. A breakeven trader can keep detailed logs regarding setups tried, stop sizes used, win rates, confidence in the read, etc. and narrow choices to a small set of setups that work for him. Continuous focus on this small set of setups over time will slowly flip these setups from net breakeven to net wins.

The hard road to consistency V - Poor price action days

In the post Off days, I spoke about the trader not being upto his game despite the price action being conducive to his type of trading. The flip side is when the trader is focused and ready but the price action is extremely poor. Today was such a day on ES.

Of course what constitutes poor price action varies based on trading strategy. For someone who takes very few trades and swings them to the max, a small range day with overlapped TTR action on most of the day is probably the worst kind of price action. On the other hand, a tick scalper would probably love a day like this.

There was no clear signal that worked the entire day and the biggest moves on b1 and b74 arguably were not off clear signals. New traders may get chopped up losing entire weeks worth of earnings on a day like this. This is mainly due to focusing on patterns and ignoring market context.

The risk management strategy to deal with such a day is exactly the same as the off day. You need to stop trading after two losses. Occasionally, you could look for an additional PM setup if a good one sets up (it did not today).

Expert and agile traders (I'm not one) may be able to switch context and switch to fading entry bars to get 10t on quite a few trades (for example, fading the second push down by selling close of b23 or buying close of b31 with 4t risk and 8t target)

Remember that every day does not have to be a winning day. Some days are simply not meant for swinging style trading. Since I choose to not trade unless my potential reward is 2x the risk, I prefer to stay out and reduce my exposure than to take smaller rewards (There were a few 1:1 setups).

The hard road to consistency IV - Very few low risk trades

Your consistency will only improve when your outlook changes from looking eagerly to make a profit to watching cautiously to minimize risk. Letting trades go if they dont seem to match the risk to reward expectation is the basic underlying framework of any profitable trading system.

As long as you try to recognize every tradable patterns and act on them, you are likely to stay a breakeven trader or slightly better. Once you are comfortable letting trades go, you become a far better trader.

The larger your risk, the higher your chances of making a trade work, but also higher your loss if the setup were to fail. The bare minimum risk on ES is 5t.  If you are just starting out, your win rate is probably near 50%. At 50% a 1 point win such as the long above b11 versus a 5t loss actually works against you. To account for commissions and other costs, you need to take at least 6t just to breakeven.  You would really need to look for trades that give you 2x your risk.

On an average day, there may be about two to five low risk/high reward trades. Your goal should be to focus on them and not bother with the minor trades.

For example, today there were only three setups that gave 10t while respecting a 5t stop (marked with dots on chart). Technically, some other bars such as b60 and b20 may have worked but they were second entries or not clear setups.

The best risk to reward is the first deep pullback in a new move. b17L was the first deep pullback in a bull move and b69S was the first deep pullback in a bear move.

Measuring risk is also about knowing when you can trade and when you need to sit out. When bars are small (b23-60) you are usually better off sitting out until bars come back to normal. Otherwise, you risk the pattern play out just as you expected but unable to reach your target. Wait for decent sized bars and then look for setups.

The hard road to consistency III - The heavy cost of education

Trading is very expensive to learn. There are countless ways to trade, many of which are unprofitable and many others profitable only to their sole practitioners. Of these countless ways of trading, only a couple are probably suited for you. Most people who try to trade systems without proving it to themselves will end up losing everything they put into it.

It is my opinion that a couple of observations of market behavior are insufficient to be branded setups and traded off. Its like observing the number thirteen is unlucky or people with the zodiac sign Leo are born leaders. It may seem true due to selection bias but most likely its just simple superstition. Many trading setups are superstitions and you should not trade them until know the probabilities for each setup.

Whatever setup you observe, read on a blog, hear from some hotshot trader or otherwise obtain from other means needs to be tested and measured to determine the following:

• Potential reward:risk (Needs to be at least 1:1, 2:3 or better recommended)
• Stop size required (Smaller is better or you may get shaken out)
• Probability of success: (Theoretically 50%+ but 60%+ recommended)
• Invalidating conditions and subtle variations (the fewer, the better)

The best way to get this information is to actually trade the setups. A sample of 20 trades will quickly eliminate poor setups. A sample of 40 should be sufficient to calculate probabilities. A sample of 100 should be sufficient to calculate stops.

Setups have subtle variations that make a given setup clear or strong vs muddy or weak. For example, today's trend down b12-27 from the W reversal was broken by a counter-trend move b35-49 and then we got a deep mW b50-55 (two inside bars b52,54 make this three tiny pushes). The subtle difference between the three pushes ending a leg versus an actual reversal of a trend takes experience and many traders could fail to realize that this is not an actual reversal. If they did not take a scalp profit, they probably were stopped out. Such losses add to the overall cost of your trading education and only screen time will make you better.


I believe the first year of trading can be done entirely in SIM and will probably save tens of thousands of dollars for the average trader. I have yet to meet a single trader who became profitable in the first year. Save the capital for once you know what you are doing. Modern SIM trading is extremely realistic and enables you to keep the same detailed records of wins, stops required, etc. The only thing missing is your mental discipline and ability to trade exactly as if it was the real thing. If you wish, you can toss a coin and switch between real trading and SIM trading arbitrarily until your mind does not differentiate.

Most traders fail because they run out of capital and the severe loss of the first few years of trading makes them give up. Reduce the cost of education by carefully evaluating and choosing setups and practicing your system until your prove it to yourself.

The hard road to consistency II - The off day

"A Samarian warrior does not fear death, nor does he rush out to meet it"

                                                            --Conan the Barbarian

Trading requires you be at your very best. You need to be alert and focused. You need to be rested and undistracted. You need to have eaten and your body should be healthy. Do not party unless the market is closed the next day. Despite diligence to your alertness and despite years of good trading, you will most certainly have an occasional off day when you are just not in the game.

Many traders who have an early brush with consistency accumulate enough points to think they have made it and start increasing their trading size. This is dangerous because a single off day can wipe you out. The most dangerous thing about nacent consistency is that you won't believe you can be wrong repeatedly on the same day and will have the confidence to think that you can win back everything you lost.

This is why I have a strict two failed trade limit. You may take a PM trade if you lose two trades in the AM but only if a great trade sets up  (for a maximum total of three losses a day).

The following signs should alert you that today is an off day:

1. You already have a reason to believe you may not be at your best (did not sleep/eat)
2. You lapsed into poor habits you thought were broken long ago
3. You are repeatedly reading the market worse than usual
4. You already hit your max losses

The moment you realize you are off, you need to stop trading. Even many years later, you will certainly encounter a day where you simply are not in tune with the market. Stop before you damage yourself more. Release yourself from the pressure to make money and focus on studying your newfound situation. This day is a poor trading opportunity but a great educational opportunity. Study your behavior and study the market's behavior. 

The hard road to consistency I - Overtrading

The trouble with trading is that you are in a position to do whatever you want and need to struggle to develop the discipline not to do things that hurt you. This is exactly the opposite from the real world where you are in a position to do very few things and have to struggle to do things you want to do.

You will learn very quickly that doing everything that comes to your mind leads quickly to ruin. The only way out is to learn not to do things. Your focus needs to change to stop doing things that cost you money even though they work some of the time.

In trading nothing is guaranteed. No setup is guaranteed to work every single time and even the best setups can have a repeated sequence of many losses. Everything is a probability and probability works only with a large number of samples. Even a 50% setup should be expected to see at least 6 consecutive losers in 100 attempts. (Go ahead, toss a coin 100 times).


Despite having a profitable system, many traders fail and this is because they are unable to follow their own rules. A trader needs to figure out what habits are damaging their trading and root them out.


The most dangerous bad habit is over-trading. What over-trading is depends on your style of trading. If your goal is to trade the 3 to 5 large swings of the day, then any day over 10 trades is probably over-trading. If you are a scalper who wants to take 10 trades a day, 20 may not be that bad but 40 certainly is. The best measure of overtrading is a poor win/trade ratio. 2 points from one trade is decent, 2 points from 20 trades is not.

Overtrading usually is caused by the trader reacting poorly (emotionally) to a loss. There are two kinds of reactions to a lost trade: Retrying and flip-flopping. A trader who has decided the market is going down will continue to short the market over and over, regardless of stop-outs. He thinks he is right about the direction of the market but incorrect about timing or stop size. The next time has to work!

The flip-flopper is far worse. He will go long if stopped out of a short trade and vice-versa. If a great long setup was  stopped out, then the market certainly should drop, right? (Answer: wrong. See b14)

The correct way to react on a loss is to look at the market objectively and enter only if there is an extremely good reason. A trader susceptible to overtrading should just sit out a few bars even if there appears to be a good reason to re-enter. Usually, if you were stopped out of a good setup, the market probably is in chop and you should not trade for a while.

Wait for the price to move away from the area you were stopped out from or give two swings in opposite directions after the bar that stopped you out. Most traders who enter right away after being stopped out have a state of mind thats a possible combination of disappointment, surprise, sense of urgency and desperation all of which are likely to cloud their judgement. Until you are consistent, stay out until price moves away or gives two more swings after a losing trade.

The mind treats losses like a mini-trauma and needs time to recover. Most losses due to over-trading are caused by poor judgement due to recent loss.

You also need to protect your account from being blown up because you cannot accept to have a losing day and will keep trying to trade your way out of a drawdown. Over traders should have a strict rule regarding the number of losing trades they have per day. If you are in a state of mind that  is causing you to lose over and over, trying harder is likely to make it worse, not better.

Understand that your main goal as a trader is to manage risk and once you have crossed a certain number of losing trades, your risk of ending the day with a larger loss is higher if you continue to trade and manage the risk by stopping trading.