Entering into a trade is given a great deal of weight by non-professional traders but there are equally important skills needed in risk management and good exits. It is OK to get into a bad trade as long as you manage it well. As a starting or intermediate trader it will be your skill at running with good trades and cutting bad trades short that will make you profitable because you will have more bad trades at this stage than you will later on with more experience.
Why Does Trading Work & What Results to Expect
Let’s compare trading to a skilled profession to understand the important differences. In a skilled profession where you are the craftsman you perform a sequence of tasks based on your experience. You are largely in control of the future events that will complete the job. In trading you cannot control any future events in the market.
If you saw a person walking down the street then how accurately could you predict his action in the next minute? 15 minutes, hour? day? week? month? With each time frame extension the information you have gained over the last few minutes becomes less relevant and future outcomes are less reliable. However, what if you knew a lot about this person: you knew what their car looked like, where they lived, worked, and their favorite places to eat. With this information you could make accurate general predictions of their most likely actions on a longer time frame. You can’t account for illness, dentist appointments, and other less predictable changes in their patterns. It is the recognition and use of patterns that we use to trade the markets. It is impossible to perfectly predict the outcomes of patterns due to the number of unknowns that still exist, so we settle for 58-60% as a sign of excellent performance. With proper risk management and exit management we can be profitable down to 50% winners.
Sports betting is quite similar to securities trading. A good record for a sports bettor is any record equal to or larger than 52.4%, because that number or anything higher means you’re not losing money. A 53% winning record, while not impressive on paper, means you’re actually beating the sports book and putting money back in your pocket. If you bet through an organized betting establishment then you odds are much lower because they will skim 10% from the betting. This does not occur in securities trading.
Three Elements to Successful Trading
1. Trade Size
Let’s play a coin flip game. Heads you win $1, tails I win $1. The only difference is I have infinite money, and you have $100. Even though the coin flip is a 50/50 chance, this game will end with me having all of your money. The reason is, once you lose your last dollar on the inevitable losing streak, you don’t have any more dollars to bet against me. In trading the risk and reward do not need to be equal. If your profit target is $75 and your stop loss is $50 then you will make money when you play me if you don’t bet too much. Never forget that high bets will wipe you out on even a short losing streak. Calculating the right amount to trade is not hard and is covered below on this page.
Ralph Vance did an experiment with 40 PhD’s in which they would gamble 100 times in a game where they would be guaranteed to win 60% of the time. They started out with $1,000. If they had bet exactly $10 on each round they would have each had $1,200 left at the end of the test. If they had bet the mathematically optimal amount of 20% (the Kelly Value below) then they would have had $7,490. However, only 2 had more than $1,000 at the end of the test. Over sized bets is not unusual among traders and is the reason for trading disasters that happen to some of them.
How to Calculate Trade Size
In probability theory, the Kelly strategy is a formula used to determine the optimal size of a series of trades. In most trading scenarios the Kelly strategy will do better than any other in the long run. It was described by J. L. Kelly, Jr in 1956. Kelly mathematicians (and me) usually argue for fractional Kelly (betting a fixed fraction of the amount recommended by Kelly) for a variety of practical reasons. The Kelly formula does not account for non-deterministic events (variations in results due to unpredictable short term variations in the winning percentage). In recent years, Kelly has become a part of mainstream investment theory and well-known successful investors including Warren Buffett and Bill Gross use Kelly methods.
If your winning percentage is 60% and your risk/reward is 1.5:1 then the formula would be .33 = (1.5*0.6-0.4)/1.5 or 33%. I like to use a fractional value of 20%-25%. So if you have a $5,000 account with 60% winners and a 1.5 risk/reward ratio then your Kelly value would be $1,666. Multiply $1,666 by the fractional value of 20-25% then you get $333-$417. Therefore $333-$417 is your maximum stop loss for the entire trade. Do not enter a trade unless you can use a $333-$417 stop loss on the entire trade, you have a profit target of $500-625, and your winning record is about 60%. To the extent that you do not follow these calculations your risk of losing your entire account becomes significantly greater than zero.
For more in depth coverage of the Kelly strategy see the following article: Optimizing your Trade Size for Maximum Long Term Profits: Kelly Criterion.
2. Opening a New Trade
When we open a new trade it is a thoughtful process of weighing the risks vs. rewards and the probability of a successful outcome. We study the charts for familiar patterns and seek secondary confirmation from other sources of information.
In the previous example of predicting the future actions of a person walking down the street, we want to look for patterns that repeat. If that person walked into a restaurant at lunch time then we could predict that he would remain in that establishment and eat for 30-60 minutes. He might just use the bathroom and take only 10 minutes, but at least 60% of the time he will eat, so we have a good trade on that information.
There are many other similar patterns like playing sports, going to work, etc. that we could eventually define that would give us good predictive value. In the same manner we look for patterns in the market that will give us short term information on what the market will do next.
Where to Look for Patterns
- Raw Price Action
The following bullish patterns use the raw price action in that the charts have not had their appearance altered and we are not relying on any indicators. These are reversed for bearish trades. The picture at the top is an example of the use of higher lows off of a support level. The pictures below represent examples of some common patterns. There are whole books written on them so we won’t cover them in detail here but I am showing you my favorites.
These types of patterns are little gold mines when they occur, but we will need more ways to trade because you may not see them often enough each week. The chart below shows the most frequently occurring intra-day and daily patterns.
If you trade stocks then you will see these patterns more often due to the large number of stocks to pick from, but you will need to do a lot of looking each day.
For more in depth coverage of chart patterns see the following article: Mastering Chart Patterns – A Guide to Profitable Trading.
Support and Resistance
The above example speaks for itself. A support level is a price level where the price tends to find support as it is going down. This means the price is more likely to “bounce” off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely to continue dropping until it finds another support level.
A resistance level is the opposite of a support level. It is where the price tends to find resistance as it is going up. This means the price is more likely to “bounce” off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely that it will continue rising until it finds another resistance level.
For more in depth coverage of support and resistance trading see the following article: Trading Support & Resistance.
Floor Trader Pivots
Floor Trade Pivots are an important source of intra-day support and resistance. The FTP levels are calculated each day based on the previous day’s high, low, open and close.
Candlestick Patterns
Candlestick patterns are another source of patterns. They usually involve just a few bars.
You can combine patterns that are weak but frequent to make stronger ones:
Under no circumstances should you place your trade against the current price direction in anticipation that the market is about to change direction. Picking tops and bottoms is a sure way to lose money.
For more in depth coverage of candlestick patterns see the following article: Understanding Candlestick Patterns and Charts.
- Derivatives of Price Action
Renko bars, Range Bars, and P&F charts are often seen as magic tools to trade successfully. This is mostly because they look great in retrospect. As long as you just look at historical patterns it looks like easy money. In real time trading it is not so clear and traders are often no more successful than they were with regular charts. Day traders often use tick volume bars, which is a good alternative to time based bars (the bars look like regular bars but they are based on trade volume not time).
I have seen people refuse to entertain anything other than a range bar chart because they were convinced that these charts held the secret to success and everything else was inferior, but they could not get them to work. It is usually just a mirage but some people are successful with them.
If someone is praising the virtue of a funky looking chart, always ask him how much money he is making with it. I had to look through a lot of charts to get one that looks as clean as the one on the right. The rest of the charts looked pretty untradeable.
- Indicators with Price Action as Input
Indicators are a way of smoothing out the price action or to mathematically evaluate it. Indicators can remove the short term noise to see the underlying trend. They can also be used to establish rules that will keep your trading consistent.
For example. you could use two moving average lines and only buy when the faster moving average is above the slower one and only sell when the faster moving average is below the slower one. If it helps you to be consistent then it can make you more profitable by giving you consistent action points. The below indicator set is an example of a number of similar packages that can help you make better choices.
Confirmation
Every day there are a number of different signals generated from different methods for predicting the future direction of the market. Some signals are generated very frequently but are well below our target of 60% winners. We can use these signals to weed out some of our bad trades. The confirmation signals need to be present often enough and of sufficient quality to avoid vetoing too many good trades.
The key to making good trading decisions is to pick good primary signals and good confirming signals.
Charles Dow was an important trader that founded the Dow Jones Industrial Average. He used the rail stocks (Transports) to confirm moves in the industrial stocks. The idea being that the industrials had their product moved by the rails in most cases. Strong rail volumes confirmed that the industrials were producing more.
Confirmation improves your overall performance by increasing the percentage of winners. It reduces the number of winning trades and losing trades, but the reduction in losing trades should be greater in its effect than the reduction in winning trades. If you had 120 winning trades and 90 losing trades, then you have 57% winners. By using confirmation you will probably remove 19 winners and 31 losers. The new numbers are 101 winners and 59 losers: 63.3% winners.
The improvement that confirmation provides is a key step in achieving the highest levels of trading performance.
A classic way to confirm a trade is volume. If a breakout occurs on above average volume then the move can be considered confirmed. Confirmation needs to be thoughtfully applied because there are no “Laws of Confirmation” that always work. On a gradual advance higher, there probably won’t be volume confirmation.
From the chart on the right you can see that volume does work sometimes, but not always. Sometimes volume indicates a blow-off top. It will take some practice to make volume work for you.
Using candlestick chart interpretation theory you can find confirmation. Patterns like the Hammer, Hanging Man, and Shooting Star can provide effective trade confirmation.
Indicator signals are a very common way to find confirmation. Some indicators are based on the price action and primarily serve a delaying effect to get you to wait a little longer. A classic example of the delaying effect is to use two moving averages: when they cross over to the up side then go long and when they crossover to the downside then exit (or go short). MACD is often used for similar reasons.
3. Exiting a Trade
The skill of the exit is probably more important than the entry. Most people will lose money below 55% profitability because they trade too much size and wait too long to exit a loser. But exiting a loser too soon will drop you winning percentage so low that you will also lose too much money. The key is to exit neither too soon nor too late.
You need to give the trade some room to go against you or you will miss out on too many winners. The market has a thing called “noise”. It is just the randomness that increases as you look at smaller and smaller time frames. Don’t let the noise knock you out of a trade and always pay attention to the underlying trend. If you leverage support and resistance then you can tighten up your exits.
If support is broken, then more selling is likely to be done and you should exit your long trade. If resistance is broken, then more buying is likely to be executed as short sellers cover their positions. If you are short then you should exit. If you are long then move up your stop loss.
Price tends to travel to the next S/R level when an S/R level is broken. When an S/R level is broken then the price tends to move quickly so you need to have your plan ready before the acceleration starts.
At the market open there is usually a complex adjustment that occurs in the first few minutes of trading where the S&P 500 Futures price and the prices of the component stocks of the S&P 500 are brought into alignment through computerized arbitrage. During this time a reversal will occur if the market has opened significantly higher (“Gap Up”) or lower (“Gap Down”) than it closed on the previous trading day (3-8 points on the S&P 500). If the market opens a lot higher (more than 11 points on the S&P 500) then the reversal may not be very strong. I call this the “Technical Reversal” and it usually occurs within the first five minutes of the open and is complete within the first 20 minutes.
If the market opens flat or nearly flat (less than 4 points difference on the S&P 500 from the previous day’s close) then use the Tells to decide your entry time. If you are going long then the action in the Tells should be bullish. If you are going short then the action in your specific stock should be bearish, the overall market action and the Tell action is less important.
When entering long (buying) into a mildly bullish market you should wait for the Technical Reversal to make your entry. If the Technical Reversal goes too far and becomes a real reversal, then consider exiting until it resolves itself (usually not more than 30 minutes). Do not buy into a declining market or short into a rising market; wait for the turn to occur before you pull the trigger.
If the open is very bullish (more than 11 points up) then get in ASAP if you are planning to get in. If you are short and want out then get out ASAP. If the open is very bearish (more than 11 points down) then get out ASAP if you want out of a long position. If you want to go long then wait until the afternoon. If you are short then you may want to consider taking profits before the market closes.
An Exchange Sweep occurs when a big order suddenly cleans out all the bids or offers within a price range across all the markets that a stock is traded in. This will cause a very brief spike down or up in the price, depending on if it was a buy order or sell order. If you run with a live stop loss that is near the current market price, then you may get taken out of your position by this spike. It is better to run with a live stop loss if your positions are unattended, but if you are there to watch it then using a manual exit will avoid exposure to an Exchange Sweep. If an Exchange Sweep occurs then allow 10-30 seconds for the price to recover. If it has not recovered by then or if it is trending out of control then you should exit.
Scott Tafel was the founder and principle partner in Falcon Trading Systems: computers for traders. He has been a trader since 1999. Mr. Tafel spent 27 years working in the Nuclear power industry, principally as a Nuclear Reactor Operator.
