My Thoroughly Enjoyable Interview with Charles Kirk

Peter Brandt

The following is an interview I recently conducted with Charles Kirk of the Kirk Report. I highly recommend his research service. PLB

 

To conclude my summer interview series, I cannot think of a more interesting, knowledgeable and experienced trader to interview than Peter Brandt!

When I asked members in the mid-year membership survey for recommendations on who to interview next, Peter’s name was near the top of that list. It is obvious to see why – his website has become a trusted resource among many and, like many of you, I have also found Peter’s analysis consistently interesting and insightful.

Peter has shared quite a few gems with us in the following interview and offers keen insight for both new and experienced traders alike. We hope you find this interview helpful to explore some ideas and methods in the development of your own strategy.

Q&A with Peter Brandt

Kirk:  Hi Peter. First off, thank you so much for doing this interview and, more importantly, for sharing your perspectives with others in the way you do. For those unfamiliar with you please tell us about yourself.

Peter:  First off, let me thank you Charles for the opportunity to present myself to the Kirk Report members. I am a fellow member. I subscribe to very few paid research services, mainly because my own approach is so well established. The Kirk Report is one of the services to which I subscribe. The Kirk Report is perhaps the best value out there for the price available. I am not really interested in your market opinions, but you offer so much else of educational value. Thank you for the service you provide.

Now, to your questions.

My wife Mona and I have lived in Colorado Springs, CO for the past 16 years. Before that we lived in Nisswa, MN where we were fortunate enough to raise our kids on a lake in a small rural wooded area. And before that we lived in Chicago for 11 years where I worked at the Board of Trade. We love living in Colorado. The mountains are majestic and the weather is quite nice. I am sure you can relate to our living surroundings where you live.

My wife, Mona, and I have two very grown sons, ages 42 and 38. We have been married going on 43 years and have four great grandkids located in Minnesota and Arizona.

Two factors rule my personal interests – my job and my health. Trading is a tough job. It has the tendency to overwhelm a trader’s life. In the summer when I am awoken by thunder I wonder if it is raining in the corn belt – and how that will affect any grain positions I have on – as if it should even matter because I do not trade the fundamentals. The markets I trade are 24-hour markets. While I don’t need to watch the markets every minute, I do need to know when I have an entry order filled that will require a protective stop loss.

The second factor is my health. In 1984 I suffered an 18-foot fall onto a cement slab as a result of walking in my sleep off my deck. Talk about a rude awakening. Severe damage was done to my spine. I spent 41 days in the hospital and six months in a body cast. Fortunately I recovered mobility and movement. Yet, my accident has been the gift that keeps on giving. I have had four major spine surgeries. I now suffer from a severe neurological disorder (called radicular neuropathy) and arthritis in my spine. I used to be very active in golf, tennis, water skiing, flying my airplane, snow skiing, hunting and biking. Even until 1999 I biked 20 miles every day.

My spinal disorder has really taken its toll. I am able to do few of the things I used to love. I still occasionally shoot trap, skeet and targets. While in many ways I am disabled, my accident could have been worse and I count my blessings each day.

Professionally I trade. I am also registering with the CFTC and NFA as a pool operator and plan to launch an investment pool using about 10 outside traders, selected based on their risk management acumen. Then, finally, I have been working with the wonderful folks at Elliott Wave International to hold events in Atlanta and Orlando for traders who want to more fundamentally understand risk management and the human element of market speculation.

Kirk:  When and how did your interest in the market originally begin?

Peter:  After college we moved to Chicago where I took a job with a major advertising agency. Advertising and marketing had been my double major at the University of Minnesota. We lived in Evanston and through our kids’ sporting activities I met a guy who was a soybean trader on the floor of the Chicago Board of Trade. He invited me to lunch at the CBOT and told me about the trading business. I was hooked. There was no MBA fast track into the CBOT – everyone started at the bottom. I got a job with Continental Grain Company, at the time the second largest grain exporter in the world. I remember when I told my wife in 1975 that I was quitting my adverting job paying about $30,000 per year to take a job paying $15,000 per year (but only for the first year). Before I quit I asked the ad agency president if they would hire me back for more money in a year if trading did not pan out. He committed to do so and that gave me the license to fly.

I knew from the beginning that I wanted to trade my own money, which at the time I did not have. At the agency I handled the Campbell’s Soup account. I approached the president of Campbell’s and suggested that hedging might be a good fit for the company. Without going into the long story behind it, Campbell’s became a big client of Continental and basically paid my salary while I learned the business.

I had a couple of wonderful mentors at the CBOT that were responsible for the fact I made it as a trader. They were selfless in helping me avoid many of the mistakes a trader will make along the way. One of the guys in particular, a man by the name of Dan Markey who had been a boy-wonder at Cargill, became a dear personal friend and took me under his wing. In fact, Dan loaned me the money to buy my first home. Dan, who died way too young of a rare illness, was probably the single best trader I have ever known. He was brilliant. He taught me things that were absolutely priceless about the process of market speculation. Dan’s philosophy of the speculative process had a huge impact on me.

Kirk:  That’s an inspiring story Peter. Thank you for sharing it. If you don’t mind, I’d like to explore what you currently do further. Can you provide us with an overview that helps us understand your focus and strategy to making money in the markets?

Peter:  Let me summarize my answer to this question with 8 major points.

  1. I trade leveraged instruments.
  2. I trade on the basis of classical bar chart formations, such as head and shoulders, rectangles, wedges and the like (Edwards and Magee).
  3. I focus my attention on finding really big patterns, using the weekly and monthly charts. I like patterns that take months to form. My preoccupation is with identifying the best 10 to 20 examples of classical charting principles each year. These are the trades I want to be in.
  4. I may nibble with a position if I think we are in the late stages of finalizing a big pattern, but as a general rule I trade breakouts and take profits at targets.
  5. I am obsessed with risk management. I am also obsessed with finding trade set ups with an obscenely asymmetrical reward to risk profile. I may develop a strategy around a big pattern that offers me a 10 to 1 reward to risk ratio. I seldom risk more than 70 basis points (that is 7/10ths of one percent) of my trading capital on a trade.
  6. For me the real challenge is in overcoming my human urges and emotions. Finding great patterns is simple if I stay focused on weekly charts. My battle, and it is a constant battle, is to stay in the sweet spot of patience and discipline.
  7. In my way of thinking, patience has two faces – the patience to wait for the exact right set up and then the patience to stay with a winning trade. Discipline also has two aspects – the discipline to NOT to take a trade that lacks the right criteria and then the discipline to take a well leveraged position when the right set up presents itself.
  8. This last point is my accountability factor. Every trade I do – entry and exit – needs to stand the test of historical scrutiny. This means that all trades, when plotted on a chart a year after the fact, should make sense. Whether or not the trade made money is not what I want to know.

Kirk:  Excellent. Among all the traders I have interviewed for many years, I think your summary is one of the best. So, what types of markets and trading vehicles dominate your trading now, Peter?

Peter:  I have a commodity futures background, and futures contracts are mainly what I trade. But, I also trade forex pairs, stocks and ETFs. I monitor about 50 or so different commodity markets and forex pairs markets globally. The ETFs I trade usually are stock market expressions of a futures market opinion. For example, if I am bullish on silver I may trade the silver ETF in addition to or as a replacement for silver futures. There are times when the risk in futures is greater than I am willing to accept, so the ETFs are a great way to go.

I am starting to review a more robust list of ETFs. I see myself moving into ETFs in a bigger way down the road.

I am primarily a “flat price” trader. I think I might have traded one commodity option in my life. I just put on an option trade in a stock. We will see how that goes.

Kirk:  What methods do you use to analyze the market?

Peter:  I pretty much stay with straight classical bar chart analysis. I have played around with indicators from time to time. If I was a range trader, or if I specialized in trading channels, then various indicators such as RSI, MACD, ROC, Stochastics and the like would make a great deal of sense because I would be interested in reversion to the mean. I do watch a moving average as a proxy for trend. I also will periodically look at a 14-bar ADX indicator. If this indicator reads 12 or lower when a pattern breaks out, it is a very good sign that the pattern will work.

Time framing is a complicated issue without an easy answer. The time frame used for deriving at a market opinion may be different than the time frame used tactically for a trading maneuver. For example, my price opinion on Sugar and Soybean Meal is presently influenced by multi-decade chart configurations. These opinions bias my shorter-term analysis in that I tend to interpret multi-month or multi-week chart developments in the direction of my multi-year framework. For the purpose of trading, I want patterns that are somewhere in the zone of 10 to 20 weeks in duration for reversal signals or six to ten weeks for continuation signals. So, annual and quarterly charts can provide a direction for my trading while weekly and daily charts give me the set ups for entry and risk control.

Kirk:  What would you say are your favorite kinds of setups?

Peter:  This is an easy question to answer. My favorite setup – my real sweet spot – would look like this:

  1. A price scenario to be formed by a pattern of one to two years.
  2. A weekly and daily chart pattern of 13 to 26 weeks that is very clearly defined, yet not being talked about much by the street.
  3. A smaller pattern of 4 to 6 weeks that forms near the end of the pattern.
  4. The pattern breakout will be accompanied by some other chart phenomena, such as the violation of a major trendline.
  5. In the case of futures, I like to see the continuation and nearest delivery month charts breakout before the deferred contract months.
  6. Again, in the case of futures, it is best when the trade is supported by the CFTC COT report. I like to trade on the same side of the market as the commercial interests and on the opposite side of the speculative public.
  7. Many of the most profitable trades through the years involved pattern breakouts on a Friday or Thursday before a three-day weekend. But even if it is not a three-day weekend, I love Friday breakouts. The reason is that Friday breakouts are being supported by position traders willing to hold the position for the entire weekend. This is an indication that “strong hands” are supporting the move. I could show you chart after chart of huge trends that kicked off on a Friday.
  8. I am attracted to unconventional trades, although they don’t come around very often. An example is a recent gold/Swiss Franc spread. I basically was speculating in gold denominated by the Swiss Franc, so it was U.S. Dollar neutral.

While the above describes my ideal trade, I wish I could say that this is my typical trade. But, traders need a standard to shoot for.

Kirk:  Very interesting, Peter. How do you find and select potential trades?

Peter:  The main platform I use is Trade Navigator by Genesis Technologies. This platform offers me simple uncluttered charts as well as the ability to enter my trade orders right on the chart screen. I clear my trades through four different brokers – this is more by evolution than by design.

I fondly remember the days of using paper charts. Actually, if I had my wish we would return to those days, although technology only goes forward. I still print out hard copies of the markets I am involved in and hand update these paper charts. This is a process I go through every weekend for the upcoming week.

The less I do during the week the better. My guess is that if I could total up the net result of all trades based on intra-week decision making, it would represent a loss. My best trades are those that I decide on during a weekend.

Kirk:  That’s interesting. I wonder how most traders’ performance would be impacted if they removed the intra-week decisions and just stayed with their weekend research. I suspect their results would be similar overall.

Please take us through a previous trade that offers insight to what you do and how you do it.

Peter:  Let me explain two trades – one a winner and one a loser.

First, the S&P 500 futures. In early July I labeled the daily chart a possible H&S top. I made a hard copy chart and started plotting prices. I placed sell stops below the neckline (June low). The market declined in mid-July and then rallied in late July. This set up for me the possibility that the right shoulder would be a small double-type or failure top. I entered a sell stop below the July 18 low at 1291 and became short a layer at 1288. My risk was to above the July 28 high at 1313. Then on August 2 the decline completed the H&S top. Not shown is the fact that the market also penetrated a trendline from the March 2009 low. I added to my short position on August 2 in the 1250s. Finally, I added a layer at 1258 on August 4 when the market experienced a hard retest of the neckline.

The target for my trade was 1155. I took one-third of my position off at this price on August 8. I covered another one-third at 1121 on August 9. I remain short one-third as of this date (September 20). I will probably ride this back for a loss.

The next trade was a loss. I am a long-term bull in Sugar based on the completion in 2009 of a 29-year base pattern. I think Sugar will eventually go to 60 cents, although how it gets there remains to be seen.

In early September I started to think that the decline in March Sugar would hold above the 4-month trendline and form a right shoulder of a continuation inverted H&S pattern. I went long at 27.72. Really good H&S patterns have symmetry between the shoulders. Thus, it was important that the right shoulder was completed quickly and that a rally would start. Yet, the market could not rally and on September 16 it rolled over, penetrating the trendline and the September 12 low, which in my way of thinking should have been the right shoulder low.

Kirk:  How different is it to trade commodity futures and the forex markets vs. stocks or ETFs?

Peter:  In my opinion, trading futures, forex or stocks/ETFs is the same thing. There is no difference. In the final analysis, we trade price. Whether that price represents some foreign exchange currency pair, a precious metal, a row crop, a company, an industry, or the economy of a region of the world makes no difference. Traders make their money on price change and price change only. Getting caught up in what the price represents is not something I am interested in doing, nor does it matter.

Kirk:  Agreed. How actively do you trade?

Peter:  I trade more than I should trade. In a typical month I put on about 10 to 15 new trades (all markets combined). The figure needs to be closer to 5 to 8 trades per month. I am working on the implications of moving from one level of activity to another. Whenever one aspect of a trading program is changed, there are implications that are unexpected in performance baselines. I take seriously the matter of changing my rules and guidelines. They have evolved over the years, and continue to evolve. But one of the worse things a trader can do is tweak trading rules based on the result of the last trade or brief series of trades. I have statistical probability models that completely support this thesis.

Kirk:  What are your average hold times for positions?

Peter:  For losing trades the holding time is short – sometimes I am out the same day. The average holding time for losing trades is probably three days.

The evolution of my trading approach now calls for two exit strategies – this is the advantage of having a multiple contract position in futures. The first strategy is something I call the Quick Profit Rule. With this strategy I attempt to take a profit within a week of entry, hopefully catching the initial thrust of the breakout. I hold the remaining position until hopefully the target is hit. This may take a month, it may take three months. I seldom hold a position for more than three months.

Let me add something here. During the past one to two years, the Quick Profit Rule has outperformed every other money management protocol I use by a significant degree. I think this is due to the influence of the mean reversion trading schemes used by the huge trading firms. Markets seem to thrust out of big patterns and then quickly reverse to a degree unprecedented in my trading history.

Kirk:  That’s a useful and important way you’ve adapted to the environment, Peter. Excellent job!

Do you have a profit target you try to hit every week, month, quarter and year?

Peter:  No, I do not think this is possible for a trader to do, although it is a nice thought that trading can be some sort of an annuity. My goal is to trade my plan with discipline, according to the rules and guidelines of the plan. Hopefully the profits will take care of themselves if I am obedient to the intent of my plan. I have no control over the outcome of a trade. I only have control over the orders I enter. My accountability is to my trading philosophy, rules and guidelines, not to some profit objective.

Kirk:  In other words, focus on the process and not the result. This is such an important skill that all traders must develop.

Now we have a very good idea of your approach, please take us through your daily routine from start to finish.

Peter:  I will take you through an ideal week. Of course, we never attain “ideal,” but it is something to shoot at. Some weeks I come close.

On Saturday I go through the weekly charts of about 60 futures markets and forex pairs. I look at the weekly continuation chart as well as the weekly chart of the nearest delivery month in the case of futures. Of course, this list would include any market in which I have an existing position. I look for weekly chart patterns that are at least 10 to 12 weeks in duration. At any given time there may be about 10 markets that are forming or have completed such patterns. Again, this includes markets in which I am currently involved in.

This then becomes my working list for the following week. I next look at the daily chart of each market identified, and actually make a hard copy of the daily charts. I will maintain these daily charts by hand during the following week. There is a very subtle nuance at work here. I find that I can retain a much clearer mind about the markets if I only pay attention to the printed hard copy charts and ignore charts on the computer screen. This may sound really weird, but it is what it is.

On Sunday, early afternoon, I determine the orders I want to enter for Monday. Some of these orders are for existing positions, some for new entries. Usually I am dealing with about a dozen orders. I need to determine whether these orders will be hard stops in the 24-hour market, hard stops entered for daytime hours, or mental stops based on closing prices.

Once all my orders are entered, my trading day is done. There may be entry stop orders filled for which I need to place a protective stop. But watching the markets trade is not something that contributes positively to my net bottom line.

I then update my daily charts at about 3:30 PM Mountain time each day and determine the orders I want to work the next day.

Periodically a daily chart in a market other than those on my monitoring list will catch my eye, but I intentionally try to keep these instances to a minimum.

Personally, I think any time I spend beyond one to two hours per day maintaining charts and entering orders is counterproductive to my profitability.

Kirk:  How has your approach toward the markets changed and improved throughout your career?

Peter:  Improved? Who said anything about “improved?” Of course, that is the goal, but trading is an extremely difficult job. In the early days I took more risk. I was more of a gun slinger, so to speak. It was not that I traded with reckless abandon, but perhaps it could be defined as trading with controlled reckless abandon. I pay much more attention to risk management protocols today than I did in my first decade of trading. In some ways this is good. But in other ways I would like to regain the “eye of the tiger” mentality. I have become a bit more defensive in my trading than I would like.

But, in terms of market analysis, nothing has changed. I have been a classical chart pattern guy all along. I am an Edwards and Magee devotee. But the nuances of my trading have evolved. Without going into the details, I think that I am on Trading Plan V4.3. To me each change has been significant, but to those not really intimate with classical charting the changes would have appeared as insignificant.

Kirk:  Has the growing influence of program trading had any impact whatsoever on your approach?

Peter:  Absolutely! The markets are very different today than they were when I started. I think the changes are due to three factors.

First, we have gone to electronic exchanges. This means that the order flow is in a computer queue rather than hidden in the hands of a pit order filler.

The first factor leads to the second factor – the high frequency algo trading programs. These programs operate on exploiting the order flow. The algorithms running the HFT operations are built not only to capture the bid/offer spread, but to expand the bid/offer spread by cascading stop orders.

The third factor is the enormous growth of “reversion to the mean” trading programs. There are literally billions of dollars devoted to reversion trading. The result, in my opinion, is that markets are much choppier and more volatile than they used to be. This is not good for me. Choppy markets are an enemy of my trading approach.

Kirk:  Choppy markets can be enemies of just about everyone, even those who don’t trade Peter! Looking back was there any specific thing that you thought was a key turning point for your career?

Peter:  Yes, three things represented significant moments or events in my trading career.

The first was being introduced to classical charting principles through the Edwards and Magee book. I had tried many different approaches up until that point. Once I was introduced to classical charting I knew I had found my niche. Classical charting provided me with a combination of advantages, including:

  1. Price direction
  2. An entry point
  3. A logical point to protect trades
  4. A target
  5. A framework to develop a process of trading

The second event was nailing a trade in the forex markets in the early 1980s. I took way too great of a risk on the trade, but I got lucky. The trade worked, worked right away and worked big time. All of a sudden I had an account size that allowed me to take trading seriously. Had the trade not worked we would probably not be doing this interview. That is the truth.

The third event was the U.S. stock market in 1987 – not the collapse in October, but the bull thrust in the first quarter. This was trade that set up in a way that the reward to risk relationship was so asymmetrical it was crazy. It was like a 20 to 1 reward to risk trade. And it worked. The move increased my capital six fold.

Kirk:  What is the most important thing you’ve learned so far that would have really surprised you initially had someone told you?

Peter:  There are three important lessons.

The first is that trade identification is one of the least important components of successful trading. Yet, novice traders spend 80% of their time, energy and money chasing the trade identification component. I have learned that my default mode should be to expect the next trade to be a loser.

The second lesson is the degree to which I am my own worst enemy in trading. The role of emotions in trading is far beyond what most people acknowledge. This is far truer for discretionary traders than for systematic traders. I am a rules-based discretionary trader.

The third lesion is that risk management is far, far more complex than simply using protective stop orders. Trading programs – all trading programs – are governed by statistical probability theory that can produce results far different than simple math and the win/loss ratio might indicate.

Kirk:  I think many may find the first lesson in particular very odd considering that the focus for most is upon trade identification. Can you imagine what portfolio managers would discuss on CNBC without being able to pump out stock tips?

Along those same lines, I must tell you, Peter, that the “Trading Lessons Learned” you published is terrific and one I’ve recommended others to read. Among all of the rules you listed there, which were the most difficult for you to learn and why?

Peter:  Having more patience is my biggest hurdle to take my trading to the next level. I see patterns develop – really big patterns – and I get impatient. I want to jump the gun and get in before the fireworks are lit. I find an excuse for an early entry. The result is that I may get chopped up before the real breakout takes place. An additional result is that I lose focus on the really big patterns and narrow my time frame for analysis. I need to stay focused on weekly charts, only look at daily charts that flow from weekly charts, and never look at an intraday chart.

The other area where I sometimes falter is in keeping the price machine turned off during the day and not limiting my order entry and decision making to just one hour per day. The markets are mesmerizing and can become addicting.

It is interesting to note that both areas where I can become an even more effective trader deal with the human element and the upstream swim against human nature that is market speculation. Most traders who have been at the game for more than five years know instinctively what they need to do to be more profitable. The challenge is in doing what needs to be done.

Kirk:  Why do you think your trading method is the best fit for you versus other kinds? And, more importantly, what recommendations can you provide for aspiring traders who desire to find, figure out, and then employ a system that works best for them?

Peter:  Charles, this is a GREAT question and I am glad you asked it! Let’s start with two premises. First, I do not know any two consistently profitable traders who trade alike. There are similarities in how they think about risk and the speculative process, but in terms of trading tactics and implementation, every successful trader has his or her own niche. Second, it is next to impossible for a novice trader to make money by piggy backing on another trader. I could spend 30 minutes explaining why this is so, but let’s just leave it as a given.

Every trader needs to find his or her own unique niche. Chances are great that the exact niche found by a trader will reflect his or her character weaknesses and strengths, risk tolerance, time available for market activities, capitalization and a few other factors. An engineer will think differently than will an air traffic controller or an artist. These traits will emerge in a trading plan for each.

I believe that developing a trading plan is an evolutionary thing. Sometime during the first three years of trading aspiring speculators will pick up a scent on an approach that instinctively makes sense to them. At this point an aspiring trader can start to build the necessary description of a trade, money management protocols, trading guidelines and rules, etc.

Too many novice traders come into the arena expecting to make money out of the block. A very small percentage of them will be profitable right away – perhaps 1 in 25 who attempt. The learning curve is steep.

It is for these reasons that novice traders need to risk very little capital per trade initially – perhaps only 20 or 30 basis points per trade (2/10th of one percent of capital). The reason is that aspiring traders do not want to lose their pile of chips before they figure out what the game is all about.

This is also why I am so against day trading. While experienced already proven traders can venture into day trading activities, this arena is no place for a novice. The reason is that the number of trades made is in direct proportion to the number of decisions required. And the decision-making skills of a novice leave much to be desired.

Kirk:  Thanks for your comments on day trading. Let me ask a follow up question. You’ve written that “except for a few tremendously gifted traders (not including me), day trading is a loser’s game.” I think we should talk about this a little further and, if you don’t mind doing so, please explain your thinking on this matter.

Peter:  I need to provide a little history and perspective on this question. Back when I started the vast majority of day traders were the pit traders at the exchanges. As a whole, they made their money through the bid/offer spread, which still exists in the markets today. Exchange members paid as much as a half million dollars to be members of the certain exchanges. In return, they were able to buy at the bid price and sell at the offer price. They were, in effect, market makers. Pit trading is now a dinosaur, although some markets still have pit trading. In the “good old days” outside speculators were more of the position trading variety who always bought at the offer and sold at the bid price.

The bid/offer spread is now being taken by the algo systems and large trading operations. The small spec buys at the offer and sells at the bid. Losing the bid/offer spread can be overcome by position traders looking for meaningful price moves. But giving up the bid/offer spread is too much to overcome by day traders (who almost by definition are active, thus giving up the spread many times each day). Even if a day trader uses limit orders, they still sacrifice the bid/offer spread.

As I mentioned in an earlier question, day traders, by definition, make many decisions each day. Until a trader learns the ropes, decision making usually carries a penalty. The markets charge tuition to learn the ropes.

Kirk:  If day trading is not the right path for most, then what is the path you think is best for the vast majority of traders?

Peter:  The trading world has become increasingly short term in its time horizon. I do not believe this is a good thing. New traders should have a price horizon of at least five to 10 days, and that is to carry a profitable trade. Bad trades need to be closed more quickly. More preferably, I think new traders should seek a time horizon of a month for analyzing a market.

The problem with shorter-term trading is it requires shorter-term attention. And the more closely a trader pays attention to market behavior, the easier it is for emotions to start negatively impacting trading decisions. So to some degree the real problem is not holding time for a trade but the amount of noise a trader must expose himself to in the process of trading.

Kirk:  Two rapidly growing trends among the retail, individual “little guy” is to trade ETFs with leverage and also Forex. What are your thoughts about these trends and approaches? Also, do you have any words of wisdom for those who have that as a foundation of their approach?

Peter:  I am leveraged trader. I have always been a leveraged trader. Leverage is dangerous when it is fully employed. I risk 70 basis points on leverage trades. I risk the same 70 basis points on ETFs purchased in my IRA account. As a general rule I seldom have more than 10 to 15% of my capital employed in the form of margin requirements. The remainder is in cash. I don’t see a problem with leverage per se. Risk per trade as a percent of capitalization is what really counts.

I saw a TV commercial last night from a brokerage firm, offering to allow a 10 to 1 leverage to highly capitalized account on any market traded. This is the recipe for very bad things to happen.

Kirk:  So, leverage can kill, but not always!

In your experience, what is the best way to learn how to trade and implement a plan that works? For example, do you advise newcomers to trading to do paper trading before they start with real money?

Kirk:  Paper trading is not just for newcomers – it is equally important for professional discretionary traders. I paper trade and have done so from the start.

First, for newcomers. Paper trading is an absolute must. In fact, I think newcomers should paper trade for two years before they ever put skin into the game. Of course this never happens. A newcomer who is paper trading will be right on two or three trades in a row and not want to wait any longer. We all know what happens next in this story. Paper trading is the laboratory for continuing education and experimentation.

Next, for professionals. There is a concept I call “leakage.” Professional traders who are intimately familiar with their discretionary algorithm know when they make a trade that is not completely consistent with their guidelines and rules. The results of these trades, measured in basis points, must be tallied. Failure to comply with the rules and guidelines of a trading approach must be measured. Traders need to keep track of the cost of their leakage. Also, professional traders can test out new ideas, especially money management protocols, using paper trading as their laboratory.

Kirk:  Wise words of advice. What are the biggest mistakes made by novices and aspiring traders?

Peter:  

  • Over trading
  • Taking too much risk
  • Not being properly capitalized
  • Attempting to mirror another trader
  • Not having a clear trading program that accounts for all possible contingencies
  • Assuming their approach will work
  • Chasing momentum within a trading range

Kirk:  How many years do you think it takes for a trader to learn the ropes?

Peter:  Every successful trader I know trades their own unique way. Each has found a niche that works for them. Finding a niche and a plan that works takes time. I think it takes two to three years for a novice trader to really catch the scent on the approach they will use for market speculation. It is a process, not a moment in time. It probably takes about five years for a trader to really become excellent at the craft. Trading is a craft. Traders are craftsmen. It takes time to learn a craft.

There are two facets to this process. The first facet is that learning to trade requires paying tuition, and the markets determine the tuition rate, we don’t. Trading is learned from making mistakes, and mistakes can be expensive. The second facet is that most trading wannabes never make it up the learning curve because they run out of money first. So, new traders have to be focus on not taking large losses. Learn with small losses. If a trader can be even, or even slightly up, after the three year learning curve they are in great shape for eventual success.

Kirk:  In your recent and most excellent book, Diary of a Professional Commodity Trader, you say that managing losing trades is the single most important trading component. Why is this so important?

Peter:  The very best trader I ever knew would often say that his job was to pay attention to his losses and ignore his profitable trades. He said that profits would take care of themselves. Trading is like playing poker. Once you lose your chips you are out of the game. Once your chip pile is greatly reduced your only chance is to go all in at probably the wrong moment.

It is also said that it is easy to make money in the markets, just try to keep it! So true. Big losses can do great damage.

If I could go back and do every trade again with only one difference – I would liquidate any trade that ever closed at a loss – my net bottom line over the years would be substantially more profitable. A trader is, first and foremost, a risk manager. Being a risk manager means managing losses.

Kirk:  How do you manage your risk? What methods do you employ to minimize losses when your analysis or positioning is wrong?

Peter:  I use stops, hard or mental, intraday or closing price, that limit the risk on a trading event to 70 basis points maximum. If I am trading highly correlated markets, I limit the risk on a multiple market trade to 150 basis points. For example, short EURUSD, long DX, long USDCAD, long USDCHF are basically the same trade. So, if I got a signal in all the correlated markets I may just take the two or three best and alter my risk to acknowledge the high correlation.

Let me add this: To be profitable, a trade must be right on both direction and timing. If one of these is wrong, the trade is wrong. Timing is as important as direction. That is why the idea of being bullish or bearish is meaningless.

Kirk:  How do you determine that a trade has failed and you must exit other than its subsequent performance after entry?

Peter:  Of course a trade that hits my initial stop point is a trade that failed. But the hardest part of a trade is when prices are somewhere between the entry price and the eventual target, especially if prices start to chop. Other traders have shared with me that this is the hardest phase in their trading as well.

I do not like giving back open trade profits. But I have had my share of trades that almost reached the target before retracing the entire move and stopping me out for a loss. I call these “popcorn” trades or “round trippers.” I wish I had the secret for knowing when to bail out of a profitable trade that has not yet hit the objective. This area of trading has caused me more grief through the years than any other area of trading. This area breeds doubt. I have experimented with several different money management methods over the years to deal with these trades.

One method I use is called the “trailing stop rule.” This is basically a three day setup. I was recently long the Dec. U.S. Dollar Index. The first day of the three-day setup is a new high day. Sept. 12 was a high day. The second day in the setup is when the market closes below the low of the high day. This occurred on Sept. 14. The third day of the setup, or the stop out day, is when prices take out the low of the second setup day. On Sept. 15 the market took out the low of Sept. 14, triggering the trailing stop rule.

I cannot tell you that the trailing stop rule is the end of my wandering through the desert on this matter. Let me tell you where my head is on this topic right now. I think that when I take a position based on a well developed and lengthy chart pattern the proper way to manage the trade is with a simple moving average system – like a 14 day moving average. But, chances are great that I will die without resolving this part of my trading. I just need to live with the tension it causes.

There is a lesson for novices in my struggle on this matter. Learning to trade is a voyage, not a destination. You may think to yourself, “if only I could figure out this part of my trading I will have arrived.” Wrong! As soon as you clear one hurdle, another one pops up. It is never ending.

Kirk:  Do you ever average down into a losing trade? Why or why not?

Peter:  Never, never, never! I think this can be an acceptable thing to do under certain circumstances for commercial interests and very long term macro-economic speculators with deep pockets, but I am a momentum trader so averaging down is contrary to my trading algorithm. I want my initial layer to be profitable before I add another layer.

Kirk:  I know everyone will be interested to know more particulars concerning your stop loss method.

Peter:  I cannot imagine making a trade without a protective stop loss order in place – whether it be a mental stop or a hard stop. Increasingly I have paid attention to the closing price of the day (usually around 3 PM Mountain) as the single most important price of the day, therefore the price upon which a stop should be based. This requires using a mental stop. Back in the day of pit trading, most markets accepted a “stop, close only” order. I loved to use these orders. Basing a stop on the close eliminates intraday volatility.

Another issue relating to stops in futures and forex markets is whether the stop is active during the overnight hours. I think 24-hour stops are proper in the really actively traded markets such as the major forex pairs, gold, silver, crude oil and a few others. But, 24-hour stops are not advised for the thinner markets. I have gotten my pocket picked a number of times by having stop orders in during the overnight sessions in thin markets.

I do not like stops based on some fixed dollar amount. Most preferably, stops should be set at levels that, if hit, would alter the interpretation of the market. I want the market to prove my interpretation wrong, not simply pick my pocket. It is my preference to find some technical barrier and place my stop relative to this barrier.

Kirk:  How do you determine leverage or sizing in your trades?

Peter:  Leverage is calculated based on two variables – my entry price and the price at which I will throw in the towel. I always think in terms of $100,000 units, even though my actual trading account is a multiple of this amount. So, I determine my sizing per $100,000. Let me more carefully explain this concept with three examples.

First, let’s take a stock, GLD (gold). While I traded the futures in my trading account, I traded GLD in my IRA. On July 12, GLD completed a 10-week symmetrical triangle at its close of 152.77. My stop was set at 149.77, which was below the low of the last day within the pattern, or a concept I call the “:ast Day Rule.” Thus, the risk on my trade was $3 per share. My maximum risk per $100,000 of 70 basis points converts to $700. Thus, my size was 230 shares (230 shares times $3 per share equals a risk of $690 or 69 basis points). Of course, actual execution prices can change the final figure.

Next, let’s look at futures. The December Meal broke out of a very clear rectangle pattern at 373.6 on August 22. My risk was to 362.4, or $11.20 per ton. This equated to $1,120 per contract. Thus, my size was only 1/2 of a contract per $100,000 unit of capital, meaning that I needed two units of capital to support one contract. The risk, then, was 56 basis points ($1,120 divided by two = $560).

 

Finally, let’s look at a spot forex trade. On Sept. 8 EURUSD completed a 4-month descending triangle top and penetrated a 14-month trendline. I shorted the cross at 1.3948. The risk on the trade was to 1.4106, or a risk of 158 pips. I shorted 40,000 EURUSD per $100,000 of capital using the mini spot market. My risk was 63 basis points (158 pips times 40,000 equals $632 per $100,000).

Kirk:  That’s great. To give others some idea of overall performance, what is your historic win/loss ratio?

Peter:  Actually, this is one of the metrics I have monitored since the beginning. I track quite a few metrics in my trading – probably more than actually might be useful. My historic win/loss ratio is around 37% winners to 63% losers. Of course, this can vary substantially over shorter time frames. I can go several months at a 20%/80% ratio, and can spurt to 50%/50% over a couple of really good months. My goal is to someday reach a benchmark of 45%/55%. I think that novice traders chasing a 70%/30% are chasing the rainbow.

More important than the win/loss percent ratio is the win/loss value ratio. The size of the loss to the size of the gain is what determines long-term profitability. Hypothetically, a trader at a 35%/65% win/loss ratio needs to have a $1.85 to $1.00 win/loss value to break even.

Kirk:  You explain in your book that you use charts as a trading tool but not as predictive tool. Can you briefly explain what you mean by this?

Peter:  Charts show where prices have been, not where prices are going. The vast majority of chart patterns fail and morph into larger and more complex chart patterns, which in turn fail and morph into even larger chart patterns. Charts can show where large blocks of buying and selling might exist and they can show when these blocks have been absorbed. Charts are useful because they can provide timing and some concrete ways to manage the risk of a trade. Many sizable moves occur absent from a recognizable chart pattern. Further, no single market can be constantly understood based on its chart.

I am amused by chart book economists who predict economic and fundamental outcomes based on chart patterns. For me, chart patterns may have price implications, but I do not convert that into an economic scenario. Of course there are times when a chart pattern is predictive, but that is the exception, not the norm. I know and respect a number of chartists to disagree with me on this matter.

Kirk:  You’ve written that “managing my emotions (fear, greed, false hope) is my primary challenge in trading.” What methods do you employ to address this challenge that all of us face?

Peter:  I have found one very simple process to deal with emotions. Identify the markets I am interested in once each week (on the weekend when markets are closed) and do not add to the list during the week. Then, enter my orders once each day – of course, if a new entry is made I need to enter a protective stop loss. Finally, turn my machine off during the day and find good things to read or other things to do. I found, for myself, that the amount of time I spend looking at a price screen and charts during the trading day is inversely correlated with performance. My guess is that this truth holds for many, many traders, both novices and professionals. Of course, there are some very gifted traders who have the instincts needed to trade off the screen. I do not count myself among them.

Kirk:  Given your success Peter, I think your method should be at least tried by those having trouble with this. If my email is any indication, most are and it is something I also struggle with from time to time.

While you have traded for decades, you are relatively new to the world of sharing your thoughts, opinions and analysis with the public. What have you learned from sharing your experiences with others recently?

Peter:  With the exception of the book I wrote in the early 1990s with the late Bruce Babcock (we only printed 1,000 copies), I have led a fairly private life as a proprietary trader. That is until February when John Wiley released “Diary.” I have found myself thrown into the public stream since then. It has been an eye opening experience in many ways.

Frankly, I am still not sure if standing in the public domain is for me. The jury is still out. I would not be surprised if my existence in the public domain is very short lived. We will see.

There are four discoveries that stand out.

First, there is a new generation of young turks that have no respect whatsoever for those who came before them. Perhaps this is just a generational thing. Back in my days at the CBOT new traders had to prove they had staying power before becoming too cocky – and in fact, cockiness was not a trait that ever went over too well. There was a deserved level of respect shown to traders who had stood the test of time. There is a level of arrogance that is quite amazing among some of the young guns who have maybe a one- or two-year track record, big mouths and an internet connection. I do not enjoy sharing the public domain with these people.

Second, there are some really good people who offer novice and aspiring traders very good information and guidance at little or no cost. Charles, you stand out in this regard, but there are others out there providing great service through blogs and online sites. The problem is that with the explosion of information and content, 90% of the information in the public stream is garbage and new traders do not always have the discernment to separate the good from the bad. Novice and aspiring traders need to be skeptical about everything they hear and read. With cable TV and the internet, there is a flood of information and opinions coming at new traders. New traders need to become very suspicious content consumers.

Third, I cannot believe how personally some market participants take their positions. They view any contrary opinion as if their grandmother was shot. People lock onto certain stocks or commodities (especially precious metals) and cannot see past their assumptions and biases. I took an extremely hard shot at Silver a few months ago (calling the top within 24 hours after it had been made) and I received hate mail. It is clear that many traders value being right more than they value making money.

Fourth, it has become strikingly clear to me just how short-term the trading community has become. Sure, there are position traders out there joining in the flow of information, but in the main the information streams are flooded with time horizons of minutes and hours based on hourly charts, 30-minute charts and so on.

Kirk:  Trust me when I say, I understand all of these issues as I have personally battled with each and every one of them and more for over 8 years. But, in the end, I think Peter your experience and trading skill shines through (just read this interview for example) and I truly hope you continue to be a positive force out there in the sea of misinformation and hype. Also, I think that like all trends, things will eventually shift back to focusing on longer-time frames. Given the current choppy conditions, it won’t be long before those focused only upon the very short-term will be forced to realize the value of taking a long-term view and analytical framework.

Before we wrap it up, of all the things you’ve written online, what would you say are the most recommended must reads so far?

Peter:  Mainly my recommended list would be posts on the process of trading, dealing with human emotions and managing risk. I would recommend the following posts:

I know this is a lot to read, but a reader would really get to know how I think by wading through these posts.

Kirk:  Your book has been very well received by many and I recommend it for all who desire to improve their trading. Is there another book in your future?

Peter:  I have no plans at this time for another book. If I did write another book, it would probably deal with risk management theory and concepts. There are not many good books out there on risk management. But, writing a book is such a huge undertaking, paying about $5 per hour.

Kirk:  Writing a book is much like running a membership-focused trading website – it has to be a labor of love! What are you plans for the future, Peter?

Peter:  There are two things I really want to do, and hopefully my health holds out long enough for me to accomplish these things. I am in my mid 60s and due to some health conditions it is hard for me to put in long and productive days. Thankfully my mind is still working overtime.

First, I am super bullish on the managed futures industry. Managed futures is the fastest growing component of the alternative investment space. My firm plans to launch a multi-trader investment pool (I would not be one of the traders). The 10 or so traders assigned to manage capital for the pool will be selected based on a rigorous algorithm related to risk adjusted performance. I want to know how traders have done during their worst periods. I want traders obsessed with risk control. I very much dislike the Sharpe ratio, preferring to focus on the Calmar, MAR and Sortino ratios as measures of risk-adjusted performance and volatility. Our goal is to select and manage a stable of traders who can provide a total portfolio rate of return in the area of 15% per year with a worst annual drawdown less than 8%.

Second, whatever success I have achieved I owe to the fact a couple of guys at the CBOT took me under their wings and mentored me. I am not yet sure what it will look like, but I want to develop some means for passing that on. It might be through a blog. It might be by email. It might be by developing an online community whereby I establish the forum subjects and moderate ongoing discussion. I am not sure yet. I know that you too, Charles, have the same passion for mentoring other traders. I am especially passionate about communicating the importance of risk and emotion management. These are two areas that are not given enough attention. I am working with the good folks at Elliott Wave International to do some training on these subjects through small-group boot camps.

As long as my mind is working I do not ever see myself retiring. I hope to die with a chart in my hands.

Kirk:  Thank you so much Peter. We appreciate it tremendously and wish you the best in your future endeavors both in the markets and beyond.

* I encourage all members to add Peter’s site to their watchlist. (By the way you can also view updates through The Wire). I also recommend you check out his book and the recommended links he previously provided. I’m sure if you have any questions about anything he said in this interview, he will be more than happy to help you.

###

Traders Boot Camp

Two exclusive 3-day Boot Camps for serious high-net-worth traders in 2012. If you trade at least $500,000, have three to five years of experience but have not achieved the performance you desire, this Boot Camp may be for you.
Only 40 seats are available in 2012. The next possible Boot Camp in the U.S. will be late summer 2014. Click banner for more information.

June 14-16, 2012
Garden of the Gods Country Club
Colorado Springs, CO October 11-13, 2012
The Broadmoor
Colorado Springs, CO

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

You might be interested in:
blog comments powered by Disqus