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ON
DAY TRADING
friend. First I asked him why he cared about wheat. He said he had been contacted by
"some broker" who wanted him to buy options in wheat because it was "going to go way
up!" I explained to him that it didnt look like it wanted to go up to me. In fact, it looked
quite the opposite. If he really wanted to impress the broker, he should tell him that he
didnt want to buy the options, but that he would be glad to sell them to the broker and
take the other side of the trade.
That was the last I heard about it. A couple months later (Wheat was at 278), I asked him
what he had done about that wheat. He said "Oh, gee, Lee! That was the worst
experience of my life!" I asked him if he actually bought the options, and he said "Yeah,
I bought them. I lost $30,000! I'll never do that again.that stuff is too risky for me".
So, he had asked a professional for advice, but then went against it. where did the risk
come from?
Risk comes in many forms, but the greatest risk you can ever take in life is the risk of
never giving yourself an opportunity. That isn't necessarily a trading-related statement,
but it certainly does relate to the "risk" involved in trading.
Risk in trading can be defined as the amount of money that one can theoretically lose on
a given trade. That risk is absolutely huge.almost infinite. In an attempt to control that
risk sufficiently, it is always prudent to trade the most liquid markets, or those with the
most volume. The Treasury Bond futures, for instance, often have 300,000 to 400,000
contracts traded during a trading day. That amount of volume almost insures you the
ability to get out of the market whenever you want to. That means if you have placed a
stop loss order to limit the loss to $500, there is about a 98% probability that your loss
won't be more than $500.
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Another way to quantify risk in trading is to attempt to determine how much risk you
might have in following any given trading methodology. That can be a slightly more
difficult aspect to corral accurately.
Most traders are concerned about the maximum drawdown of any given methodology.
Systems are sold with the historical maximum drawdown shown, and are often rated on
the basis of how low (or high) that drawdown is. Let me make a statement that I believe
is unequivocally true. Maximum drawdown is probably the most unreliable figure you
can get from either a realtime or hypothetical track record. It tells you how bad things
ever got over the course of the track record. It is not an indication that things will ever
get that bad again, nor is it a guarantee that things will not get worse. In short, it doesnt
tell you anything about what you can anticipate in the future.
Let's look at a common scenario, where "experts" tell you to capitalize your account to
expect 1.5 or 2 times the historical maximum drawdown. Now, let's say you have a
system that makes $150,000 over ten years with only a $2500 drawdown. If you trade
that and suffer a $6000 drawdown, does that invalidate the system? If someone showed
you a system that made $150,000 over ten years with a $6000 drawdown, wouldnt that
look like a good system to you?
Maximum drawdown truly offers you no clue as to what to expect in the future. The only
thing you can deal with is the immediate, which to my mind means to attempt to quantify
the risk on the current individual trade.
In general, you should attempt to keep the risk on each individual trade as a fixed
percentage of your overall account. That can be 1%, 2%, 5%, 10%, or whatever you
wish. You should understand, however, that the more you risk, the more volatile your
return is going to be. More risk should bring about more profits over the long run, but it
definitely will bring larger drawdowns, including the potential of a catastrophic one that
will wipe you out.
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Let's assume you have a $50,000 account and decide to risk 2% per trade. Now, this
cannot be quantified precisely due to slippage and overnight gaps, but you can maintain
rough guidelines. If the trade you are considering has a potential risk of $300 per trade,
you can trade 3 contracts since 2% of $50,000 is $1000. You simply divide the chosen
percentage of your account by the risk, then trade just the whole number answer. 1000
divided by 300 is 3.333, which you round to 3 contracts. If the risk was $450, you could
only trade 2 contracts, since $450 goes into $1000 twice. If the risk is over $500 you
could only trade one contract, and if the risk is over $1000 you have to bypass the trade.
While this is not a perfect solution, it does manage to keep you basically out of trouble,
and it allows you to trade larger size as your account grows. As a rule, smaller accounts
have to risk a larger percentage out of necessity. It is not uncommon for a $10,000
account to risk 10% or more, while the multi-million dollar fund will risk 1/4 of 1%, or
less. Who do you think has the greatest potential rate of return? Obviously, the amount
you risk and the amount you can make are generally NOT inversely proportional. The
more you are willing to risk, the greater your potential return is, but then you also have a
greater likelihood of losing it all.
If you are in doubt as to how much you should risk, always err on the conservative side.
Risking less may cost you money on individual trades, but it greatly increases the
likelihood of your account still being around to take the next profitable trade. If you risk
your entire wad and lose, you can't trade. And if you can't trade, you can't make any
money in the markets. Longevity is a key to success.
Using a small percentage will keep smaller accounts out of a fair number of trades, but
that has a very interesting benefit; If you are trading a methodology where the risk is
defined by market activity, the smallest risk will be when the market is the quietest. That
is, trading in very small ranges. Those small, tight ranges tend to be an indication that a
substantial move may be imminent. This is a benefit to larger accounts as well, since the
smaller risk will allow them to trade more contracts. Smaller accounts simply have to
have more patience to survive and prosper.
If I had to make a suggestion based on various account sizes, I would suggest a $15,000
account risk no more than $1000 on any given trade; a $25,000 account risk no more than
$1250; and a $50,000 risk no more than $1500. This is about 7%, 5%, and 3%
respectively. You can risk more or less, depending on your personal tolerance for risk,
but those are reasonable guidelines.
Additionally, you should also put a limit on the total amount of an account at risk on all
trades combined. This can be a fairly liberal figure, say anywhere from 30% to 50%.
The chances of having 10 trades, each with 5% risk, all go against you simultaneously is
fairly small, but you should always prepare for the unexpected that can't possibly happen
and probably will. (I just love that quote!) When approaching this total risk limitation
(or margin constraints) you either have to cut out the trade that is performing the worst at
the time (has the largest open loss), or not take any additional positions until the
limitation enables you to. My preference is to not take additional positions until my risk
parameters say I can.
Again, there is no magic number for risk per trade or total amount of risk. It has to be
based on your own tolerance for risk (and pain) and your own comfort level.
Equalizing the risk on each trade is the only logical method of asset allocation. The focus
has to be on risk, since it is the only aspect of trading that you have a modicum of control
over. Let's say you have decided that you dont want to risk more than $1000 on a trade.
Now, there can be overnight gaps; you can have slippage; you have to pay commissions;
there are potential execution problems. Within reason, however; you can come very
close to being certain that you dont lose more than $1000 on that trade. On the other
side of the coin, what if you want to make $1000 on a trade? You can't do anything to
ensure that you will make $1000. You simply put on the trade, then hope, pray, drink,
curse, or whatever, but it is out of your control. Risk can basically be controlled, and that
is our primary job as traders.
That basic truth is that each bar has to make both a high and a low. It doesnt matter how
active or inactive, or whether the market is going up, down, or sideways. Each and every
bar will make a high and a low.
It should be equally obvious that one has to make before the other. That is, a bar will
either make a low and then go make a high, or it will make the high first and then go
down to make the low. Attempting to understand exactly which is unfolding can be a
tremendous help in anticipating price action.
The direction that any given price bar takes is directly related to when the high and low
forms. If a market is going to up for the day, for instance, it will generally make the low
first, then spend the majority of the day traveling up to make the high. Conversely, a
market that is going down will normally make the high of the day first, then go down to
put in the low.
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How can this information help you? By making you aware of probable direction. When
I daytrade, I am always trying to determine if the market has created the high or low for
the day. I dont need to be the hero that picks the exact high or low in order to make
money. I just need to be aware of what has happened, which clues me in to what should
happen. If I can recognize that the low for the day has probably already been created,
then I can assume that we need to go up to make the high. I have a firm opinion on what
the probable direction should be, so I know which side of the market I want to trade on.
The time frame that you trade in is a personal decision. It should be directly related to
your personality and temperament. Everyone has a different comfort level, both in terms
of risk and length of time holding positions. While I make use of the directional bias for
daytrading, there is no reason it can't be used by longer term traders.
A monthly bar, for instance, also has to make a high and a low. If you can recognize that
the market has probably made a high, you can look to the short side of the market
knowing that it has to go make the low for the month somewhere.
If you remember that a market going up will generally make a low first and a market
going down normally makes the high first, it can also clue you in to problems with a trade
you are already in.
Let's say you are short some market and you are anticipating that it ought to go down for
3 months or so. If you can recognize that the current month seems to be making the low
first, isn't that important information? You could perhaps exit the position and make
more money than you would have. You could even go back short once the market goes
up to make the high, if you still think your original position is correct.
In 1997, the Japanese Yen started the year absolutely falling like a rock. It had been as
high as 12625 in April of 1995, and had been coming down hard ever since. In early
1997, it reached back down to the levels it had been trading at in 1992. it certainly
looked like it was making the low for the first year. I am primarily a daytrader, but I told
numerous clients that I thought it was making the low for the year around 8000. it went
as low as 7894 on May 1 (making the low for the month first), and was over 9000 by
June 11! These indications can be dramatically profitable!
There is no magic way to always know whether the high or low for any given price bar is
in. if you can make some reasonable assumptions based purely on recent price action, it
will greatly enhance your understanding of the flow of the markets.
market to take will be much clearer to you, and it should help you obtain much better
trade location for your positions.
Of course, the vast majority of traders need to be able to trade on a reasonably short time
frame in order to control the risk, but at the same time, dont have real time quotes and
the ability to monitor the markets on intraday time frames. There needs to be a logical
way to make use of our knowledge of how markets operate without forcing us to become
full time traders. Fortunately, such methods do exist.
The best way for most traders to participate in probable market moves on a short term
basis is probably to use some form of opening range breakout as a trade entry. This
involves buying or selling a market once it has moved a certain distance away from the
morning opening. For instance, you could have a rule to buy any time the market has
moved more than 50% of yesterday's range above the open. You would simply multiply
yesterday's range by that percentage (let's say 55%), then add that to the open to place
your buy stop.
Here is an example: The June 1997 S&P 500 (SPM) on 6/5/97 had a range of 870 points.
It had a high of 85130 and a low of 84260. If you subtract the low from the high (8513084260) you get 870. Now, we will multiply that 870 by .55 (which is 55%) to give us
478.5. We always round our answer up to the nearest whole tick increment, and the S&P
trades in 05's. That means our answer could either be 475 or 480, but since we always
round up, it would be 480.
That 480 is the figure that we will add to the next day's open to get our buy price, or
subtract to get the sell price. The open on 6/6 was 84425. 84425 minus 480 equals
83945. We would place an order to sell the SPM at 83945 on a stop. 84425 plus 480
equals 84905, which is where we would place our order to buy on a stop.
The data for 6/6: open 84425, low 84410, high 86270, close 86250. If you had bought at
84905 and exited on close at 86250, your profit on one single contract would have been
$6725, minus any slippage and commission. Not bad, huh?
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Buying some fixed percentage movement away from the open makes use of the concept
of utilizing the direction in which the daily price bar gets created. Studies by numerous
people over the years (Hadady, Crabel, etc.) all suggest that the opening price of any
given day is within 10% of either the high or low of the day about 90% of the time.
Obviously, any significant move away from that opening price is a good indication that
we have started on the basic direction of the day.
Exactly what percentage to use is a difficult question. The smaller the percentage used,
the earlier you will get into the move. That means better trade location, but it also means
more false signals and more losses. As a rule of thumb, you probably want to use at least
50%, with figures up to 100% and higher generating far fewer trades (and less profit) but
more reliable entries. There is, however, no universal, magical figure.
Percentages aren't the only way to do it. You can also wait and buy a breakout of the first
hour of trading. It could be 30 minutes, 45 minutes, 90 minutes, etc it doesnt have to
be just the first hour. You wait for the market to create the range for the first however
many minutes, then only trade if it makes a new high or low after that. Incidentally, if
you had used that strategy on 6/6/97 in the SPM, you would have bought at 84980.
We are discussing this as if you simply take these positions, then exit on close with
Market on Close order. There may very well be good reasons to hold them longer but we
are simply discussing daytrading.
There are a whole bunch of other little tricks you can use to improve your daytrading
performance. You can only take trades that go opposite the direction of the previous
close, for instance. Believe it or not, there is a higher probability that a market will close
up today if it has closed down yesterday, and vice versa. Fading the direction of the
previous close is a pretty good filter! You can also only buy a market that opened lower
than the previous close, or sell one that opened higher. None of these are necessities to
be profitable, but they are reasonable filters if you want to cut down your trading
frequency. Trading too often not only generates more commissions, it also increases the
strings of losses, which is never a pleasant experience.
IN CONCLUSION
1. Control the risk.
2. Finding a way to get positioned in the proper direction.
3. Understanding the basic flow of the market for direction.
These are the cornerstones of good, profitable trading. There is not just one single
correct way to trade. It is up to each individual to find both method and a time frame that
is suitable to his or her personality and temperament.
Hopefully, there are enough clues and good information contained in this manual to at
least get you started in the right direction. Remember those three cornerstones, and you
should always have a leg up on the competition. Good luck with the journey ~ and may
it be a profitable one!
Cordially,
Lee Gettess