Classes of Knowledge

Anyone taking up trading for a living will eventually ask themselves if trading profitably is possible. This is natural and really is part of an assessment of the mechanics of price action.

The trader is faced with the following possibilities:

1. A profitable trading system is impossible to construct
2. A profitable trading system may be possible, but no known system exists
3. I'm familiar with a profitable trading system, but my knowledge is incomplete.
4. My knowledge is reasonably complete, but I'm unable to follow its rules.
5. I'm reasonably knowledgable about my trading system and have the discipline to follow its rules.

#1 and #2 are practically the same, except that #1 has a formal proof. Since no such proof exists, we can easily cross it out. The presence of great traders and professional traders suggest that there are indeed systems that enable traders to trade profitably consistently, no matter how hard it may be.

If you accept the above premises then the only steps between you and success are #3 and #4. #3 is about knowledge and #4 is discipline.

Knowledge and discipline work hand-in-hand. The more knowledge you have, the less you need to do dangerous things and have a greater command over your impulses.

When you first starts trading, the initial waves of success fool you into thinking "I know it all, I have it made". The market schools you over and over and you learn new things. Along with the new knowledge comes the burden of breaking old habits, of dropping setups and patterns of behavior that no longer fit into your understanding of the markets. 

As your discipline holds and you break your old habits, you catapult to a newer level of knowledge and the process repeats. You have not quite mastered your knowledge till you have developed discipline to obey your own rules.

I believe there are four areas of learning and discipline. 

1. Trend and Chop
2. Location
3. Pattern and Bar
4. Execution

Trend and Chop is possibly the most important to master since without it, your reading is invalid more than half the time. Setups that work beautifully in a trend will fail miserably in a chop and vice-versa. This will confuse and frustrate you and until you master it, you have no line of sight to success. Trend and chop also includes adjustment for hard trends and soft trends.

Good location is easy using trendlines. There are some intricacies but for simplicity, you can simply stick to the trendlines from HOD and LOD, which should work in most cases.

Pattern and bar are a bit more involved and this is where most traders focus (including this blog). Patterns are important, but they are a small part of your overall success. New traders should focus on the other three aspects of trading first and simply take any multi-leg poke of the trendline and not worry too much about specific patterns. 

Execution is very important and includes proper stop placement, money management and trade management. Good money management is more important to your trading success than all the patterns in the world put together.

A good starting point for a trader is to work on trading at good location and executing trades flawlessly.  This is fairly straightforward and sets the trader on the path to discipline. You should be able to follow the simplest rules before you can follow rules on patterns. This is a good application for simulator trading. Once the trader is comfortable spotting location and by implication the general market direction, the trader should focus on determining when the market has started to trend and when it has stopped trending. Staying out of chop is the single best thing you can do after good money management.

The general behavior of patterns and bars come last and they complete your education. Each area has its burden of discipline, which cannot be overstated. Knowing you have to wait for the trendline, yet having to take this one exception will be a struggle till you are able to master your own rules.

In future posts, I will elaborate more on each of these areas.

Trend and chop

The most important criteria to optimize your odds is to trade in the direction of the trend, which implies sitting out when there is no trend. This gives rise to the question of how to determine when the market is trending. A related concern would be the strength of the trend, which can help determine targets.

A trend simply defined, is higher highs and higher lows for bull trends and lower highs and lower lows for bear trends. However, this is too simplistic in practice. Technically, a trend is a sustained move in one direction. The opposite of a trend is chop.

For example, today's open was a choppy open and its pretty obvious from the sequence of opposing bars. But then a trend broke from b16. (Identifying the breakout of a trend before it breaks is called the breakout problem and is an active research topic.)

Once the trend breaks, you would need to wait for a setup at the trendline. In general, the setup needs to be a multi-legged and/or deep pullback. The picture above shows several ways to draw trendlines. The purple line is simply an inferred trend line drawn parallel to the TCL from the prior two pushes. The bear trendline from b7-b16 is the shallowest bear trendline that can be drawn from the HOD. Similarly the trendline b37-40 is the shallowest bull TL that can be drawn from the LOD.

The shallowest TL is the safest, highest probability TL and is the only place you can take swing trades (trades with indefinitely large targets). A sustained breakout such as the one below b11 enables the drawing of a steeper TL that sometimes works at least once (this is due to the fact that strong breakouts usually have at least one more leg). Note that the breakout above b33 for example was a strong move but not a sustained breakout since it did not continue for many bars and many ticks.

In most cases, there are at most two trendlines, the shallowest bull and the shallowest bear. In a bear move such as today, every new pullback after a new push down will attempt to create a new shallowest bull TL that could break and give a new move down. The steeper the shallowest TL, the stronger the trend.

The first achievement in trading is predicting the direction of the market correctly. The shallowest TL is the simplest way to learn to guage direction. Waiting for the price to poke beyond the trendline before taking a trade will ensure at least directional correctness. To start with, disregard, breakouts and reversals. Wait for an obvious trend and wait for price to pullback to the shallowest trendline and take every trade. You may use a bar stop in the beginning or even a tight stop and not worry about the win/loss because your goal not really to profit but to learn to read direction.

Once you are comfortable with your sense of direction, you can fine tune your entries to work with a tight stop and later move to optimize exits.

The openers: 1W

Its a common suggestion to trade with the trend whenever possible and while its a good idea, often it takes a while for a trend to be obvious. Often the big moves occur early in the day when the trend is indeterminate. Some days such as today, the big move may lead to a sustained trend. Once a trend is obvious, say b40 or so, its a simple matter of waiting for a deep pullback to the trendline (around b57) and then finding the right place to enter.

On most days however, it pays to be on the right side of big moves early in the day, since that may be your only opportunity to take a sizable profit.

Even the open has some repeat patterns that signify potential large moves and studying them enables you to be on the right side of a large move.

The overall idea is that the first bar or the first few bars represent either a trend or a trading range and the way price moves beyond it will enable you to determine the pivotal move of the day.

Openers fall into various classes based on how the first few bars relate to each other. A large first bar usually signifies high volatility and potentially a large day.

The simplest opener is 1W (first wedge of the day). This represents a 3 push move in one direction that turns into a reversal. Sometimes the 1W can be a 3 push pullback after a large move in one direction.

1W usually results in a sustained move for the rest of the day (or at least the next couple of hours). 1W that are also WfBO adds strength to the pattern and are usually good for at least the other end of the range.

In general, its beneficial to take the higher low (b21) rather than take a bad bar (b15). When the move takes out the other end of the W in one leg (did not happen today), its usually a sign that the price will move a measured move in the same direction (which did occur).

ProTip: Any weak move from the open could 1W and turn around.

The first principles

The single most important factor in your success is your ability to distinguish when a given market is tradeable and when its not. Until you are able to make this distinction, you will never be a successful trader.

The primary criteria for trading is the presence of a trend or potential for a trend. A trend simply defined is when swings in one direction are disproportionally larger than swings in the opposite direction.

This brings us to the first primary skill that a trader needs to work on. The ability to notice that longs were the direction to trade in the AM today until about b35 or so. The ability to notice when the swings are no longer disproportionate is an integral part of the same skill.

Once you identify swings are larger in one direction and smaller in the opposite, the trend direction is obvious and you should only take trends in the direction of the trend. When the swings are large, it may be possible to trade swings in both directions such as when the trend turns into a broad channel but my advice is to avoid counter-trend trading until you are profitable trading with-trend. If a trend is present but the swings are not large enough (shallow trend), you should not be trading. Learn to sit out of the action.

The second criteria in trading is knowing whats a reasonable target for your chart. Your target needs to be larger than your stop. Ideally, your target should be twice your stop or better. Otherwise, the win-rate you would need to be profitable is unrealistic. In case of CL, 20t seems to be a reasonable profit target on days with good trend action. For example, b1,b11 and b29 all went 20t before pulling back.

My investigations into MAE have shown that 5t is a reasonable stop for the best trades and therefore, I can trade with a target at 4x the stop size. I have eliminated setups that would require larger stops. I have also eliminated ema and related setups. I expect to exit my position fully at 20t in more than 90% of my trades.

The heaviest losers in trading lose because of three reasons. I call them the three Cs

1. Chasing
2. Counter-trend trading
3. Chop

The first two great evils can be controlled by trading only setups at the trendline. (Chop is much harder to avoid (I'm still learning) and we shall talk more about it in future posts.) Indeed, the trendline is all you need to draw, and in many cases, it may be obvious enough to be superfluous.

Tight stops and other simplifications

I've been trading 5t stops for a while and so far, its been rough on my win-rate, even though my general direction on a trade may be right. For example, a larger stop (but not 10t stop) would have probably yielded a 20t profit on the short below b7.

The small stop is possibly changing my behavior as well, making me take on some riskier trades. This could be something I just need to work on and get used to. However, I believe that in the long term the 5t stop will pay off very well.

Meanwhile, I've been working on general simplifications to the trading model. One of the reasons traders cannot recall their knowledge base during trading is due to the way human mind works in times of stress.

A trader looking at the screen has four loads on his brain: Visual, Intellectual, Memory and Motor. This is called the VIMM model. The more visual elements on the screen, the harder your brain needs to work just to recognize patterns. Removing everything possible helps you focus on a smaller set of variables. Ideally, you would only focus on one variable. Removing the ema and volume bars has direct effect of freeing up visual work.

Once your vision has processed symbols, your intellect works on recognizing patterns and performing analysis. Your memory enters the picture next, recalling every piece of data relevant to the situation at hand. Last but not the least, you need to actually enter the order in time.

It is a known fact that each stage when simplified, frees processing power for the others. Its also known that stress impairs memory and instincts are heightened. This is why memory failure during stress is so common.

My current hypothesis is that the innumerable patterns and setups scanned for by price action traders are a huge load on the intellectual and memory systems of traders. Under stress, people are unable to process information efficiently and this often results in making mistakes that are obvious in hindsight.

My approach to this problem is to have very few setups. The real factors in trading are time of day, volatility and money management. Setups are important, but secondary. As you can see today, one or two hours on the open is the best time to trade. The rest of the day is often lukewarm. Today is also a poor day to trade because there is no real volatility. On a big day, you can simply enter with trend and ride it out. The 5t stop is the money management and trade management piece. Despite a win rate of only 20%, my Profit Factor for the day is 1.78, which is decent. This enables me to take on more experimental trades enabling me to broaden my knowledge and enhance my trading system.

I'll post more on these in the coming days.