Trading Coach

How To Lose Everything – Use A Bad Trading Strategy

2008-05-06T21:38:00.000-07:00

In the last few chapters we wrote about trading, we touched on the importance of back-testing your strategy and how this can help to identify both poorly performing and trading good systems. In this trading article, we discuss a trading strategy that has been touted around quite a bit but is probably the worst strategy you can use.

By showing you this trading strategy it is hoped that:

It should teach you what not to do ...
Encourage you to do the exact opposite

Unfortunately, for the beginner, this strategy seems quite logical but it is fundamentally flawed. Many people have become stuck in its claws and have lost substantial amounts of money because of its apparent logic. Do not be one of them!

The trading strategy is called averaging down. An example may help to illuminate how this works.

Averaging Down – An Example

Let us assume that you have just bought 1000 shares of stock XYZ for $50 a share. Your intention was that this stock should hit $100 in the next 6 months. You place a stop at $25.

About a month after you bought it, the price has declined a little and it is now trading at $40.

You then decide that you will buy more of the same company at $40 per share. As such, you place an order for your broker to buy 1000 shares at $40 each.

You now have 2000 shares altogether – 1000 shares bought at $40 and a further 1000 shares bought at $50.

In total, you have paid $90000 for 2000 shares ($40*10000 + $50 *10000) which make the average price you paid per share at $45 ($90000 / 2000).

You now have 2000 shares that are currently at $40 per share. The average price you paid for this is $45.

Let us now assume that the decline continues to $30. You then decide to purchase a further 1000 shares at $30 per share.

This means that you now have 3000 shares at a total cost of $120000. This makes the average price of each share you paid $40.

The above example can go on indefinitely, however, let us assume that you have had enough buying and eventually sell all your stock at $25 per share when you are stopped out.

The example above shows what averaging down means. It effectively means that you dilute the price you paid for each share by buying more shares at a lower price. The theory is that you pay a smaller amount per share and thus reduce your risk accordingly.

Let us now take two situations. The first situation is that you did not average down from the beginning and the second situation being that you did average down. How much would you lose in each situation?

Situation 1 – No Averaging Down

In the example above, you bought 1000 shares at $50. This cost you a total of $50000. When the price decreased to $25, you would have sold all your shares at $25000.

This means that you took a loss of $25000 to your account.

Situation 2 – Averaging Down

In the example above, you eventually bought 3000 shares at a total cost of $120000. You sold all of these shares at $25 releasing $75000.

This means that you took a loss of $45000 to your account.

In the example above, you took almost 80% more losses in averaging down than by not averaging down – and that is a very big hit to take. The trader in the example did not take into account the following:

You added to a losing position. Remember the old saying – “Follow the trend.” This means that you do not add to a position that is already losing as the share price will probably continue to go in the same direction!

You took on more and more risk. Remember that by adding to your trading position, you are increasing your risk and loss in that position if the trade starts to go against you (and it probably will)!

It is much better never to add to a losing position and never average down.

However, averaging up – that is to add to a winning trading position in a similar manner - is a winning trading system. By adding to a winning trading position you are effectively doing the opposite to averaging down. You are building more into a position that is already winning and therefore potentially magnifying your gains in your trading.

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===============

The Vital Statistics - Discover Why It’s Critical To Run Your Trading As A Business

2008-05-06T21:23:00.000-07:00

If you have ever run a business you will understand the importance of continually analysing its performance and improving on the current position. In order to do this you will need data and information to make decisions.

Trading is very similar. You need access to information to ensure that you monitor your performance and that you are in a state of continuing improvement. In actual fact, going one step further and actually trading as part of a lawfully recognised business that you have registered may also bring several tax advantages but this is out of the scope of this trading article. In this trading article, we are specifically interested in the transfer of analytical skills from a business model to a trading model.

There are a few important statistics that you need to know and you will need to discover through your testing of the system. Knowing these statistics will give you more confidence in your system through bad times and help to control your ego in very good times!!

Reward / Risk Ratio Or ‘R’ Multiple

You need to know how much risk you are taking on for the profits you are making. If you are taking on too much risk then you may have a system that is an ultimate loser. For example, if you risk an average of $200 per trade and your average win is $1000 on company XYZ then your Reward/Risk ratio is 5:1 or in other words your R multiple is 5. On the other hand, you risk the same amount on company ABC and you get an average return of $100, then your Reward/Risk ratio is 1:2 or your R multiple is 1/2.

In the example above, it shows that you are taking on too much risk on company ABC as you are more likely to lose money on average than taking on the same risk position on company XYZ. In this instance, you will be more likely to trade company XYZ.

Number Of Wins And Losses

Another statistic to look at is how many profitable trades as opposed to losing trades did the system produce. If you look at 100 trades and on average, 40 of those are winners, then you have a profitable system approximately 40% of the time. This will be important if you start to doubt the effectiveness of your trading.

Another fact to note is that if, for example, you had an overall profitable trading system but the majority of the profit had been made from only one or two trades then is it possible that this is simply a stroke of luck as opposed to a good system?

For example if you have 20 trades and each one of them gave you $100 loss and then one trade managed to net you $3000, you would have an average profit – but you will then need to look at the system in more detail. It may be possible that you have a very good system but this is a decision that you will need to make.

Types Of Markets

Back testing your trades on a variety of different markets will allow you to test to see if the system favours any particular market or stock over another. This may give you vital information as to the types of markets you should trade and avoid.

A very good book to help get you started on the topic of back-testing and analysing your results is “High Probability Trading” by Marcel Link.

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===============

Discover Why Back Testing Automatically Increases Your Confidence

2008-05-06T21:16:00.000-07:00

After creating your system, there is one final element to any trading system – you must make sure that you test your trading system using historical market data. By doing this, you can increase your confidence that your system produces the results that you desire. Additionally, if your system consistently produces poor results when you test it then this may be an indication that while your system may work on paper, it may not actually work with real data and you may want to look at the system in more detail.

There are additional benefits of back-testing:

You can test data safe in the knowledge that there will be no actual money lost when you work out your trading winnings or losses.

You can test your system in a variety of different market conditions – bull, bear and sideways in a relatively short space of time.

If your trading system is completely mechanical you can programme a computer to work out the system parameters automatically saving you a lot of work and time

While it may seem that this is the ideal way of testing a trading system, there are drawbacks to back-testing.

You may forget or disregard essential expenses such as spread of stocks and broker fees – these can alone make a system that indicates a winning performance to a system that actually loses money.

The back-testing will automatically assume that you are in and out of the trade at the optimal level. For example in very fast moving markets or in markets that are low in volume, you may actually get filled at a level that is not quite what you indicated to your broker. As such, “slippage” is another cost that must be taken into account when back-testing your system.

While back-testing increases your confidence in your system, it does not guarantee that your system will be a winner – remember the market will do what it wants to when it wants to!

It does not take into account the emotion relating to trading – this must be factored into any system. In other words, can you trade this system without emotion?

One of the reasons why trading systems that are actually produce good results in the testing phase but are awful in real time trading is that the drawbacks are not taken into account or that they have been underestimated.

The last thing that you need to take into account is that some systems are very difficult to back-test. For example, how easy would it be to calculate fundamental statistics that were relevant a few years ago if it is crucial to your system or how would you react to a piece of news that was released 5 years ago? The easiest systems to back-test are the systems that rely entirely on mechanical buy and sell signals relating to price action – data in these instances are much easier to obtain and analyse by computers.

There are many programmes that enable back-testing. For example, Metastock has an inbuilt system analyser. However, to get an even more realistic performance, programmes such as TradeSim can be used.

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Advanced Trailing Stop Loss Methods - A Sneaky Technique I Use

2008-05-06T20:57:00.000-07:00

The previous trading article showed the principles behind a trailing stop. In this trading article we will look at taking this one step further and using stop losses not just to limit risk and lock in profits but also to enable you to produce even more profit but increasing the level of risk you are in the trade at the appropriate time. This does not mean that you trade at a more risky level – remember this is a cardinal sin for traders. It does mean, however, that you take on more risk at a time in a trade that is already in profit. This way, you can be assured that the trade will never lose you money but you will be able to give it more freedom to develop without being stopped out too early!

Non-fixed Average True Range (ATR) Based Stop Losses

The average true range is an indicator that takes into account the volatility of a stock. The more volatile a stock, the more room is required for a stop to prevent the trade from being stopped out too early intraday. ATR takes into account the volatility of a stock unlike other more basic forms of stop loss such as a trailing percentage or point stop loss. For a more detailed discussion of ATR (and other indicators), please visit Technical Analysis from A-Z available at www.equis.com/customer/resources.

As an example, it is possible for you to set your initial stop loss to 2*ATR below the low of the day and then increase the stop loss to, for example, 3*ATR once the stock is in profit. This will allow your trade a little more room to breathe with very little chance of losing any money in your trading.

The red line is the stop loss that is not based on the traditional approach of trailing behind a fixed ATR while the blue line is a stop loss that is based on a fixed ATR. The trade was entered on the 19th September and it can be seen that, in this case, the blue stop loss is activated much quicker than the red stop loss. In other words, in this case, a non-fixed ATR produced much more profit than the fixed ATR based stop loss.

Mixed Stop Loss Methods

It is also perfectly possible for you to mix the initial stop loss method with a totally different method of stop loss calculation later on. For example, the initial stop loss can be based on a 2*ATR and then be trailed based on the low of the past “X” number of days. So, if we take X to be 40 days, then as soon as the low of the past 40 days is greater than the initial stop loss, the stop loss is trailed to the newly calculated method and so on.

Summary

The above state two methods of advanced stop loss calculation in a trading system you might have. There are a number of different other methods and you will need to find a method that is suitable for you. Remember, there is no method that is ideal in all situations and you may find that one method may be better in one stock and not another. It is therefore important that you back test your method on different stocks to ensure that the method, in general, works. Above all, keep it simple and manageable. Without sounding too harsh remember the following pneumonic - KISS – Keep It Simple Stupid!

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Who Else Wants To Learn The Closely Guarded
Secrets Of A Trading Veteran? Simply Visit
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===============

Advanced Protective Strategies - How To Maximize Your Trading Profits

2008-05-06T20:36:00.000-07:00

In the previous trading article, stop losses were discussed as being crucial to prevent excessive losses from building up. In this article, we will discuss a more advanced method of using stop losses not only to protect you from excessive losses but also to help you produce profits on winning trades.

The Trailing Stop Loss

This is a reasonably complicated strategy but is essential to help ensure that your trades are as profitable as possible. A trailing stop is exactly what it sounds like – it is a stop loss that ‘trails’ a trade as it progresses. This means that the current stop loss is reviewed every day and adjusted according to the current market conditions.

Assuming you are ‘long’ in the market, there are two trading rules you must abide by:

1. A stop loss stays the same or is increased if the stock price increases
2. A stop loss is never decreased in response to a declining stock price – the stop loss will always stay the same in this instance

Types Of Trailing Stop Losses

There are many types of trailing stop losses. Some of the common ones are mentioned below:

· A stop loss that is trailed a certain number of points away from the low of the day
· A stop loss that is trailed a certain percentage away from the low of the day
· A stop loss based trailed on an indicator such as the Average True Range (ATR)

An Example

Let us assume that you bought a stock, XYZ at $10 and have placed a stop loss 10 points away from the low of the day. We now want to trail the stop loss and follow it for a period of 15 days.

The stop loss will be increased or stay the same if the stock price increases.

The stop loss will stay the same if the stock price decreases.

The stop loss will only be increased if the stock price is more than 10 points away. It will be moved to a position that is 10 points away. In other words, if the low of the day is $10.30 and the previous stop loss is at $10.10, then the stop loss will be moved 10 points away to $10.20.

Looking at the chart above, it can be seen that at around days 5-7 the low of the day started to decrease but the stop loss remained the same (as the difference between the low and the stop loss was less than $0.10). A similar thing happened from day 11-15 except that on day 15, the low actually went through the stop loss. The price we would have therefore exited the stock at would be $10.20. This means that we have made a $0.20 profit per share using a trailing stop loss!

The Benefits Of Trailing

There are several benefits of trailing a stop loss.

The example above shows that from day 3 onwards, the stop loss was $10.00 and above. At this point, the trade could not lose and you would, at worst, come out unscathed. If you had not trailed the stop, you could still lose as your stop loss would still be at $9.90.

You can lock in profit. In the example above, from day 5 onwards, your stop loss is effectively over $10.00. This means that from this day onwards, you can only win on the trade!

The Disadvantages Of Trailing

Unless you have a facility that allows a trailing stop to be automated, you will need to review your trade on a daily basis and alter your stop loss accordingly. This means that using a trailing stop can be labour intensive.

It is possible for you to be stopped out of a trade and then the stock then increases in price further. However, trading is about limiting risk and if you get stopped out of the trade with only a small profit, be grateful for it! There are plenty of other stocks for you to trade.

Summary

On the whole, using a trailing stop loss can be very profitable in the long run. You need to ensure that the method you use to calculate your stop loss works in line with the current market conditions and the particular stock that you are trading.

===============
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===============

Don’t Be Afraid To Let The Good Times Run!

2008-05-06T19:08:00.000-07:00

In order to make ensure that you have the best possible trading system, you need to adhere to a fundamental rule in trading – “let you profits run and cut your losses short.”

Letting Your Profits Run

This is a trading mantra that you will hear time and time again in all the books or trading courses that you will ever read or attend. What exactly does it mean?

The detail of this has been looked at in previous trading articles but to summarise, it means that if you have a profit on a trade, you should let it run until it loses steam. The time it loses steam is also the time to exit from the trade.

The problem is that when the trade starts to lose steam, it will inevitably start to decline in price. This means that the best time to exit is not actually at the “top” but a little bit after the top has been made when the share price is slightly lower. The diagram below shows this in a little more detail.

As can be seen above, there is a small gap between the top and the exit point. This means that you will have to give up a small proportion of the profit you have made when the trend starts to decline.

A top is very difficult to exit at. It requires great skills of technical analysis and even then there is no guarantee that you will be right in your trade. Worse still, you will be kicking yourself if the trend were then to continue upwards after if you had just exited at a point that you thought was the top! The best way, therefore, of exiting a position is to wait until the trend has changed and then, using your trading system rules, exit at a point lower than the top. This does mean that you will be sacrificing some of your profit but in the long run, your trades will be much more profitable. You will be letting your profits ride upwards until something tells you to get out.

Cutting Your Losses Short

We have now discussed the best way to make a profit – but what do you do if you start making a loss?

Again, as stated in previous trading articles, you will inevitably make trades that lose. This does not mean that you are a bad trader, it just means that the markets decided to not work in the way you expected!

What will make you a bad trader is if you decide not to get out of a trade that is going very wrong! This is where having a stop loss in place is essential. A stop loss will get you out of a trade without you even having to think about it if it all goes wrong!

A stop loss should be placed below your entry point at a point where, if the characteristic of the stock were to change for the worse, you would be able to get out as soon as possible. You do need to make sure that it is not too close to the entry point or otherwise you risk getting kicked out of the trade too early.

There is no ideal stop loss method for all situations but the ideal characteristics of a stop loss point should be to place the stop loss at a point not too low to cause excessive losses and also at a point to allow room for the trade to breathe a little.

The diagram below demonstrates this:

It can be seen that the very tight stop loss (1) would have been triggered too early and the trader would have been kicked out of the trade before the trade had a chance to go up.

Stop loss (2) on the other hand was placed at the right point and was not triggered prematurely. The trader in this situation would have been in the trade when it started to go up.

A Common Issue

Finally, this trading article concludes with the following message. Human instinct is to do the exact opposite to the above. Most traders when they start to trade do the exact opposite i.e. they let there losses run and cut their profits short. You have to do the exact opposite to what nature has wired you up for – and that is a difficult task. With conscious effort and training, you will eventually succeed!

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===============

Position Sizing Is Critical In Trading

2008-05-06T18:56:00.000-07:00

Follow These Rules And Watch Your Profit Grow

Position sizing is basically a process to calculate the amount of money that you will invest into a trade based on all of the rules from previous trading articles. Position sizing isn’t about guess work – it is an exact science. The example below will show the process in more detail.

Example

Your trading rules are as follows:

· You will not place more than 25% of your account in any one trade
· You will not risk more than 2% of your account in any one trade
· Your stop loss is based on a 10 day average of the Average True Range (ATR) and is placed at 2 times the value from the low of the day

Your current account is worth $20,000

The brokerage fees are $40 (to buy and sell the stock)

You are currently looking at stock XYZ with a current value of $10 per share

The ATR of the stock is currently $0.10

The Process

The following process will enable you to calculate how much you will place on the trade and whether it will conform to your risk criteria.

Firstly, 25% of your trading float of $20,000 is $5,000. This is the total value of shares that you will buy

The shares are currently at a value of $10. As you are prepared to spend a maximum of $5,000 on the trade (from point 1 above), you will purchase 500 shares of XYZ

Your stop loss is twice the ATR value. As ATR in this instance is $0.10, the stop loss will be set to 10-(2*ATR) = 10-(2*0.1) = $9.80

Now, you will only risk a maximum of 2% of your trading float on any one trade. This is the equivalent of $400 (2% of $20,000).

Your brokerage fees need to be taken into account. As they are $40, this means that you can only risk a maximum of $360 on the price movement of shares (taken from $400 in point 4 minus the brokerage fees)

You will purchase 500 shares at $10 and exit if they reach $9.80. This means that if you are “stopped out” of your trade, the value of the shares would be $4,900.

If you were stopped out of the trade, the amount of money that you would have lost from the trade will be the equivalent of $100 ($5,000 - $4,900). This is less than the original risk set out in point 5 of $360.

The conclusion of this process in this instance is that the trade conforms to all your trading rules and criteria. The trade does not involve excessive risk. In summary, you will enter the trade at $10 and purchase 500 shares. You will exit the position if it reaches $9.80 per share.

A Further Example

If the above had an ATR of $0.40, then the stop loss would be set to:
$10 – (2*0.4) = $9.20.

This would mean that the stock would be exited at a value of:
$9.20 * 500 = $4,600

This would mean that the overall risk involved with the movement of shares is:
$5,000-$4,600 = $400

This would mean that the overall risk is more than the $360 that has been outlined. This suggests that the trade is too risky and should not be entered.

Using the above process will enable you to keep out of risky trades and keep you in trades that offer a better risk profile. Using this strategy will limit your losses during losing streaks and allow your account to grow during winning streaks.

===============
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Secrets Of A Trading Veteran? Simply Visit
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Who Else Wants The First Practical, Step-By-Step, Formula For Designing Profitable Trading Systems?

2008-02-13T01:53:00.000-08:00

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