Welcome to MarketPulse, Australia’s most insightful look into the markets and trading!

Over the last few MarketPulse articles, we have discussed the various steps which traders need to go through to design a robust trading system. For those who may have missed those articles, a trading system contains a series of conditions which need to be met before we enter a trade. When these conditions are met we are said to have a ‘setup’. Setups are an integral part of our trading plans and are essential to improving our consistency and performance in the markets.

This week we will put into practice the trading system we designed in the previous article. To recap, the trading system involved:

Long term trading system

Entry Rules

Condition 1

Before a long entry can be considered, the 100 day moving average must be at its greatest level in the last 20 periods, and the last closing price must be above the 100 day moving average.

Condition 2

Buy when the 20 period ma crosses above the 40 period ma, or if a cross up has occurred within the last 40 days, then the 20 day ma must still be above the 40 day ma.

Holding and Exit Rules

Condition 3

Initial stop loss is to be placed 2.5% below the 40 day moving average.

Condition 4

Stop is to be trailed higher each day to 2.5% below the 40 day moving average at the conclusion of each trading session.

Back to the future

We are going to take the approach most professional traders will use when testing a system and run a ‘back test’. A back test is a simulation of how a trading system performed on historical data.

To run a back test we need to choose a sample of data and record in meticulous detail each entry and exit for the system based upon its explicit rules. We then sum the results of many trades over an extended period of time to get an idea of how effective a system has been in the past.

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For this back test we are going to use a security which has been in the news quite a lot of late, the Australian Dollar versus the US dollar (AUDUSD). Of course, one could back test on any asset which has a history of prices, so you may wish to further the research on this system and test over your favourite stocks or commodities.

The period of time we test over should be far from random. If we are going to design a system, then preferably the system works over all types of market conditions (rising markets, falling markets, sideways markets and variations thereof). This article is not meant to be a comprehensive tutorial on back testing, but I will make one important point on this topic here: We must choose a period to test which contains each of the various market conditions in the past.

To highlight the importance of this item, consider if we chose to test over a period of data which happened to only contain strongly rising prices. If we discover our system works very well, it is highly likely that the system will work only in a similarly strong market into the future. If the market into the future is not as it was in the sample testing period, we are likely to experience significant losses. Similarly, we may find the system failed miserably in testing over this sample, yet worked very well in the ensuing bear market. In summary, if we wish to obtain a system which is robust over multiple market conditions, we therefore need to test over multiple market conditions.

Secondly, (and again briefly here because the topic of back testing is a vast one) it is also important not to run a test up to the current day. We should select a period of time in the past which contains multiple market conditions, and then a similarly diverse period of time subsequent to this period to conduct further testing on. This is because we can test the strategy on the initial period, optimise any parameters to improve its performance, and then test the optimised system on the second, most recent sample.

This is called ‘out of sample’ testing and is far preferable to simply testing up to the current date and then taking the system ‘live’. In each case, the system will be tested on data it hasn’t seen before, however in the latter, we have no risk of losing our shirts during the testing process! Testing on out of sample data invariably leads to a more robust trading strategy and better real life results.

Taking all of the above into consideration, we will select the period of time from December 1998 to December 2007 to do our initial testing (see below).

 

We can see from the price data above that the AUDUSD has moved in all manner of trends over the sample period. Importantly, the period of time subsequent to this and up to today (on which we can eventually conduct our out of sample trading) has a similar variety of price trend conditions.

For our system we will assume that an entry (green arrows) is only made when each one of our official entry conditions are satisfied. As this system is based upon end of day data, a setup is only confirmed at the conclusion of a trading day. This means that when a signal occurs, we may only enter a trade on the open of the next trading day (we will use the open price in our results). We will also assume that upon entry we immediately placed our stop loss 2.5% below the 40 day ma and then trailed it dutifully in this fashion each day (exits are red arrows).

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This is a long only system (we never go short), and we only traded in one contract at a time, not increasing our position even if subsequent buy signals to our original were encountered. By the way, anywhere we refer to ‘days’ in this example, we mean trading days – not calendar days. Finally, as our stops are automatic, we assume that they were triggered in real time. For simplicity, there are also no commission costs, financing, or slippage in our example (this is the reason why we chose to test over an FX pair as these are typically very small anyway).

When we overlay our trading system on the AUDUSD Spot, we get the following series of entry and exit points over a 9-year period.

Our simple moving averages system allowed us to make 2,264 pips profit. On one standard contract, which is worth US$10 per point, this would amount to US$22,640 profit over 9 years. This is an annual return of approximately $2,500 on an investment of approximately $500 margin for one standard contract. Better than a poke in the eye – yes, but it’s fair enough to say it’s not enough to retire on!

Note that our strike rate was less than 50% and our system was still very profitable. This is because our average win size was nearly three times greater than our average loss size. Our average profit or loss per trade was a profit of 174 pips. Again we have to emphasise that strike rate is not all that important in building a good trading system. It’s how much you can expect to make on each trade, and overall, in the long run that really counts.

That’s all we have time for in this week’s MarketPulse. For now it is important to note two things:

Firstly, that just because a system made zillions of dollars over the last 50 years, it doesn’t mean it will make a cent in the next 50 minutes! All we can do is take our back testing with a pinch of salt and understand that in the future anything can happen.

Secondly, the system we have outlined here is a very basic system and has a very long way to go before it is actually tradeable. I.e. read between the lines here: these articles do not constitute a recommendation to trade this system! It’s just an example, and one which we will expand on next week.

Until then, happy systems testing!

See Carl Speak at a FREE Trading Workshop near you. Click for more!

   Written by: marketpulse   Other posts from: marketpulse

Over a number of previous MarketPulse articles, we have discussed the various steps which traders need to go through to design a robust trading system. As a recap, a trading system contains a series of conditions which need to be met before we enter a trade. When these conditions are met we are said to have a ‘setup’. Setups are an integral part of our trading plans and are essential to improving our consistency and performance in the markets.

Over the next couple of weeks we will attempt to put everything together, and design a trading system which readers might actually wish to implement for themselves. We’ll also point out a few important practical considerations traders need to take note of when designing and testing a trading system.

System 1 – Simple, but effective

As we said in the last article on this topic, systems need to have objectives. The objective of the system we will design and test today is to capture major long term swings in the market the system is operating on. Generally such systems are trend-following systems which have wide stops and open-ended targets. This trading system would be suited to a long term investment portfolio or a self managed superannuation fund.

Whilst this might not sound too exciting for many of you ‘seat of your pants’ traders out there, we conduct this analysis to show how timeframes and objectives are important in successful system design. We will test some shorter term systems in future weeks.

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Once we have our objectives, we must begin to construct the ‘Framework’ we described in Part III of this series of articles.

1. The trading system needs a set of rules for entry.

Any long term trading system should first and foremost start with defining and following the long term trend. Our proxy for the broader trend will be the 100 period moving simple average (ma). So, Condition 1 for our set of entry rules becomes:

Long term trading system – Entry Rules

Condition 1

Before a long entry can be considered, the 100 day moving average must be at its greatest level in the last 20 periods, and the last closing price must be above the 100 day moving average.

What the above should do is only put us in trades where the long term trend is up, and the trend is still in place (as the 100 day ma has been rising over the last 20 periods, and the price is still above the average).

On top of this basic condition, we will now add further conditions or ‘filters’ to improve the effectiveness of our overall entry signal. For this system, we are going to try and filter out trades where the shorter term momentum is not strong – even though Condition 1 may have been met.

Condition 2

Buy when the 20 period ma crosses above the 40 period ma, or if a cross up has occurred within the last 40 days, then the 20 day ma must still be above the 40 day ma.

An entry signal will occur when each of the above conditions are met. We talked in Parts III and IV about ‘setups’ and the above is an example of purely technically based trend setup. We think that there is more to a setup than just the entry signal however, and each setup should be considered in terms of risk and reward, and where we can place our stops.

Only fools rush in…

An entry signal is only a small part of a trading system. As we showed in the case of the coin toss example in Part I, it is also sometimes the least important element of a system. This brings us to items 2, 3, and 4 of our Framework.

2. The system needs a set of rules to determine how we take profit,

3. The system needs a set of rules to determine how we take losses, and

4. The profit we take should be larger than our losses.

A trade setup consists not only of the entry signal, but also some consideration of where a stop loss can be safely placed, and how much we are risking at that stop loss compared to the potential profit we may make if we are successful.

We feel that with trend based systems, we’re better off just letting our profits run and letting the market decide how much profit we eventually take. For such systems, whilst we might have a ‘loose’ target in mind, we prefer not to set a hard-and-fast point for where to exit at a profit.

For stops, we are prepared to give the trend based system some room, but we also have a motto when it comes to the relationship between setting stops and setting profit targets:

“Whilst we are brave in victory, in defeat we run like frightened animals!”

This means that whilst we like to let our profits run, we want to keep our losses as small as possible. This will help in building a system with positive expectancy.

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We have discussed each of the above elements of the Framework in detail in previous articles, and based upon those considerations and the ones above, we will add the following conditions to our trading system:

Long term trading system – Holding and Exit Rules

Condition 3

Initial stop loss is to be placed 2.5% below the 40 day moving average.

Condition 4

Stop is to be trailed higher each day to 2.5% below the 40 day moving average at the conclusion of each trading session.

We have now defined each element of the setup, from entry to stop placement. So what do we do now? How do we know if the system is any good!?

Well you might want to start testing this system on a few stocks, FX pairs, or commodities to see how well it works. However rather than calling up the bank manager and taking out a second mortgage on the house to have a go, you may prefer to take the approach most professional traders will when testing a system and run a ‘back test’.

A back test is a simulation of how a trading system performed on historical data. We will choose a sample of data and record in meticulous detail each entry and exit for the system based upon its explicit rules. By summing the results of many trades over an extended period of time, back testing allows us to get an idea of how effective a system has been in the past.

Back testing itself is a major field of technical analysis, and if performed correctly, it can also give us some valuable insights into how a system may perform when we trade it live with real money in the future.

Next week we’ll do just this and investigate how well the above system is likely to work in practice. Until then – happy testing!

See Carl Speak at a FREE Trading Workshop near you. Click for more!

   Written by: marketpulse   Other posts from: marketpulse

Welcome to MarketPulse, Australia’s most insightful look into the markets and trading!

In previous MarketPulse articles we have been discussing in detail the steps required to create a robust and effective trading system. As a recap, a trading system is a significant part of a broader trading plan which defines the conditions through which we engage the market.

A trading system is certainly not a complete trading plan however! Getting into the market is just one of the considerations a trader must take into account when trading over a period of time. Other factors such as risk management, portfolio allocation, exit rules, and self assessment and adaptation are all far more important to long term trading success. Nonetheless, few traders will start anywhere else but in systems design. The search for the Holy Grail is on!

Setups revisited

In the last MarketPulse article on developing a trading system we introduced the concept of a setup. We said that a setup was a series of conditions which needed to be met before we entered a trade. Traders strictly only ever enter a trade when a valid setup is observed.

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Here’s an example of a purely technically (using charts only) based setup which may trigger a system entry:

1.     The size of Candle 1 must be greater than 1% of the share price and be in the colour of the prevailing trend (e.g. black candle in an downtrend and white candle in an uptrend).

2.     Candle 2 must open below the open of Candle 1 and close above the close of Candle 1 for a long trade and open above the close of Candle 1 and close below the open of Candle 1 for a short trade (i.e. a ‘bearish engulfing’ pattern).

3.     RSI must have crossed above 30 within last 3 periods for long trade, or crossed below 70 within last three periods for short trade, or enter after conditions 1 and 2 have been met and an RSI cross subsequently occurs.

Setups can generally be defined as trend, reversal, range, and breakout setups. If there’s another phase of the market – we haven’t thought of it yet. But generally prices are in one of these phases. The above example is primarily a reversal setup.

Reversal Setups

Reversal setups tend to be very responsive. A setup’s responsiveness will determine how much of a price move will be missed before an entry is made. Given that reversals are generally rapid changes in price direction, we’d want to use the most responsive tools available to us to identify them. We find that pattern based technical analysis tools are best suited to reversal setups rather than fundamental tools which may have a significant delay before actually affecting prices.

For reversals setups, we find that candlestick patterns are extremely useful, as are more conventional bar chart patterns such as double tops, double bottoms, and head and shoulders. Indicators such Bollinger bands, stochastics, and the MACD with timeframes less than 20-periods can be used for confirmation of the observed price patterns.

Whilst reversal setups are generally suited to those trading with shorter time horizons, of course, quite often when a reversal is made a new trend is commenced. Thus the trader may find that a trade initially entered on a reversal set up is maintained because it also ends up meeting the criteria for a trend setup down the track.

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Trend Setups

Trend setups are generally less responsive than reversal setups because trends tend to last for a long time, and therefore the timeliness of an entry is not as important as for reversals. Also, we generally want to be pretty sure that we are actually in a trend before we enter, and thus should be prepared to trade off some profitability for certainty of the trend being in place. Trend setups are therefore better suited to those who have a longer term trading horizon.

For many traders, setups conditions may also include fundamental aspects such as price to earnings per share ratio (PE), and earnings growth. These are used as broad filters to whittle away those stocks less prone to trend. It’s fair to say that stocks with attractive valuations, and both growing earnings and a solid history of earnings growth, are more likely to trend than those who don’t meet these criteria.

From the subset of stocks generated by our fundamental analysis, we will generally then run a series of technical filters to ascertain the direction and strength of the trend. In this case, we prefer to use moving averages of a duration appropriate to the timeframe we are looking to trade, and look for confirmation from the tools such as the momentum indicator, relative strength index (RSI), and on balance volume (OBV). Generally, we are using longer timeframes on these indicators – of more than 20 days in duration.

Here’s an example of a trend setup which takes into account both fundamentals and technicals:

1.     PE should be less than 15

2.     Earnings in last 3 reporting periods must have increased by 10% pa on each occasion

3.     Consensus estimates for 1 year future earnings growth are great than 10%

4.     Price must be above 50-day moving average

5.     20-day moving average must above the 50-day moving average and rising

6.     RSI must be above 20 but below 80

Really, in the above example, stocks which meet the criteria will be trading on fairly cheap price to earnings multiples, have a consistent history of growing earnings and likely to continue to do so for the near future, be in a medium to long term uptrend as measured by the 50-day moving average, and price momentum will be increasing given that the shorter term moving average is rising and the RSI is still in an expansion phase.

Setups give us better trades

Imagine if you only ever considered trades which met the above criteria? How much better would your portfolio have performed over the last 5 years or so?

Well, that’s the whole point of your setups: To try and put you in trades which have a high probability of success and which are of a similar nature each time. Anything else but stocks which fit your entry criteria will be ignored.

In each case, it is important to clearly define the set of rules under which a trade will be entered. There should be little-to-no room for discretion or interpretation – otherwise you don’t have a system! So, be very specific in defining exactly what needs to transpire before a trade signal is generated.

Be careful however to not make the number of criteria required to be met too onerous so that very few signals are generated, or so loose that too many signals of a lesser quality are generated.

We’ll investigate further in future MarketPulse articles.

See Carl Speak at a FREE Trading Workshop near you. Click for more.

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So far in this series of articles on building a trading system, we have defined what a trading system is, why it is so important to have one, and some of the basic elements required in constructing one.

In this week’s article, we want to present some important considerations in the build up to actually selecting elements for, and testing a trading system. We will stick with the theory a little longer, but promise the practical aspects of constructing a trading system, and more importantly testing your system are not far way.

System Objectives

There’s an old saying that ‘you need to know where you’re going so you can figure out how to get there’. Well, this is true for trading systems as well. There is no such thing as a one size fits all approach. A trading system should have a clear set of goals which it is to accomplish, and as the saying goes, this will define the elements of the system.

Obviously, the overall goal of any trading system is to make you money. Sure, but how much risk do you want to take to make that money, in what time frame would you like all of these profits to occur, and what mix would you like – income or capital gains?

Ok, a few of you smarty pants out there just answered ‘None’, ‘as fast as possible’, and ‘both’. But in reality, these are important questions to ask when developing a system. As an analogy, if your objective is to build a birdhouse, then you’ll need a certain set of materials, the right tools, and a well planned methodology. If you try to build your birdhouse with a set of plans for a doghouse, you could end up in one.

A trading system works in the same way. The objectives of a system will define the type data which you will need to gather, what specific fundamental and technical tools will be required to get the job done, and your plan or methodology. Let us focus on these elements a little closer.

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Timing is everything

Before you think about the timeframe over which your system may work, you must first determine how much of your own time you can devote to trading. Are you able to watch the market constantly (in real time), or are you only able to view data a few times a day when decisions can be made? Perhaps your non-trading commitments mean you can only analyse data once a day? Once a week? Your ability to access data and make time to perform the analysis required to make decisions will influence the type of data you need to source, and therefore the timeframe your trading system should be designed to suit.

There’s no point designing a trading system which requires constant attention to real time price data if you can’t possibly be in front of your screen to analyse that data, make a decision, and implement a trade. If you can only spare enough time to do the above once a day, then your trading system should be based around end-of-day data, and trades which therefore last for days or weeks. If you can realistically only do your analysis once a week, then weekly data is the way to go. Don’t be in too much of a hurry, and don’t try and trade in a timeframe which you can’t possibly devote enough time and effort to.

Once you’ve determined a timeframe you can reasonably be expected to commit to, you will find that this requires a specific arsenal of tools to get the job done. For example, analysing end of day data will generally involve you setting trades as ‘limit orders’ or ‘on-stop’ orders, to be executed in the market by remote the following day. Should you be able to watch the market constantly, you may find yourself using ‘market orders’ to enter a trade setup which has just fired based upon intraday data.

Also, some fundamental and technical analysis tools are better suited to different timeframes of trading than others. For example, using a 20-day – 50-day moving average crossover to generate buy and sell signals would more than likely yield you better results on a medium term, end-of-day system than a short term, intraday system. In this case, one would be better off using a 20-minute – 50-minute moving average cross-over.

This realisation that some tools are better for longer term trading, and some are better for shorter term trading, is important for system design. Good system design is all about using the appropriate tools for the job. But, having said this, many of the principles on which indicators and price patterns are based upon can be applied over different timeframes. So that killer candlestick pattern you’ve seen work time and again on a daily chart will more than likely work on an hourly chart, and perhaps even a 15-minute chart. You just have to match the timeframes of the tools you’re using with your ability to perform the analysis.

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I’ve been setup!

Once you’ve determined your timeframe, you can now begin to define your setups. A setup is a series of events which are required to occur before a trade is entered, the prevalence of these events being predictive of the price action which is likely to occur next. A setup defines your edge in the markets: this is what gives your system its positive expectancy (for more on expectancy see MarketPulse article How to Build a Trading System Part 1).

The conditions which we use in our setups can be drawn from any field of analysis, including fundamental analysis and technical analysis. Some traders use even astronomy, but whatever your approach is, the events which occur to define our setups need to be discretely identifiable with no room for discretion. It’s either a setup and all rules are met, or it’s not.

Rather than get into the old Fundamentals versus Technicals argument now (we’ll leave that to another MarketPulse article) we’ll try and keep this discussion as practical and concise as possible and simply focus our attention on technically based setups, that is, setups derived from charts.

Alas, we’ve run out of time in this week’s article and will pick up the discussion with some actual examples of tradeable setups in next week’s MarketPulse.

See Carl Speak at a FREE Trading Workshop near you. Click for more.

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Welcome to MarketPulse, Australia’s most insightful looking to the markets and trading!

The recent volatility is a good reason to take pause, and conduct an audit of our trading systems.

Trading systems need not be embedded in concrete. Rather, they need to be flexible enough to bend and sway a little when market conditions warrant; but not so much so that rules are constantly adjusted to match the market on the fly.

In the first case, how much flexibility is too much? And in the second – how do we know when are ‘curve fitting’ our system to past results?

At the end of the day, a trading system is only valid if the rules of the system are adhered to. If we are not going to follow the rules, we should not expect to REALLY know whether our system is fundamentally sound – or flawed. So despite possessing the ability to create a robust and effective system, the trader’s discipline is equally important in the system’s ultimate success or failure.

Today begins a series of MarketPulse articles which will attempt to address these issues, and others, in what should be a checklist for setting up a trading system and a set of parameters for periodic system review.

What’s a trading system?

In its most basic sense, a trading system is simply a set of rules which determines how we act in the market. It will have a set of criteria that determines how and why we would enter a trade, what we do once we are in the trade, and finally, how and why we exit the trade.

It will also consider how much we intend to risk on each trade as well. Often, this is far more important than how we enter the trade in the first place.

Before we go into the aspects of determining the components of a trading system and capital management, we first want to talk about some broad concepts to help us understand the need for a trading system.

Expectancy

Do you know your expectancy?

Do you realise that if you don’t know your expectancy, you don’t actually know whether you are a profitable trader, or are possibly doing more harm than good by attempting to manage your own money! Expectancy is the single most important concept in understanding whether a trading system is worth pursuing or tossing on the scrap heap of broken trading ideas.

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So what is expectancy?

Expectancy is simply the average amount you can expect to win or lose per dollar you risk per trade. Here’s the formula:

E = (PW x AveW) – (PL x AveL)

Where:

• E = expectancy
• PW = probability of a win
• AveW = Average win
• PL = probability of a loss
• AveL = Average loss

 

Let’s say for example, Alice flips a coin to determine whether she should buy or sell. Heads, she buys – tails she sells. It turns out that this system produces winning trades 50% of the time. Alice places $1 on each trade.

Alice is disciplined enough to cut her losses at 50c when they occur, but also to let her profits run to $1 should she get into profit. She places $1 of capital in each trade position.

Therefore, the Alice’s expectancy is:

E = (0.5 x $1.00) – (0.5 x $0.50)

E = $0.25

So, each time Alice does a trade, she can expect to make a $0.25 profit for every dollar she risks – or 25%. This doesn’t mean that she automatically makes 25% on each trade. It just means that on average, over many trades, this is what she should expect from each trade.

Think about this for a second. We’ve just demonstrated that flipping a coin, and taking a 50% loss, whilst taking a 100% profit would on average, make you 25% before commissions over many trades.

With performance like that, it makes you wonder why people have so many technical indicators on their screen! We’ll lend you a dollar coin and you can get started straight away!

Now, of course, it is not as easy as that – if it was, we’d all be millionaires. But, this example hopefully illustrates some very important points in constructing an effective trading system:

1. The system needs a set of rules to determine entry,

2. The system needs a set of rules to determine how we take profit,

3. The system needs a set of rules to determine how we take losses,

4. Preferably, the amount of profit we take should be larger than our losses,

5. If we have a system with positive expectancy, we need to trade in a market which gives us as many opportunities as possible.

(There are others but we’ll run with these for now!)

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Importantly, from the coin toss example, traders should note that strike rate does not factor highly in this equation. The above example only had a 50% strike rate, yet on average over 100 trades, this system would make you $250,000 if you used $10,000 equity on each trade.

In fact, the strike rate could fall to as low as 33% and still break even.

Obviously, the higher the strike rate, generally the better your outcome is likely to be. But, what would you prefer – a trading system which had a 90% strike rate and made you $100,000 on you winners, but lost you $100,001 on your losers? Or a system which had only a 10% strike rate and had the opposite outcome?

Profitable trading is all about expectancy – not just strike rate. I wish I had a dollar for how many times a punter has asked me “So what’s your strike rate?” It’s just not relevant, or at least not the most relevant determinant of the success of a trading system.

Before we move on, there are also some potential flaws in our system, regardless of expectancy, which we need to consider:

1. What happens during a string of losses? (Yes, we have a 50% strike rate, but what if we get the first 50 out of 100 wrong before getting the next 50 right!?)

2. How do we know in advance our system works? (How can we trust the system and keep plugging away if we get a string of losses?)

We’ll talk about each of these points, and other points about what constitutes a good trading system in further detail in next week’s MarketPulse. In the mean time, I hope I’ve whet your appetite for learning more about trading systems!

See Carl Speak at a FREE Trading Workshop near you. Click for more.

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Welcome to MarketPulse, Australia’s most insightful look in to the markets and trading! In this week’s MarketPulse we’ll conclude our discussion on the ‘Three R’s’.

What are the Three R’s I hear newcomers ask? Well, we all remember the Three R’s of grade school: Reading, Writing, and Arithmetic. No doubt these were fundamental building blocks of our early education. When it comes to the markets and managing our money, the Three R’s of Trading are just as important, if only to stay sane! They are: Recuperate, Regroup, and Rethink.

As a quick recap, the first of the Three R’s, Recuperate, entailed going cold turkey, switching off the computer and genuinely removing oneself from the day to day gyrations of the markets. We discussed this concept in detail in the article on May 5th, where we mooted it was looking like a fantastic time to quite literally ‘go and sit on a beach’.

At the time, markets were becoming increasingly schizophrenic as they grappled with everything from earthquakes to European debt crises. The S&P ASX 200 was trading around 4700, and with it now nearer to 4500, investors would certainly have benefited from simply selling up and being out of the market. Bank interest and cocktails on the beach would certainly have been a much better way to go.

In the second article on this topic on May 18th, we discussed the next of the Three R’s, Regroup. This R was about looking back out our trading and identifying the market scenarios which caused us the most angst. We postulated that it was essential for traders to note certain market conditions which tended to put them in an unstable emotional state, and therefore more prone to losing money.

We can all probably think of a certain type of market condition which sees us vulnerable to succumbing to the two basic emotions of investing: fear and greed (for example high volatility). If we are cognizant of these scenarios, we will be better equipped to avoid them and therefore protect our vital trading capital.

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Rethink

Apart from the psychological mumbo jumbo, a break is also a good time to further hone your trading system. This brings us to the topic of today’s MarketPulse, the final of the Three R’s: Rethink.

I expect most would agree that markets are constantly changing, and are doing so at an ever increasing rate. You might find that your trading system as a result is not capturing all of the opportunities it was designed to originally capture. It may be losing its ability to keep you in winning trades longer, and it may not get you out of losing trades as fast.

Take the time over your recuperation to do some back testing of your trading systems to see if modifications can’t be made to improve performance. With a clear head and a renewed focus on the market, this would also be a good time to perhaps even develop one or two more new systems better equipped to deal with the current market conditions. (For those who are not familiar with the concept of back testing, well, you absolutely need to be! This is probably one of the most important differentiators of successful traders from the rest of the punting public. It’s a substantial topic and is probably worth a whole run of MarketPulse articles…so tune in next week.)

When considering your current batch of trading systems, also think about how well suited each system you use is to your trading style, your personality, and your logistical limitations. A system is only useful if you can follow it. You may find that some of your systems are not performing as well as they could have because you simply couldn’t devote enough attention to monitoring and trading them. Perhaps your circumstances have changed – a new addition to the family, a new job etc. Some systems may have to be modified; some may have to be discarded altogether.

These are examples of the various adjustments you can make to your trading with just a little time and thought. Often, in the heat of battle, there is little opportunity for such rational thought and analysis. Similarly, there is often little understanding of what needs to be done when we are so emotionally attached to what we are doing, hence the need to take time to Rethink.

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In conclusion, don’t be a loser!

According to Dr Tharp, the losing trader is one ‘who is highly stressed and has little protection from stress, has a negative outlook on life and expects the worst, has a lot of conflict in his or her personality, and blames others when things go wrong’. (Market Wizards, Schwager, p. 414)

Now, that’s quite a profile! Whilst not all of these problems may be solved by implementing the Three R’s, it’s hopefully easy to see that the process of Recuperate, Regroup, and Rethink is going to far better serve the trader than continuing to bang their heads against the brick wall of an unpredictable market!

A temporary clean break will likely help give a trader some time and space to focus on any of the elements of their personality or trading system which, over time, have become detrimental to responsible and disciplined trading.

Most importantly, a self-imposed hiatus will give the trader perspective. Rarely are good trading decisions made in the heat of the moment, or after some substantial financial, emotional, and psychological setback. The most beneficial thing anyone can do for their trading is to ensure that they are in a calm and rational state when making their decisions. It is only in this calm and rational state that we are most likely to follow our trading system. Consequently, when we follow our trading system, we are most likely to experience success.

Often, distance is required from the market to get your perspective back – to realise that trading is not the most important thing in the world. Now get out there and do nothing!

See Carl Speak at a FREE Trading Workshop near you. Click for more.

   Written by: marketpulse   Other posts from: marketpulse

Welcome to MarketPulse, Australia’s most insightful look into the markets and trading! In this week’s MarketPulse we’ll pick up a discussion we started a couple of weeks ago regarding the ‘3 R’s of Tough Trading Markets’.

The gist of the first article was that when the markets get tough, traders don’t get tough, they get out of the market! There are no prizes in trading for slugging away in a choppy market. Traders who trade in a choppy market…you guessed it: Get chopped up!

The ‘3 Rs’ refer to the three key things trades can do when markets get too tough to trade: Recuperate, Regroup, and Rethink. In the last article we discussed the need to recuperate. This week, we’ll look at another one of the other two ‘R’s’, Regroup.

Guess what. We were right!

Where we left off last time, we assumed that the trader had identified that prevailing market conditions were completely counter-productive to the likely success of their trading system and the disciplined application of it. They therefore decided to enact the first rule of tough markets trading: Recuperate.

Recuperate involves traders doing the sensible thing by exiting all trades which are causing them angst, trailing stops on those which were still doing well, and getting away from the markets altogether. The trader would not even glimpse the markets until both their emotional state, and the market’s emotional state, had returned to some semblance of ‘normal’.

Coincidently, the current market conditions provide us with an excellent real-life example of a ‘tough’ market. Volatility is way up, clarity is way down, and the emotion of fear has gripped investors all over the world. This is the perfect market to avoid.

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We postulated on May 5th that it would indeed be a good time to take a break and recuperate from what has been an exhausting rollercoaster ride in the markets. The ASX 200 at the time was trading at 4753. Today it’s trading around 4700 with nothing but chop in-between. A wonderful two weeks to be out of the market!

So, what do we do once we’ve recuperated? That’s the second ‘R’, the topic of today’s article, Regroup.

Regroup

When it’s time to talk about trading psychology – it’s time to talk Tharp. Van Tharp.

Dr Tharp suggests that ‘emotional control’ is more important than ‘keener analytical skills’ (Market Wizards, Schwager, p. 420). Generally it is when our emotions are running out of control that we require taking a break from trading.

In our self enforced trading break, we should try to imagine all of the external factors which have lead us to making poor trading decisions. How do these factors then affect us on an emotional and psychological level? If we find that certain market factors tend to produce consistently poor emotional and psychological outcomes, you can be sure that poor trading outcomes aren’t too far behind.

When we are emotional in making a trading decision, we tend to make a poorer decision. By determining what the roadmap is for your trading failures, you will be better able in the future to identify and avoid ‘high risk’ situations.

To help identify when these high risk situations occur, it helps to do an audit of all of our trades. Separate them in to winning and losing trades. Try to think back to how the market was behaving around the time of each trade. Write down each of the external elements that may have been prevalent at the time and may have influenced your trading decision for good or bad.

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For example, if you find that your losing trade entries were consistently made at times the market was highly volatile, or at a certain time of the day, or after a major announcement etc., it’s probably a good idea to refrain from making trading decisions at these times in the future.

As a more specific example – We find that three of our losing SPI trades occurred when we tried to buy the SPI after a sudden sharp drop in prices. We were only trying to scalp a few points on a bounce on each occasion, but each time, it turned out that the market continued to fall. Each time we didn’t use a stop, and it turned out that trying to scalp a few points ended up as a major loss.

We have found that trading in the craziness of the first 20 minutes of the session, or after a major news announcement on a company, consistently produces losing trades. We will now note each of these ‘high risk setups’ as confluences of negative influences on our trading. We simply won’t trade when these setups are in place.

As a more personal example, a little while ago, a company (let’s call it XYZ) made a dire announcement regarding its financial woes and opened down a whopping 60% – I can assure you there was a great temptation to ‘punt’ XYZ all day. There was bound to be many opportunities to scalp a few points each way. Right?

Maybe. I guess I’ll never know. I didn’t log into my trading account on that day. Nor did I log in the next day, or the day after that. You see, I simply didn’t trust myself not to look at XYZ, to not be tempted to ‘have a crack’ at picking the bottom, that is, to not stick to my trading system.

Based upon previous experience, I identified this scenario as a high risk time for me personally to trade – and simply stayed out of the market.

Would I have made a truckload by trading XYZ over those four days? Perhaps. But perhaps I would have lost a bundle as well. It simply wasn’t worth finding out. The risk to reward in such a scenario simply wasn’t there.

Incredibly, for my near one-week break from trading anything during the Australian day session, I am none the worse off. I can still function as a human being, none of my existing positions were adversely affected by my forced absence, and the market is still there! Hopefully, that’s enough proof for all of you that taking a break from the market will also have similar results.

Next week, the final ‘R’, Rethink. In the mean time, why are you still looking at the markets! Recuperate and Regroup!

See Carl Speak at a FREE Trading Workshop near you. Click for more.

   Written by: marketpulse   Other posts from: marketpulse

Welcome to this week’s edition of MarketPulse, Australia’s most insightful look into the markets and trading! Given the nasty swings we’ve had in the market recently – and the fact that we have just entered the notorious “Sell in May and go away” period – we thought we’d discuss the need for traders to occasionally take a break to regroup, rethink, and most importantly – to recuperate.

Volatility is up, clarity is down

This year in particular has been absolutely gruelling for traders. Mid-East governments being both (relatively) peacefully and violently challenged, a Japanese earthquake, accompanying tsunami and nuclear meltdowns, a soaring Australian dollar, continued concerns about European and US debt, local natural disasters and a spike in inflation…I could go on!!!

The easy days of ‘rise upon rise’ during the Bull market pre-2007 seem to be well and truly behind us. Now, each day sees brutal hand-to-hand combat between the Bulls and the Bears. Neither party seems to be able to land the decisive blow with sharp rallies being followed by equally sharp drops.

Volatility is up, clarity is down, and the market is behaving more irrationally than ever. Investors are jumping at shadows, gripped by alternate waves of optimism and pessimism – of fear and greed. And here we are, lowly traders just trying to pick our way through the mine field.

It’s exhausting and sometimes debilitating work.

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The 3 R’s

One can only maintain the concentration and discipline required to function properly under the conditions of the present market for so long. Each day, a little more emotional and psychological baggage builds up in the trunk of your psyche.

You start to see trades which aren’t really there, and miss other good trades through utter distraction. Potentially, you end up overtrading, or just as bad – start to doubt yourself and your system, and arrive at an emotional and psychological gridlock.

Of course, there is another alternative: any combination of the above costs you your trading capital, and you arrive at financial gridlock. If this sounds familiar to anyone out there, then you need to take a break. It’s probably time to turn off those screens, and walk away.

Sounds easy doesn’t it? To just walk away?

Rest assured that everyone in the Australian Stock Report Trading Team has been there before. Sometimes it’s pretty damn hard to walk away. What if I miss a trade? What if the market bottoms, or what if it breaks out – I want to be there for that…What if the market crashes? I need to be there – I need to know what’s going on. Maybe I can do something about it – maybe I can make some money.

We hate to miss out don’t we? But here’s a news flash: The market isn’t going away. Sure, it may go up and go down – we concede on this point. It will still be there when you get back from your break. Stocks will still be soaring and crashing, investors will still be just as irrational, and there will be more tops and bottoms.

Unless you’ve just been chosen to head the first manned mission to Alpha Centuri – then you have the luxury of taking some time off and coming back to the market at a later date with a fresh outlook.

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Recuperate

You need time to recharge your physical, emotional, and psychological batteries. If you find yourself at the point where it is becoming increasingly difficult to stick to your trading system and make unemotional decisions, it’s time to take a break.

This means closing out those positions that are in trouble, and or those that are causing you the most distress. This is hard to do. There is always the fear that as soon as we close out a losing trade, it will immediately bounce back into profit.

Whilst it may seem at times that the whole market, nay – the whole world – revolves around every action you make: well, it doesn’t. Sorry to spoil that for you. Close those losing trades out!

The trades which are in a winning position need not be closed – after all, why would you exit a trade which is doing nothing but good for you? Trail stop losses on these positions up to a point where you would be comfortable to take a profit if it all happened to go wrong on those positions. Perhaps even set up some optimistic limit order targets. Leave these trades – they’ll be fine without you. Finally, cancel all pending orders you have in the system.

Now walk away. We suggest for a period of at least a week. Don’t even check prices for this time. Don’t even watch the 6 o’clock news for fear that you will see something that will make you want to check prices. Relax. Enjoy being away from the market for a while.

This process will teach you that the market does actually continue to function without your undivided attention. Your winning positions are just fine without you fretting over them every minute of the day. You don’t move the market, and when you return, it will still be there.

If you are able, try get out of the office/study/house – wherever you normally conduct your analysis and trading. Get some fresh air and some exercise. Healthy body, healthy mind and all that sort of stuff.

But the important thing is to change your routine. You never know – you might like ‘not trading’ so much that you never return! Let’s hope things aren’t that bad!

That’s all we have time for in this week’s MarketPulse, but we will pick up this discussion and muse over the other two “R’s” next week.

See Carl Speak at a Trading Workshop near you. Click for more.

   Written by: marketpulse   Other posts from: marketpulse

In the last few weeks we have been discussing the pros and cons of trading in the foreign exchange (‘Forex’, or ‘FX’) markets. So far, we have learned that FX markets are big, really big, trading over US$4 trillion a day. This is in the order of magnitude: one hundred times bigger than the turnover of all of the stock markets in the world combined!

This means that in such a busy and crowded market, FX traders have to merge very close together in their buy and sell prices, also known as the ‘bid-ask’ spread. As the spread is an inevitable cost of dealing to all traders, the extremely small spreads in FX markets make this type of trading very cheap and very efficient indeed. Certainly, this marginal cost to deal is probably the biggest advantage in trading FX, and is no doubt a major driver behind professionals flocking to this type of trading.

For the average investor controlling transaction costs is an equally important consideration. When one is starting off with a modest capital base, transaction costs are an insidious drain on profitability. Whilst FX trading certainly meets the needs of smaller investors in this regard, there are many other very good reasons why traditional ‘mum and dad’ investors are also flocking to FX trading. Let’s investigate a few of them today.

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All trading needs to be treated like a business. This involves having a well documented approach based upon strictly defined and proven profitable rules. We’ve talked at length in these articles about trading plans and I refer you to the archives for more information. For FX traders, the FX markets offer the ultimate small business proposition.

Staff? Potentially just one! No calls at 8am in the morning from Barry putting on a cough and a sniffle because (you’re guessing) he’s had a big night last night! No salaries, no super, no annual leave to pay…No whinging. No hiring or firing.

Boss? Look in the mirror! You really are the master of your own destiny when it comes to trading.

Clock on, and clock off? FX markets trade 24 hours a day, 5 days a week (early Monday morning our time until early Saturday morning). Pick and choose your hours because there’s always at least one major financial centre around the world open, and therefore some action somewhere in the FX markets.

Time off? That’s up to you. What you put in is what you get out. Also, there are trading approaches and strategies which range from always active to set and forget.

Overheads? Most FX trading platforms are offered free of charge and come with an array of advanced news, analysis, and charting tools. One simply needs a laptop and an internet connection and a place to sit. Hopefully this is a nice sunny place with a great view…it really can be anywhere these days. No rent, no inventory, great! As we’ve mentioned before, FX trading is generally commission-free so the FX trader’s only overhead is typically the spread in their transactions.

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Without a doubt, get this game right and the rewards are substantial both from a financial and lifestyle perspective. However, before you get too excited and begin to entertain dreams of sitting on a beach somewhere on your own little private island, sipping cocktails with the supermodel of your choice whilst tapping away on your laptop making millions in the FX markets…here’s a reality check: Very few FX traders actually make money in the long run!

Why? Well, it’s actually got very little to do with the FX markets themselves. For all of the reasons we’ve already talked about, the FX markets are arguably the most cost effective and efficient markets on the planet. The reason why the vast majority of people fail to make money in the FX markets is because they plunge in with great expectations, too little capital, too little time and dedication to the cause, and little-to-no experience. In addition, very few have the well defined and proven profitable trading plan we mentioned above.

The rewards are great, yes, but so are the risks. So too is the amount of hard work you’ll have to do in order to get yourself to the stage where you are earning a steady and reliable income from the FX markets. Well, what are you waiting for? The ultimate trading market is waiting for you…always!

If you would like to learn more about FX trading, or more importantly learn more from one of the most respected FX traders in the country, Australian Stock Report is proud to offer an exclusive FX workshop presented by Kel Butcher.

The Fast Track FX Workshop is a one-day intensive training session which will show you all of the ins and outs of FX trading and give you a number of great short term FX trading strategies to help you trade profitably from the start. It certainly is a not-to-be missed event! Click here for more…

   Written by: marketpulse   Other posts from: marketpulse

In last week’s MarketPulse article we introduced the concept of Foreign Exchange (FX) trading and a few of the significant advantages associated with this rapidly growing sector of the markets. This week we’ll continue on with the discussion and discuss some of the factors driving FX markets with special attention on the outstanding performance of the Australian Dollar.

To recap, FX trading simply involves the exchange of one country’s currency for another. FX is quoted in ‘pairs’ of currencies, that is, how expensive one currency is in terms of another. Much like you would say that an avocado costs $0.99 Australian dollars; we would say that one Australian Dollar (AUD) costs $0.9900 US dollars (USD). In the same way that A$0.99 buys you one avocado, we could equally say that one avocado buys you A$0.99 (hard to imagine people exchanging avocadoes for cash – however, imagine you were returning one you purchased and just changed your mind on to Coles. Your avocado would indeed fetch A$0.99). In the AUDUSD example all we are saying is that one AUD will buy US$0.99 and US$0.99 will buy you A$1.

The more AUD an avocado fetches (say $2.99), the more expensive we say an avocado is, or that it has appreciated in value. Likewise, the greater the cost of one AUD in terms of USD (say $1.01), the more expensive we say the AUD has become versus the USD, or that it has appreciated against the USD. If the AUD becomes cheaper versus the USD (say $0.8000), we say it has depreciated against the USD.

Avocadoes or Yen?

There are five ‘major’ currency pairs, and countless ‘exotic’ or ‘minor’ currency pairs. Many FX traders focus only on trading the majors, and these are:

- The European Euro versus the United States Dollar (EURUSD), more commonly known as “The Euro”;

- The European Euro versus the Japanese Yen (EURJPY), more commonly known as “The Euro-Yen”;

- The Great British Pound (Sterling) versus the United States Dollar (GBPUSD), more commonly known as “The   Cable”;

- The United States Dollar versus the Japanese Yen (USDJPY), more commonly known as the “Dollar-yen” or simply “The Yen”;

- The United States Dollar versus the Swiss Franc, (USDCHF), more commonly known as “The Dollar-Swiss”, or simply the “Swiss”, “Swissy” or “Chief”.

Until recently, our own Australian Dollar versus the United States Dollar (AUDUSD or “The Aussie”) was considered a minor currency pair. Over the last few years however, its popularity amongst global investors has spiked due to our economy’s large exposure to China and other emerging markets in Asia. As a result, the amount of AUD traded, especially against the USD in which many bulk commodities (nickel, copper, coal and iron) are traded in, has soared.

According to the Bank of International Settlements (BIS), the rise and rise of the Australian dollar as a world standard currency means that it is now the fifth most traded currency pair in the world. This is an astonishing achievement when one considers the size of Australia’s population, and its relatively small economy on a world scale.

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The Lucky Country

As you are probably aware, the AUDUSD exchange rate has risen strongly since the depths of the Global Financial Crisis (GFC) from around US60 cents per A$1 to roughly parity (US$1 to A$1). This means that if you were to have travelled to New York when the GFC was at its worst, you would have only received US$60 for every A$100 you exchanged. Today, you would receive approximately A$100 – a major improvement in the value of the AUD versus the USD and a whole lot more shopping at Bloomingdales!

There are a number of other reasons apart from the Aussie Dollar’s exposure to the Chinese economy which can help explain its amazing appreciation against the USD. A country’s currency will tend to appreciate against others if the rate of interest paid within that country is superior, on an inflation-adjusted basis, compared to other countries.

Since the GFC, Australia’s economy has remained far more robust than its American counterpart, both in terms of economic growth as measured by Gross Domestic Product (GDP), and unemployment as measured by the unemployment rate. Each has significantly outperformed corresponding US measures of growth and unemployment.

The result is that interest rates in Australia have remained very high compared to those in the US. Further, as inflation in each country has been equally subdued, returns on safe Australian interest paying assets like Australian Government Bonds are far more attractive than those achievable on US equivalents.

The final factor in the Aussie Dollar’s spectacular rise is a massive ‘terms of trade’ boom. This simply means that Australia is getting far more foreign currency for the goods and services it exports than it pays for the goods and services it imports from the rest of the world. You don’t have to be a rocket scientist to figure this one out…as the ‘Lucky Country’, we have buried in the ground all of the good stuff the rest of the world wants! In combination with the other factors discussed above, there has been a veritable flood of US Dollars to purchase Australian Dollars forcing the AUDUSD higher.

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Scalpers

The big question of course is whether the AUD can keep rising, will it stagnate around parity, or potentially even fall back to more historically familiar levels around US80 cents. Note though that for many FX traders, such bigger picture questions are merely a distraction from the day to day ebb and flow of the FX markets.

You see, most retail FX traders, including small private traders potentially even like you, tend to be very short term in nature preferring to ‘scalp’ small fluctuations in various exchange rates. They can afford to do so because of the tremendous leverage afforded to FX traders. Leverage simply means putting up a small amount of money to take a bigger position in the market.

As we discussed last week, FX is traded in very small price increment points called ‘pips’. A one pip move in the AUDUSD, for example, is 0.0001 of one dollar (imagine the AUDUSD going from 0.9951 to 0.9952).

Typically, an FX trader will aim to make a few hundred pips a week. Depending on the size of the account they have, and the size of the contracts they are trading, this could be as little as a few hundred dollars a week, to a few thousand. Certainly, for many FX traders, trading is a constant and exciting battle of wits with the markets.

We’ll pause there for now and pick up our discussion on FX trading next week and ponder why it is the fastest growing source of enquiry from Australian Stock Report members.

Don’t forget Australian Stock Report’s new Fast Track FX workshops with legendary trader Kel Butcher.
Kel will be unlocking the secrets of short term FX trading for a living – learn more here!

   Written by: marketpulse   Other posts from: marketpulse