Tag Archive for: $STUDY

Lessons from a difficult year of trading

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This correspondence details lessons I have learned about myself, my trading and the markets as a result of a difficult year of trading.

Perhaps these lessons can benefit you, especially if you are a discretionary trader who uses chart patterns for trading.

I am not shy about hyping my good trades. I am also not hesitant to point out my unprofitable trades as well. In fact, traders who know me best would say that I am much more inclined to discuss my struggles than my victories in trading.

Touting only profitable trades is a violation of full disclosure because profitable trades are not representative of overall trading performance. On the other hand, an analysis and discussion of the trials and tribulations of trading can produce trading insight. In fact, I believe that the best thinking by traders occur during periods of adversity. It is during these periods that traders think most deeply about their trading and risk management protocols and practices, about market behavior and about the human dimension of market speculation.

I am presently experiencing a quite unpleasant 12-month period in the markets. It has been Chinese water torture. I have been forced to go back to the drawing board to re-examine every aspect of my trading.

Background

First, some perspective is in order.

Coming into 2010, I had three pretty good years of trading. In 2007, my trading account gained 95 percent (due mostly to Gold). I was up 59 percent in 2008 (EURUSD and GBPUSD). Then, 2009 was an okay year with a 24-percent gain (due almost exclusively to a mid-year Sugar move). I had a fair first four months in 2009, up about 7 percent, but trading has been a struggle since then. I am in a 12-month drawdown of around 13 percent. The peak-to-valley magnitude of this drawdown (marked by red box) has been mild by historical standards, but the duration has been a 30-year record. The scatter graph below displays all my drawdowns in excess of 10 percent.

 

I have had some excellent trades in the past 12 months, but they have been too few and far between. As I stated earlier in this correspondence, this past year has been like Chinese water torture…drip…drip…drip! Of all the drawdowns I have encountered over the years, this one has without a doubt been the emotionally toughest to endure.

Since 1981 I have experienced more drawdowns than I can remember – at least two in excess of 5 percent every year I have traded. I have survived every drawdown. I have no doubt I will survive this drawdown – and that I will emerge as a better trader.

As has always been the case with drawdown periods, I attempt to ask (and hopefully answer) three questions.

1. Has my trading plan/guidelines/rules been out of synch with the markets?

  • If so, in what ways? Has the drawdown uncovered some basic flaws of the plan? [Note: Basic flaws in trading plan are masked during profitable periods – they show their hand during drawdown periods.]
  • What modifications could I make to address foundational flaws of the trading plan, not to optimize the plan against the recent time period, but to improve upon the plan. [By the way, I am not a believer in the optimization of indicators.]

2. Has the basic behavior of the markets changed?

  • If so, might the change in market behavior be permanent?
  • If permanent, what might be the reasons?
  • If permanent, what are the implications for the trading plan?

3. Has my trading execution been out of synch with the plan? (Note: this applies more to discretionary traders than to systematic traders.)

  • If so, in what ways has my execution been out of synch with my trading plan?
  • Have there been any particular patterns in the breach of the trading plan?
  • What changes are needed to bring execution back into line with the plan?

As I analyzed the past year, the answers to the three questions are YES, YES, and YES. My analysis attributes a percentage contribution to trading results by each item. Perhaps in a future post I will address the attribution analysis.

Over short periods of time nothing can really be done to address #1. All trading plans are cyclical in terms of their alignment with market action. Addressing foundational flaws of a trading plan is an ongoing effort for all traders. This is a healthy and needed process.

But a “Yes” answer to item #2 is a more complicated matter. I believe the basic behavior of markets has changed permanently. See my blog post here for my thinking on this matter. Yet, I also believe that my solutions for items #1 and #3 will address the changing nature of the markets.

Action plan

The bottom line issue for me is simple – What changes do I need to make to my trading plan (and the execution of the same) and to my risk management protocols to return my trading plan to consistent profitability? Without going into depth on each item, the following represents my action plan. Some of these items represent modifications, some new twists and some a rededication to basic principles.

Focus on charts from an elevation of 40,000 foot

Daily chart patterns have become increasingly unreliable. In fact, the changing nature of the markets (especially in forex and futures) has almost made shorter-term patterns things to be faded. This means that I will not look at an intraday chart and only look at a daily chart if the weekly or monthly charts have given me a reason to do so. Fortunately, the weekly and monthly charts have not been compromised by changes in shorter-term market behavior.

Decrease risk per trading event

My historical maximum risk per trade has been 100 basis points, with the entire position entered at once. I have readjusted this maximum risk to 60 basis points, with positions being established in halves or thirds.

Avoid range-bound markets

The past year has greatly reinforced the concept of “markets at rest remain at rest and markets on the move remain on the move.” I have lost a significant amount of capital in the past year anticipating breakouts that did not occur.

Be much more aware of the underlying trend

Defining “trend” can be a difficult challenge, but I have begun monitoring some moving averages – not in the sense of developing or using a moving-average trading system, but as a proxy for trend. A majority of the chart pattern trades that have cost me money in the past year have been countertrend (as measured by the moving average proxy).

Transition away from high/low/close bar charts to closing price charts

“Noise” has increased in my primary markets (futures and forex). I have had way too many orders executed at intraday price extremes, only to have the markets close at prices favorable to my trades. The most important price of the day is the closing price. The most important price of the week is Friday’s close.

Modify my protective stop protocol to reflect increased intraday noise

I have always believed in having protective stop orders in place at all times. I am no longer a strong advocate for this practice. I have been stopped out of too many positions only to see better exit spots within hours or days. Rather, I am now an advocate of the following protective stop protocol.

  1. No stops in overnight markets, including forex
  2. Mental stops based on closing price charts – the use of mental stops requires disciple to follow through with intentions
  3. Very wide actual stops (daytime session) to protect against a “worst case scenario”

Actively trade a portion of a position

Historically, I have held onto my entire position until the target was reached or until the initial protective stop was hit. This strategy has not treated me well during the past year, and, in fact, has negatively impacted my bottom line for the past two years. Rather, I have adopted a strategy to hold half of a position while trading half of a position, selling only on strength and buying only on weakness.

Avoiding ambiguous market situations

As a discretionary trader (as opposed to a systematic trader), there are always market situations that fall into a grey zone – “is there a set-up or isn’t there a set up?” I have historically erred on the side of giving a set-up the benefit of doubt, believing that I would benefit if just one in four questionable set-ups worked. My theory has been that making money is more important than being right. I have reappraised this trading strategy in favor of demanding more clarity from chart patterns. I still believe that making money is far more important than being right — but with less reliable chart patterns, erring on the side of caution is now part of this belief system.

Limit my decision-making time window

I have long had a rule to determine and enter my orders each afternoon and then avoid exposure to the markets during the trading session. At the same time, I love the markets and, like so many other traders, get caught up in the price-making process. The degree to which real-time decision making has negatively impacted my bottom line really hit home in the past year. I am NOT a good intraday trader – never have been, never will be. Paying attention to the markets during the trading session is detrimental to my financial (and emotional) health.

Another aspect of intraday decision making is worthy of note. There was a time in the markets when the trend of the first several hours would continue through the day. This is no longer the case. Directional price momentum during one time slot seems to have no correlation to momentum in subsequent time slots. Markets now routinely make new highs and lows frequently throughout the day.

Let me close this post with one other thought. I am in a drawdown. Yet, I am in no hurry for a new NAV peak. I have seen too many traders blow-up by “doubling up to catch up.” I can only control what I can control – but profitability during any given time period is not a controllable variable.

That’s it for now, folks.

So you want to be a money manager?

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There are a lot of you out there on StockTwits.

I get more questions via email from traders like you about the managed futures/forex world than about any other subject. It seems that a lot of you aspire to manage money in stocks, futures or forex.

While I mostly have been a proprietary trader through the years, I do know a lot about the managed futures and forex space within the alternative investment category. A number of the other StockTwit bloggers know the ins and outs about managed funds from the stock market perspective (knowledge I do not possess), such as my friends Joshua Brown at TheReformedBroker and Derek Hernquist, Howard Lindzon, Dragonflycap, Quinttatro, johnsontrades, valueplays, and joefahmy.

I was a trader in the 1980s and early 1990s with Commodities Corp. (CC), the original multi-trader futures and forex prop house. My performance during those years for CC was acceptable, but not great – 18.52% AROR, no losing years, worst drawdown of about 10%. Frankly, I was a boy among men at Commodities Corp. CC launched the trading careers of the superstars – the guys you read about in Market Wizards. I do not place myself in their league.

Consider this post to be the first of many on the subject of managed futures and forex, what the industry is like and what steps you would need to take to qualify as a player. I think that you will be very surprised with some of the information I will share.

Presently about $290 billion is being managed in futures and forex. This is money dedicated to Commodity Trading Advisors (CTAs), as reported by Barclay Hedge. Other areas of the alternative investment category also have commodity and forex exposure.

I believe that within five years the managed futures space will grow to $1 trillion or more. It is the fastest growing subset of the hedge fund world. The opportunities in the next five to ten years are great for emerging traders that have the right stuff.

The ten largest CTAs manage $82.4 billion, or more than a quarter of all assets under management (AUM). You would think that these CTAs are superstars. Not so!

Ten largest CTAs by Assets Under ManagementThrough March 2011
Category Average Range
Assets Under Mgmt $8.2 bil $1.8 bil to $23.6 bil
5-yr AROR 7.86% -3.23% to 19.27%
5-yr worst drawdown (11.09%) (8.49%) to (29.43%)
5-yr. Calmar ratio .71 -.11 to 1.53
Duration of longest DD – peak to valley to new peak  23 mos  9 mos to 46 mos

 

I want to note two things.

First, the performance of the largest CTAs is pathetic, in my opinion, although with a losing year going in 2011, I am a bit shy to be too critical. These CTAs receive huge asset infusions because institutional money flows to the big boys, despite their poor performance. CTAs with a long history, big staffs and huge AUM levels receive the assets allocated by pension funds, huge Commodity Pool Operators (CPOs), etc. The $100 million AUM level is the minimum for a CTA to be considered for institutional funding. The CTA with the most AUM ($23.6 Billion, that’s with a “B”) has a five-year AROR of 4.74%.

Secondly, I believe that the Calmar Ratio  is the best measure of risk-adjusted performance (although the Sortino Ratio is not bad either). To determine your own Calmar, divide your compounded average annual rate of return by your worst month-ending peak to valley drawdown.

The managed futures industry is obsessed with the Sharpe Ratio, which I think is a useless measure, mainly relied upon by institutional money placers to justify poor performance. At industry conferences, such as the Altegris event in San Diego two weeks ago, investors and pool operators drooled during a presentation of the Sharpe Ratio. Yet, the Sharpe Ratio penalizes upside performance. A trader who holds his or her money together with solid risk management for 10 months, then has two wonderful months to make a year, would be murdered by the Sharpe Ratio.

Third, are you surprised by the duration of the longest peak-to-valley-to-new peak drawdowns? Would you have guessed these drawdowns would have been so long? The truth be told, even CTAs in which I have great respect experience long drawdowns.

In the next post I will focus on the performance stats of the CTAs I have selected for my own IRA funds. I want my IRA money in managed futures, traded by people other than myself. 

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Blogging vs. trading!

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 What do the two have in common?

An opinion is NOT a position. A position is NOT an opinion. In the final analysis, the two have nothing in common. Yet, be aware that in this blog I sometimes present opinions and market perspectives (and misc. things I find interesting at the moment) and other times venture into the world of positions.

I have supported myself and my family by trading commodity futures and forex since 1980. Along the way I have made every mistake possible – many more than once. I have had really great years, and I have had losing years. I have had spectacular trades, and I have regularly had drawdowns (in fact, I am in a drawdown right now, so ignore any specific trading idea I might present).

Over the years I have formed principles that guide my trading. One of those principles is that an opinion is not a trade. I may have an opinion – even a strong one – about a particular market, but that does not mean I will have a position. Similarly, whenever I have a position I try not to form an opinion, because opinions lead to biases, and biases can lead to bad trading decisions. Frankly, I think that market opinions are dangerous when they are mixed with trading strategy. All too often I mix this fatal brew.

So, if market opinions do not guide my trading, what does? The charts…and specifically, classical chart patterns that are usually eight or more weeks in duration (preferably 14 weeks or longer) and offer specific risk control set-ups for entry. Because I always risk much less than my profit target, my ratio of losers to winners is quite high and always has been. Historically I am unprofitable on 65% of trading events, although over short periods of time that figure can range from 50% to 80%. Personally, I think the idea of chasing trading approaches that are right 80% of the time is a joke. I believe that the payoff in trading comes from risk control protocols, not from trade selection.

I have made my net-bottom line profit from fewer than 10 percent of my trades. The other 90 percent of trades have been wash-outs. Wouldn’t it be wonderful if I knew in advance which 10 percent of the trades would deliver the goods? Although even if I did know this in advance, my human emotions would probably push me into some of the other trades.

Some of my blogs have expressed opinions or perspectives on markets in which I have not had a position. I have no position in Silver nor is there any chance I will have a position within the next two or three months. I am long Gold and have been since April 5. The market came within an eyelash of my target on Monday, so I will now jam my stop.

A lot of my blog posts (perhaps the majority) reflect opinions or market commentaries or market perspectives that are disconnected from my trading operations. If you only heard from me when I took a position, you would not hear from me very often (perhaps you would rather have it this way). Similarly, I post a number of charts on Chart.ly that I find interesting, but do not even come close to qualifying for an actual trade.

But, periodically I will tout a trade I am entering – and again, a position is not an opinion and an opinion is not a position. A position, purely and simply, is a specific market set-up that provides certain risk/reward characteristics.

I have touted several of my actual, real-time trades in this blog. I laid out the specifics of a shorting strategy in Apple Computer – that trade did not work, but it provided the type of a risk/reward profile I dream about. I only get about ten or so set-ups per year like I had in AAPL.

On April 21, I posted a long strategy in the S&Ps and Nasdaq. I went long the Nasdaq on April 20 and the S&Ps on April 25. The jury is still out on these trades. Currently my stop in the Nasdaq locks in a small profit and my risk in the S&Ps is about 40 basis points.

On March 25 and April 1, I laid out a technical case for a bull move in the emerging stocks markets. I did not play this one in futures, but moved 50 percent of my IRA funds into emerging markets and China between March 23 and March 30. I pointed out this situation before I finalized my trade. The jury is still out on this trade as well.

On April 13, I made the case for being long Soybeans and short Corn. I am in this trade. This is a trade that may require two or three years to fully play itself out, but it is a single trade than could return 20 to 30 percent to a portfolio. I completely understand that in the age of day trading, a trade that requires two or more years to work is not something most of you care much about. But, nevertheless, it is a trade I am carrying and will likely be carrying for a considerable period of time. BORING!

Over the years my trading horizon has gotten longer while the horizon for most traders has gotten shorter. Apparently I am out of step with the world.

So, once again, in my mind, positions are not opinions and opinions are not positions. Yet, in this blog I deal cards out of both decks. Hopefully as readers you will become aware of the deck from which I am dealing in any given blog posting, and will react to the post accordingly. If my opinion runs counter to your opinion or your position, please do not take it personally.

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