Thursday, January 23, 2014

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.

Thursday, January 16, 2014

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.