PRINCIPLES OF SUCCESSFUL TRADING

PRINCIPLES OF
SUCCESSFUL TRADING

 



As we’ve discussed, trading can be a great business. However, the majority of people who trade fail to make money consistently. In this chapter, we’ll discuss trading principles that are the foundation of my trading. I urge you to read and reread this section. You must understand and apply these principles in your trading to succeed. I can’t stress this enough: The implementation of these principles in your day-to-day trading will allow you to develop emotional discipline. And only with emotional discipline can you become a successful long-term, independent trader.

Trade within Your Capital

In trading, everyone makes mistakes. Even the best, most experienced traders
occasionally misread the market. In addition, you may do everything right on a
trade, but something happens out of the blue that causes the market to reverse
direction. Either occurrence—a market misread or an out-of-the-blue event—will
result in a losing trade. Losing trades are part of the business. They happen to
everyone, and they will happen to you. That being the case, you always want to lose small.


To lose small, you must trade small relative to your overall capital. If you have a $20,000 account, you don’t want to risk $2,000 on a single trade. It’s too much of a hit to take given your overall capital. A small series of $2,000 losses is going to destroy your confidence and likely will cause you to stop trading entirely or take too much risk on an all-or-nothing trade in hopes of recouping your losses. To stay in the market for the long haul, you need to trade small.


I’ve often seen traders increase the size of their trades following a series of winning trades. Think about the logic of that for a moment. It’s axiomatic that losing trades are inevitable. After a series of winning trades, do you think a losing trade or series of losing trades is more or less likely? In my experience, a winning streak is usually followed by a losing period or at least a few losing trades. If you increase the size of your trades, you’re likely to give everything back and then some.



Beginning traders often come into the market with unrealistic ambitions. They
think they will consistently make money, continually raise the size of their trades
as their account grows, and within a short period of time, they’ll amass a small
fortune. A more realistic goal for a beginning trader is to learn the business while making modest profits and taking small losses. First, you learn to survive. Then you learn to thrive. Yes, you can grow your account and, at some point, increase your size. But you have to go after it like a turtle, not like a Ferrari.


There is another element to trading small. Every trader has a position size that he/she cannot exceed without endangering his or her emotional discipline. I call it my core position. Although I can trade much larger, my core position is 10 E-mini contracts, which is equivalent to two Standard & Poor’s (S&P) contracts. This is my maximum position. If I trade larger, I’ll begin to lose my emotional discipline. You need to find a position size that allows you to execute your trades objectively, unemotionally, and consistently. It may be much smaller than what you’re currently contemplating.


It might be 10 shares of a $100 stock. That’s fine. As you get comfortable, you can increase your position size—within reason. The point is that you never want to trade at a size where the emotions of hope, greed, and fear overwhelm your rational mind and objective decision-making process. The business of trading is all about controlling emotions. You should not fight the market or other traders. You should not fight yourself. You need to keep greed and fear low and discipline high. Hope is a great emotion in other aspects of life, but not in trading. Find your core position and stick with it.

Quiet Confidence

Of course, we are emotional creatures and we can’t completely strip emotions out of trading. The feeling that I recommend you cultivate is quiet confidence.
Quiet confidence comes from following your trading rules and faithfully executing high-probability trades. It comes from trading within your capital and exercising emotional discipline. And it comes from the knowledge that if you do the right things in trading, good results will follow.


When you have quiet confidence, you are in complete control of your trades.At a gambling casino, you have less than a 50/50 chance of winning. The odds always favor the house. I’ve read that a player’s odds in most Las Vegas establishments are about 46/54. What that means is that once you’ve rolled your dice at the craps table, you’re committed to a bet where the odds are stacked against you and you can’t do a darn thing about it. You never want to do that in trading. In trading—at least the way I go about it—you never really let go of the dice.



You wait for the high-probability trade to materialize. You make the trade. You
monitor the position. Depending on market action, you get out of the trade with
either a profit or, at worst, a small loss. In a sense, you never really let go of the dice in this type of trading. You remain in control throughout the process. When you lack confidence, you can’t win. The quickest way to lose your confidence is to violate one of your trading rules. It’s OK to make an incorrect call on the market. But it is not OK to violate a trading rule. Once you start making excuses for violating your rules, the entire foundation of your trading will crumble and you’ll be back to square one.


You are most vulnerable to breaking your rules following a string of good trades. For a period of time in the late 1970s and early 1980s, I found myself doing much better than normal. I attributed my improved results to better trading on my part. Thinking that I had now reached a higher level of trading proficiency, I increased my trading size. I remember getting emotional and little greedy. Then the inevitable happened.


The market went against me and I took a big hit. Lesson learned. If you are making more money than usual, it’s probably because the market conditions are creating more trading opportunities, not because you’re a better trader. When you’re doing well, refocus your energy on following your trading rules and avoid thinking about money. Don’t let quiet confidence develop into overconfidence.


Similarly, confidence should not cause you to become too committed to a market
view. Market conditions can change several times during an active day. A trader
needs to be pliable and adjust his/her viewpoint in concert with changing market
conditions. You can’t think that you know better than everyone else and you know better than the market. That’s not confidence—that’s arrogance. And arrogant traders never win.


When you are quietly confident, you can trade without beating yourself up over setbacks or getting too high after successes. Assuming you have a good trading process in place, you should trade the same regardless of your recent results. Don’t become more aggressive, and don’t become more cautious following success or failure. Don’t dwell on the past. Focus on the now and the next trade that’s in front of you.

Sell Too Soon, Not Too Late

I’m an in-and-out trader. I focus on short-term situations where I have an 80 percent chance of winning. On a typical day I make three or four trades. Given my style, it’s important for me to grab a quick profit or liquidate a trade if it doesn’t move in my favor. I exit quickly. Good traders don’t worry about missing a chunk of a big move. They take their profits without regrets. They know they can always get back into the market. In a sense, they’re content with taking a piece of the pie and coming back for seconds.



In trading, everyone agrees that you should cut your losses. However, you sometimes hear or read that you should ‘‘let your profits run.’’ The idea is that you wait until the move is exhausted before selling. I don’t agree with this tactic at all. Here’s why:It’s a rare event for a market to make a move early in the morning and then continue in that direction the entire day. Typically, there are pullbacks or small consolidation points along the way. Sometimes the market reverses, sometimes the trend continues, and sometimes the market transitions into a trading range. The patterns are endless. The trader who had the mind-set of letting his/her profits run is, in essence, hoping for an unusual market structure: a trend day that moves strongly in one direction and never looks back. Those days happen, but they are a rarity.


In most circumstances, if you ‘‘let your profits run,’’ you’ll end up waiting too long and selling after a protracted pullback. You’re likely to give back a good portion of your profits on the trade. Moreover, by overstaying the trade, you may miss out on the next trade. The pullback where you exited may be setting up for another 80/20 trade.The best time to sell is when the momentum is in your favor. You see the 80/20 trade. You get in. The market moves in your direction, and you have a nice profit on the trade. Take it. Get out and get ready for the next trade. Do this three or four times a day and you’ll end up winning most days and nearly every week.


That’s how a lot of professional traders make a living. You never want to find yourself wishing or hoping for the market to do something. You want to remain in control of the trade and in control of your emotions. Winners come into a trade for a quick profit. If it doesn’t work out, they get out. Losing traders hold on to hope. And if the trade doesn’t work for them, their hope usually turns to regret or despair over losing money. That’s not a path to long-term trading success.


As you gain experience in the market, you’ll get a better sense of market action
and the right time to get out. There will be times when you catch a trade just right and the momentum is very strong in your favor. In those cases, you can hold on a little longer than usual. In other cases, where the market doesn’t move much at all after putting on a trade, you might elect to get out earlier with maybe a scratch or a small profit.


You always want to control your trade. If you have doubt about a trade, get out of it right away and stay out until the situation becomes clearer to you. You always want to strive for an objective appraisal of the market and unemotional trade execution. Hope, doubt, fear, and greed are enemies of good trading.


Take Personal Responsibility for Your Trading

You alone are responsible for your results in trading. You get to pick how to trade, what to trade, and when to trade. You are the reason you succeed or fail in trading.A sure sign of a bad trader is one who places blame on factors other than himself for his results.


Bad traders can come up with a variety of excuses for a losing trade:

■I got a bad tip.

■ The pros went gunning for stops—and they got mine.

■ My broker gave me a bad fill.

■ My computer crashed.

■ The price quotes were delayed.

■ I was interrupted or distracted.

■ A news event caused the market to reverse.

■ And on and on.


Again, losses are inevitable in trading. You need to learn to handle them without
getting down on yourself or blaming an external factor. While it’s fine to analyze
a losing trade to understand what went wrong, don’t dwell on it. Don’t dwell on winners either. Get back to the market and get ready for the next trade. I make about 15 trades on the average week.


I expect about 12 of them to be profitable. Some will be marginally profitable, and some will be very profitable. The losses on the losing trades will be small. At the end of the week, I’m almost always in the black. That said, I do have losing days. That’s acceptable. If I have a losing week (which is very rare), I examine what I’ve done to see if some bad habits have crept into any aspect of my trading. A bad month is completely unacceptable.

Wait for 80/20 Trades


As I’ve said, the heart of my approach is to trade high-probability setups, which I
define as trades that have an 80 percent chance of winning. I have created templates, which I share in later chapters, to recognize these trades. The key for me is to wait patiently for the high-probability trade to materialize before putting on a trade.


There will be many times when you have a strong feeling that the market is going to move in a particular direction. Maybe the market has broken out from a trading range and looks ready to go higher. Or maybe an up move has run out of steam and the market is turning the other way. These types of situations happen all the time, and it’s natural as an observer of market action that you get a sense of the market’s next move. However—and I can’t emphasize this enough—do not trade on these feelings until they are corroborated by the 80/20 trading template.


I like to say I’m a ‘‘sore loser.’’ I do not trade 60/40 situations, and you shouldn’t either. At the end of the day, the profit margins are too small to make these trades worthwhile. And when you lose 40 percent of the time, you’re more prone to losing streaks, losing days, and losing weeks. Also, when your loss rate is 40 percent, you are more likely to second-guess your signals and have difficulty pulling the trigger. It’s OK to stay on the sidelines when the market is giving you mixed signals. I trade the market by my own set of rules. If the current market action doesn’t give me the kind of opportunity I demand, then I don’t play.

Play Great Defense

A good trader is more focused on controlling risk than maximizing profit. He or she does this by accomplishing the following:

■ Controlling emotions so that fear and greed do not undermine the decision-making process

■ Getting out of losing trades quickly

■ Following the trading rules

■ Trading small relative to the size of his/her capital.


It’s very important to get out of bad trades quickly. Always keep in mind that the
market continually presents new opportunities. If you overstay a bad trade, chances are you’ll miss the next good opportunity. Similarly, when a trade is working for you, don’t inflate the potential profits. Don’t expect too much from a single trade. Take your profits while they are ripe on the vine—when the momentum is still in your favor.


Everybody has good days in this business. And everybody has bad days, too. By
thinking defensively all the time, you can limit the damage done on bad days. When you handle bad days well, you are on your way to becoming a good trader.

Pull the Trigger

Trading is not for the weak-minded. You need to do the necessary background work before the market opens, and you need to have your trading templates in place.You need to monitor the market and anticipate 80/20 situations. And once the situation presents itself, you have to be decisive. Trading well requires a sense of urgency. Don’t fall victim to the ‘‘paralysis of analysis.’’ You have to act when the opportunity presents itself.


If you get a buy or sell signal on the template, then make the trade. Generally speaking, the better the opportunity, the shorter the time it will be available. There are many good traders in the market. When a great opportunity materializes, many of these traders will recognize the situation and act on it. As a result, the market will move quickly and decisively in one direction. If you wait too long to analyze the opportunity, it will pass you by.

Opinions Are for Pundits, Not Traders

Everywhere I go, people have an opinion about the stock market: on television, the Internet, and even on the golf course. It gets to the point where it’s hard for me not to have an opinion. People who know I’m a trader naturally ask me about the market. I’m sure the same thing happens to many of you. Remember, whatever your opinion is, we trade 80/20 opportunities, not our opinions.


I come into each day with an open mind, ready to go long or short as the market
action dictates. Based on my background work, I may think that there’s more potential for the market to go in one particular direction, but I don’t let that view
prevent me from trading in the opposite direction if the opportunity presents itself.

Strictly Follow Technical Data

The financial press usually attributes every move in the stock market to something in the news, most frequently an economic report. And security analysts look at corporate fundamentals to determine whether a stock is fairly valued. I purposefully ignore both economic and corporate fundamentals. It’s simply not my game.


Technical indicators and charts record all the buying and selling activity in the market, organized in a manner that allows me to spot high-probability trading situations. That’s all I need to focus on to make money in the market. As a trader, you can’t follow everything. Charts are very important for short-term trading because they show the underlying market psychology. And technical indicators help to time exit and entry points. Both are indispensable.


To get a better picture of market dynamics, it’s valuable to assess the market one time frame greater than your trading time frame. For example, if you are trading with a 5-minute chart, use a 30-minute chart to gain additional perspective. You want to be sure to get confirmation from technical indicators and charts before taking a position. For example, don’t buy or sell a market only because prices have dropped or risen substantially and the market seems hugely under- or overvalued. Wait for the indicators and charts to signal a buy or sell.


As you gain experience with charts and technical indicators, you’ll develop a
sense of anticipation about changes in trend. You’ll see momentum flagging, spot
divergences, and sense that the balance of power between buyers/sellers is shifting from one side to the other. When you see the trend changing, get focused on your trading templates and get ready to trade.


Market Entry Tactics: Use Limit Orders, Buy/Sell Zones, and Position Scaling


Regardless of the time frame that you trade, it’s very difficult to pick a precise top or bottom. Instead, based on your analysis, you should target a buy and sell zone where you project it’s safe to be long or short. Whenever possible, you should use limit orders to establish a position in your buy/sell zone. A limit order guarantees that you’ll get in at your price or better. While it’s possible that your limit order will not get filled and the market may move quickly in the direction you anticipated, I’ve found that rarely happens if I placed my limit order at a reasonable price. In many cases, I’ll scale into a position. For example, I may place a limit buy order for two E-minis. If I’ve caught the beginning of a strong move, I may purchase another two E-minis at a higher price and then perhaps another two E-minis at an even higher price.

Use Defensive Stops


I advocate the use of stops to limit potential losses. You can set them at specific
prices or at values created by your technical indicators. You need to be disciplined about setting stops with every trade so that you don’t allow a small loss to turn into a big loss. I typically place my initial stop two ticks away from my entry price. Once the market moves in my favor, I move my stop to lock in a profit. I won’t wait for the market to slow down or retreat before exiting. I’ll get out with the momentum still in my favor. If you’re trading on a longer time frame, your stops should be larger, more in the order of 5 to 10 ticks.


There will be times when you are right about market direction, but you’re wrong
on market timing. In those situations, you may very well get stopped out of your
trade. There’s nothing wrong with getting back in the market shortly thereafter if another 80/20 setup materializes. If the market moves in your favor, you should adjust your stops to lock in gains. Markets can move against you quickly; you don’t want to transform a nice profit into a loss. Again, if you get stopped out on a minor pullback after adjusting your stop, you can always get back in. If a trade is showing a loss toward the end of the day, I’ll liquidate the position before the market closes. I don’t want to hold losing positions overnight.


I may average up or down in certain situations; however, I do not average up or down above my core position. To average down means that you buy additional
stocks or contracts at a lower price after the market has dropped below your initial purchase price. To average up means you sell additional contracts at a higher price after the market has risen above your initial short position. Again, my core position is my maximum position based on my psychological comfort level. For me, it’s 10 E-mini contracts.

Track Your Results

At the end of each trading day, I note my profits and losses (P&L) for the day, for the week, and for the month. I’m very precise in my record keeping. I feel that precision carries over into my trading and helps keep me focused. I’m always aware of how each new trade contributes or detracts from my P&Ls. By focusing on high-probability trades, my P&Ls typically show continuous growth, with a few relatively small down periods. However, the returns are not consistent. You can extract from the market only what the market gives you, and your returns will vary depending on market conditions.


  You cannot demand consistency in your returns; it’s just not in the nature of the business. New traders, particularly those with a background in a structured business environment, need to understand and accept that their weekly and monthly P&Ls likely will show a wide range of returns. But while your returns will vary, you must demand consistency in your discipline and adherence to your trading rules. You should review your trades daily to determine if you acted in concert with your rules. You should reread and study your trading rules on a regular basis. Make them part of your trading DNA. They are the blueprint for your success.

Managing Your Trading Account

If you are showing consistent profits, for psychological reasons, it’s a good idea to pay yourself something from your trading account. You deserve to be rewarded for your success. It will help to keep you motivated and give you positive feelings about your trading.


You should not intermingle your trading account with your investment account.
In-and-out trading and long-term investing are two distinctly different disciplines.
By having the two activities in the same account, you may be tempted to change a trading position into an investment position, which is usually not a good idea. In addition, with the two accounts intermingled, it’s more difficult to segregate the trading P&L and evaluate your trading performance.

Take Advantage of Market Conditions



Trending markets and trading range markets present different opportunities and
require different strategies and tactics. First and foremost, you should be aggressive in trending markets in establishing a position in the direction of the trend. Given the profit potential in a trend, you can afford to give up a tick or two to get into the market. Be aware that prices usually move faster in downtrends than uptrends. In downtrends, protective stops get hit and investors close long positions.


To avoid losses, there is often a rush to the exits. In uptrends, investors are faced with a less pressing situation: establish a new long position, add to an existing long position, or close a long position for a profit. Investors have more time to make a decision. As a result, there’s a slower pace of buy orders and slower price movement on uptrends. There are times that the market goes into what I call a ‘‘white heat’’ condition where prices move very rapidly, sometimes gapping up or down.


If you’re fortunate enough to have a position in the direction of white heat, my advice is to take advantage of the situation and close your position while the momentum is still with you. If you wait until the white heat move loses steam, it very well may gap in the opposite direction. In trading range markets, you should be more selective in establishing a position. To the degree possible, you want to buy at the bid and sell at the offer.


The profit potential in trading range markets is smaller than in trending markets, so you want to get the best possible trade location. If a market has been in a trading range for three or four days, it’s likely that the market will make a big move when it finally breaks out of the range. In most situations, it’s best to trade in the direction of the short-term trend. However, you want to avoid chasing the market. Usually, there will be a pullback where you can get a better price than jumping on a breakout. As you gain experience in markets, you’ll develop a sense of market sentiment.


When the majority opinion is either bullish or bearish—and the market doesn’t move in the direction of the market consensus—the market will likely move strongly in the opposite direction. My indicators are sensitive to changing market conditions and will sometimes get me into positions a little early. Generally, that’s a good thing. You get a better feel for the market once you have a position.

And assuming the indicators were right, being early usually translates into a more profitable trade.

 Review the Rules Every Week

Please don’t read these rules, nod your head and agree that they make sense, and then pretty much forget about them. These rules are the product of my years of experience in the markets. If I had had the rules when I first started trading, my path to consistent profitability would have been much shorter. Read the rules regularly and make them your own.

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ONLY TREND FOLLOWING WORKS

ONLY TREND FOLLOWING WORKS


Do you think you can control the world? I do not believe it can be done. The world is a manifestation of change and cannot be controlled. Trying to control leads to ruin. Trying to grasp, we lose. Just as you breathe in and breathe out, the world is a manifestation of change; sometimes ahead, sometimes behind, sometimes dynamic, sometimes static, sometimes vigorous, sometimes feeble, sometimes being safe, sometimes being in danger. Therefore, refuse to distinguish excesses and extremes. See only oneness. Flow with Infinity and exist in peace and harmony.


All trading methods fall into one of two basic categories:

1. Trend-following methods
2. Against-trend methods


Trend-following methods try to “Flow with Infinity.” Against-trend methods try to
“control the world.” We will now see why the former approach is the intelligent way to engage the markets, while the latter approach cannot succeed in the long run.

Trend-Following Methods



Trend-following methods result mainly in “buy high, and sell higher” or “sell low and buy back lower.” A market’s trend is driven by its internal forces. It reflects the market’s own symmetry. Trend-following methods work because they act on the market’s actual direction, rather than acting on assumptions associated with the news or a trader’s own ideas. The market has its own character and personality. We cannot stop or change it. But to be successful we must merely ride on it. Its movement is natural and smooth. It can be ridden, just as easily as gliding on a boat downstream, and small efforts can achieve big results. See more about why trend following works in the pages that follow.

Against-Trend Methods


Unfortunately for them, the majority of traders trade against the market trend. They follow the precept of “buy low and sell high.” We were taught this strategy from a very young age. It feels natural to most people. If a store has a sale where it offers big discounts, people tend to buy more. If prices are up, people tend to buy less.

This approach does not work in the world of trading as a viable business plan. The money of traders who fight against the trend often becomes the fuel for increasing the movement of trends. Even so, there are many trading theories, methods, indicators, and systems that are designed as a result of these arbitrary ideas. Ten or so years ago a wellknown article was published with the title “Trend is your enemy.” 


Rather than following the market trend, many trading ideas and formulas, such as oscillators, cycles, turning points, Elliott wave, Stochastics (%K, and %D), and RSI, among others, are specifically designed to trade against the markets.
If you wish to trade the markets with consistent success, you must abandon against trend methods and begin to follow the natural law of trading with trends.

Why Trend Following Works

 

Trend Refers to the General Direction

If we know the general direction that the market is heading, we can achieve a profit by simply riding on the natural course of the market’s flow. The market itself determines the most highly probable direction in which it is likely to continue, coupled with support and resistance levels. The trend and support and resistance levels are defined by the market’s own prices. We cannot predict the trend—but we can follow it to our benefit. This is a major difference between the trading method that underlies Able Trend and other approaches to trading. The primary purpose of this book is to define a trend objectively so traders can follow the trend for profits in trading.

How much simpler—and more successful—trading becomes when we get out of the predicting business and get into the business of simply following trends as they unfold before us.

Act on Facts

Trend-following methods work because they act on facts—the actual market direction—rather than acting on assumptions associated with news or a trader’s
own ideas. Just think of how many times we feel that the market is “too high” or “too low,” or has gone “too far.” Then we try to fake out the market. Just think of how many times we hear a very bad or very good news report, and yet we see the market reacting  by going in the opposite direction from what we would expect. 

You might think it just doesn’t make any sense at all. And then you wonder what is going wrong, and what happens next? The market has reached another new high or another new low! Our minds just cannot accept the reality of the market. We try to justify in our minds why it should or shouldn’t be this way or that way, when all we really need to do is see what the market is telling us and act on that.


The Majority of Traders Trade Against the Market Trend

Again, bearing the standard of “buy low and sell high” before them. But when the market is nearing new highs, it is clearly saying, “I am going up now.” So why is it that so many people still don’t hear the market’s voice, but try to sell the market? In fact, no one can stop a market’s trend except the market itself. As I said earlier, the money of traders who fight against the trend becomes the fuel for further movement of the trend. (With regard to this, read about the “80-20” rule in this chapter.) I clearly remember something that happened when the British pound crashed in 1992.


When the pound crashed, one report said that the British central bank kept buying the pound in order to shore it up, but the British central bank still lost over $1 billion a day at that time, even with help from many other central banks. It just shows that even the most powerful forces cannot overcome the market trend. To trade against it will always be a losing proposition. Another example was provided by the U.S. stock market in 2008. After the DJIA index reached a top at 14,198 points on October 11, 2007, the U.S. stock market started to drop. 


When the market dropped to about 10,000 level in early October 2008, many mutual funds and big traders start to buy. They predicted that the market had reached the “bottom,” and this was a good time to “buy low.” However, the market has its own way, which could not be predicted by anyone. The market continued to move all the way down to 6,500 point level in March 2009. Most of those buyers panicked and sold out their positions as the DJIA index neared the 6,500 level—but it was too late.

Another example came when a big Hong Kong firm “hedged” the Australian dollar in 2008. In fact, they were not hedging, but purely speculating! After July 2008, the AUD/USD reached 0.9800, and the Hong Kong company predicted the U.S. dollar would become weaker due to the economic crisis that had started in the United States. They began to heavily buy AUD/USD. However, the AUD/USD kept dropping to 0.8800, then 0.7800 (that’s a loss of 2000 pips per contract, i.e., $20,000 loss per contract!). They kept buying more and more contracts. Eventually, their losing positions were too big to handle and they had to exit with a net loss greater than $2 billion near the low at 0.6000. In 2009, the CFO and CEO of the Hong Kong company were fired by their parent company in China.

Trend Is a Trader’s Best Friend, an Ally—the Strongest and Truest of All

As we have mentioned before, the trend flows like water, and as it goes it defines the course of the market. There is nothing in this world more supple and pliant than water, and nothing easier than to be in a boat, just floating along with the current downstream.This is more than just a poetic thought. It is a significant lesson that traders would be wise to take to heart. To trade by “following the way of the water”—that is, to move with the trend – is to trade effortlessly, without emotional upheaval. By this same analogy, moving against the trend is like trying to direct our boat against the natural flow of the current. It takes effort and we often end up where we never intended to go.


It’s All About the Market Price

The wish to “buy low and sell high” has been ingrained in our thinking since we were young. There are times when it paid off as we watched our parents buy groceries at the local store. If a store is offering a big discount on your favorite brand of coffee, it makes sense to stock up. When the price is high, it makes sense to buy less. But the question is, why does this work in our daily life, but not
in trading? 


The biggest difference is what we know about the price. Prices for goods at the store are far different from the prices paid at the trading markets. For tangible goods, such as a cup, or a pound of carrots, or clothes, or gasoline, or an automobile, we have a very good sense of what price is fair. However, when it comes to trading, what is the fair price for a stock, or a commodity, or a bond? The fair trading price is so hard to determine or to know that we cannot all agree with each other.


This is why there are buyers and sellers at all price levels as trading progresses. And this is also why trading is the most difficult thing in the world. Because we don’t know what the fair value price for a market is, and it certainly does no good to guess, we have to let the market tell us its own thought about what the correct price is. The way the market tells us is that it goes up if the fair price is above the current price, and it goes down if the fair price is below the current price. 


The hidden fair price always guides the way the market moves. We cannot see or know the fair value, therefore, we have to wait and let the market go ahead of us. Then we can follow it. Why is trading viewed as the most exciting game? It is mainly due to its unknown results and unpredictable nature. By following the trend, we let the market tell us the fair price, and that is how we make our decisions. We are no longer playing a game. We are acting scientifically on the facts. Isn’t that better than playing a game with your future?

Why AbleTrend Works


AbleTrend is a trend-following trading method. Based on trend definition and concepts that are described in Chapter 2, we designed four sets of proprietary AbleTrend indicators. AbleTrend uses these four sets of independently calculated indicators to truthfully follow and visually display a trend, and then to confirm its direction. It has been my experience that AbleTrend catches every trend in its early stage and never misses a big move. Using historical data, anyone can test AbleTrend’s performance with regard to a variety of major historic moves, such as “Black Monday” of 1987, 9/11 of 2001, and the economic crisis of 2008. If you take the time to do so, you will clearly see why I can say with confidence that AbleTrend never missed any big move in the past 20 years.


It is important to understand that a trend is not a trend until it is on its way. Therefore, AbleTrend cannot and is not designed to pick the top or bottom ahead of time, or even as it is happening. On the contrary, AbleTrend acts on the facts as they present themselves (i.e., what the market is doing now) and simply follows the market’s lead. We can only truly identify a top or bottom after prices confirm that a change in trend direction has occurred. AbleTrend never makes assumptions about what the market should be doing. 


AbleTrend is powerful because it creates the lens through which people can observe real market actions without altering what is seen. AbleTrend is live and updated with every coming tick in real time, so its data is always current. And because of the power of its mathematical formulas, AbleTrend can identify a change of trend with minimal data—and therefore, at its early stage. In its identification of where to place optimal stops (i.e., at support and resistance levels), AbleTrend furnishes traders with great flexibility for entering and re-entering the market.


Those stop values are directly driven from the market price’s action and reaction, not from any arbitrary idea. AbleTrend provides optimal stops for every trade objectively. And as my experience has shown me again and again, if you know where to exit the market, you can enter the market at virtually any time. Above all, AbleTrend is universal and based on the natural law, which works for any market and any time chart. It’s time-tested and timeless.

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TRADING IS A BUSINESS

TRADING IS A BUSINESS

 


What do you see trading as? Do you see it as:


* An exchange, involving the buying or selling of goods or services?
* A game that can be exciting for speculators?
* A tool, for example, one that enables traders to hedge the market?
* A war, albeit one without bloodshed?
* A business that happens to be the most difficult thing in the world?


Depending on the person giving the answer, there are elements of all of these in
trading. However, our answer is that we choose to see trading as a business. There are two basic types of participants in the futures and commodity markets:
hedgers and speculators. The hedgers are those seeking to minimize and manage price risk. Speculators are those willing to take on risk in the hope of making a profit. It doesn’t matter whether you are either a speculator or a hedger. We all need to treat trading as a business.


Why Do You Need a Business Plan for Trading?

 


In the following, we will reason why you need a business plan and how to compare it with a normal business.

Turning Crisis into Opportunity



In 2008 and 2009, some individuals and mutual funds found that their accounts lost 50 percent of their value. If you had been holding stocks of blue chips—General Motors (GM), AIG, or Citibank (C)—for 20 years, those stock values dropped 90 percent. It’s a very scary situation. To protect what you’ve earned is not an easy job in today’s fast-changing, volatile market. Should you exit or hold tight? Should you buy more shares or take partial profits? Able Trend helps you answer these questions. 


The software allows you to quickly and easily auto-scan the markets in your 401(k) or IRA accounts. You can instantly con- firm that support levels are still in place for your retirement investments. You can place stop orders to ensure that a market crash won’t mean a major setback to your financial security. To prepare for the greatest financial crisis we’ve ever seen in modern times, you need to use an advanced trading tool, such as Able Trend, for a ground-zero look at what’s unfolding globally. You need a more precise view of the markets than has ever before been possible! You need a more coolheaded guide, helping you find early trends around the world that offer the greatest investment opportunity, while helping you manage your risk. Instead of following the crowd, you’ll have a chance to get in ahead of the crowd as you find early trends that most investors don’t even know exist yet.

Zero-Sum Game



Remember, trading is a zero-sum game. Trading doesn’t create wealth, but rather it transfers wealth from one to another. It is peaceful on the surface, but it is a war without guns and bloodshed. Remember, if you win, someone must lose, and vice versa. As we know, the final purpose of any war is to achieve economic or financial goals. Some people view trading as a big gambling game. Many years ago, if you told others that you were a futures trader, people might think you were a risky speculator, and you were not considered as being anything other than a gambler. In fact, trading actually arises from the real needs of the economic and financial activities of society. I don’t need to spend much time explaining this.


 There are libraries of books about what trading and the markets are. The critical point is this: Trading is a business. Since it is a business, we must treat it as a business, and not as a gambling game. Since it has the nature of war, we should be well prepared before jumping into the “war zone” of trading. However, as yet there are no business schools or universities that officially teach the business of trading. There are no such trading-related courses, or majors, or degrees for trading within our school system. Hundreds of billions of dollars exchange hands each year from one to another through the trading business, and yet there is little in the way of education to help people run their trading as a business, rather than a game of chance. Most traders come to the markets without a business plan for trading or even knowing what the basics of their business plan should be.

Beware of Fighting a War without a Plan

 



Fighting a war without a plan is equivalent to suicide. The only way to succeed is to use a proven winning system and stick to it. You must have a trading plan before you make any trades—and while a trade is under way, you must stick to it. Do not change your plan during the trading session unless you have a very good reason to do so. You can change your plan in future trades based on what you learn, but changing your plan mid-trade is usually based on emotion and leads to more severe losses. Enter the trading battlefield armed with time-tested risk management and money management strategies. This helps to remove guesswork and emotion in trading. The strategies and signals you will use to execute your trade are critical aspects of your overall trading plan.

Summary: Trading Is a Business

As when starting any business, you need a business plan to run your trading business. Table 4.1 is an outline of the basic features you should incorporate into your trading business plan, as they compare to the features that are normally included in any standard business plan.


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SUPPLY AND DEMAND

SUPPLY AND DEMAND



Price is the balancing point of supply and demand. In order to estimate the future price of any product or explain its historic patterns, it will be necessary to relate the factors of supply and demand and then adjust for inflation, technological improvement, and other indicators common to econometric analysis. The following sections briefly describe these factors.


Demand

 

The demand for a product declines as price increases. The rate of decline is always dependent on the need for the product and its available substitutes at different price levels. In Figure , D represents normal demand for a product over some fixed period. As prices rise, demand declines fairly rapidly. D′ represents increased demand, resulting in higher prices at all levels. Figure  represents the actual demand relationship for potatoes from 1929 to 1939. Although this example is the same as the theoretical relationship in Figure , in most cases the demand relationship is not a straight line. Production costs and minimum demand prevent the curve from going to zero; instead, it approaches a minimum price level.



 This can be seen previously in the frequency distribution for wheat, Figure  where the left side of the distribution falls (lower price) off sharply. On the higher end of the scale, there is a lag in the response to increased prices and a consumer reluctance to reduce purchasing even at higher prices (called “inelastic demand”). Coffee is well-known for having inelastic demand—most coffee drinkers will pay the market price rather than consume less. Figure shows a more representative demand curve, including extremes, where 100 represents the cost of production for a producer. The demand curve therefore, shows the rate at which a change in quantity demanded brings about a change
in price. Note that, although a producer may lose money below 100, lack of demand and the need for income can force sales at a loss.


Elasticity of Demand

 



Elasticity is the key factor in expressing the relationship between price and demand and defines the shape of the curve. It is the relative change in demand as price increases A market that always consumes the same amount of a product, regardless of price, is called inelastic; as price rises, the demand remains the same, and E D is negatively very small. An elastic market is just the opposite. As demand increases, price remains the same and E D is negatively very large. Figure  shows the demand curve for various levels of demand elasticity. If supply increases for a product that has existed in short supply for many years, consumer purchasing habits will require time to adjust. The demand elasticity will gradually shift from relatively inelastic  to relatively elastic . 


 Supply



The supply side of the economic equation is the normal counterpart of demand.
Figure  shows that, as price increases, the supplier will respond by offering greater amounts of the product. Figure demonstrates the supply at price extremes. At low levels, below production costs, there is a nominal supply by those producers who must maintain operations due to high fixed costs and diffi- culty restarting after a shutdown (as in mining). At high price levels, supply is erratic. There may be insufficient supply in the short term, followed by the appearance of new supplies or substitutes, as in the case of a location shortage. When there is a shortage of orange juice, South American countries are willing to fill the demand; when there is an oil disruption, other OPEC nations will increase production. In most cases, however, it is reduced demand that brings price down.

Elasticity of Supply

The elasticity of supply E S is the relationship between the change in supply and the change in price The elasticity of supply, the counterpart of demand elasticity, is a positive number because price and quantity move in the same direction at the same time.


 Equilibrium

 

The demand for a product and the supply of that product cross at a point of equilibrium. The current price of any product, or any security, represents the point of equilibrium for that product at that moment in time. This is the basis for the technical assessment that the price, at any moment in time, represents the netting of all fundamental information. Figure  shows a constant demand line D and a shifting supply, increasing to the right from S to S ′. The demand line D and the original supply line S meet at the equilibrium price P; after the increase in supply, the supply line shifts to S ′.




 The point of equilibrium P ′ represents a lower price, the consequence of larger supply with unchanged demand. Because supply and demand each have varying elasticities and are best represented by curves, the point of equilibrium can shift in any direction in a market with changing factors. Equilibrium will be an important concept in developing trading strategies. Although the supply and demand balance may not be calculated, in practical terms equilibrium is a balance between buyers and sellers, a price level at which everyone is willing to trade, although not always happy to do so at that price. Equilibrium is associated with lower volatility and often lower volume because the urgency to buy or sell has been removed.Imbalance in the supply-demand-price relationship causes volatility. Readers interested in a practical representation of equilibrium, or price-value relationships, should study “Price Distribution Systems” in Steidlmayer’s Market .

Cobweb Charts

 

The point at which the supply and demand lines cross is easily translated into a place on a price chart where the direction is sideways. The amount of price volatility during this sideways period (called noise) depends upon the price level, market participation, and various undertones of instability caused by other factors. Very little is discussed about how price patterns reflect the shift in sentiment between the supply and demand lines, yet there is a clear representation of this action using cobweb charts. shows a static (symmetric) supply-demand chart with dotted lines representing the “cobweb.” A shift in the perceived importance of supply and demand factors can cause prices to reflect .


the pattern shown by the direction of the arrows on the cobweb, producing the sideways market represented by Figure. If the cobweb were closer to the intersection of the supply and demand lines, the volatility of the sideways price pattern would be lower; if the cobweb were further away from the intersection, the pattern would be more volatile. 4 Most supply/demand relationships are not static and can be represented by lines that cross at oblique angles. In Figure  the cobweb is shown to begin near the intersection and move outwards, each shift forming a different length strand of the web, moving away from equilibrium. Figure  shows that the corresponding price pattern is one that shifts from equilibrium to increasing volatility. A reversal in the arrows on the cobweb would show decreasing volatility moving toward equilibrium.

 

 Building a Model

 

A model can be created to explain or forecast price changes. Most models explain rather than forecast. Explanatory models analyze sets of data at concurrent times: that is, they look for relationships between multiple factors and their effect on price at the same moment in time. They can also look for causal, or lagged relationships, where prices respond to other factors after one or more days. It is possible to use the explanatory model to determine the normal price at a particular moment. Although not considered forecasting, any variation in the actual market price from the normal or expected price could present a trading opportunity. Methods of selecting the best forecasting model can affect its credibility. An analytic approach selects the factors and specifi es the relationships in advance.


Tests are then performed on the data to verify the premise. Many models, though, are refined by fitting the data, using regression analysis or some mass testing process, which applies a broad selection of variables and weighting factors to find the best fit. These models, created with perfect hindsight, are far less likely to be successful at forecasting future price levels. Even an analytic approach that is subsequently fine-tuned could be in danger of losing its forecasting ability. The factors that comprise a model can be both numerous and difficult to obtain. Figure  shows the interrelationship between factors in the cocoa industry. Although this chart is comprehensive in its intra market relationships, it does not emphasize the global influences that have become a major part of price movement since the mid-1970s.

The change in value of the U.S. dollar and the volatility of interest rates have had far greater influence on price than some of the “normal” fundamental factors for many commodities. Companies with high debt may find the price fluctuations in their stock are larger due to interest rate changes than increases or decreases in revenues. Models that explain price movements must be constructed from the primary factors of supply and demand. A simple example for estimating the price of fall potatoes 5 is.

P/PPI = a + bS + cD


where

P = the average price of fall potatoes received by farmers
PPI = the Producer Price Index
S = the apparent domestic free supply (production less exports and
diversions)
D = the estimated deliverable supply
a, b, and c = constants determined by regression analysis


This model implies that consumption must be constant (i.e., inelastic demand); demand factors are only implicitly included in the estimated deliverable supply. Exports and diversion represent a small part of the total production. The use of the PPII gives the results in relative terms based on whether the index was used as an inflatorr or deflator of price.


A general model, presented by Weymar, 6 may be written as three behavior-based equations and one identity:

Consumption

C t = f C ( P t , P t L ) + e C t




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THE 10 POWER PRINCIPLES MAKING SURE THAT YOUR TRADING PLAN WORKS

THE 10 POWER PRINCIPLES MAKING SURE THAT YOUR  TRADING PLAN WORKS



Having a trading plan is like having a solid blueprint to build your home, or having a map when traveling to a new location. You already know that a professional trader won’t survive in the markets without a good trading plan.
Now that you’ve defined your goals and created your trading plan, you need to make sure it really works. Thus far, everything might look great, but how can you be sure that the system works when you start trading it with real money?


Evaluating a trading strategy is easier than you think. In this topic you'll find 10 Principles of Successful Trading Strategies that we’ve developed and refined over the last couple of years.You should use these Power Principles to evaluate your trading strategy, whether you developed it on your own or are thinking about purchasing one. By checking a strategy against these principles, you can dramatically increase your chances of success.

 Principle #1: Use Few Rules – Make It Easy to Understand

It may surprise you that the best trading systems have less than ten rules. The more rules you have, the more likely that you’ve "curve-fitted" your trading strategy to past data, and such an over-optimized system is very unlikely to produce profits in real markets. It's important that your rules are easy to understand and execute. The markets can behave very wildly and move very fast, and you won't have time to calculate complicated formulas in order to make a trading decision. Think about successful floor traders: the only tool they use is a calculator, and they make thousands of dollars every day.

 Example:

Take a look at the trading approaches presented in the section “Popular Trading Approaches.” The easy rules are: buy when the RSI drops below a reading of 20, or, sell when prices move above the upper Bollinger Band.

Avoid a trading strategy that has an entry rule like this:

Buy when the RSI is below 20, and the ADX is between 7 and 12, and the 7-bar moving average is pointing up more than 45 degrees, and there is a convergence between the price bars and the MACD, and, and, and...

Do you really think that you could follow this strategy while you’re watching the markets LIVE?

Principle #2: Trade Electronic and Liquid Markets

I strongly recommend that you trade electronic markets, because commissions are lower and you receive instant fills. You need to know as fast as possible if your order was filled and at what price, because you plan your exit based on this information. You should never place an exit order before you know that your entry order is filled. When you trade open outcry markets (non-electronic), you
might have to wait awhile before you receive your fill. By that time, the market might have already turned and your profitable trade has turned into a loss!

When trading electronic markets, you receive your fills in less than one second and can immediately place your exit orders. Trading liquid markets means you can avoid slippage, which will save you hundreds or even thousands of dollars.
Fortunately, more and more markets are now traded electronically. The recent addition of the grain futures markets in the summer of 2006 was a huge success: in January of 2007, the volume traded in the electronic contracts surpassed the volume traded in the pit markets. In December of 2007, the pit-traded corn contract traded with 621,800 contracts, while the electronic corn contract had a trading volume of 2,444,400 contracts. Most futures markets, all forex currency pairs, and the major U.S. stock markets are trading electronically. So why would you even want to trade Pork Bellies or Lumber?

Principle #3: Have Realistic Expectations

Losses are part of our business. A trading system that doesn't have losses is "too good to be true." Recently, I ran into a trading system with a whopping winning percentage of 91% and a drawdown of less than $500. WOW!

When I looked at the details, though, it turned out that the system was only tested on 87 trades and – of course – it was curve-fitted. If you run across a trading system with numbers too good to be true, then it's probably exactly THAT: too good to be true.

Usually you can expect the following from a robust trading system:

1.) A winning percentage of 60-80%
2.) A profit factor of 1.3-2.5
3.) A maximum drawdown of 10-20% of the yearly profit

Use these numbers as a rough guideline, and you’ll easily identify curve fitted systems.

Principle #4: Maintain a Healthy Balance Between Risk and Reward

Let me give you an example: if you go to a casino and bet everything you have on "red," then you have a 49% chance of doubling your money and a 51% chance of losing everything. The same applies to trading: you can make a lot of money if you’re risking a lot, but if you do, the risk of ruin is also high. You need to find a healthy balance between risk and reward.

Make sure your trading strategy is using small stop losses and that your profit targets are bigger than your stop losses.

Stay away from strategies that have a small profit target of only $100 and a stop loss of $2,000. Sure, the winning percentage will be fantastic, but 2-3 losses in a row can wipe out your trading account.

The perfect balance between risk and reward is 1:1.5 or more – i.e. for every dollar you risk you should be able to make at least $1.50.

In other words, if you apply a stop loss of $100, your profit target should be at least $150.

Principle #5: Find a System That Produces at Least Five Trades per Week

The higher your trading frequency, the smaller your chances of having a losing month. If you have a trading strategy that has a winning percentage of 70%, but only produces one trade per month, then one loser is enough to have a losing month. In this example, you could have several losing months in a row before you finally start making profits.
 In the meantime, how do you pay your bills?
If your trading strategy produces five trades per week, then you have on average 20 trades per month. If you have a winning percentage of 70%, then your chances of a winning month are extremely high.
And that's the goal of all traders: having as many winning months as
possible!

Principle #6: Start Small – Grow Big

Your trading system should allow you to start small and grow big. A good trading system allows you to start with one or two contracts, increasing your position as your trading account grows.
This is in contrast to many "martingale" trading systems, which require increasing position sizes when you are in a losing streak. You’ve probably heard about this strategy: double your contracts every time you lose, and one winner will win back all the money you previously lost.

Principle #7: Automate Your Exits

Emotions and human errors are the most common mistakes that traders make. You have to avoid these mistakes by any means necessary, especially when the market starts to move fast. You might experience panic and indecision, but if you give in to those emotions, you’ll suffer a much greater loss than you had originally planned for.

Your exit points should be easy to determine. The best solution for your exit points is the use of “bracket orders.” Most trading platforms offer bracket orders, which allow you to attach a profit target and a stop loss to your entry.

This way, you can put your trade on autopilot, and the trading system will close your position at the specified levels.

Of course, this assumes that you have easy exit rules. A stop loss of $100, or 1%, of the entry price can easily be specified in today’s trading platforms.

Exit rules like “2/3 of the average true range of the past 5 trading days” are more complex to automate. In the beginning, you should keep your trading as simple as possible.

If you can’t make money with simple entry and exit points, you won’t be able to make money with more complex trading rules. Think about driving a car: if you can’t drive a Ford, you definitely won’t be able to drive a Ferrari.

Principle #8: Have a High Percentage of Winning Trades

Your trading strategy should produce more winners than 50%. There's no doubt that trading strategies with smaller winning percentages can be profitable, too, but the psychological pressure is enormous.

Taking 7 losers out of 10 trades, and not doubting that system, takes a great deal of discipline, and many traders can't stand the pressure. After the sixth loser, they’ll start "improving" the strategy, or stop trading it completely.

It’s very helpful for beginning or novice traders to gain confidence in their trading, and if your strategy gives you a high winning percentage, let’s say more than 65%, your confidence will definitely be on the rise.

Principle #9: Test Your Strategy on at Least 200 Trades

The more trades you use in your back-testing (without curve-fitting), the higher the probability that your trading strategy will succeed in the future. Look at the following table:

Number of Trades      50     100     200   300    500
<>Margin of Error    14%   10%     7%    6%     4%


The more trades you have in your back-testing, the smaller the margin of error, and the higher the probability of producing profits in the future.

You need at least 40 trades for a valid performance report. As you can see from the table above, 200 trades are optimal, since the margin of error decreases fast from 14% to 7% with only an addition 150 trades.


If you test your system on more than 200 trades, the margin of error decreases at a slower rate. The next 100 trades only increase the confidence by 2%.

Principle #10: Choose a Valid Back-Testing Period

Take a look at your trading strategy and run it against these 10 Power Principles. How many principles apply?

If your trading strategy doesn’t fulfill all 10 Principles, is there any area in which you can improve it?


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EVALUATING YOUR STRATEGY

EVALUATING YOUR
STRATEGY




Once you’ve determined which markets you want to trade, selected a time frame, and defined your entry and exit rules, it’s time to test and evaluate your trading strategy.
There are three ways to test your trading strategy:

Back-Testing

Back-testing is a method of testing which will run your strategy against prior time periods. Basically, you’re performing a simulation: you use your strategy with relevant past data to test its effectiveness. By using the historical data, you’re saving a ton of time; if you tried to test your strategy by applying it to the time periods yet to come, it might take you years. Back-testing is used for a variety of strategies, including those based on technical analysis. The effectiveness of back-testing relies on the theory that what has happened in the past WILL happen again in the future. Also, keep in mind that your backtesting results are quite dependent on the moves that occurred in the tested time period. It’s important to remember that this increases the potential of risk for your strategy.

The Monte-Carlo Simulation

The Monte-Carlo Simulation is a problem-solving technique used to approximate the probability of certain outcomes by running multiple trial runs – called simulations – using random variables. It is a way to account for the randomness in a trading parameter – typically, the sequence of trades. In Monte Carlo simulations, the basic idea is to take a sequence of trades generated by a trading system, randomize the order of trades, and calculate the rate of return and the maximum draw down, assuming that x% of the account is risked on each trade.
The process is repeated several hundred times, each time using a different random sequence of the same trades. 


You can then pose a question such as "If 5% of the account is risked on each trade, what is the probability that the maximum draw down will be less than 25%?" If 1,000 random sequences of trades are simulated with 5% risk, for example, and 940 of them have a maximum draw down of less than 25%, then you could say the probability of achieving a maximum draw down of less than 25% is 94% (940/1,000). Keep in mind that the data used in Monte Carlo Simulations is still historical data; therefore, one could say that this simulation is a more sophisticated way of back-testing.

Paper Trading

Paper trading is a method of “risk-free” trading. Basically, you set up a dummy account, through which you can test your trading strategy with paper money. 

There are two methods to this:

you can either pretend to buy and sell stocks, bonds, commodities, etc., and keep track of your profits and losses on paper, or you can open an account online, usually through your broker (and usually for free). This is a fantastic way for new traders to kill a whole tree full of birds with one stone. First off, you’ll learn the tricks of the trade without putting your own money at risk. Second, you’ll be able to gain some much-needed confidence when it comes to maneuvering in the markets. And third, you’ll be able to test out your trading strategy in real-time simulation. This is probably the best way to test a trading strategy, since it doesn’t rely on historical data. On the other hand, it’s the most time-consuming strategy, since it might take weeks or months until you have enough data for a statistically relevant performance report.

Conclusion

When back-testing, there are definitely things you need to be aware of. It's not enough to just run a strategy on as much data as possible; it's important to know the underlying market conditions. As outlined in previous chapters: in non-trending markets, you need to use trend-fading systems; and, in trending markets, you should use trend following methods.


That's when clever back-testing helps you. If your back-testing tells you that a trend-following method worked in 2011-2013, but doesn't work in 2014 and 2015, then you should not use this strategy right now. And vice versa: when you see that a trend-fading method produced nice profits in 2010 , 2011 and 2012 then trade it.

How to Read and Understand a Performance Report

While testing your trading strategy, you should keep detailed records of the wins and losses in order to produce a performance report. Many software packages can help you with that, but a simple excel sheet will do the trick just as well. If you get in contact with us here at Rockwell Trading®, we can send you an excel sheet that will automatically produce a performance report for you after you’ve entered several trades.


 Total (Net) Profit


The first figure to look for is the total, or net, profit. Obviously you want your system to generate profits, but don’t be frustrated when, during the development stage, your trading system shows a loss; try to reverse your entry signals.


You might have heard that trading is a zero sum game. If you want to buy something (e.g. a certain stock or futures contract), then somebody else needs to sell it to you. And, you can only sell a position if somebody else is willing to buy from you at the price you're asking. This means that if you lose money on a trade, then the person who took the other side of the trade is MAKING money. And vice versa: if you’re making money on a trade, then the other trader is losing money. In the markets, money is not "generated." It just changes hands. So, if you’re going long at a certain price level, and you lose, then try to go short instead. Many times this is the easiest way to turn a losing system into a winning one.

Average Profit per Trade

The next figure you want to look at is the average profit per trade. Make sure this number is greater than slippage and commissions, and that it makes your trading worthwhile. Trading is all about risk and reward, and you want to make sure you get a decent reward for your risk.

Winning Percentage

Many profitable trading systems achieve a nice net profit with a rather small winning percentage, sometimes even below 30%. These systems follow the principle: “Cut your losses short and let your profits run.” However, YOU need to decide whether you can stand 7 losers and only 3 winners in 10 trades. If you want to be “right” most of the time, then you should pick a system with a high winning percentage.

Understanding Winning Percentage

Let's say you purchased or developed a system that has a winning percentage of 70%.

What exactly does that mean?

It means that the probability of having a winning trade is 70% – i.e. it is more likely that the trade you are currently in turns out to be a winner rather than a loser. Does that mean that when you trade 10 times you will have 7 winners? No!
It means that if you trade long enough (i.e. at least 40 trades) then you will have more winners than losers. But it doesn’t guarantee that after 3 losers in a row, you’ll have a winner.

Example:

If you toss a coin then you have 2 possible outcomes: heads or tails. The probability for each is 50% – i.e. when you toss the coin 4 times, then you should get 2 heads and 2 tails.

But what if you tossed the coin 3 times and you got heads 3 times?

What is the probability of heads on the fourth coin toss?

50%, or less?

If you answered 'less,' than you fell for a common misconception. The probability of getting heads again is still 50%. No more and no less.

But many traders think that the probability of tails is higher now because the three previous coin tosses resulted in heads. Some traders might even increase their bet because they are convinced that now “tails is overdue.” Statistically, this assumption is nonsense; it’s a dangerous – and many times costly – misconception.

Let's get back to our trading example: if you have a winning percentage of 70%, and you had 9 losers in a row, what’s the probability of having a winner now? It's still 70% (and therefore there's still a 30% chance of a loser).


Average Winning Trade and Average Losing Trade

The average winning trade should be bigger than the average losing trade. If you can keep your wins larger than your losses, then you’ll make money even if you just have a 50% winning percentage. And every trader should be able to achieve that. If you can’t, reverse your entry signals as described previously.

Profit Factor

Take a look at the Profit Factor (Gross Profit / Gross Loss). This will tell you how many dollars you’re likely to win for every dollar you lose. The higher the profit factor, the better the system. A system should have a profit factor of 1.5 or more, but watch out when you see profit factors above 3.0, because it might be that the system is over-optimized.

Maximum Drawdown

The maximum drawdown is the lowest point your account reaches between peaks.

Let me explain:

Imagine that you start your trading account with 10,000, and, after a few trades, you lose 2,000. Your draw down would be 20%. Now, let's say you make more trades and gain 4,000, which brings you to 12,000 (8,000 + 4,000 = 12,000). And after this, on the next trade, you lose 2,000. Your draw down would be 16.7% (12,000 - 2,000). The 12,000 was your equity peak; that was the highest point in the period we looked at. If you started your account with 10,000 and the lowest amount you had in your account over a six-month period was 5,000, then you had a 50% draw down You would need to make 5,000 from the lowest point in order to recoup your losses. Even though you lost 50% from your high of 10,000, you would need to make 100% on the 5,000 to get back to your original amount.

Measuring Drawdown Recovery

Drawdown recovery can confuse many traders. If a trader loses 20% of his account, he thinks he needs to make 20% in order to get back to even. This isn’t true. If you started with 10,000 and lost 2,000 (20%), you would need to make 25% in order to get back to even. The difference between 8,000 and 10,000 is 2,000. If you calculate the 2,000 as a percentage of 8,000 (not the original 10,000) it works out to 25%. A famous trader once said: “If you want your system to double or triple your account, you should expect a drawdown of up to 30% on your way to trading riches.” Not every trader can stand a 30% drawdown. Look at the maximum drawdown that your strategy has produced so far, and double it. If you can stand this drawdown, then you’ve found the right strategy. Why double it? Remember: your worst drawdown is always ahead of you. It’s best to plan for it now.

Conclusion

The above examples provide you with some guidelines, but it’s up to you to decide whether the numbers in the strategy’s performance report work for you or don’t. Ultimately, YOU’RE the one trading the strategy, and YOU’RE the one who has to feel comfortable with the expected results of your strategy.

Action Items:

* Start back-testing your trading plan on at least 40 trades. The more trades the better. You can download an excel sheet to record your trades from our website.

* Analyze the performance report and decide if YOU feel comfortable with the statistics.


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