Trading Philosophy and Strategies

WHAT IS YOUR EDGE?

You may notice that there is a distinct lack of indicators or in fact anything remotely high-tech on my charts as I read them.  I do respect Technical Analysis to the extent that market participants anchor price expectations according to past price behaviour and I often employ simple patterns of compression and expansion, support and resistance or the occasional trend channel in my trading analysis.  I do not, however, consider my “edge” to be in Technical Analysis and I am happy to leave it to the systematic program traders with back-testing skills to utilise mathematical relationships and correlations inherent in the market.  This brings us to an important point.  To have any chance of succeeding as a trader you really need to consider what your edge is.  I am a complete ludite when it comes down to programming or back-testing strategies and so there is no point in me trying to compete in this space.  Likewise, for those of you trading on laptops from the poolside, most probably through spread-betting companies, I can tell you that your edge is not in intra-day trading off of the 15min chart or less.  This is the domain of market depth scalpers with years of experience of reading the ladder or using spread machines.  Speed is of the essence when it comes down to intra-day scalping and even in this space we are seeing traditional forms of scalping give way to the emergence of high-frequency algorithmic models using complex strategies such as flash-orders and micro-structures that are executed in nano-seconds through servers located next door to the futures exchanges.  If you are insistent on trading intra-day (I know I have been prone to scalping one side of the order book if I have a strong directional bias) then you should really stick to the highly-liquid haven of Forex rather than the shark infested waters of exchange traded derivatives.

As an off-floor speculator, therefore, you should really be looking at the bigger picture and thinking about what your edge is.  This doesn’t mean trying to trade off of a deductive fundamental hypothesis regarding the state of the economy as many Retail trading outfits with their catchy slogans will lead you to believe.  How can you really have an edge in this space when you are competing with entire institutional research departments? Even then it is no secret that the market rarely responds logically to the release of underlying fundamental data.  This is because often it has already been discounted in the price (for various disconcerting reasons) and as a “liquidity event” is simply giving the big players an opportunity to re-position.  Hence the old adage: “Buy the rumour. Sell the fact”.  So where does this leave me you may ask? Well I strongly believe that one of the best ways of trading is as a speculator who doesn’t have to commit any money to the market unless the best opportunities arise.  This is both a timeless strategy based on the unchanging nature of mass psychology and herd-mentality in the market, as well as being far less stressful then other forms of trading.  If you read books by various successful traders including the Market Wizards collection, then it will become apparent that you do have a real edge as a speculator and with patience and discipline you can make money.   As Larry Hite says in Market Wizards:

“In any situation or game, you can define a positional advantage for any player – even the weakest one.  In trading, you can define three categories of players: the trade, the floor, and the speculator.  The trade has the best product knowledge and the best ways of getting out of positions.  For example, if they are caught in a bad position in the futures markets, they can offset their risk in the cash market.  The floor has the advantage of speed.  You can never be faster than the floor.  While the speculator doesn’t have the product knowledge or the speed, he does have the advantage of not having to play.  The speculator can choose to only bet when the odds are in his favour.  This is an important positional advantage.” (2006)

So how do we specifically relate this to trading strategies for the speculator? Well, I think many of the more traditional axioms of trading apply to speculators more than any other form of trading.  These would include; discipline, patience, risk-reward and money management to name but a few.  There have been numerous texts written on the importance of trader psychology, patience in waiting for high-probability trades and discipline in cutting your losses.  These are demons the individual trader will have to address, but in terms of my trading strategies, I can’t stress enough the importance of risk reward.  You have to get the odds in your favour and shouldn’t be taking any trade with less than 1:1 risk reward as a bare minimum.  With 1:1 risk reward you will only make money in the long-run if your accuracy is more then 50% and even then you will not grow your account very quickly.  With a risk reward of just 1:2 you can significantly under-perform 50% accuracy and still make money in the long-run.  Various studies have been done that would even indicate that a totally random entry strategy with 1:2 risk reward can be profitable!  Interestingly, however, this was only the case on a larger timeframe when reasonable risk parameters were used for individual trades.  As you go down the timeframe to the intra-day minute by minute price behaviour, the ratio of noise to direction becomes much higher and the risk reward ratios become skewed to the point of uselessness. This point is driven home by the legendary trader/fund manager’ess Linda Raschke during a presentation at a recent trader conference which can be viewed on You Tube http://www.youtube.com/watch?v=g1hs6-mr6PU.  

To summarise this point; As a speculator trading high-probability set-ups on a daily timeframe we should be able to take advantage of increased directional momentum and the massive benefits of risk-reward at the expense of other market participants.  Put simply, this is our edge and we should only be concerned with trading strategies that maximise this edge.  In my next article I will discuss some of the strategies and techniques that I use to consistently profit from the markets.          



TRADING STRATEGY.

Any Trading Strategy must necessarily be founded on certain axioms or ontological believes about the nature of the market itself before attempting to develop an approach to profit from this understanding.  Essentially, without going into too much detail, it is my believe that the market is not perfectly efficient or random and very susceptible to irrational behaviour such as panic, fear and greed which will dislocate price from its theoretical fair value.  If we conceptualise the market as a matrix of interlocking feedback loops or cycles within cycles (such is common amongst many Elliot Wave or Fibonacci based theories of the market), then it can be argued that in some cases even the smallest impact or shock to the smaller cylces within the hierarchy of this ecosystem can have magnifying knock-on effects to the status of higher cycles.  In practise, such a phenomenon may occur when a significant market moving event or individual causes a shock to the price at a pivotal point, such as around key levels, that will trigger stops on a lower timeframe and may lead to re-positioning of trades or an introduction of new entrants to the market on the higher time frame.  This causes a cascading effect that can significantly move the price, and in turn people’s conception of value, sometimes for very little underlying reason.  It is this constant observation of irrational behaviour in the markets that can lead us to identify certain key pivotal points and price-action set-ups that act as catalysts to induce a magnified dislocation of price in higher level cycles.

This ontological interpretation of the market dynamic is certainly nothing new and has much in common with general theories of Technical Analysis vs Fundamental Analysis or Random Walk Theory.  The key difference is the importance given to the catalysts.  Much Technical Analysis exists independently of volume or liquidity events such as News and in doing so neglects the importance of the catalyst in dictating future price discovery.  Many common Technical Analysis set-ups are actually counterproductive for the ordinary speculator as they often illustrate where the majority of market participants are positioning and anchoring price expectations.  It is common knowledge that the majority of trades loose money and the majority of traders also therefore loose money at the expense of the few!  If we except, as I do, that institutions will drive price in the short-term and are certainly far better informed in terms of fundamentals then other market participants (unfortunately the utopian model of perfect information is as much of a delusion in financial markets as anywhere else in the economy), then it stands to reason that we should be looking to profit by positioning ourselves with the few/ smart money/ strong hands etc.. and profit with institutional money as they consume the stops of smaller trades and continue to drive price expectations in the market.  In the longer-term, there is no doubt that price will be dictated by supply and demand, and there are numerous examples throughout history of attempts by individual organisations to corner the market unsuccessfully. However, in the lower-time frames, such as Daily, many examples can be found of big players stepping in around key levels or after liquidity events such as the News, to re-position and push price in an unexpected direction.  It is these unexpected price moves that cause the biggest impact and catch traders on the back foot and therefore provide us with the best profit opportunities.

So how does this philosophical view of the market translate into a Trading Strategy? As previously argued, the edge of the retail speculator is to be found in patience and risk management.  We can afford to wait on the sidelines until the best opportunities present themselves or when the risk reward is firmly in our favour before pouncing.  Based on my explanation in the preceding paragraph, it stands to reason that in my opinion these opportunities occur when there has been a liquidity event and the big players have positioned themselves in an unexpected direction that will catch the majority off-guard.  An example of this would be if there is a scheduled or unscheduled News release which is unambiguously positive but despite numerous attempts for risk assets to rally there is continued selling blocking any upward move.  As a result two things will become evident.  Firstly, the majority are getting long but price continues to get re-buffed as the big-players are re-positioning to either get short or sell out of their longs, either way the underlying sentiment is Bearish.  Secondly, as the majority realise that their long positions are not profitable, they will start to sell-out of them or stops will automatically get triggered and the cascade will begin.  An actual real-time trade that I posted of the NFP release on 3rd Feb 2012 demonstrates this.  Another example would be when we had co-ordinated liquidity measures (30 Nov 2011) and the knee jerk response to the risk currencies markets was unanimously Bullish.  Over the next couple of days, however, price struggled to continue the momentum resulting in a series of rejections or “hammers” on the daily candle before the Euro resided its downward trajectory (you could have simultaneously bought European Bank stocks to lock in some profits). Apart from News catalysts, other opportunities may arise around key chart levels/ obvious Technical Anchors.  We are referring to “false-breaks”.  This may occur when a major level is broken before price eventually migrates back through it again before settlement. On the candle chart this will be depicted as a long wick penetrating the level before re-tracing completely.  This may also occur with trend lines, Fibonacci retracement levels or other obvious price anchors.  As the majority of market participants have traded the breakout and liquidity surges; strong hands step in and price unexpectedly is rejected thus catching smaller traders on the back foot.

As previously discussed in my What is your Edge article, it is important to incorporate this immediate price-action trading approach with other longer-term factors to put the odds in your favour in terms of both trade success probability but also risk reward.  Such longer term factors would include trading with the dominant prevailing trend and considering fundamentals.  When I talk about fundamentals I am not referring to a deductive hypothesis about the underlying state of the economy (as previously discussed, this is not your edge) rather, I am referring to awareness of potential fundamental News releases/ time of day/ time of year etc.. so for example if the week ahead has Fed, ECB, B of E rate decisions and press-conferences scheduled, then we might expect the price action to be uneventful and volumes to be low in the preceding Mon and Tue.  Or if it is Option Expiry today then we would expect futures indexes to be particularly volatile and “noisy” (great for intra-day scalpers, not for position trading), or during a Bond auction we may consider staying out of certain Bond market, or we may avoid selling stocks during the last 2 weeks of the year or during the Budget report.. the list goes on.  I provide a link on this blog to weekly economic calendars and News that will keep you abreast of what traders are focussing on.  Of course, one of the reasons that I recommend using Daily and 4hr Charts over smaller time-frames is to avoid the noise in the market which is generated by constant 24hr news flow and the use of Algorithms that are programmed to trade (often incorrectly) off of Reuters/ Bloomberg, however, it definitely pays to be aware of the larger fundamental issues at play in my opinion.  In terms of trading with the prevailing trend; there are obvious risk reward benefits of running a trend but, equally, many tantalizing price-action trade set-ups, even at key levels, simply do not have the same success rate if traded against the trend.  The reason for the eventual sell-off in the EUR/USD pair after the co-ordinated liquidity injection was due to the dominant Bearish sentiment in the market, manifest as a down trend, which caused the spike to be merely a selling opportunity.  This brings us to the final aspect of my trading strategy which is all about confluence.  For high probability trades with the best risk reward ratios, we need to be trading with the trend; at key chart levels or fundamental drivers; with price-action entry signals.  These three rules along with strict adherence to principles of Risk/ Reward generally constitute what I am looking to trade in the market.  Occasionally I will deviate from these rules, but it is dubious how successful I have been when I do and in the long run it is probably not efficient to do so but as a trader you are constantly searching for the next opportunity to develop new trades.