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 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 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.

Stop and Scalp size for swing trading

In a previous post, I discussed a way to optimize your stop size. From an extensive history of trades, including various experimental trades, I deduced that my best entries pullback 4t or less after entry. This implied that I could possibly get away with a 5t stop for most trades.

On the left you see a chart displaying the Maximum Adverse Excursion (MAE) of over 100 winning trades. (Losing trades are irrelevant since they always have MAE of where the trade was stopped out.)

The most striking feature of this chart is that most trades are crowded in the first 5 columns (0t, 1t, 2t, 3t and 4t). Entries that have pulled back beyond 4t after triggering and have eventually been profitable less than 10% of the time. Out of those only 3 have managed to give more than 10t profit. I have not made a lot of trades with stops larger than 2 points recently so the sparsity on the far right is probably simply insufficient data. But when I did the same analysis long ago with price action stops (beyond bars) I noticed a similar pattern.

I focus on large market moves and signal bars that lead to large market moves pull back very little after a they trigger. The obviously important turns and their pullbacks today were  b8(4t), b23(2t), b40(0t) and b59(1t). If you notice, they pulled back very little after they triggered. For swing trading, you need to only focus on the large moves and ignore small moves, i.e. your aim is to buy a bar like b40 and hold it till b59 rather than buying the low of b50, b54 and selling at +1 profit each.

Therefore, if you are looking to swing and the price pulls back more than 4t from your entry price, it may not end up being a good swing at all. The next step then is to tune your trading to accurately assess the largest market turns of the day and take only those setups.

Once you have a fixed stop size, then your scalp size is automatically twice the risk if you want to swing half your contracts. (If you want to take a fixed profit, anything larger than your risk is acceptable). This gives a 5t fixed stop and 10t scalp target for my style of trading. Since most of my entries eventually end up being large moves, on an average I'm always better off swinging at least half.

Naturally, 5t/10t above is determined based on my personal trading history and for my strategy of trying to only trade major swings. Your mileage may vary and you would need to determine your stop and scalp points based on your own trading data and strategy.

Breakeven odds

Some of you may have noticed me go from +2 scalps to +2.5. This represents a shift in my risk management strategy that was under extensive testing. Previously, I have posted a risk management system that could be used by traders to take a moderate fixed profit with a small fixed risk.

That system works because every win is larger than every loss and a breakeven trader should still accumulate points. However on some days such as today, the price action obviously favors swinging your position.

Traders who wish to swing should use the following risk management strategy. This strategy is methodology neutral, i.e. it should work with any kind of trading/entry system.

• Initial Stop is -5t for full size.
• 1st target is +10t for half size.

Never loosen or tighten the stop until the first target is filled or stop is taken out. If not, you lose the benefit of the math. When first target is filled, move stop on balance to your entry price and let it run. The swing portion can be exited at any price above your entry price but you should try to get at least 4 points.

In the breakeven case:

• 50% of trades stop you out without filling first target. (10t loss)
• 50% of trades fill first target and pullback to take your breakeven stop. (10t profit)

This means even if you can never ever swing a trade, the worst you can have is breakeven as long as your win-rate is at least 50%.

If you can manage to keep your win-rate above 50%, your account should slowly accumulate winnings. You can do the following to keep a better than 50% win rate:

• Trade only after an obvious trend has broken out.
• Trade only deep pullbacks in the trend.
• Never take reversals. 
• Extreme caution between b24 and b60.
• Avoid poor signal bars (overlapped, tails, too large, wrong color, etc.)

If your win rate is less than 50%, just stop trading anything else except an obvious trend and first get above 50%. A win rate under 50% means you are doing something very very wrong.

Your trading edge

A trader will pick up a few skills after trading for a while. If those skills are better than the average trader, he gains a small edge over other market participants. These skill sets are common across trading systems:

1. Correctly determine market direction
2. Roughly estimate how far the market is likely to move
3. Find precise entries
4. Determine stop size for an entry.
5. Hold through the trade and not be shaken out by any minor pullbacks or loosen stops
6. Hold a winner for extended duration
7. Gain important market information from losing trades and apply to next trade

Once you have identified your edges, tailor your trading to amplify those edges and insulate yourself from market action where you don't have an edge.

For example, if you can gauge market direction and estimated move accurately but your entries usually get stopped out, consider trading options instead. For example, if you estimated a 10 point down day in the first few bars but would usually be stopped out if you tried a price action entry (as I was on my b4 short), you could simply buy SPY puts in the AM and hold it till it reaches your target or till end of the day and exit with a profit.

On the other hand, if your sense of direction is weak and consequently you have no ability to hold a position for too long, but you can enter and exit precisely, you can take multiple small scalps with small fixed profits.

Unable to hold, exiting early II - Recency Bias

Recency bias is our ability to recall recent events and experiences more readily than earlier ones. This means that anything you experience recently is likely to have a disproportionately strong impact on your decision making than older events. Recency bias is very hard to fight since its an essential part of our cognitive and learning processes.


For example, today I exited a bit earlier than I could have when I bought above b9. When the initial move off a first reversal (b9-29) is strong, you can often swing a trade till the end of the day or an obvious overshoot of the TCL. However, after adapting to the recent narrow range days, I exited at +6  right above b24 instead of my planned +8.

The permanent solution to this is to accumulate experience and develop the skill to quickly recall and adapt to changing conditions. The more experience you accumulate, the less recency bias impacts you. The tactical solution however, is to trade mechanically and stick to the plan. At the least, I should have exited on an L2 (after fL2 b21) below b30 for my swing position.

Unable to hold, exiting early I - Drawn out move

Human beings are naturally impatient and this often works against trading profits. While being unable to hold for long durations is far better than being shaken out, it can often cut profits deep enough to be of some concern.

For example, today if a trader bought b19 and held through the horizontal movement around b20-24, he would probably plan to exit on an L2 if the signal is good or on the third push up. Technically, he should exit when the price ticks below b37 or just above b35 (during b39) and then wait for more price action.

However, the sideways movement right after entry is likely to have caused him some distress and question the strength of the setup. He may consider the movement as BW and expect any BO above to fail and cause the market to drop below. He may read the bear bar b23 as a break in the trend or b21 and b23 as two interruptions in the trend making b26 a third push up to the ema and exit (or worse reverse his position). After all, thats exactly what happened at b10-13. If b21 had been a large trend bar with a strong close, he would have less of a problem sticking to his plan.

The solution to this to understand what b20-24 really is. Its an attempt to fail the reversal and many reversals have such a pattern right after if the entry bar is not a large trend bar. b15 was an fH2 that triggered off the first attempt to reverse at b9 and succeeded in failing the attempted reversal. b23 was a signal bar that attempts to fail the reversal off b19, making it an fH2 if it triggered.

Price action such as b20-24 is to be expected right after a reversal if the entry bar is small and the trader has two techniques to deal with it. First, take a first profit at +2 and move stop to breakeven for the remaining position. The very act of taking a profit increases your confidence in the setup and your trading in general. The act of moving the stop to breakeven releases anxiety since the mind perceives lighter risk. Once you hold through the first pullback, sticking to your plan becomes much easier.

Kryptonite days

A trader eventually graduates from having mostly losing days with a few winning days to the inverse: mostly winning days with a few losing days. But the losing days are likely to be disproportionally large. This happens occasionally due to the trader not being physically or mentally in top shape on that day due to lack of sleep, illness, relationship issues etc. But usually, this is because the trading system has a real weakness under certain kinds of price action that has been exposed by the market.

If you find yourself at this point, you are probably already a break-even trader. If you can tame or eliminate these disastrous days, you probably already made it as a consistent trader.

The first one or two disastrous days can be pretty devastating. This is because your initial success has encouraged you to increase size and your growing P&L has given you an enormous confidence boost. This probably meant you traded large size and re-entered every time you lost and at the end of the day were shocked to see a week or two's profits wiped out.

The very first thing you need to ask yourself is if you have lapsed into old habits. Confidence and a high win-rate can make you feel invincible like Superman and you may have lapsed into your old habits. Eventually Superman is taken down by Kryptonite. If your discipline has been good and you haven't yielded to the temptations of poor habits, there is a good chance that certain kinds of price action may simply destroy your success rate.

For example, today's wide slightly sloping channel is a kryptonite to AM trend traders such as myself. Narrow range days are also kryptonite for traders who like to take 2 points or larger on each trade. Overlapping signal bars are kryptonite for traders who like to enter on stops with a price action stop. Today was all three and if you know your kryptonite you can avoid it by not trading.

Similarly, trend days are kryptonite for traders who like to fade every breakout. Soft-trend days are kryptonite for traders who rely on only patterns for their trading decisions. Hard trend days are kryptonite for traders who take every reversal signal and so on.

The key is to know what kind of price action is unsuitable for your style and avoid trading on that day. Since realization comes too late, the best course of action is to exit after a certain number of losing trades on any day. Barring this, the second approach is to not take another trade for at least two swings after you are stopped out.

With experience, it may be possible to recognize the kind of price action and switch to a different style that's conducive to the current price action.

Two strikes

A decent win rate and a favorable win size/loss size ratio is the key to accumulating profits. A trader with poor win rate is likely to have extremely high number of trades. For one, the moment he is stopped out, he looks to getting in right away and often operates in an emotionally distressed state and is bound to compound mistakes. Ironically, the more he trades, the worse his performance is likely to get.

There are some steps a trader needs to take in order to avoid falling into this very common trap. The first is that a trader should look for major turns in direction and on a given day there are unlikely to be more than five.  So the question a trader should ask himself is not if he thinks the market will go up over the next bar or two, but if its a major change in direction.

The ability to locate these turns require a trader to trade less than he normally would. A trader who trades with-trend off a non-overlapping signal bar with a strong close near the ema or trendline is likely to be at least 50% successful. So if your success rate is under 50%, the first thing to do is to trade nothing else.

The next thing you can do is to adopt a "two strikes" policy. If you lose two trades, you are done for the day. You should also be done for the day if you took five trades total. In the beginning, you may end up finishing your quota in the first half hour after open, but with over time, you will be able to stake out longer and be able to focus on large moves.

The chart above is meant to be illustrative but shows how a two strikes policy would work with a -1.5 stop and a +2 target. As seen from the chart above, there is a very good chance you will be stopped at two trades on a large number of days and conversely on some rare occasions, you may get four or five wins. Nearly half the time, it expects a loss on the first trade and nearly three out of four times, a loss on either the first or second trade.

Even so, there is an expected value (EV) of about a point accumulating per day. The loss policy above can be abbreviated as 2/5 (two losses out of five maximum). You can try other variations such as 3/6 or multiple contracts and targets or anything else that's suitable to your trading style. Note that positive expected value is a side effect and the main goal here is to improve your ability to consistently take good trades and focus on major moves. Note that on many days, there may be only three or four trades, so don't be surprised if you take in less than the EV.

Note that the -1.5 stop is tuned for my proven setups. Other setups may need a wider stop but your stop should not be larger than your target. A wider stop is likely to negatively impact your EV, so trades with wider stops should have a very large EV (such as 1PB or W1P).

Eliminating your mistakes, one by one

When you lose a trade, you have to ask yourself if you entered correctly and it just went against you or if it was an emotional or careless entry. Traders who can otherwise read price action well will still be unprofitable because they do not have the discipline to enter only on good setups.

Your first task as a trader is to assess your winning percentages over a fixed timeframe, say a week. Is your winning percentage under 50%? In that case, maybe your current trading style is unsuitable to your personality. Are you trading breakouts and you panic when it moves against you? Maybe you are better off buying pullbacks. Are you trading counter-trend all the time? Perhaps a switch to with-trend trading may improve your score. Your first goal is to find a system where you are right at least 50% of the time on most days.

The next task is to assess every losing trade at the end of every day and update a chart as shown above. List your common mistakes and how many times you committed them per day. There are two categories of mistakes. Ones that you commit on most days and ones that you commit rarely except on certain days when you make a lot of them. Some are both.

For example, in the chart above, trading BW/ol is a mistake that is committed almost everyday but also especially on certain price action (Thursday in the example). Buying the wrong signal bar triggered only on two days, but on Wednesday it triggered 3 times. Mistakes that you commit on most days is the most important to fix. Pick the one that has caused you the highest losses and work on it consciously every trading day until you make it not more than twice a week. Then move to the next one.

Mistakes that you commit on specific kinds of days are easier to fix. You just need to recognize the kind of day that triggers an avalanche of mistakes. Are you shorting your way to the top on a Spike and channel day? Once you see the channel stop trading or only take with-channel trades. Put a post-it note on your monitor that warns: "Watch for channel!" if you must. Are you buying every bull breakout in a strong bear? Fade the breakout instead.

A genuine setup that you would take otherwise that just happened to go against you is not a mistake. That's part of trading. But you should keep track of this separately. This information allows you to select setups that are best for you and you should choose only the top 2 in the beginning and add others slowly as your trading improves.