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VIEWS: 25 PAGES: 39 CATEGORY: Market Research POSTED ON: 5/31/2012 Public Domain
Trading as a Business Introduction Trading as a Business by trader and author Charlie Wright captures the essence of strategic trading with TradeStation products by combining years of practical trading experience with good old common sense! With a new chapter being released each week, you'll be provided with both the philosophy behind strategy trading and a solid foundation for developing your own trading ideas into trading strategies. Whether you're a seasoned veteran or just getting started, Charlie's insights and experience will challenge you to look at the business of trading from a fresh, new perspective. Mr. Wright is Chairman of Fall River Capital, LLC. Fall River Capital, LLC is a registered CTA and manages the Fall River Fund using the principles from Trading As A Business. He has been associated with the Fall River Group since 1973, and uses the principles in this set of articles to manage the fund. He is also chariman and co-owner of Kilbourn Capital Management, Inc., which manages the Kilbourn Diversified Strategy Fund, a hedge Fund of Funds. He also serves as a member of the board of directors of TradeStation Group, Inc. (the parent company of TradeStation Technologies). During the 1980's, Mr. Wright was an IOM member of the Chicago Mercantile Exchange, where he gained a great deal of practical experience in observing how markets move and the potential benefits of using a systematic approach. Over the years he has taught several different trading seminars, including Trading as a Business and System Trading and Development. Mr. Wright is credited with having taught many traders how to develop their own trading strategies, and there are many traders in the world today who use his techniques. Trading as a Business: The Principles of Successful Trading Over many years of trading, I've found certain principles to be true. Understanding and using basic principles provides an anchor of sanity when trading in a crazy world. Whenever I find myself under stress, questioning my judgment or my ability to trade successfully, I pull out these basic trading principles and review them. Don't Try to Predict the Future I used to think that there were experts and geniuses out there who knew what was going to happen in the markets. I thought that these traders and market gurus were successful because they had figured out how to predict the markets. Of course, the obvious question is that if they were such good traders, and if they knew where the market was going, why were they teaching trading techniques, selling strategies and indicators, and writing newsletters? Why weren't they rich? Why weren't they flying to the seminars on their Lear Jets? No one knows where the market is going It took me a long time to figure out that no one really understands why the market does what it does or where it's going. It's a delusion to think that you or any one else can know where the market is going. I have sat through hundreds of hours of seminars in which the presenter made it seem as if he or she had some secret method of divining where the markets were going. Either they were deluded or they were putting us on. I have seen many complex Fibonacci measuring methods for determining how high or low the market would move, how much a market would retrace its latest big move, and when to buy or sell based on this analysis. None has ever made consistent money for me. No one knows when the market will move It also has taken me a long time to understand that no one knows when the market will move. There are many individuals who write newsletters and/or books, or teach seminars, who will tell you that they know when the market will move. Most Elliott Wave practitioners, cycle experts, or Fibonacci time traders will try to predict when the market will move, presumably in the direction they have also predicted. I personally have not been able to figure out how to know when the market is going to move. And you know what? When I tried to predict, I was usually wrong, and I invariably missed the big move I was anticipating, because it wasn't time. It was when I finally concluded that I would never be able to predict when the market will move that I started to be more successful in my trading. My frustration level declined dramatically, and I was at peace knowing that it was OK not to be able to predict or understand the markets. Know that Market Experts aren't Magicians Some of the experts that try to predict the markets actually make money trading the markets; however, they don't make money because they have predicted the market correctly, they make money because they have traded the market correctly. The Principles of Successful Trading (cont.) They don't profit from their predictions There is a huge difference between trading correctly and making an accurate market prediction. In the final analysis, predicting the market is not what's important. What is important is using sound trading practices. And if sound trading habits are all that is important, there is no reason to try to predict the markets in the first place. This is the reason strategy trading makes so much sense. They have learned trading discipline I have watched many market gurus continually make incorrect market predictions and still break even or make a little money because they have followed a disciplined approach to trading. More importantly, they used the exact same principles that I will show you how to use in creating your strategy. It is these principles that make the money, not the prediction. To be a disciplined trader, you have to know how and why to enter the market, when to exit the market, and where to place your money management stops. You need to manage your risk and maximize your cash flow. A sound trading strategy includes entries, exits, and stops as well as sound cash management strategies. Even the market gurus and famous traders don't make money from their predictions, they make it from proper trading discipline. Over the years, they have learned the discipline to control their risk through money management. They have learned to take the trades as they come, and not forgo a trade because they are second-guessing their strategy or the market. These are the same practices that you will learn to include in your trading strategy. They profit from sound cash management & risk control Sound money management and risk control are the keys to being a profitable trader. I will say over and over again, it is not the prediction or the latest and greatest indicator that makes the profit in trading, it is how you apply sound trading discipline with superior cash management and risk control that makes the difference between success and failure. I often tell the story of the great fish restaurant that opened up just down the street from my office. It opened with great fanfare and was ranked in the top five restaurants in the city. The food was outstanding. But it only took a little more than a year and this great restaurant was out of business. Why? Because the key to running a good restaurant is not the food…it is cash management and risk control. It is making sure your business is run efficiently, keeping your costs (risk) in control, and managing your staff effectively. If you believe that the taste of the food is what makes a great restaurant, think of how great the food is at your favorite fast food restaurant. But, someday, watch how well that restaurant is run. Just as in the restaurant business, the key to profits in trading is not in the prediction or the indicator, but how well the trading strategy is designed and executed. The ability to achieve risk control and cash management will make the difference between a successful trader and an unsuccessful trader. If you ever have the opportunity to watch a successful trader, you will see that they don't worry about where the market is going or about predicting when the next big move will take place. They aren't looking to tweak their indicator. They are worried about their risk on each trade. Is the trade being executed correctly? How much of their total account is at risk? Are the stops in the right place? And so on. They don't have superior performance numbers If you want to have some fun, look at the performance of a successful market expert, one who is known for his or her market predictions and trading expertise. You will find that their performance numbers really aren't any better than an average trading strategy. The percentage of profitable trades, the return on the account, average profit to average loss, number of losing trades in a row…all of these trading parameters are within the average trading strategy performance parameters. Why is this? Because you can't predict where the market will go and when it will move. But if you use correct strategic trading disciplines, you will make money whether you try to predict the market or just trade a good strategy. You might as well save yourself a lot of time, energy, and mental anguish and trade a good strategy. Be In Harmony with the Market We make money trading when we are in harmony with the market. We are long when the market is going up, and short (or out of) the market when it is going down. If we bring an opinion with us while trading, we will end up fighting the market. We keep trying to go long as the market is declining, or we keep shorting a market that it is in a bull phase. Don't fight the Market Fighting the market is not good for two reasons. First, we lose money. How much we lose depends on how well we are managing our money and controlling our risk. Second, fighting the market affects our judgment, and causes us to try to confirm that our judgment is correct, or persist in fighting a trend so that we will eventually prove to be correct. We figure that if we persist long enough, no matter how long it takes, we will eventually be right. The same can be said for being in a canoe in a river. There is a reason for leaving your car downstream, launching your canoe upstream, and paddling downstream. It is much easier and eminently more fun to go with flow and paddle downstream. We could do the opposite and paddle upstream. Eventually we may even get to our destination, but the cost would be substantial. It would take much more time, more physical and emotional stamina, and we would be constantly fighting the current. Reaching the goal would not be worth the cost. Even if you ultimately make money fighting the market, it is not worth the price you have to pay, both financially and with peace of mind. Let the market tell you what to do and when The correct attitude for successful trading is to let the market tell you what to do. If the market says to go long, buy, and if it starts to go down, sell. This sounds easy but it is much more difficult than you think. We always like to believe that we can be in control. We want to be in control of our trading and of the market. If you accept the notion right now that you cannot control the market, that all you can control is your execution of trades, you will take a great step toward being a successful trader. nstead of trying to control the market, let the market tell you what to do. Let the market and your strategy take you long rather than you personally trying to predict or decide when to go long. Let your strategy take you out or get you short. Once you realize that you can't understand the market, and that you can't predict when the market will move, you will move into that detached state of mind where you let the market take you where it will when it wants to. The market gives and the market takes away To remove your personal biases and let the market tell you what to do is to give up control, to give up the notion that you are actually in charge of how much money you make. For profitable trading, you need to move into the mental state of letting the market determine the profits, not you. It won't be whether you predict the market correctly that determines the profits, but whether your strategy is in a profitable mode or drawdown mode as determined by the market. So, let the markets tell you what to do based on your strategy. Let it get you long and put you short. Let the market determine how much money you are going to make. Trade your strategy and let the market do the rest. And know that the market gives money and the market takes away money. Your goal should be to develop a strategy that gives you more money than it takes away. Have a Healthy Time Horizon One of the biggest problems new traders have is that they think they will make a large amount of money right away. They think they will get rich quick. This type of reasoning is very similar to the short-term thinking in American business in general, usually managing for the current quarter's profits, focusing on short-term earnings at the expense of long-term investment and profit growth. Trade for profits over time Traders tend to get wrapped up in current market conditions, the news of the day and the current trade, usually at the expense of the big picture and profits over time. My grandfather used to have a saying, "You can't go broke taking profits." He was very wrong. You can go broke taking profits. If you take profits before the market tells you to, or you succumb to fear and close out the trade before its time, you are focusing on the short-term and forgetting how to make money over the long haul. Close out no trade before its time. Give your trading strategy enough time to work We tend to be impatient, and we sometimes think that we should get instant gratification. This will not work in trading. The only way you will really know whether you are a successful trader is to be successful over time. A week or a month will not be enough time to tell you how you are doing. You should be trading with the objective of making money in the long run, consistently, and with the confidence that your strategy will make money given enough time. One of the benefits of trading with a strategy is that having done the requisite historical testing, you should know how long it should take you to start making money. You should have an idea as to the length of time that the strategy has lost money in the past, how much money it has lost, and how long it will take the strategy to become profitable. If the strategy has proven profitable historically, it should be profitable in the future. You just need to give it the necessary time to do its work. Understand the Psychological Keys of Trading There are many people who teach the psychology of trading. There have been many books written and effort spent on seminars trying to teach the discipline needed for trading. I don't think trading is that complex. I have developed a few simple psychological rules for myself, and once you accept them, they should greatly enhance your ability to trade effectively. Accept losses as a cost of doing business Most successful traders will tell you that the most difficult thing about trading is accepting the losing trade. We all have the desire to be to be right, to be correct all of the time. For novice traders, the losing trade means that something is not working and that you have somehow made a mistake. For experienced traders, losses are just a cost of doing business. Some of the best traders in the world lose money on more than half of their trades. If you look at the performance results of the best traders and money managers, you will see that they all have a large percentage of losing trades. If you trade, I guarantee you that you will have losing trades. Learn to love losing trades. They should be your friend because you will be spending a lot of time with them. Use historical statistics I don't think anyone has ever traded without first looking at historical statistics. Even some traders who deny they are strategy traders have used historical data. And before EasyLanguage and TradeStation were available, most good traders developed a strategy's history by hand. I can remember countless hours pouring over charts spread out on the kitchen table, writing down trades by hand. Before I would trade it, I absolutely insisted on knowing what the strategy's personality was and how much money it would have made. Using historical statistics gives you great peace mind, particularly in learning to love losing trades. Knowing the history of a trading strategy can give you tremendous psychological comfort during those tough periods of losing trades and drawdown. Historical statistics tell you how much money the strategy has lost in the past, how many losing trades it has had in a row, and the largest losing trade the strategy has experienced. This is very important information if you are learning to accept losing trades. Comparing historical data with the current string of losses and drawdown can give you much comfort that what you are experiencing now is not unusual and has happened before. Maybe not in exactly the same manner, but it has happened before. Let the market and STRATEGY determine the profits Don't have an opinion, don't try to predict the market, and don't try to second-guess your strategy. It's human nature to have an opinion about things, but this opinion can become a stumbling block if we let it affect our trading. One of the alluring aspects to having an opinion on the market is the exhilaration of being right. Even though we know that the chances of being right are slim, we nonetheless want to prove our intellectual prowess by being right. Your trading strategy is ultimately a little business. You have developed and tested the product and are now operating the business in the real world. Let the strategy be the strategy. Let it make the money you know that it can. And know that if the market doesn't move in the manner that will allow the strategy to make money, it won't make money. Ultimately, the market determines the profit through its movement. If it doesn't make that move, there will not be profits. Put the responsibility of making money on the strategy and the market. When they work together, you will have a profitable business. Don't Trade for the Money I have met many successful people, and the one thing that they have in common is that they love what they do. Many have told me they can't believe that they actually get paid for doing what they do. They have so much fun they feel guilty taking money for doing it. Many successful people will tell you that they would do what they do even if they weren't paid at all. Successful people don't work for the money Work hard and love what you are doing and the money will follow. Successful people work first and count the money later. Sometimes they don't ever count it, and some don't even know (or care) how much they have. They just know that they have enough to allow them to continue what they are doing; working hard and having fun. Love trading for its own sake I know that many individuals want to trade because they think that they can make a lot of money easily and quickly. Because of the low start-up costs for trading as compared to other businesses, they think that trading should be the easy road to riches. Their goal is to make a lot of money fast. These are the people who come to seminars and want an indicator that will guarantee profits. They don't want to learn the ins and outs of the business; they want the magic indicator that will get them the money they desire. They are doomed to failure. I remember a guy named John walking into a seminar I was about to teach. He threw up his hands and said, "Ah, Traders! I am glad to be home." This individual was a successful trader. John loved going to seminars, not so much for the techniques and indicators, but for the camaraderie. He loved being around traders, talking with traders, analyzing trading strategies and techniques, and learning about the latest and greatest trading technology. He loved learning the latest features added to TradeStation and finding out a new way to use EasyLanguage. He loved designing new indicators, and spent countless hours working on new and different ways to exit the market. He was excited about getting up early in the morning to monitor the overnight market information and checking what the S&P was doing in London. He looked forward to calling his broker and putting in his orders. He loved watching his strategy run on TradeStation. He was exhilarated when he had to call his broker and give him a lot of grief for the latest bad fill. He even loved losing trades. Even when he had to take a losing trade, he was still doing what he loved to do—trade. John is a successful trader. He loves what he is doing. And as long as he can keep on trading, he will be happy. The money he makes is secondary, but he makes a lot of it. He can't believe that he can have all of this fun and make money as well. Concentrate on Execution All of your market and strategic analysis should be done before the markets open. The strategy design should be clear in your mind. You should have the historical Performance Summary of your strategy at your fingertips to remind you of the personality of the strategy, how much money it has made over time, and what its largest string of losses in a row has been. You should know what kind of orders you are going to place, and how you are going to communicate this to your broker. The last thing you should have to worry about during market hours is where the market is going, and whether to be long or short. Your strategy will tell you all of this. You should not be concerned about the news, or even if you are making or losing money. You should not be concerned with analyzing the market, always reserve this for when the market is closed. The only thing you should be doing during market hours is concentrating on effectively executing your strategy. If you can't execute your strategy effectively, there really is no point in trading. There are two sides to trading, strategy development and trading execution. During market hours is when you should concentrate on execution and nothing else. Always Be In the Market I have always characterized trading the trend as keeping your costs down while waiting for the big move. We know that to trade profitably, especially for trend traders, you need to be in the market for the big move. Many traders stay out of the market when it's quiet and try to predict when the big move will occur. These people invariably miss the big move. Instead of trying to predict when the big move will occur, your task becomes to minimize your losses and drawdown while you are waiting for the big move to occur. This is a different way of looking at trading that focuses on managing cash flow and risk rather than finding magic indicators and making good predictions. Trading thus moves from a hobby to a business. The only way to ensure that you won't miss the big move is to always be in the market. Buy High - Sell Low Probably the most interesting rule for successful trading is to Buy High and Exit Higher, and Sell Low and Exit Lower. This is counter-intuitive to what we all have a natural inclination to do, which is buy low, sell high. Most great trading strategies are counter-intuitive. They are not based on our normal human nature and the normal human reaction to the markets. They consistently make money because they are designed with market sense not human common sense. In the final analysis, any market is just a collection of individuals making decisions and placing money in the market based on these decisions. Most of these individuals are doing what comes naturally to humans, buying low and selling high. Statistics show that 95% of these people lose money. To be a successful trader, you have to do the opposite of what this 95% is doing. It isn't easy, because it goes against your human nature. But any strategy that is successful over time will most likely follow the rule of Buy High, Exit Long Higher and Sell Low, Exit Short Lower. NOTE: What you have just read has been presented solely for informational or educational purposes. No investment or trading advice or strategy of any kind is being offered, recommended or endorsed by the author or by TradeStation Technologies or any of its affiliates, agents or employees. Trading as a Business: The Path To Successful Trading In the broad category of "trading the markets," there are basically three types of trading: discretionary, technical, and strategy-based. When I sat down to write this book, my intent was to write only about strategy trading. But then I realized that to fully describe strategy trading, it was also necessary to discuss discretionary and technical trading. It's important that you understand the difference between them, which is not always clear. I've met many people who believe they are strategy traders when they're actually technical traders, and vice versa. I have known and taught many traders, and have observed that there are four distinct stages of trader education: discretionary trader, technical trader, strategy trader, and complete strategy trader. All successful traders have gone through them. It is almost impossible to be a successful strategy trader without going through all of these stages. My goal with this book is to help you understand and move through the stages at much less cost in both time and money. Every trader usually starts out as a discretionary trader. The amount of money lost generally determines how long it takes the individual to start using technical indicators to make trading decisions. Eventually, as even employing technical indicators fails to move the trader into profitability, the trader moves into the third stage and starts to write strategies based on quantifiable data. It is at this stage that the trader ordinarily starts to make money. Finally, the strategies and money management approaches are refined and the individual becomes successful as a strategy trader. The Discretionary Trader A discretionary trader uses a combination of intuition, advice and non-quantifiable data to determine when to enter and exit the market. Discretionary traders are not restricted by a concrete set of rules. If you are a discretionary trader, you can make buy and sell decisions using whatever criteria you deem to be important at the moment. For example, you can use both a combination of hot tips and relevant news stories from The Wall Street Journal, and enter or exit the market based upon this information. If you begin to lose money, you can immediately exit the market and change your trading method. You don't have to use the same techniques day in and day out. It's a very flexible way to trade that you can customize based on what you think the market is going to do at any given moment. For the discretionary trader, trades are made using gut instinct and intuition. Unless a computer is generating a buy or sell signal and you actually follow the signal, your emotions will affect your trading. I explained in the introduction what problems instinct and intuition could be in trading. Remember fear and greed? In discretionary trading, technical tools such as indicators are sometimes used; however, when they are put to use, they are utilized sporadically as opposed to systematically. Fascinated by the markets, the discretionary trader is ready to put on a trade at a moment's notice. The most uncomfortable part of trading for the discretionary trader is when there is no action. So he will jump on any piece of information, anything that will permit him to take a stab at the market. Above all, he craves the action. NTUITION & HOT TIPS The discretionary trader uses several sources for his trading decisions. One is intuition, for example, "I see a lot of people in stores, so I think the economy is good, and earning will increase, so the stock market should go up, and I should buy Sears." He usually spends a lot of time talking to his broker. "What do you think Joe, isn't Woolworth's going to turn around?" Another is reading and watching the news, "Retail sales are looking strong and Woolworth's is closing stores to lower their overhead." Hot tips are a common way that a discretionary trader gets ideas. A call from his broker or good friend, or a tip from a discussion at a cocktail party are all places the discretionary trader gets his trading ideas. "Hey George, HTECH Corp. has a hot new product in the works, here's a stock you can pick up cheap." If it gets dry in the summer, our discretionary trader may decide to buy Corn, Beans or Wheat. However, when he looks out the window and notices that it's raining, he sells the position immediately. A news story on the nightly news may cause a discretionary trader to short the airline that has just had a crash. CRAVES EXCITEMENT What a discretionary trader loves is the excitement. He loves being "in the markets," playing with the big guys. He craves the risk, the excitement of trading, and the gambling rush that he gets from calling his broker and putting in the order to buy. He loves being able to sell Gyro Corp. based on the news story of the health hazards of their top selling Gyrometer. He has a real obsession for buying Cotton based on the hot tip from his broker that the upcoming crop report was going to be bullish, and he covets the tip from his friend who called to say that he just bought Techno Corp. because the latest quarterly earnings were going to be a surprise on the upside. Discretionary traders retain the flexibility of changing their buy and sell criteria from moment to moment, and change they way they trade from minute to minute and day by day. "Well, that last trade was a disaster, so tomorrow I will buy McDonald's only if it opens up from yesterday's close." They don't have any discipline, nor do they think they need any. They use their intuition and their gut instinct, and feel justified in doing so. They think, "Making money is easy, you just have to be smarter and quicker than the next guy." I personally don't know anyone who has made money by discretionary trading. They may have been lucky and won on a few trades, but overall, over time, discretionary traders always lose money. It is after enough money has been lost that the discretionary trader in some way stumbles across technical indicators. It may be from the chart book he just looked at where there was a Stochastic Indicator underneath the chart. Or he may have gone to the latest Make a Million Dollars Trading the Stock Market seminar and found out that using the Relative Strength Indicator is the sure way to stock market profits. He thinks, "So this is how they do it!" These indicators look like magic. They add some rationality to an otherwise irrational trading style. He thinks, "This must be how the big money players make the big money—they use technical indicators!" DISCOVERS TECHNICAL INDICATORS Once the discretionary trader discovers technical indicators, he or she incorporates some rudimentary ones into trading, usually as additional justification for making the trade. "Not only did Ralph (my broker) tell me to buy Gizmo Corp. but Gizmo has great relative strength. Gizmo's moving averages are bullish, and the Stochastics are oversold and giving a buy signal as well." These newfound technical indicators give the discretionary trader a new lease on trading. Now our trader has a whole new world in front of him—the world of technical trading. For a while, this newfound world combines with intuition and the discretionary trader views himself as a strategy trader. He says, "I trade a strategy using moving averages and Stochastics with a dash of daily news and tips from my broker. I am now a real objective strategy trader." While the trader may view himself as a strategy trader, this could not be farther from the truth. The discretionary trader's style is still undisciplined, based on newly educated guesses, and he is probably still losing money. For a moment, these technical tools were thought to be the answer, and while they add a little more rationale to his trades, the losses continue to pile up. Despite his continuing angst, our discretionary trader is now on the way to becoming a technical trader. The Technical Trader A technical trader uses technical indicators, hotlines, newsletters and perhaps some personally defined objective rules to enter and exit the market. As a technical trader, you are beginning to realize that rules are important and that it is appropriate to use some objective criteria such as confirmation before making a trade. You have developed rules, but sometimes you follow them and sometimes you don't. It depends how confident you feel today and how much money you are making or losing. If an indicator gives you a buy signal, you may override it because your broker told you the earnings report was going to be negative. Or maybe the bonds are up, which means interest rates are rising, and you better see how high rates go before you commit more money to this already overpriced market. You may think, "I have a profit, hmm, I just may take it now. Even though the Stochastic is not overbought, the markets are tough. It's not easy to make money. Like my father said, 'you can't go broke taking profits.' At least now I have a winning trade. I'll sleep well tonight." Our trader now begins to realize that using the intuitive and hot tip approach will not lead to profitability. He now begins to focus on the technical indicators themselves. There are so many! Moving Averages, Exponential and Weighted. The MACD, Momentum, P/E Ratio, Rate of Change, DMI, Advance/Decline Line, EPS, True Range, ADX, CCI, Candlesticks, MFI, Parabolic, Trendlines, RSI, Volatility Expansion and Volume and Open Interest, just to name a few. So much to learn and so little time! This whole new world of technical books, seminars, newsletters, and hot lines now begins to preoccupy our trader. He learns all he can about indicators. He wants to find the one indicator that will ensure profitability. He surrenders to what I call Indicator Fascination. INDICATOR FASCINATION The first assumption that our trader makes is that someone out there must know how to do this. There must be an expert, someone who knows how to make money, that has created the magic indicator to do it. This is the Holy Grail syndrome and our trader now embarks on a search for the Holy Grail Indicator. He knows intuitively that there must be an indicator that will give him the information he needs to make profitable trades…that there must be teachers out there that know how to make money trading. He thinks, "All I need to do is find him and his indicators." This is the indicator fascination phase. How are indicators calculated, what do they represent, and are they the "secret" to making money? All of these questions need to be answered so he becomes a seminar junkie, travelling the country on the quest for that great technique, the one that everyone uses to make the big money. He visits Chicago one month…L.A. the next…followed by a visit to the Chicago Mercantile Exchange. He watches the CNBC expert technicians and surfs the net looking for that magic indicator. Now he'll only buy when the ADX is moving up and the MACD is positive, and he'll sell only when the RSI gets overbought and turns down. His trading becomes more indicator-based and he listens less to his broker. For example, he may tell his broker, "No, I won't buy Apple Computer until the Earnings Momentum Indicator is over 80!" Unfortunately, even with all of this information, and all the assurances of his seminar leaders, he still is not making money. He even begins to wonder if he will be able to continue trading with all of these losses. He thinks, "If I could only control the losses, I will probably be able to trade a little longer before my money runs out." It is at this stage that he learns the value of stop losses, known as stops. He learns the importance of managing the risk on each trade. He gets a hint that there is more to trading than just the indicator, and his ears perk up when people mention the concept of controlling risk and conserving capital. He thinks, "I just want to stay in the game, to keep enough money to make the next trade. I don't want to quit a loser!" But even with the newly found indicators, and controlling his risk with stops, he continues to lose money, although he also consummates some winning trades that keep his capital from depleting too quickly. And here he has another major revelation—markets can be trending or choppy. It is at this point that he realizes, "If I could only predict the choppy markets, where I lose most of my money, I could simply stay out of the market and get back in when it starts to make the big move." So he starts another quest, that of leaning how to predict choppy markets. PREDICTING THE MARKETS Discontinuing the use of the old technical indicators, our technical trader now begins to flirt with the Elliot Wave theory, W.D. Gann techniques, and Fibonnacci Targets and Retracements. These techniques generally claim to help you predict when the market will be choppy and where and when it should be bought and sold. He does all of this studying so he can learn to stay out of choppy markets. It makes a lot of sense. Someone out there must know when the markets are going to go sideways and then step aside waiting for the next big trend. When the trend comes, they get on it and ride it for big profits. They then exit and wait for the next trend. He hears promises that he should be able to forecast all of this by using these predictive techniques. Unfortunately, after several seminars, our trader tries to predict a corrective stock market and ends up mistaking it for the next big wave up. He explains to his friends, "I missed the big move because I thought we were in Wave B but the market was really in Wave 2 ready to start Wave 3. If I had just used my old trusty indicators instead of trying to predict the move and waiting, I would have made big bucks." HISTORICAL PROBABILITIES It finally occurs to him that he should back test some techniques and see how some of his indicators would have worked historically; he reasons that if he can do this, he would have more confidence and discipline in his trades. He begins to understand that no one (including himself) can predict the market. He starts to realize that he needs to have some confidence that the techniques he is going to use have worked in the past. He now knows that he can't predict the market. He thinks, "All I really need to know is what the probabilities are when I put on a trade according to my rules, and I should make money." Our technical trader has now passed the second big initiation and begins to sense the need for trading a strategy. He realizes that there is immense value in historical strategy performance data. He purchases TradeStation and dives into learning how to design and trade strategies. The Strategy Trader A strategy trader trades a strategy—a method of trading that uses objective entry and exit criteria that have been validated by historical testing on quantifiable data. Strategy traders are restricted by a set of rules. These rules make up what is known as the strategy. As a strategy trader, you will not deviate from your strategy's rules at all, unless you have decided to use a different strategy altogether. When your strategy tells you to buy, you buy. When your strategy tells you to sell, you sell. And you buy or sell exactly how much your strategy tells you to. You read The Wall Street Journal and talk over the markets with your broker, but you don't make trading decisions to override your strategy because of something you read or heard from your broker. The reason you are restricted by your rules is that your rules are sound. As a strategy trader, you've spent a lot of time and research in creating those rules. Your rules have been hand- designed by you and tested and re-tested on years of historical data. This testing has given you positive results and the conviction that lets you know it's time to take your strategy into the future. Your emotions might still fly as high and low as the market, but at least they are not causing you to make bad trading decisions. Our strategy trader has now left behind the gurus, the hotlines, and the broker recommendations, and has stopped trying to predict which wave the market is in and how far it will go. He has purchased and learned how to use TradeStation. He is becoming knowledgeable about computers, data and technology. He has realized the value of quantifiable data and back testing, and starts to put on trades with the confidence that comes with knowing the historical track record of the same strategy for the last 10 years. He is slowly learning the business of trading. QUANTIFIABLE DATA One of the first things a strategy trader needs to understand is quantifiable data. This is the data that he will correlate to the market and use to develop his trading strategy. Without quantifiable data, he would be unable to trade a strategy. Quantifiable data is measurable data. Stock and commodity prices are quantifiable, as is volume. All technical indicators that are derived from price and/or volume are quantifiable and useable in designing a strategy. Are phases of the moon quantifiable? Yes, as are the location of the planets. They occur in a regular pattern, and each occurrence is measurable and predictable. What about earnings per share or the price earnings ratio of stocks? Yes. These are also quantifiable and can be used in strategy trading. Once you understand what quantifiable data is, it is easier to spot non-quantifiable data. Non- quantifiable data usually consists of random events that cannot be reduced to a number and that cannot be predicted. For instance, speeches by politicians are not quantifiable, although we know that they can have a profound effect on stock prices. Opinions of our broker are not quantifiable. Are earnings surprises quantifiable? No, but quarterly earnings reports are, and they usually have a significant effect on stock prices. Are weather patterns, droughts, or freezes quantifiable? No, although we know they too have a considerable effect on commodity prices, it is not possible to quantify droughts and correlate them to Soybean or Corn prices. A strategy trader thus moves into a mode of acquiring and testing quantifiable data as it relates to historical price activity. This is a marked difference from a technical trader, who tries to correlate data to price but usually through observation and intuition, and from the discretionary trader, who doesn't use quantifiable data at all or feels he needs to in order to make money. It is this acquisition and use of quantifiable data, along with the software to test it, that enables the strategy trader to investigate trading techniques historically and begin to put some rational and enlightened business practices to use in his trading. It is this process that enables him to start finally making money. HISTORICAL ANALYSIS For some time now, our strategy trader has been using TradeStation to develop trading strategies. He has learned rudimentary EasyLanguage and is actively testing various trading strategies. He has learned that just because something looks good visually and is profitable over a short period, it might not make money over a long time frame. He has also experienced the confidence that comes from knowing that a particular strategy has been profitable in the past. Even though he knows that the market will never quite replicate that past, it is much more comfortable to trade a strategy that has been historically tested than to trade intuitively. He knows that the success of a strategy is not directly tied to the indicator, but to other factors: exits, money management stops, and cash flow management. Because of the extensive time he has spent working with TradeStation, he also knows the ins and outs of risk control. He has done extensive back tests and found out that if he puts his stop losses too close, the strategy takes too many trades and makes less money. He has studied set-up and entry and how they work together to get you in the market. He knows the difference between exits and money management stops. He can now historically test any indicator or technique and immediately know how profitable it was in the past. He doesn't have to rely on anyone but himself to make trading decisions. The strategy trader has also learned much about himself in this process. For instance, he has learned how much money he is willing to risk on any trade. He knows he can't take a hit for, say, more than $1,500. He knows that he can only take a certain amount of drawdown and can only stomach a certain number of losing trades in a row. He may refuse to trade a strategy that has more than four losing trades in a row. He just knows himself, and he knows he wouldn't be able to handle it. He adjusts any strategy he develops to account for this. However, maybe he can watch his account go through a $12,000 drawdown if he knows that he won't have a lot of losers in a row; especially if he has the historical information that confirms that a $12,000 drawdown is not unusual for his strategy. The key is that he has learned to customize the parameters of his strategies to fit his personality. There is no point in designing a great, profitable strategy if you won't be able to trade it! The Complete Strategy Trader The complete strategy trader has learned to use advanced cash management principles, trades multiple markets, and may trade multiple strategies in each market. The successful strategy trader realizes that the key to long-term profitability is how the cash flow is managed, not what indicator is used. He is done with trying to predict the markets and has stopped looking for the Holy Grail indicator. He understands that strategy trading is not unlike most other businesses and, as a result, has turned his trading into a sophisticated business based on sound business principles. Remember the great fish restaurant that I mentioned in Chapter 1. It opened and immediately received rave reviews; it was ranked four stars (out of four) by all of the restaurant critics. It was hard to get in at peak times because you always got a great meal. Again, it is not the food that makes a successful restaurant. Of course a restaurant needs a good chef and good food. But to stay in business it needs much more than good food. Costs, service levels, and cash flow need to be managed effectively. I realized that many successful restaurants have mediocre to poor food (just visit any fast food joint). But they stay in business because the management has mastered restaurant management, which has nothing to do with the taste of the food. Trading is really no different. Traders become successful because they understand trading management. Trading management has nothing to do with indicators, but has a lot to do with the details of managing trades and cash flow effectively. The complete strategy trader can say, "Of course I need solid indicators, and I have my favorites. But I think with what I know about trading now, I could make any indicator profitable." Successful traders understand that to be successful and stay in business more is needed than simply a great indicator. CASH MANAGEMENT & RISK CONTROL Our strategy trader is now spending a lot of time using TradeStation to focus on cash management. He has found a group of indicators that he trusts, has back tested, and has worked with for enough time now so that he knows their strengths and weaknesses. He'll tell you, "I have finally realized that there is no Holy Grail. There is only so much money in the markets and most indicators can be rigged to catch most of the moves. The real task is to manage your money efficiently to take advantage of market moves." Our trader is now focused on refining techniques concerned with how to scale into a potential big move, and how to scale out as the market moves in his direction. He is focusing on the value of pyramiding a position to maximize the leverage of his open equity. He is using his accumulated net profit to be able to trade bigger positions without risking his own capital. The successful strategy trader focuses his TradeStation testing on the percentage of his account that should be risked with each trade, so as to maximize his profits and minimize the drawdown. Don't underestimate how critical the size of your trade is, and how important it is to add to a position at the right time. This may be more important than the strategy itself! TRADES MULTIPLE MARKETS Our strategy trader has observed that to maximize his return, he must trade multiple markets. At any given time there may be only one or two sectors moving. If you are only trading one market, you will have to wait for the next big move and fund the drawdown. The more markets you trade, the greater the chance that one will be in a big move. It is also likely that the profits in the markets that are moving will be greater than the drawdown in the markets that are not. That is the ideal situation because you can then reduce the fluctuation in equity and have a more predictable cash flow. Our strategy trader now understands the age-old notion of market diversification. With back testing, he is now able to test the combination of strategies and markets and how they integrate into a comprehensive trading strategy. An overall strategy is now coming into focus that includes trading several markets. TRADES MULTIPLE STRATEGIES IN EACH MARKET Our strategy trader has also learned to recognize that every market goes through different types or phases of movement. He is finding out that it is possible to define what that movement is and develop a strategy to profit from that action. He may say, "I used to only make money when a market was in a trend; I am basically a trend trader. But a few months ago I added a Volatility Breakout strategy to compliment the trend strategy. When a market is not trending, I can still get some money out with the VB strategy. This money to some degree funds the trend-following strategy drawdown in a non-trending market, and levels out my overall cash flow." As you can see, our trader is now talking an entirely different language. He has become a sophisticated money manager, intent on maximizing the profits of his business. He has come a long way from being a seminar junkie, consumed with Indicator Fascination. He realizes the value of technology, and the immense capacity of software like TradeStation. He adds, "I really don't know how I would do this without today's software and technology. It would be like trading blind." Or like being a discretionary trader. Decision Models I have always been interested in the science of how we as human beings make decisions. Life is really all about making decisions. If we can improve the way in which we make decisions, it stands to reason that we will be more successful in life. If we can improve the manner in which we make our trading decisions, we will become a more effective trader and hopefully make more money. In my early years of trading, I always wondered whether there was statistical proof that strategy trading was inherently more profitable than other types of trading. I knew from my own experience that it was but I was unable to prove it statistically. I then picked up a book called Decision Traps3. This is a book about the process of decision- making and I picked it off the bookstore shelf when I was attempting to learn how to become better at trading. I didn't know at the time that it would put forth the notion that objective decisions (i.e., strategy trading) produce far superior results than other non-objective forms of decision making. In this book, nine different types of decisions were tested using each of the three different decision methods. The accuracy of the decisions was then compared and analyzed for effectiveness in predicting final outcomes. The investigator looked at different types of decisions, predicting grades, predicting recovery from cancer, performance of life insurance salesmen, as well as predicting changes in stock prices. He used three different decision making processes: an Intuitive Prediction Model, a Subjective Linear Model, and an Objective Linear Model. Interestingly enough, these can be compared to our 3 types of traders: discretionary, technical and strategy. INTUITIVE PREDICTION MODEL (DISCRETIONARY TRADER) Intuitive prediction is defined as making a decision without the use of any objective or quantifiable data. For instance, in trying to predict the academic performance of graduate students, the researches asked their advisors to do so without seeing their grades and just by talking to them. The decision-makers had to rely on their intuitive impressions and any other factors they thought relevant (how the students dressed, their language skills, grooming habits, etc.). This is the same way our discretionary trader makes trading decisions—using intuition and gut instinct. Although he might think he does, he does not use any objective criteria. In predicting the stock prices, it is highly likely that the researcher engaged a discretionary trader to predict the future prices of stocks. SUBJECTIVE LINEAR MODEL (TECHNICAL TRADER) A Subjective Linear Model is a much more complex decision making process. It starts with interviewing experts in a field and learning how they make decisions. The researcher literally asks the expert how he or she makes decisions and they respond by explaining how they make their predictions. Although these experts are not using quantifiable data, they have enough experience and knowledge in their field to be successful. This decision making process is then outlined by the researcher. For instance, a physician, highly experienced in treating cancer, probably has become fairly adept at predicting the life expectancy of his patients, even without using any objective data. The researcher interviewed the physician and attempted to determine exactly how the physician made this assessment. Then the researcher put this newly quantified data into a regression model and attempted to predict the life expectancy of cancer patients. This is very similar to how our technical trader makes decisions. He goes to seminars and reads books to learn how the experts make decisions using technical indicators. He then takes what he learns and attempts to trade like the experts. In a sense, he does his own regression model of the expert's process to make trading decisions. OBJECTIVE LINEAR MODEL (STRATEGY TRADER) For the Objective Linear Model, the researcher developed an objective model based on historical tests and observations to predict results. This is defining and using quantifiable data, running historical tests, and then using the results of the tests to predict future outcomes. For instance, the researcher would look at reams of physical data from cancer patients, and correlate the data with how long the patient lived. After running the historical tests, the researcher would then obtain the physical data from a cancer patient, and using the historical test data, attempt to predict how long that cancer patient will live. This is exactly what a strategy trader does. He runs historical tests and then uses that data to take a position in the market. He uses objective, quantifiable data tested historically to make his trading decisions. Table 1 shows the results of the tests. Intuitive Subjective Objective Types of Judgments Prediction Linear Linear Academic Performance of Graduate .19 .25 .54 Students Life Expectancy of Cancer Patients -.01 .13 .35 Changes In Stock Prices .23 .29 .80 Mental Illness using Personality Tests .28 .31 .46 Grades and Attitudes in Psychology .48 .56 .62 Course Business Failures using Financial .50 .53 .67 Ratios Student's Ratings of Teacher's .35 .56 .91 Effectiveness Performance of Life Insurance .13 .14 .43 Salesmen IQ Scores using Rorsach Tests .47 .51 .54 Mean (Across all Studies) .33 .39 .64 In every case, the Subjective Linear Model outperformed the Intuitive Prediction Model but only by a small margin. If you look at predicting the changes in stock prices, the Subjective Linear Model only slightly outperformed the Intuitive Prediction Model. This correlates very closely with my experience in trading. Technical traders do only slightly better than discretionary traders and neither of them make much money. While the difference in expertise and experience between a discretionary trader and a technical trader is substantial, the resulting profitability is hardly noticeable. The real insight from this study comes when we look at the results of the Objective Linear Model. In every case, the Objective Linear Model outperformed both the Intuitive Prediction Model and the Subjective Linear Model. In some cases, the improvement was minor, and in others it was substantial. It is interesting to observe that the greatest improvement came when using the Objective Linear Model in predicting the changes in stock prices. Here was the proof I was seeking—a definitive study showing the benefits of objective decision-making as opposed to other forms of decision-making. This is my experience as well. The greatest improvement in trading results (profitability) comes when a trader begins to use objective quantifiable data and does historical tests to develop trading strategies. In this study, this is confirmed not only with changes in stock prices, but in the other disciplines also. The Benefits of Strategy Trading I believe that a trading strategy, which has been properly developed and tested, can make you more money than trading any other way. However, this is not the only reason that strategy trading is the method of choice for most successful traders. There are other benefits as well. One of the most important benefits is that you can sleep well at night knowing that you're trading a strategy that has been tested and re-tested, and is proven to be successful. No matter what happens in the market during the day, the confidence you have in your strategy makes this type of trading easier on you. Another advantage is that you can choose a market and a trading strategy that compliments your personality. The basic idea is that the trading strategy you select is based on the type of market action you are the most comfortable trading. Those who desire to always be in the market will select a different strategy than people who prefer short-term positions. If you get a thrill out of riding the big trends, then you will select a different type of strategy than someone who enjoys going against the trend. Have you ever received an unexpected call like this, "Hi, Joe. This is Stan, your broker. We need to settle the margin on your account. Looks like the market really went against you this week"? If you are a strategy trader, this is not likely to occur. Strategy traders always know where they stand financially. They know this from the financial results of the historical tests. If you do get a call like this, you will most likely be expecting it and will have planned for it. You have creatively designed a strategy based on the amount of money you have to work with. As a part of knowing the maximum equity drawdown associated with your strategy, you can determine the strategy's capital requirements and make adequate provisions to provide enough capital to maneuver through the eventual drawdown. There will be no financial surprises. I've been talking at length about why strategy trading is the most viable way to make money in the markets and what type of skills and knowledge are necessary to be a successful strategy trader. I showed you a study that in my view gives very solid proof that strategy trading (objective decision making) is the most successful way to make decisions. If there was ever any doubt in my mind, this study cleared it up. I hope you are now convinced that if you want to make money you should be a strategy trader. So let's go on to the nuts and bolts of creating viable trading strategies. NOTE: What you have just read has been presented solely for informational or educational purposes. No investment or trading advice or strategy of any kind is being offered, recommended or endorsed by the author or by TradeStation Technologies or any of its affiliates, agents or employees. Trading as a Business: Markets, Strategies, & Time Frames The first step in developing a trading strategy is to select the market action and corresponding strategy type that you want to trade. As I've discussed, selecting a strategy type is a very important part of strategy trading and you should take your time in evaluating the alternatives. Many factors will influence your decision, but your own personality will ultimately direct you to the strategy that is right for you. In making the choice, the most important thing to remember is that it is yours to make alone. Read everything I have to share with you about different types of strategies, but then decide for yourself. Only you really know what type of person you are and therefore what type of trading is best for you. This chapter will help you to understand some of the conditions that can occur in the market, and the strategy type that complements those conditions. Once you are familiar with the basic strategy types, you will be able to select the one you want to use. Three Market Types Generally, there are three types of markets. The three market types, or phases, are derived from three distinct chart patterns that appear when there is a shift in market action. The phases are trending, volatile, and directionless, and each can be characterized by specific price activity. Take a look at the following charts and familiarize yourself with each different market pattern. TRENDING MARKET A sustained large increase or decrease in price characterizes a trending market. Take a look at Chart 1. This weekly chart of Coca Cola (KO) from early to mid-1997: Chart 1 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1" ); Plot2(Average(price,Length2),"SimpAvg2" ); In fact, this stock has been in an up-trend since 1994. KO has almost tripled since then. This trending market was characterized by sustained up moves with very small and short-lived corrections. The 9- and the 18-period moving averages are included in Chart 1. A trend trader would buy the market when the shorter 9-period moving average crosses above the 18, and hold the stock until the 9-period average crosses below the 18. In this time period, he would have held KO for at least two trend moves. Now take a look at this daily chart, Chart 2, of the Swiss Franc from mid-1996 to early 1997: Chart 2 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1" ); Plot2(Average(Price,Length2),"SimpAvg2" ); In this time period, the Swiss Franc has been in a daily downtrend for many months. It has lost more than 15% of its value over the period. This market was characterized by a sustained downmove with very small corrections. The same moving averages were plotted here, the 9 and 18. Note that if you had followed these averages, you would have stayed short for several months at a time. The time frame you are looking at is important when you consider the type market action. Chart 3 shows the same Swiss Franc viewed on a monthly instead of daily chart. Chart 3 TradeStation EasyLanguage Indicator: Moving Ave Cross Input: Price(Close),Length1(9),Length2(18); Plot1(Average(Price,Length1),"SimpAvg1" ); Plot2(Average(Price,Length2),"SimpAvg2" ); The downtrend in 1996-1997 looks a little different when put in this perspective. It looks like the most recent move in a directionless market. And if you had traded the same moving averages on Chart 3, you would have been chopped around and most likely lost a lot of money. The point is that you should be aware that a directionless monthly or weekly chart might have very tradable daily trends, and vice versa. DIRECTIONLESS MARKET A directionless market is characterized by smaller, insignificant up and down movements in price, with the general movement sideways. We probably would not call Chart 3 of the Swiss Franc directionless because the movements were not insignificant. On the other hand, Chart 4 of Caterpillar in 1996 clearly shows a sideways directionless market, whose movements I would call insignificant, as the stock moved between 31 and 37 for most of the year. Markets chop around like this between trends. As you can see, I put the Stochastic Indicator on this chart. The Stochastic Indicator is commonly used as an overbought/oversold indicator. In directionless markets, you might attempt to buy CAT when the Stochastic is at or below 20 or 25 and sell when it is above 75 or 80. You could have made some money doing this with CAT in 1996. Chart 4 TradeStation EasyLanguage Indicator: Stochastic Slow Input: Length(14),BuyZone(20),SellZone(80); Plot1(SlowK(Length),"SlowK"); Plot2(SlowD(Length),"SlowD"); Plot3(BuyZone,"BuyZone"); Plot4(SellZone,"SellZone"); VOLATILE MARKET A volatile market is characterized by sharp jumps in price. Chart 5 is a weekly chart of American Software. You will notice that this type of market action involves a quick and unexpected change in volatility. At the marked points on this chart, AMSWA was quiet for the previous 7 to 15 weeks. Then the price leaped out of this low volatility trading range. This is what is commonly called a "volatility expansion." Chart 5 Volatility Expansion Examples The volatility of the market increased substantially during the breakout week as it shot out of the previous range. Strategies can be designed to take advantage of this type of change in volatility. They are generally called Volatility Expansion Strategies. Volatility expansion strategies profit from market action like the movement depicted in the AMSWA chart. Basically, the strategy measures recent volatility and attempts to trade an immediate increase by buying an upside breakout with increased volatility or selling a downside breakout as the volatility increases. Another measure of volatility might be the difference or spread between two moving averages- the spread increases with volatility. Price action, such as gap openings or an increase in the daily range, can also be considered an indication of an increase in volatility. Three Strategy Types Each of these three types of markets (Trending, Directionless and Volatile) are tradable, but with markedly different trading strategies. Let's take a look at each type of market behavior and the strategies that are appropriate to that type of market. TREND FOLLOWING STRATEGIES Like the name, trend-following strategies are designed for trending markets, and to take a position for all the big trending moves that may occur. In creating trendfollowing strategies, the number one priority is that the strategy must never miss the big move. The easy way to accomplish this is to always be in the market, that is, to always be either short or long. If you always have a position, you will always be there when the big move takes place. The other method is to always have a "stop" order in the market, resting either above or below the current price (this is the same order as a stop loss, but it is used to enter the market rather than exit). Using a stop to enter the market will protect you because if the market moves quickly in either direction, you will be stopped in before the big move begins. I can't emphasize enough how important it is never to miss a big move in trendfollowing strategies. During the choppy, directionless phases of the market, you will experience several losses in a row and most likely significant drawdown. Therefore, if your strategy misses a big move, you may not have enough capital to hold out through the drawdown for the next big move. Another design priority should be to limit your losses during the market's sideways mode. Notice how I said limit losses not make profits. It is very important to recognize that no strategy will make money in every market condition. It is therefore very important to identify the market action in which the strategy will make money and the market action in which it will lose money. Once you have found the market action in which the strategy will lose money, it becomes a strategy design priority to minimize losses during that market action. If the strategy is designed to make money in a trending market, it will lose money in the choppy phase. Your priority should be to minimize the losses in the directionless market. Many trend-following strategies make their money in one or two trades of the year and break even or lose money for the rest. The most common indicator used for trend following is moving averages, most often two, a short moving average and a longer moving average. Chart 6 of Disney shows the 9- and 18-period moving averages with TradeStation arrows indicating where a 9- and 18-period moving average crossover strategy would go long (up arrow) and short (down arrow). Chart 6 TradeStation EasyLanguage Strategy: Moving Ave Cross Input: Length1(9),Length2(18); IF CurrentBar > 1 and Average(Close,Length1) crosses over Average(Close,Length2) Then Buy on Close; IF CurrentBar > 1 and Average(Close,Length1) crosses below Average(Close,Length2) Then Sell on Close; As you can see, there were periods of trend where a significant amount of money was made as well as periods where the market was choppy and the strategy whipsawed back and forth with losses. Let's analyze what we've just learned. Most trend traders will tell you that the 80/20 rule works for trend trading: they make 80% of their profits on 20% of their trades. Even though the moving average strategy on Disney (Chart 6) made money over time, it was profitable only 39% of the time. That means that the strategy lost money 61% of the time. This is the difficult part of trend trading-a low percentage of winning trades. You need a lot of positive self-esteem and a lot of confidence in your abilities to trade a strategy that loses money on 60 or 65% of its trades. We will talk about this issue again later, but you should be thinking now about the design of the strategy you would be able to trade. If you want to be a typical trend trader, you should be prepared to lose money in a majority of trades. You should also be able to sit through significant drawdown as the market drifts through a directionless period. The table below, SPF 1, is what I call a Strategy Parameter File. It is a summary of all the relevant information that I use to create a strategy with TradeStation. Each time I test a strategy in this book, I will use this so that you can see a description of a strategy in summary form and you have all the information to reproduce the results if you so desire. SPF 1 Note that under "Entries" I have put none. I do not consider a market order technically an Entry. This is discussed in the next chapter, under the title, The Magic of Set-Up and Entry. Look at the Performance Summary labeled PS 1. As I just asked you, could you sit in front of your computer screen and place losing trade after losing trade, waiting for the big move to come? Could you sit through a string of 6 or 7 losses in a row before the next profitable trade? Could you lose $20 per share in a string of losses? PS 1 I do not include margin in my calculations as I personally look at return on Maximum Intra-day Drawdown or what I call ROMID. Margin can be placed in T-Bills to earn a risk free return. To add it to the account size thus becomes redundant. Also, using different amount of margin needlessly complicates strategy performance comparison. Note: If you are unfamiliar with Performance Summaries (Strategy Report), please refer to Chapter 8, The Science of Strategy Evaluation. As you can see from PS 1, the maximum number of consecutive losers was 6 and the maximum intra-day drawdown (MAXID) was $20.13. That means that at least once, from 1990 to 1997, you would have placed six losing trades in a row and had a cumulative loss of over $20 per share. Could you realistically put up with this? Another characteristic of a trend-following strategy is that it makes most of its profits in one or two big trades. Of the $18 profit in Disney, $10 came from one trade over the six years of data. This is not unusual for a trend-following strategy. I discuss how much profit you should permit to come from the largest profitable trade in Chapter 8, The Science of Strategy Evaluation. Many researchers have estimated that any market is in the trend mode 15% of the time and is directionless 85% of the time. A trend-following strategy then, by definition, has a low percentage of profitable trades. A trend-following strategy is psychologically difficult to trade, but if you think you can successfully trade without constant positive feedback, it can prove to be very profitable. Trend-following strategies are probably the most popular type of strategy. With a high percentage of losing trades, you might be wondering why is it so popular. Very simply, trend- following strategies can be very profitable over time. Another reason is that people like to follow (and make money on) the big trends. It is human nature to want to cash in on the big moves in the market. It is innately satisfying to get in early on a trend and watch your profits soar. SUPPORT & RESISTANCE STRATEGIES The main focus of a Support and Resistance (S/R) strategy is to profit from the price swings that occur in directionless markets. The strategy attempts to capture price movement opposite to that captured by trend-following strategies. Support and resistance strategies start with the premise that markets are directionless 85% of the time. The strategy attempts to take advantage of this price movement and catch the small swings that take place in sideways or choppy markets. This type of strategy has a higher number of winning trades, with small profits on each trade. It misses the full trend because it exits early in the trend move as the market becomes quickly overbought or oversold. An S/R strategy is built on the concept of buying low and selling high. As you are buying when prices are low and selling when prices go up, you are actually trading against the trend. Essentially, you are attempting to pick tops and bottoms. You buy low and sell high, but the market keeps going higher. You keep selling as the market goes higher, and keep taking small losses until the market finally turns down and gives you a profitable trade. Although an S/R strategy is easier to trade emotionally, many traders don't trade this type of strategy because they miss the big move (by design). The most common indicator used with a support/resistance type of strategy is probably the Stochastic Oscillator. You can see the Stochastic Indicator on Chart 7 of Caterpillar. I also applied the Stochastic Crossover strategy I created based on this indicator, highlighted in SPF 2. Chart 7 TradeStation EasyLanguage Strategy: Stochastic Cross Input: Length(10); IF CurrentBar > 1 and SlowD(Length) < 35 and SlowK(Length) crosses above SlowD(Length) then Buy on Close; IF CurrentBar > 1 and Slowd(Length) > 65 and SlowK(Length) crosses below SlowD(Length) then Sell on Close; Notice how the indicator fluctuates between 0 and 100. In this case, I used the 65 line and the 35 line to represent overbought and oversold, respectively. The overbought level for the stochastic is generally between 65 and 90 and the oversold level is between 35 and 10. You can play around with these levels to find the ones that make the most sense for you. I have designed an S/R strategy so that when the Stochastic (SlowD) is below 35 and the short average (SlowK) moves above the long average (SlowD), the strategy produces a buy signal. The opposite would be true for a short signal, SlowD is above 65 and SlowK crosses below SlowD. SPF 2 Note that in this test I have both a Set-Up and an Entry. Again, the magic of Set-Up and Entry is discussed in the next chapter. The drawback of support and resistance strategies is that they usually have small profits and larger strings of losses as they lose money when the market trends. By design, the strategy keeps shorting a market that is in an uptrend, or buying a market that is a downtrend. You can see this happened twice in Chart 7. Both times the market was in a sustained up-trend and when the Stochastic set-up reached overbought (above 65), the strategies went short. The market then kept moving up, resulting in losing trades. PS 2 Note that the average losing trade is greater than the average winning trade. The strategy was ultimately profitable because of the high percentage winners. As you can see from Performance Summary PS 2, this strategy has a high percentage of profitable trades (68%). This high percentage is needed to be profitable overall because the average losing trade was close to 1/3 larger than the average winning trade. Observe also that the strategy only had two consecutive losses in a row, which makes it much easier to trade from a self-esteem standpoint. The maximum intra-day drawdown (MAXID) was very large as a percentage of the net profit (76%). This would have to be fixed before this strategy would be ready to trade. I'll show you techniques for fixing problems like this in the following chapters. Keep in mind that, while strategy development looks easy, it is not. CAT was in a choppy market during this time whereas the stock market was in a strong bull market. If you had traded our moving average crossover trend-following strategy on CAT during this time, you would have lost a significant amount of money thinking that CAT would trend with the overall market. An S/R strategy is designed to buy low and sell high, which is an easy method psychologically to trade because it makes logical sense. However, these strategies can lose money in the long run. Generally, most successful strategy traders don't trade this type of strategy. If S/R strategies are used at all, it is to complement a group of strategies that includes trending strategies and perhaps a volatility strategy or two. VOLATILITY EXPANSION STRATEGY Volatility expansion strategies are designed to do well in volatile markets. The trades generated by this type of strategy are usually short-term, and when trading this type of strategy, you will be out of the market a significant amount of time. Volatility expansion strategies generate a high percentage of winning trades, although these trades usually generate small profits per trade. The S&P futures is a market that I would characterize as "volatile." Neither trend-following strategies nor S/R strategies work particularly well on the S&P. Chart 8 is a daily S&P futures chart from December of 1996 through March of 1997. Using a ShowMe Study, I had TradeStation highlight the gaps by placing large crosses on the opening price on the day on which the gap occurred. Chart 8 TradeStation EasyLanguage Show Me: Gap Open If Open of this bar > High[1] then Plot1(Open of this bar,"Gap Up"); If Open of this bar < Low[1] then Plot2(Open of this bar,"Gap Down"); One characteristic of a volatile market is gaps. Gaps refer to places in a bar chart where there is no continuity or overlapping of price. In this case, I have defined a gap as existing when today's open is either above the high of yesterday or below yesterday's low. Chart 8A is a small chart with two examples of up gaps. In both cases, the open gapped up over the high of the previous day, and was unable to fill the gap created between the opening price and the previous day's high. In most cases, as you can see on Chart 8, the prices fill the gap created on the open. In either case (whether the gap is filled or not) this type of chart action usually indicates an increase in volatility, or volatility expansion. A volatility expansion strategy could be designed to take advantage of market movement such as this. As you can see from the marks on the S&P in Chart 8, gaps appear to indicate that the market makes substantial daily moves following an opening gap. Let's try to capture this movement with a strategy that is designed to profit from opening gaps and subsequent movement. Let's assume that if the market gaps up it is going to continue to go up, and if it gaps down it is going to continue to go down. The up or down gap sets up the trade. We then need to figure out how we are going to enter the market once the set-up occurs. I think we should require that the market move a significant amount away from the opening price before we enter the market. SPF 3 The exit is on the next day's open. If we have a gap day and we get long or short, the strategy holds overnight and exits on the first trade of the following day. This strategy enters when the price action moves up or down an amount equal to yesterday's close plus or minus yesterday's range. The idea is that in addition to the price gap on the opening, we will require the price to move a distance at least equal to the previous day's range away from the previous day's close. This adds a second condition, assuring that volatility actually does expand. The strategy is applied to a daily S&P futures chart in Chart 9. Chart 9 TradeStation EasyLanguage Strategy: Gap Open IF Open of next bar > High of this bar or Open of next bar < Low of this bar then Buy next bar at Close of this bar + Range of this bar Stop; IF Open of next bar < Low of this bar or Open of next bar > High of this bar then Sell next bar at Close of this bar - Range of this bar Stop; Exitlong next bar at market; Exitshort next bar at market; The results of this strategy are pretty good for the first try. This is definitely something that we can work with. There are many additions and variations that could improve the strategy. We might work on different exits, money management stops, and profit targets. We might also work on different ways of entering the market after a gap occurs. The results in PS 3 indicate that this price movement has real potential for creating a viable strategy. As you can see in PS 3, the profits from a volatility expansion strategy come from a high percentage of profitable trades. Even though the average winning trade was less than the average losing trade, we still had the makings of a profitable strategy. I hope you also noticed that in this test, as in all the previous tests in this chapter, I did not include any costs for slippage and commission. If, for instance, we included $25 for commission and $75 for slippage, the average trade profit would be $91.13 instead of $191.13. In strategies that have a lot of trades, these costs can make the difference between a strategy you would trade and one you would not. PS3 Note that the high percentage of profitable trades compensates for the higher average losing trade. The largest winning trade is a small percentage of the total profits. Price explosions of one form or another characterize a volatile market. One way of defining a price explosion would be a "gap" opening, another would be an increase of "range" (high-low). Some indicators have been developed to try to indicate a change in volatility. One of these is actually called "volatility" and is included as a study in TradeStation. Typical volatility expansion strategies measure current volatility and enter the market when there is an abrupt increase in volatility. This type of strategy makes a quick exit, usually after only a few bars. Selecting a Market and Strategy Type You should now have an idea as to the different types of market action and the strategy characteristics that attempt to take advantage of the action and profit from it. Each type of market has unique characteristics and takes a different thought process for strategy design. In your own thoughts, you should begin to think about what type of market you are most comfortable with and would like to trade. Another consideration is the financial and statistical characteristics of the strategies, with specific regard as to whether you could actually trade the strategy. It is not wise to create a great strategy that would be psychologically impossible for you to trade. The first step in strategy design is to think about the characteristics of the three market types and the strategies that are effective for each. Then decide what type of trader you are, or want to be: a trend trader, who buys low and sells high, or a volatility trader, who takes selective but high percentage trades. I don't want to tell you what kind of strategy you should use. Everyone has to decide for him or herself, based on their personality and trading preferences. I think the best way to choose a strategy is to take a look at Table 1. You should determine what type of strategy is best for your temperament. There are successful strategy traders using each type of strategy, but based on my experience, a higher number of traders use trend-following and volatility expansion strategies than support and resistance strategies. Choosing a Time Frame After you select the strategy type you want to use, you need to think about the time frame in which you want to trade, and therefore the type of data you want to collect. There are three general types of data you can collect: intra-day, daily, or weekly. Choosing the time frame that is appropriate for you is almost as important as the type of market action and strategy you want to trade. The most common chart used by traders is the daily chart, and this is why I use daily charts for most of the examples in this book. Daily charts are the most common for several reasons. Because most traders also have day jobs, they want to keep abreast of the market as much as possible without it intruding into their workday. The daily chart is perfect for this type of trader. You are able to review the markets each night and make your decisions for the next day. WEEKLY VS. DAILY CHARTS Weekly charts are much more difficult to trade because it takes more discipline. To trade weekly charts, you must make your decisions on the weekends and not make any changes until the next weekend. For most traders, this is very difficult to do. It is very easy to yield to temptation and move a stop loss or a money management stop, or want to keep your profits and exit the market early. To discipline yourself not to look at the market during the week is a tough thing to do. Most people don't think of trading weekly charts. My experience is that there is a lot of money to be made trading weekly charts, simply because so few traders are able to do so. To make money in the markets, you have to tread where the average traders do not tread. Weekly charts are one of those places. Chart 10 shows the weekly S&P futures in the upper box and the daily S&P in the lower. Chart 10 The top chart is a weekly chart and the bottom is a daily chart of the S&P futures. There is more price detail in the daily chart, but also more price noise. Let's check out a simple strategy on both the daily and weekly charts. Chart 11 TradeStation EasyLanguage Indicator: Plot Channel Input: Length(50); Plot1(Highest(High,Length),"Channe l"); Plot2(Lowest(Low,Length),"Channel "); Chart 11 is a daily IBM with a 50-period channel. The 50-period channel marks the highest high of the last 50 bars and the lowest low of the last 50 bars. The strategy would go long if the close of the bar closed above the channel and sell short if the price closed below the lowest low of the last 50 bars. Chart 11 shows IBM up to and including the crash of 1987. The first thing you should notice is that this strategy is always in the market, i.e., it is either long or short. I arbitrarily chose the 50- period channel for this test. I will then compare the results with the same length channel on a weekly chart. In these tests, I will assume that 50 days is about equal to 10 weeks. So, to compare a daily strategy with a weekly strategy, we will use the same lengths in time although measuring the length on daily charts in days (50) and on weekly charts in weeks (10). Let's take a look at how a simple channel breakout strategy works, first on a daily chart, then on a weekly. Our working premise is that the strategy will be more profitable on weekly charts than on daily. Ask yourself why should a strategy, basically the same strategy, work better on a weekly chart than on a daily. I can come up with several reasons. First, very few people have the patience and the discipline to trade weekly charts. Second, by their very nature weekly charts smooth the price fluctuations of the daily chart. If there is a long trending market, we should be in the trend longer. We might get in the trend a little later than on the daily chart, and out later, but we will probably not get whipsawed as much in the directionless markets. I chose IBM again arbitrarily because it went through some frustrating choppy periods and some very fine trending periods in its action packed history since 1970. The Strategy Parameter File SPF 4 shows how we would design a strategy to test this theory. SPF4 Note that in this test we have for the first time used a cost for slippage and commission. I assumed you would pay about $0.15 per share in commissions and we would have slippage of $.35 per share. Slippage is the difference between the price of the order and the actual price at which you get filled. Let's look at the results for the daily chart, shown in PS 4. PS 4 TradeStation EasyLanguage Strategy: Channel Breakouts Input: Length(10); IF CurrentBar > 1 and Close > Highest(High,Length)[1] Then Buy on Close; IF CurrentBar > 1 and Close < Lowest(Low,Length)[1] Then Sell on Close; This strategy was profitable over the 27 years. IBM moved from a low of 24 to a high of approximately 110, an 86 point rise. The strategy made $29 per share from 1970 to 1997. Now let's look at the same indicator and strategy on an IBM weekly chart, Chart 12. Chart 12 TradeStation EasyLanguage Indicator: Plot Channel Input: Length(10); Plot1(Highest(High,Length),"Channe l"); Plot2(Lowest(Low,Length),"Channel "); Keep in mind that this is essentially the same indicator and strategy as the daily chart. The Strategy Parameter File is shown in SPF 5. Notice that the only difference is that it is a 10-period channel on a weekly chart instead of a 50-period channel on a daily chart. SPF5 Note that in this test we have also used a cost for slippage and commission. I assumed you would pay about $0.15 per share in commissions and we would have slippage of $.35 per share. Slippage is the difference between the price of the order and the actual price at which it is filled. All else being equal, the strategies should perform about the same. However, as you can see in PS 5, in almost every category the weekly strategy outperformed the daily strategy. PS 5 Note that there is a large open position profit of $32.44. This is the profit on the current trade and should be considered when comparing the two strategies. Both strategies took their first trade within two days of April 22, 1970. From that point on, the weekly chart had a greater profit on fewer trades and less drawdown than the daily chart. The rest of the data is about the same. Clearly this data comes down on the side of the weekly chart rather than the daily. This is just one very simple example of why you should consider weekly charts and not just assume that daily charts are your only option for trading. INTRA-DAY VS. DAILY CHARTS Intra-day charts are the 5-, 10-, 30-, and 60-minute charts that are compiled from intra-day tick data. To trade intra-day charts, you must give almost your full attention to the markets during the day. It is virtually impossible to have a full-time job and trade intra-day charts well. As a percentage of traders, relatively few traders are able to trade during the day. I think it is for this reason that there is significant money to be made trading intraday. The relative lack of competition has to be in your favor trading intra-day. Chart 13 is an example of a 30-minute S&P futures chart placed on top of a daily chart. Chart 13 There are 14 intra-day bars in a 30-minute chart. However the last bar is only 15 minutes because it covers the time from 4:00 to 4:15pm (EST). The top chart is a 30-minute chart and the bottom is a daily chart. Trading intra-day data permits you to put a microscope on daily activity and filter trades so that you can take advantage of the intra-day timing. I want to show you the benefits of looking at a technique and strategy through the intra-day microscope. To do so, let's analyze a technique that I taught in my seminars many years ago. I called it a RangeLeader Breakout. A range leader is a special type of bar that has two attributes. The first is that the range of the bar must be greater than the range of the previous bar. Range is defined as the bar's high minus the bar's low. The second characteristic of a range leader is that the midpoint of the bar must be above the previous bar's high or below the previous bar's low. Range Leader bar The mid-point is greater than the high of the previous bar, Or The mid-point is less than the low of the previous bar, And The range (high - low) is greater than the range of the previous bar So let's create a strategy using the range leader. And make it simple. If a range leader occurs today, on the current bar, we will buy tomorrow one tick over the high of the range leader, or we will sell one tick below the low of the range leader. That's about as simple as I can conceive it. The daily chart of the S&P with both the ShowMe Study and the RangeLeader Breakout strategy on TradeStation is shown in Chart 14. Chart 14 TradeStation EasyLanguage ShowMe: RangeLeaders If RangeLeader = 1 then Plot1(High + 100 points,"RangeLeader"); TradeStation EasyLanguage Function: RangeLeader Vars : Value1(0), Cond1(False), Cond2(False); Value1 = (High + Low) / 2 ; Cond1 = Value1 > High[1] OR Value1 < Low[1] ; Cond2 = Range[0] > Range[1] ; If Cond1 and Cond2 then RangeLeader = 1 else RangeLeader = 0; What type of a strategy is this? Trend-following, support and resistance, or volatility expansion? This the first question you should ask yourself as you look at this or any other strategy. In this case, since we're looking at a breakout based on the previous bar's range, it is a volatility expansion strategy. The Strategy Parameter File is shown in SPF 6. SPF 6 TradeStation EasyLanguage Strategy: Daily RL Breakouts If RangeLeader = 1 then begin Buy at High + 1 point stop; Sell at Low - 1 point stop; end; Exitlong next bar on Open; Exitshort next bar on Open; Note that this strategy introduces the concept of Money Management Stops ("MMS") and Price Targets ("PT"). An MMS is an order you place in the market to conserve your capital. In this case I decided I did not want to risk more than $500 per trade. The strategy design therefore includes a provision that when it gets filled, it immediately puts a stop loss $500 away from the entry price. Price targets are placed if you want to exit the market at a particular profit level. This, of course, limits your profit per trade. In this case, I decided that if the price moved $1,500 in my favor, I would take the profit. For this strategy, I arbitrarily decided on the $500 MMS and $1,500 PT amount, but if we want to we can use TradeStation to test for the optimum amount for both of these. For the exit, if my price target was not hit, that is, I did not make the $1,500, I decided that I would want to get out a soon as possible. I had two choices as to how to exit: on the close of the entry bar or the next day on the open. I chose the next day on the open as I wanted to take advantage of possible gap opens. I could also test other options for exiting the market. So, if I did not make $1,500 on the day the strategy entered the market, I would exit the following day on the open. This strategy was not too bad right out of the box. The Performance Summary for this strategy is shown in PS 6. PS 6 Note that our largest winning and losing trades were greater than our money management stop and profit target. This happened because our stop and target were not always hit. The next day the price gapped and we exited on the open. The gap was beyond either our stop loss or our price target. We made 125% return on our drawdown in one year. All in all, not a bad first try. Are we able to improve on this basic strategy by using the microscope of intra-day charts? Let's try using a 30- minute chart and see what we find. The Performance Summary results are shown in PS 7. PS 7 TradeStation EasyLanguage Strategy: ID RL Breakouts Condition1 = Time <> Sess1StartTime; Condition2 = Time <> Sess1EndTime; If Condition1 and Condition2 and RangeLeader = 1 then begin Buy at High + 1 point stop; Sell at Low - 1 point stop; end; If Time = 1615 then begin Exitlong next bar on Open; Exitshort next bar on Open; end; This obviously didn't work. We simply put the same strategy for the daily chart on the 30-minute chart (with one small change). The Strategy Parameter File is shown in SPF 7. SPF 7 TradeStation EasyLanguage Strategy: ID RL Breakouts If RangeLeader = 1 then begin Buy at High + 1 point stop; Sell at Low - 1 point stop; end; If Time = 1615 then begin Exitlong next bar on Open; Exitshort next bar on Open; end; Again, the strategy entered on RangeLeader Breakouts with a $1,500 PT and a $500 MMS. This time it lost some money. Let's look at the minor change I made to it and then think for a moment about what went wrong. An important consideration for this strategy, as with any intra-day strategy, is the first and last bar of the day. If the first bar of the day is a range leader, this means that the range of this bar is greater than the range of yesterday's last 30-minute bar, and that the mid-point of this bar is either greater than the high or less than the low of the last bar yesterday. I have always thought that with the intervening time, this information was meaningless and shouldn't be used to trade. Therefore, I added a Condition1, which eliminates the first bar from use (Sess1StartTime). Notice that I have also eliminated the last bar of the day (Sess1EndTime). If the last bar of the day is a range leader, the breakout will occur tomorrow during the opening bar. The fact that the last bar of the day is a range leader is irrelevant to tomorrow's first bar, and the breakout is meaningless. Condition1 and Condition2 in the TradeStation EasyLanguage for this strategy deal with these issues. Now, let's look now at what went wrong. I believe the reason that the strategy lost money on the intra-day chart is because we didn't take advantage of the strengths of using intra-day charts. It stands to reason that there must be certain times of the day when the market moves and other times when it rests. We simply used each 30-minute bar as if it was no different than any other bar. I have always thought that there were different times of the day that are more important. Perhaps we should test each individual bar for a RangeLeader Breakout and then put in our MMS and PT and exit on tomorrow's opening price if we don't reach our target or get stopped out. There are 13 30-minute bars during the day, and a 14th bar which is the last 15 minutes between 4:00 and 4:15pm (EST). I changed the strategy to test each bar, designated by its ending time, for a RangeLeader Breakout, using a $1,500 PT and a $500 MMS. If neither the MMS nor the PT is hit, we then exit the next day on the open. A summary of the results for each 30-minute intra-day bar is shown in PS 8. PS 8 TradeStation EasyLanguage Strategy: ID RL Time B/O Input:Bartime(1500); Condition1 = Time <> Sess1StartTime; Condition2 = Time <> Sess1EndTime; If Condition1 and Condition2 and Time = Bartime and RangeLeader = 1 then begin Buy at High + 1 point stop; Sell at Low - 1 point stop; end; If Time = 1615 then begin Exitlong next bar on Open; Exitshort next bar on Open; end; PS 8 shows that there were only three time periods that produced profitable trades, 11:00, 12:30 and 15:00 (3:00pm). Clearly the 15:00 bar was the most profitable. It looks like we can conclude that most of the action in the S&P takes place after 3:00 in the afternoon. SPF 8 TradeStation EasyLanguage Strategy: ID RL Breakouts Input:Bartime(1500); If Time = Bartime and RangeLeader = 1 then begin Buy at High + 1 point stop; Sell at Low - 1 point stop; end; If Time = 1615 then begin Exitlong next bar on Open; Exitshort next bar on Open; end; SPF 8 shows a summary of the final design of the 3:00 intra-day RangeLeader Breakout. Key elements of this strategy are the time of day, the $1,500 profit target, the $500 money management stop, and the exit on the open of the following day if neither of the stops are hit. PS 8A shows the whole Performance Summary using only the 15:00 bar as the RangeLeader Breakout. PS 8A This strategy is a 3:00 RangeLeader breakout on 30-minute charts with a $500 money management stop and a $1500 profit target. As you can see in PS 8A, the results of using 30-minute bars and only using the 15:00 bar the RangeLeader Breakout strategy were very good. In 1993, it produced a return on maximum intra-day drawdown (MAXID) of 659% with 57% profitable trades. In every category, this strategy outperformed the daily chart. Keep in mind that this is only for 1993. Before I would get overly excited about this strategy, I would test this in other years as well. So, after all of this information, what's the point? The point is that intra-day data, if used correctly, can give you a distinct advantage over daily charts. If you have the time and energy, you can take advantage of the microscopic look at the markets using intra-day charts, and you may be able to improve your return. Summary Let's recap what we have covered in this chapter. First, we took a look at the three types of markets: trending, directionless and volatile. We noted their individual characteristics and how to recognize each of them. Next we studied strategies that take advantage of the three different types of market action. First, we looked at trending markets and the trend-following strategies that attempt to profit from this type of market. We saw that this type of strategy tries to catch the big move, and usually loses money while it waits for the trend. Trend-following strategies take trades with a low probability of profit, with the eventual profitable trade usually being a big winner, covering all of the losses and more. We then looked at both support and resistance strategies and volatility expansion strategies and noted their characteristics. Generally, these strategies are designed to intentionally miss the big trend. They attempt to make money by entering trades that have a high probability of success, but have limited profits. S/R strategies buy low and sell high. Volatility expansion strategies capture an increase in volatility and profit from this short-term explosion in price. We then looked at the different time frames available for the strategy trader. I noted that most people instinctively trade daily charts. However, the successful strategy trader looks at the time frames that will maximize profits, not necessarily those that are most convenient. We compared the same strategy on the same data on both a daily chart and a weekly chart, and found that in this case the weekly results were much better than the daily. While this won't be the case for every strategy in every market, it makes the point that using weekly charts is something you should at least consider. We then turned to intra-day charts. I hoped to show you that the same issue exists for intra-day charts. Are there markets and strategies that would be improved by using intra-day charts rather than daily? We found at least one instance where this was true, using my concept of range leaders for an S&P strategy. Our first step was to test an indicator, the RangeLeader, and use it to develop a reasonable strategy on a daily chart. We then modified the daily strategy for intraday data, eliminating the first and last intra-day bar. This didn't work. Undaunted, for the next step we decided to use the 30-minute intra-day data as a microscope to find the periods that did work with intra-day, 30- minute range leaders. For that reason, the last step was to test each of the individual bars to see which bars (if any) produced a viable strategy. We found the 1,500 bar to be very profitable and modified our strategy accordingly. In this chapter, I hoped to show you that it is not necessary to be locked into trading daily charts. Although daily charts are the most common, and for most people the easiest to use, a case can be made that this is precisely the reason that you should consider trading other time frames. The decision rests on three factors: individual preference, personal discipline, and time. The move to consider weekly charts involves some self-evaluation. Do you have the discipline to only look at the markets once a week? Can you effectively ignore market action during the week? In many markets, trading weekly charts can be a Chapter 3: Markets, Strategies & Time Frames 69 big advantage; weekly charts tend to smooth out the price action, reducing many of the daily whipsaws into small insignificant corrections. This can be a distinct advantage for trend traders. I showed you one instance where using a weekly chart for a trend strategy was an advantage. The intra-day time frame has its own advantages and disadvantages. First, you must have the time to watch the markets during the day. Second, you will probably be entering many more trades, and the cost of commissions becomes a larger factor. And third, the software and data costs are greater. These are the first issues that you must consider as you begin to develop a strategy and trade it: the type of market, the strategy type and the time frame. Let's now move on to the major elements of creating the strategy itself. NOTE: What you have just read has been presented solely for informational or educational purposes. No investment or trading advice or strategy of any kind is being offered, recommended or endorsed by the author or by TradeStation Technologies or any of its affiliates, agents or employees.
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