COACHING CUE
A simple rule that has greatly aided my executions has been to wait for buyers to take their turn if I’m selling the market and wait for sellers to take their turn before I’m buying the market. Thus, I can only buy if the NYSE TICK has gone negative and if the last X price bars are down. Similarly, I can only sell if the NYSE TICK has gone positive and the most recent X price bars have been up. This reduces the heat I take on trades by entering after short squeezes and program trades juke the market up or down. Once in a while you’ll miss a trade if you wait patiently for the other side to take their turn, but the extra ticks you make on the trades you do get into more than make up for that.
LESSON 79: THINK IN THEMES—GENERATING GOOD TRADING IDEAS
Notice how successful businesses are always coming up with new products and services to meet the changing needs and demands of consumers. A great way to become obsolescent in the business world is to remain static. If a current product is a hit, competitors and imitators are sure to follow. What was hot at one time—large vehicles during periods of cheap gasoline, compact disc players for music—can go cold quite suddenly when economic conditions or technologies change.
It is the same way in the trading world. For a while, buying technology stocks was a sure road to success. Thousands of day traders gave up their jobs to seek their fortunes. After 2000, that trade vanished with a severe bear market. Now, selected technology firms are doing relatively well, while others languish. Markets, like consumer tastes, are never static.
As we saw in the lesson on diversification, if you base your trading business on a single type of trading—a limited set of ideas or patterns—it is a vulnerable place to be. I recall when breakouts of opening ranges were profitable trades; in recent years, those breakouts have tended to reverse. We all hear that the trend is your friend, but in recent years buying after losing days, weeks, and months has—on average—been more profitable than selling. Market patterns, as Niederhoffer emphasized, are ever-changing. That means that successful traders, like successful business people, must continually scout for fresh opportunity.
The best system developers don’t just develop and trade a single system. Rather, they continually test and trade new systems as part of a diversified mix.
One of the skills I see in the best traders is the ability to synthesize data across markets, asset classes, and time frames to generate trading themes. These themes are narratives that the trader constructs to make sense of what is going on in markets. These themes are the trader’s theories of the financial marketplace. Their trades are tests of these theories. The successful trader is one who generates and acts on good theories: themes that truly capture what is happening and why.
This thematic thinking is common in the portfolio management world, but I see it also among successful short-term traders. The scope of the theories—and the data used to generate them—may differ, but the process is remarkably similar. A portfolio manager might note high gasoline prices and weakening housing values and conclude that a lack of discretionary income among consumers should hurt consumer discretionary stocks. That might lead to a trade in which the manager shorts the consumer discretionary sector and buys consumer staples stocks that are more recession-proof.
The short-term trader may look at a Market Profile graphic covering the past week and observe a broad trading range, with the majority of volume transacted in the middle of that range. As the market moves to the top of that range, the trader sees that many sectors are nowhere near breaking out. Moreover, overall market volume is light during the move, with as much volume transacted at the market bid as at the offer. From this configuration, the short-term trader theorizes that there is not sufficient demand to push the market’s value area higher. She then places a trade to sell the market, in anticipation of a move back into the middle of the range.
Thematic thinking turns market data into market hypotheses.
The key to thematic thinking is the synthesizing of a range of data into a coherent picture. Many traders, particularly beginners, only look at their market in their time frame. Their view is myopic; all they see are shapes on a chart. The factors that actually catalyze the movement of capital—news, economic conditions, tests of value areas, intraday and longer-term sentiment—remain invisible to them. Without the ability to read the market’s themes, they trade the same way under all market conditions. They’ll trade breakout moves in trending markets and in slow, choppy ones. They’ll fade gaps whether currencies and interest rates are impelling a repricing of markets or not. Little wonder that they are mystified when their trading suddenly turns from green to red: they don’t understand why markets are behaving as they are.
There is much to be said for keeping trading logic simple. The synthesis of market data into coherent themes is a great way to distill a large amount of information into actionable patterns. In the quest for simplicity, however, traders can gravitate to the simplistic. A setup—a particular configuration of prices or oscillators—may aid execution of a trade idea, but it is not an explanation of why you think a market is going to do what you anticipate. The clearer you are about the logic of your trade, the clearer you’ll be about when the trade is going in your favor and when it is going against you.
Intermarket relationships are particularly fertile ground for the development of themes. You’ll notice in the TraderFeed blog that I regularly update how sectors of the stock market are trading relative to one another. This alerts us to themes of economic growth and weakness, as well as to lead-lag relationships in the market. These sector themes change periodically—financial issues that had been market leaders recently became severe laggards—but they tend to be durable over the intermediate-term, setting up worthwhile trade ideas for active traders.
Other intermarket themes capture the relative movements of asset classes. When the economy weakens and the Federal Reserve has to lower interest rates, this has implications not only for how bonds trade, but also the U.S. dollar. Lower rates and a weaker dollar might also support the prospects of companies that do business overseas, as their goods will be cheaper for consumers in other countries. That situation might set up some promising stock market ideas.
Track rises and falls in correlations among sectors and markets as a great way to detect emerging themes—and ones that are shifting.
Short-term traders can detect themes from how markets trade in Europe and Asia before the U.S. markets open. Are interest rates rising or falling? Commodities? The U.S. dollar? Are overnight traders behaving in a risk-averse way or are they buying riskier assets and selling safer ones? Are Asian or European markets breaking out to new value levels on their economic news or on decisions from their central banks? Often, these overnight events affect the morning trade in the United States and set up trade ideas about whether a market is likely to move to new highs or lows relative to the prior day.
The short-term trader can also develop themes from breaking news and the behavior of sectors that are leading or lagging the market. If you keep track of stocks and sectors making new highs and lows often, you will highlight particular themes that are active in the market. If oil prices are strong, you may notice that the shares of alternative energy companies are making new highs. That can be an excellent theme to track. Similarly, in the wake of a credit crunch, you might find that banking stocks are making new lows. Catching these themes early is the very essence of riding trends; after all, a theme may persist even as the broad market remains range bound.
As your own trading coach and the manager of your trading business, you need to keep abreast of the marketplace. That means that considerable reading and observation must accompany trading time in front of the screen. On my blog, I try to highlight sources of information that are particularly relevant to market themes. I update those themes daily with tweets from the Twitter messaging application (www.twitter.com/steenbab). Ultimately, however, you need to figure out the themes that most make sense to you and the sources of informati
on for generating and tracking those themes. The more you understand about markets, the more you’ll understand what is happening in your market. Like a quarterback, you need to see the entire playing field to make the right calls; it’s too easy to be blind-sided by a blitzing linebacker when your gaze is fixed!
COACHING CUE
It is particularly promising to find themes that result from a particular news catalyst. For instance, if a report on the economy is stronger than expected and you see sustained buying, track the sectors and stocks leading the move early on and consider trading them for a trending move, especially if they hold up well on market pullbacks. Many of those themes can run for several days, setting up great swing moves.
LESSON 80: MANAGE THE TRADE
Business success isn’t just about the products and services a firm offers to the public. Much of success can be traced to the management of the business. If you don’t hire the right people, supervise them properly, track inventories, and stick to a budget, you’ll fail to make money with even the best products and services.
So it is with trading. The best traders I’ve known are quite skilled at managing trades. By trade management, I mean something different from generating the trade idea and executing it. Rather, I’m referring to what you do with the position after you’ve entered it and before you’ve exited.
Your first reaction might be: You don’t do anything! It’s certainly possible to enter a position and sit in it, waiting for it to hit your profit target or your stoploss level. That reaction, however, is inefficient. It’s like selling the same mix of products at all stores even though some products sell better and some sell worse at particular locations.
To appreciate why this is the case, consider the moment you enter a trade. At that point you have a minimum of information regarding the soundness of your idea. As the market trades following your entry, you accumulate fresh data about your idea: the action is either supporting or not supporting your reasons for being in the market. For instance, if your idea is predicated on falling interest rates and you see bonds break out of a price range, that would be supportive of your trade. If you anticipate an upside breakout in stocks and you see volume expand and the NYSE TICK move to new highs for the day on an upward move, that is similarly supportive. If you track market action and themes while the trade is on, you can update the odds of your trade being successful.
Trade management is the set of decisions you make based on the fresh information that accumulates during the trade.
One way that I see traders utilizing this information is in the way that they scale into trades. Their initial position size might be relatively small, but traders will add to the position as fresh information validates their idea. My trading capital per trade idea is divided into six units. I typically will enter a position with one or two units. Only if the idea is finding support will a third or fourth unit enter the picture. I have found that, if my trades are going to be wrong, they’re generally wrong early in their lifespan. By entering with minimal size, I incur small drawdowns when I’m wrong. If I add to a position as it is finding support, I maximize the gains from good trades. This trade management, I find, is just as important to many traders’ performance as the quality of their initial ideas. Indeed, I’ve seen traders throw lots of trade ideas at the wall and only add capital to the ones that stick: the management of their trades makes all the difference to their returns.
Such trade management means that you have to be actively engaged in processing information while the trade is on, not just passively watching your position. Good trade management is quite different from chasing markets that happen to be going in your favor. It is a separate execution process unto itself, in which you can wait for normal pullbacks against your position to add to the position at favorable levels. If you are long, for example, and the market is in an uptrend, the retracements should occur at successively higher price levels. By adding after the retracement, you gain the profit potential when the market returns to its prior peak, but you also ensure that risk/reward will be favorable for the piece of the trade that you’re adding.
Each piece added to a trade needs a separate assessment of risk and reward to guide its execution.
While I’m in a short-term trade, I’m closely watching intraday sentiment for clues as to whether buyers or sellers are more aggressive in the market. I will watch the NYSE TICK (the number of stocks trading on upticks minus those trading on downticks), and I will track the Market Delta (www.marketdelta.com; the volume of ES futures transacted at the market offer minus the volume transacted at the market bid). These trackings tell me if the balance of sentiment is in my direction. If the sentiment turns against me, I may decide to discretionarily exit the position prior to hitting my stop-loss level. That, too, is part of trade management. To be sure, it is risky to front-run stop-levels: it invites impulsive behavior whenever markets tick against you. I’ve found, however, that if I’m long the ES futures and we see a breakdown in the Russell 2000 (ER2) futures or a move to new lows in a couple of key market sectors, the odds are good that we will not trend higher. By proactively exiting the position, I save myself money and can position myself for the next trade.
What this suggests is that it is important to be right in the markets, but it is even more valuable to know when you’re right. Very successful traders, I find, press their advantage when they know they’re right, and they’re good at knowing when they’re right. This means that they are keen observers of markets in real time, able to assess when their trade ideas—their hypotheses—are working out and when they’re not. They are good traders because they’re good managers of their trades.
Your assignment for this lesson is to assess your trade management as a separate profit center. Do you scale into trade ideas? Do you act aggressively on your best ideas when you are right? If you’re like many traders, this is an underdeveloped part of your trading business. It may take a return to simulation mode and practice with small additions to trades to cultivate your trade management skills. It may also mean that you structure your time while you’re in trades, highlighting the information most relevant for the management of your particular idea. Most of all it means cultivating an aggressive mindset for those occasions when you know you have the market nailed.
As your own trading coach, you want to make the most of your assets. It’s easy to identify traders who exit the business because they lose money. It’s harder to appreciate the equally large number of traders who never meet their potential because they don’t make the most of their winning ideas. A great exercise is to add to every position at least once on paper after you’ve made your real-money entry. Then track the execution of your added piece, its profitability, the heat you take on it, etc. In short, treat trade management the way you would treat trading a totally new market, with its own learning curve and need for practice and feedback. You don’t have to be right all the time; the key is to know when you’re right and make the most of those opportunities.
COACHING CUE
Track your trades in which you exit the market prior to your stops being hit. Does that discretionary trade management save you money or cost you money? It’s important to understand your management practices and whether they add value to your business.
RESOURCES
The Become Your Own Trading Coach blog is the primary supplemental resource for this book. You can find links and additional posts on the topic of coaching processes at the home page on the blog for Chapter 8: http://becomeyourowntradingcoach.blogspot.com/2008/08/daily-trading-coach-chapter-eight-links.html
Jim Dalton’s books are excellent resources when it comes to developing a conceptual framework for trading. I recommend Mind Over Markets as a first read, then Markets in Profile. Both books are available on the site where Jim and Terry Liberman offer training for developing traders: www.marketsinprofile.com
An excellent book on risk and risk management is Kenneth L. Grant’s text Trading Risk (Wiley, 2004).
Exchan
ge Traded Funds (ETFs) are an excellent tool for achieving diversification. Two good introductions to ETFs are David H. Fry’s book Create Your Own ETF Hedge Fund (Wiley, 2008) and Richard A. Ferri’s text The ETF Book (Wiley, 2008).
I receive a number of questions regarding seminars, courses, and other resources that are offered for sale under the general rubric of trading education. My impression, and the feedback I get from blog readers, is that these offerings are often expensive and of limited relevance to the particular strengths and interests of individual traders. Similarly, I receive many inquiries into proprietary trading firms, which allow traders to trade the firm’s capital in exchange for a share of profits. Some of these firms are quite professional and ethical; others are not. I strongly encourage due diligence: talk to a number of people who have taken these courses or who are trading at these firms. If you cannot get direct feedback from actual users (not just one or two stooges), move on. Don’t pay thousands of dollars for something unless you know exactly what you’re getting.
CHAPTER 9
Lessons from
Trading
Professionals
Resources and Perspectives
on Self-Coaching
Anyone who fights for the future lives in it today.
—Ayn Rand
In this chapter, I sought the perspectives of experienced traders who share their views on the Web. The question I asked them was simple:
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