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.

Random walks and predictable trends

The random walk hypothesis suggests that market moves are purely random and what appears to be trends are simply accumulation of sporadic random moves that happen to occur in the same direction for a duration of time.

The idea is that buyers and sellers mostly cancel each other out, and the net difference causes a perturbance in the  price of the underlying.

The random walk hypothesis is pretty absurd since it assumes that the probabilities of buys and sells stay same with price movement. It should be obvious to even the lay person that a stock at $1 can have twice the buying pressure as a stock at $2.

Traders know very well about herd mentality, the rush to join a successful move and abandonment of a spent move. Fear and greed are the true drivers of the market, not randomness. This is true at least for trending markets.

However, when the market is not trending, random movements are perfectly possible. To figure out what movements are random, I ran a simulation where every move went up or down based on probability. When the probability is 50%, the market essentially becomes BW (as in b2-b5). When the probability is slightly imbalanced, we get a sloping channel (b49-59).  In general, if the bodies are sloping, its a slightly imbalanced channel. In either case, they are traded the same way. You wait for a trend to break (b9 was LL-LH-LL) and then take the first pullback (b15 or a better bar at b17) or wait for the breakout to reverse and take the reversal (b24 or the next HL, b30)

Taking the correct bar with the right stop is tricky and deserves its won post but as you can see on this day, its possible with some practice. Moves from randomness often lead to sharp trend attempts that often reverse or otherwise get arrested, so its important to take profits conservatively.

Smaller stops, larger gains

After an in-depth survey of my trading results, I discovered that my best trades have the least maximum adverse excursion (MAE) or pullback. Many were under 5t. Therefore, I embarked on an investigation to figure out if it was actually possible to trade on a 5t stop if I chose my trades very carefully. The trick was to find a way to objectively measure the effectiveness of such a small stop and whether a larger stop (10t) would succeed on the exact trade if a 5t stop would fail. One way to do this was to have two stops, one at 5t and the other at 10t. And then measure fraction of trades that were successful on 5t stops.

The plan was to have two stops on entry at 5t for two contracts and 10t control for an additional contract. Once the price moves past the entry bar, all stops could be tightened to 5t.

The three possible results are:

• both stops taken out: Trade was a total failure
• 5t stop taken out, trade eventually fills at least 20t: Trade was a partial success
• neither stops are taken out: Trade was total success

Preliminary results suggest that most trades that are stopped out with a 5t stop would also be stopped out with a 10t stop.

At this point results are preliminary and I do not believe I have sufficient data to draw a broad conclusion in all market conditions.

However, I do believe that for people whose success rate is under 60% or so, the benefits of smaller losses from tighter stops outweighs the small number of gains lost from partial failures. A 20t gain vs a 5t stop is a 4x profit factor and can greatly steepen your profit curve.

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.