Thursday, November 28, 2013

Choppy waters

Success in trading (or investing or gambling or any kind of speculation for that matter) is primarily the mastery of balancing risk versus reward against probability of win. A buyer of a lottery ticket makes a rational choice of wagering a nearly zero-impact amount on a potential windfall of low probability. A casino gambler is essentially in it for the thrill and may choose to do something similar (bet on number 6 on roulette or bet on red) to maximize gains on a low probability but much more realistic than the lottery buyer.

A trader should aim to only trade when a win far outperforms the losing trade by probability. This means that if on an average if you have a 50% win rate, your wins have to be at least larger than your losses by just a bit. The larger your wins compared to your losses, the steeper your account growth. You should typically only trade when your wins are expected to be twice as large as your losses. This will enable you to be a break-even trader with 33% win rate.

Your win rate depends on your skill of course, but more importantly, it depends on how the price action is unfolding. In a very strong trend, taking with-trend trades is a good win/loss ratio regardless of the probability of success. This is why sometimes in a strong trend, its ok to re-enter right after you were stopped out (as long as the trade was in the direction of the trend).

The worst time to trade is when your win/loss ratio is poor even with high probability of success. Today's price action reflects such a day. When the bars are small and doji-ish and the swings are small, its unlikely you will make huge profits on runaway trends. Even your scalps may fail despite the patterns you expected playing out as predicted.

Therefore the first lesson in profitability is to be able to simply recognize chop and sit out.

Friday, November 1, 2013

Quick breakeven exit strategy for experimental trades

When you start out trading your primary concern should simply be avoiding total destruction of your account. This is a hard goal to achieve, but one of the ways many traders approach this is to quickly move to breakeven when possible. This means that you give up potential profits in exchange for lower risk. All experimental trades (where you are trading to collect data rather than make money) are also traded in the same manner.

There are many breakeven strategies and this the one I'm currently trying:

  • Trade 3 contracts with -10t stop
  • Exit the first one at +10t
  • On fill, tighten stop to -5t
  • Exit second contract at 20t and tighten stop to entry price 
  • Exit last contract at 40t (or swing last contract)
Your varying degrees of success are:
  1. Trade fails: -30t
  2. First target filled but pullback is 5t or more: 0t
  3. Second target is filled followed by 0t stop taken out: 30t
  4. Third target is filled: 70t
Lets assume that the chances of the outcomes are as follows
  1. Half your trades will breakeven: -0t: 50% 
  2. Of the remaining, half will be total losers: -30t: 25%
  3. Of the remaining, half will work for profit: 30t: 12.5%
  4. Remainder: 70t: 12.5%
Your net average chances of a win are about 5t per trade, barely enough to cover commissions. However, you never really had hopes of winning trading a different exit strategy anyway, so this approach may work better simply by reducing the risk of losing from 50% to 25%. Note that you are now able to trade breakeven with only 25% win rate, which is a significant lifeline for a novice trader.