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Method to Madness

"Though this be madness, yet there is method in it."
Polonius, Hamlet by William Shakespeare

Couple posts ago I promised to return to the idea of the setup's structure. In order to come to it, however, I need to start with more broad theme - one of the adjustment and re-adjustment to changing conditions. Here is where the importance of the topic stems from: for many trading presents enormous difficulties because market is an unstructured environment. We are not readily wired to act correctly under such conditions. Our comfort zone lies in having schedules, guides, instructions, manuals, road maps and signs. When we are not familiar with the structure of our surroundings, we overcome the difficulties by learning it - looking at the map, reading the manual... but what do you do when you need to act with certainty in uncertain environment? Environment that changes by minute, by day, presenting new challenges, obeying new rules, being influenced by new factors? You work out the method to your own actions. You create algorythm which governs not only your course of action but also your course of adjustment - the way you change your behavior when the surroundings change. Those who trade long enough know very well how often they had to adjust to constant change. Fractions to decimals, anyone? 25K rule? Order routing? Bull to bear to lull?

This kind of changes for an experienced trader is similar to finding a new route for his routine trip when city authorities close the road for renovation. Not a biggie, right? Inconvinient, sometimes time-consuming but not a big deal. However, for a newer trader starting out in this profession the analogy would be more dramatic. Moving from a ghost town in prairies to New York perhaps? Let's throw in different language, absence of any prior information of what the big city is about, unfamiliarity with the concept of municipal transport and apartment buildings... now we are talking. Total chaos, no structure to dictate your action, strange life seethes around... and you need to do something. Will your first steps be the right ones? Most likely not. They will be much better when you learn the structure of what's going on, what elements are there and how they interact. This is what a trader starts with as well - providing he or she realizes the need to learn instead of diving in headfirst (always amazes me how many do just that, what is it about this profession that makes it look like it can be mastered without learning??).

So, you start with attempting to learn more about markets... and wierd thing happes - it doesn't get you anywhere. You just mastered the concept of earning announcements, EPS, price to earnings, learned to read balance sheets, you feel like deep dark secrets known to few have been opened for you... yet price action doesn't match your expectations. Wait, but what happened to our analogy? Learning the layout of the streets in your new city and what transport is available and what its schedule is, wouldn't you become capable of getting around? You would - but the analogy has ended earlier. It described your lack of understanding of what was happening around you, and that's it. Major differencies started after that - city is STRUCTURED. Markets are NOT. Not in the way you expect them to be, anyway.

Next thing that is likely to happen to you is getting familiar with technical analysis. Ahhh, that's where the problem was - there is this voodoo that for some reason impacts the movement... or does it? Or does it just reflect the movement in a certain visual way providing some hints for a scholar? Those are questions you start encountering while studying MAs, BBs, dark clouds and hanging men hit by shooting stars, and all other dolls and pins also known as studies and indicators. Your knowledge grows by day... does your trading account? Ummm... most likely not.

By no means do I want to say that all I listed above is not needed. Why, all this learning is necessary, or at least some elements of it - I for one still wouldn't be able to tell the balance sheet of Microsoft from one of Bre-X. It's just that it's not enough - not until you create YOUR OWN METHOD. Remember our very first article in this blog? We talked about indicators not being able to create profit by themselves and serving only as a tool. This is where we return to this theme. All this learning provided you not with answers but with tools to get them. No hammer goes ahead and drives nails in the wood without you. It just provides you with means to do just that. Now it's time to create your trading approach utilizing those tools. What kind of hammer do you need for the job? How do you hold it? How do you swing it? What kind of nails? Answer these questions, practice a bit and your nails hold two wooden details together.

What kind of questions do you ask (and answer) in order to create your trading system? And finally, how do you form your setups and what is their structure? Next post.

Let's Add Voice to the Text!

Yesterday I gave little interview to Tim Bourquin, Founder and CEO of http://www.traderinterviews.com/ . Knowing Tim for many years now, I am not in the least surprized by the quality of the site. Top notch material, rich and innovative. Have a look at http://www.traderinterviews.com/idealab while browsing the site.

You can listen to the interview here

A Trader's Development

We had an interesting exchange in the trading room on Friday, discussing a trader's development, things to focus on, typical mistakes etc. This kind of discussions breaks out now and then amidst all the market chatter and particular calls. It presents invaluable opportunity to review one's path and make necessary corrections, mostly because, unlike generic books and articles, this kind of discussions is usually triggered by particular question, thus becoming very relevant and personalized. Check it out in our trading log (link on the right under Education tab) for May 18, from 9:58 to 10:30 (times are PST).

STOPS: Why Don't We Keep Them

With everything said and written on the subject of stops, it should be given that everyone is conditioned to keep them religiously even before they start trading. No matter what source a newer trader turns to, utter importance of stops will be underlined and emphasized up to the degree that keeping them is heralded as the ultimate key to success. We all heard adages like “Take care of your losses, profits will take care of themselves”.

Do all the stern warnings work? Not really.

Time and again traders blow their stops, widen them in a course of a trade, hold losing position in a false hope it will make them whole. If this destructive behavior continues despite all the warnings, there must be deeply rooted reasons for this. As with most trading flaws, failure to keep stops roots in fundamental misconceptions about the very nature of the market and trading. Such misconceptions cause incorrect psychological makeup which, in turn, results in behavioral patterns harmful for a trader’s performance. In order to re-condition oneself it is necessary to work out fundamental, even philosophical if you will, understanding of the market as an environment in which a trader operates.

Let us list and analyze the misconceptions that cause failure to keep stops.

Right action must result in profit.

This misconception stems from misunderstanding of the very nature of the market as an uncertain environment. Newer trader sees a market as a conglomerate of firm links between reasons and outcomes. In such a conglomerate, every reason results in single possible outcome. The simplest case of such link would be “good news – up, bad news – down”. We know it’s not true – price reacts to news in a wide variety of ways.

Similarly, an inexperienced trader applying the setup he knows “should work” expects every trade to be a winner, providing all the components of the setup are right. Have you ever heard complaints like “Everything was exactly like in that book, yet the trade failed”? That is direct result of this misunderstanding. Everything may be right, yet the trade fails – just because markets work in probabilities and not in certainties.

If a system produces certain percentage of wins over time, it’s just statistics – and, as it is always the case with statistics, it cannot predict an outcome of a particular trade. No matter how good the setup is, any given trade can fail. That’s why it’s imperative for a trader to distinguish between two kinds of losses.

The first kind is a loss caused by a trader’s mistake – failure to follow all the rules of system applied, or impulsive entry without any reason at all. Such losses must be taken as a lesson. The second kind is the case where every piece of puzzle was in place, yet the trade failed – such losses must be written off as a part of trading game, as a tribute to uncertainty of the markets.

Of course, if you identify a component of your trading system that regularly causes trade failure, you can and should tweak your system in order to minimize failures. However, during the trade a stop must be taken as soon as signal of failure appears. The line of thinking “The setup was so good, it must work eventually” is a disaster waiting to happen.

Failure to perceive the market as an uncertain environment can result in another misconception:

Losses can be eliminated.

In a paradoxical way, this erroneous notion leads to more losses. A trader tweaks his system endlessly trying to get rid of losses completely. In such constant adjusting and re-adjusting, the system evolves into something totally different, losing its original logic, or even stops producing entry signals at all. As a result, a trader either abandons his system, which was not a bad one to begin with, or in a worst case, simply refuses to take losses. After all, he made his system so perfect by eliminating all the reasons for failures, it just MUST work! Meanwhile, had he stayed with original approach, maybe with some minor tweaks, it would continue producing steady results.

My trade is who I am.

This is one of those hidden subconscious misconceptions that cause us to refuse to take our stop. A trader perceives the result of his trade as a reflection of his personality, his abilities. A trade failure makes him feel as though he is a failure. Winning makes him feel "right", while losing makes him feel "wrong". Nobody likes to be a failure, to be wrong. That’s why, in order to avoid being wrong, we refuse to take our stop. You can be right and still lose on this particular trade. You can be wrong and win, too.

It’s important to differ between good and bad trade, and we will be back to this later, in the Random reinforcement part. At this point it’s important to separate your self-perception from the result of your trade. Taking a stop loss, you are stopping your loss – nothing foolish about that. The major trigger for the right approach here is a realization that by accepting the market as an uncertain environment, we already have accepted the possibility of losses. If we haven’t expected the market to work in our favor every time, there is no reason to feel foolish when it doesn’t.

A loss is just a paper loss until it’s taken.

This is a big mistake in thinking. If a loss gets out of hand, it’s very real. It paralyzes you, it clouds your judgment, and it makes you miss plenty of other opportunities. Instead of taking a pre-determined loss and moving on to another trade, you sit and watch your losing one, twitching in pain and feeling remorse. Your chance to take a small stop is long gone. You are agonizing now over big one that is going to deplete your account too much and inflict serious emotional wounds. You hardly notice many other opportunities. The market has moved on, other sectors and stocks are in play, and you still nurture your losing trade, hating it and not being able to finally drop it. At some point you will ask yourself "Why was this trade so important to me? What made me hold onto it?" And this takes us to the next common error:

Putting too much importance into single trade.

A newer trader tends to see each trade as overly important, as if it’s going to make or break him. The market is an endless stream of opportunities. The next trade is right around the corner. No single trade is so important that it would be worth abandoning all other opportunities. Perceive your trading as a process, not as separate events. With the correct approach trading becomes natural, like breathing. Each entry is inhale, each exit is exhale. Breathe in and breathe out. Don’t choke yourself trying to hold onto each given breath.

Random reinforcement.

This is an important concept to understand. The market is not always rewarding right decisions and punishing bad ones. The practical implication is that a trader runs a risk to stop applying proper techniques if he sees wrong ones being rewarded sometimes. Take a stop, observe a stock reversing and going into profit zone – and you get tempted to skip your stop next time. If you try it and it works, there is significant chance that you continue doing just that – the bad habit gets reinforced. You may win several times by breaking your rules. What happens eventually is that one trade that does not reverse destroys your account. It’s important to define what good and bad trades are. Unlike many think, a good trade is not always a winning trade; a bad trade is not always a losing trade.

- A good trade is a trade where you kept all your rules that you know to be working in a long run. A good trade can be a winning one when the market acts accordingly to what your system indicates. It can be a losing trade when the market acts against it, but it’s still a good trade.

- A bad trade is a trade made against your better judgment, against your rules. It can be a losing trade when a market acts as it “should”. It can be a winning trade when the market rewards your bad judgment, and it can be a very dangerous trap as a bad habit gets reinforced.

The last thing to say in conclusion is that a certain psychological barrier for a trader to overcome to start applying his stops with no hesitation. When this barrier is taken, things suddenly become so clear and automatic that a trader can’t even believe it was ever a problem for him. When this barrier is overcome, you feel that stops became natural part of your trading, that you take them with no slightest hesitation and forget about them instantly, moving on to search for your next trade, that taking stops do not trigger any negative emotions. This is wonderful feeling of total self-control. Not only will it do plenty of good to your trading performance, it’s a very rewarding feeling in itself.

STOPS: a Deeper Look

In previous post I described a general approach to stops placement and trailing, and I also touched on the subject of contrarian trading. Let’s expand on this matter.

Obviously, if a method of a stop placement becomes commonly known and broadly used, sooner or later you will run into situations where the method “stops working”. In practice it means that the way you place your stops starts producing a higher percentage of cases where your stop gets hit just before the trade reverses and returns into a profitable zone. This phenomenon reflects the very nature of the market – it works in a way that allows the minority of players to take the majority’s money. According to this concept, every strategy goes through certain life cycles. At first it’s used by minority and produces a high percentage of success. As it becomes widely known, this percentage reverses and the strategy starts losing money. As the majority gets frustrated and abandons the strategy, it “starts working” again. You can read more on this in The Master Profit Plan .

So, how can we utilize this understanding? There are two approaches to this matter. The first is defensive: Change your strategy in a way that puts you outside of the zone targeted by Smart Money. In practice it means that you need to analyze the charts of failed trades to find out more optimal level for your stops. Let’s illustrate this. Fig 1 shows a generally accepted approach to stop placement for a simple case of range breakout.








Fig 1. Original strategy

This method works successfully while trades executed in this manner work as shown in Fig 2: they reverse before hitting a stop (line 1) or, if a stop is hit, they proceed lower (line 2).








Fig 2. Original strategy works.

However, if you run into an increased number of situations, where your stop level is hit just before the trade reverses and returns into the profit zone (as shown in Fig 3), your method is getting “faded” – Smart Money has recognized the majority’s ways as an opportunity and started trading against it. You have probably heard the expression “gunning for stops” – this is exactly what is shown on Fig 3.








Fig 3. Original strategy is faded.

In order to incorporate this change in your strategy you are going to have to change your stop placement so that it is located under the point of reversal. It involves observations to spot the most probable level of reversal after hitting the stop. Obviously, you will also have to decrease your shares size since your stop became wider. I would call this action an attempt to escape Smart Money stop-gunning.

While this approach is acceptable to remain profitable, my heart goes to another method: an offensive approach. It essentially comes to placing yourself on the Smart Money side. This is where your strategy gets way more sophisticated. If you are in a choppy market where the breakouts are faded on a regular basis, start fading them instead of trading them – after all, pattern failure is a pattern, too. Or, if you are still in trending market but the pullbacks like the one on Fig 3 occur on a regular basis, change your entry idea: Instead of an entry at the breakout point, look for the reversal under the conventional stop placement level, to utilize this new pattern. This is a very powerful way to optimize your trading. By doing this, you place yourself against the crowd and side with Smart Money.

You can feel that this approach requires constant monitoring of market conditions and adds a certain creativity in your trading approach. This is exactly what separates a seasoned trader from an amateur: being in tune with the market, changing with it, spotting new opportunities and weeding out those that cease working.

Now, if you review the second paragraph of this article again, you will probably ask yourself: is it correct to say that the strategy stops or starts working again? This is a valid question and that’s why I put those expressions in quotes. A strategy never stops working – it changes the way it works, presenting you with a different set of opportunities.