In Chapter Three, we began a case study of how I streamlined the trading process. This chapter examines the logistics of pure directional trading.
The Devil is in the Details
We’ve all experienced it: an elegant concept that proved impossible to implement. That’s when we learned that behind the success of any great idea, there must be a real-world plan of execution.
New traders often focus exclusively on the development of timely buy and sell signals while the logistics of trading, that is, how to handle the niggly details of the trade, is given little attention. Yet this is often where the battle is won or lost. Why?
When we accept Mark Douglas’ Five Fundamental Truths, that trading as a probabilistic activity, we know that the long-run outcome is a function of the edge. If there is more to a sword than the cutting edge of the blade, then buy and sell signals are only part of our trading edge.
NOTE: If we were discussing card games, all would agree that the game we play, the players we play against, the size of our bankroll and how we bet each hand are equally important as when to hold ‘em and when to fold ‘em.
Directional trading is defined as attempting to profit from long (buy something now to sell later) and/or short (sells something borrowed now to cover later) trades. Let’s break it down into components:
1. The Symbol Universe
What markets to play? Which stocks to trade? There are many approaches to identifying candidates for short-term and intraday trading, but the goal is the same:
Investment philosophy defines an investor’s approach to generating portfolio returns …Market returns stem from three sources — asset allocation, market timing, and security selection — with each source of return providing a tool for investors to use in attempting to satisfy institutional goals. — David F. Swensen, Pioneering Portfolio Management
Funds and institutions must execute in size; therefore, they gravitate toward stocks with liquidity, financial futures and currencies [Griffin, Harris & Topaloglu, 2002]. Competition is fierce and pricing is extremely efficient. Lack of resources puts individual traders at a distinct disadvantage [Griffin, Harris & Topaloglu, 2005].
Serious individual traders pick battles they can win by
- operating in situations and time frames that attract less-skilled noise traders [Black, 1986] and lottery traders [Statman, 2001];
- trading securities that are relatively more difficult for uninformed market participants to value (no dividends, less analyst coverage) and therefore, more prone to bubbles [Hirota & Sunder, 2006] and beauty contests [Camerer, 1997];
- avoiding extreme high frequency intraday trading in order to reduce transactions cost, slippage and the risk of participating in non-meaningful moves;
- trading stocks with certain desirable characteristics [for example, O’Neil, 2004] over longer time horizons such as swing trading with daily charts.
- using leverage in a judicious way; and,
- acknowledging that making better-than-market returns is not necessarily the same as beating a benchmark on a risk-adjusted basis, that the volatility of returns on pure directional trading are apt to be high.
To paraphrase Swensen’s description of the top-down approach, our success depends on a number of factors: where we look for opportunities, our ability to select the right ones, how much we allocate to each and the effectiveness of our trading method. In that order.
2. Capital Required
The market is a mechanism where, in exchange for taking on risk, we get the opportunity to compound our surplus cash faster than we can with T-Bills or bank interest.
A potter makes pots with clay. A carpenter makes furniture from wood. A trader makes money with money. A trader’s capital is the same as a gambler’s bankroll: our goal is to preserve and grow it.
Short-term returns are uncertain. Monthly expenses such as the rent/mortgage should be paid from sources outside of trading, just like investment and hedge fund managers pay overhead with fixed fees charged to clients (as a percent of assets under management).
3. Use of Leverage
[Long Term Capital Management]’s trading strategies were secret. …One thing was disclosed. LTCM used a lot of leverage. That was how they were able to obtain better-than-market returns from a nearly efficient market.
…In 1996 one of LTCM’s investors spoke by phone with several of the partners. …[he] learned that the fund was using leverage of about thirty times. For every dollar of investor money, the fund borrowed $29 more. — Fortune’s Formula
A minimum of US$25,000 is required for active stock trading. Switching to options, futures, Forex or CFDs for the sole purpose of circumventing this capital requirement makes little sense. The reason is leverage.
Hedge funds employing 20:1 leverage routinely go bust. Failure is typically not due to lack of skill; it happens because the higher the leverage, the smaller the adverse price move needs to be in order to wipe out the capital in an account.
Undercapitalized traders often find it difficult to resist combining small time frames with tight stops and high leverage. But consider this: stops must be calculated and placed to reflect prevailing volatility. They cannot be made smaller on account of the trader’s capital.
Let’s look at a few examples. The 21-day average true range (ATR) for GOOG is 1.85%; therefore, on an average day, we can expect GOOG to bounce around this much. If we wish to allow a trade to go against us by three “typical” bars, we need to budget for a move against our position three times this amount (3 bars x 1.85% = 5.55%) as a minumum stop loss.
The 21-bar average true range for the 5-minute intraday chart of GOOG is 0.108%; the minimum stop loss would be 0.324%. Note that the range on intraday charts varies considerably during the course of a day. For example, the ATR (%) on the 5-minute GOOG chart was three times more in the morning than it was at the end of this day. And this is when the ATR (%) on the daily chart is very low.
The 21-bar average true range for the 15-minute EUR/USD chart is 0.03839%; the minimum stop loss would be 0.11517%.
Let’s do a back-of-the-envelope calculation of how many losing trades it takes to wipe out the account equity, using typical margin for each symbol and time frame.
Swing trading a stock:
50% Own Capital / 5.55% Loss = 9 Trades
Intraday stock trading:
25% Own Capital / 0.324% Loss = 77 Trades (probably closer to 30 with typical range)
Intraday Forex trading:
0.5% Own Capital / 0.11517% Loss = 4 Trades
That’s the killer effect of leverage, and why the typical leveraged Forex trader survives less than 45 days [Wall Street Journal].
In practice, it would probably take months to set up 9 swing trades off the daily GOOG chart compared to perhaps a month to make 77 trades off a 5-minute GOOG chart. It certainly would take no more than two days to make four trades off the 15-minute EUR/USD chart.
To stay in the game, the prudent trader trades in accordance with the amount of his own capital. It may feel counterintuitive, but when undercapitalized, the right thing to do is go easy on leverage, reduce the number of shares, and trade in a larger time frame to reduce transaction costs.
4. The Stop Loss and Pyramiding
Stops should be used. They also need to be placed strategically. In directional trading, my practice is to allow sufficient wiggle room to accommodate natural fluctuation. The time to leave is when the magnitude of a reversal has (in all probability) risen above the noise.
Douglas’ Seven Principles of Consistency is reflected in the following:
One common adage on this subject that is completely wrongheaded is: You can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance. …
What really matters is the long-run distributions of outcomes from your trading techniques, systems, and procedures. But, psychologically, what seems of paramount importance is whether the positions that you have right now are going to work. Current positions seem to be crucial beyond any statistical justification. It’s quite tempting to bend your rules to make your current trades work, assuming that the favorability of your long-term statistics will take care of future profitability. Two of the cardinal sins of trading - giving losses too much rope and taking profits prematurely - are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance. — William Eckhardt interviewed by Jack Schwager, The New Market Wizards: Conversations with America’s Top Traders
Stop loss placement is a prime example of the right thing feeling counterintuitive. The popular perception is that tight stops are a good thing because it allows us to take small losses. But they also force us to take small profits. Small stops also tend of increase the frequency of trading, adding to transaction (commission and slippage) costs.
So why do traders do it? There are several reasons. First, many traders somehow believe that a high batting average is correlated to superior performance. Second, locking in some profits, however small, makes us feel good. Third, giving back paper profits feels bad. Fourth, highly leveraged directional traders may do not have enough equity to place a proper stop.
My solution? Give a trade the room it needs, even if it means reducing size and moving to a different time frame since we can add to a winning trade (pyramid) as a trend unfolds.
Using Stops to Calculate a Strike Price
Properly calculated stops have another use: directional option trading.
Example: EMC was the highest volume winner on June 15 stock scan. I can see that the trading system has been long since March 30, 2007 and pressed this profitable long position twice (on April 26 and June 7) already.
If I want to buy it now, what should I do? I could step in mid-trade with options because I know it closed at $17.35 with the stop loss at $16.18 below. The strike price closest to the stop loss price is $16.00, last traded at $1.63.
If the trade does not work out, I want to do two things to recoup as much of my option premium as possible, 1. make sure that I leave the trade with about ten days left before expiry and 2. sell the call just above or at the strike price of $16.00. Why? 1. Because traders never intentionally let a directional bet go to zero since our capital is our lifeblood and 2. at-the-money options have the maximum time value.
Now, the back-of-the-envelope calculations. The July calls expire on July 13 (always the third Friday of each month). We have four weeks. We need to reserve nearly two weeks in case the trade doesn’t work out, leaving us with a window of around two weeks of play. The stock has been going up since March, so in all probability, it is getting late. Two weeks are just fine.
How much do we buy? This is where it gets interesting, because this example also shows how traders with less than $25,000 can maximize their money. If the individual has $10,000 in his account and uses a fixed 2.5% of the initial capital on each trade, it would take 40 consecutive losing trades before the money is gone. What makes more sense is to always use 2.5% of the balance, since he will use more money on the way up and less of it is down.
($10,000 x .025) = $250 / $1.63 = 153 / 100 (shares per call) = 1.53 calls. Round that down to 1. If EMC reverses right after we buy the call, we sell it as EMC trades back to $16.00. If the EMC continues upward until expiration, great. The stops will be automatically calculated as the price rises, and we can use the updated stop loss points to exit the call, just as we would if we were long the stock.
5. Commissions, Slippage and time frame
It is important to select a time frame with a trading range in excess of slippage.
This is especially important when it comes to intraday trading of futures and Forex. Slippage can be considerable. For example, ES features a bid-ask spread of 1/4 point. We must factor in 1/2 point per contract of slippage just from opening and closing a trade. Lack of trading range is another constraint. As a rule of thumb, we can use the 20-bar ATR to check the trading range to make sure that there is enough room to clear slippage, commission and profit.
6. Trends
While it certainly feels good to say that we picked an important top or bottom, it pays to capitalize on trends.
Unfortunately, overcoming the tendency to follow the crowd, while necessary, proves insufficient to guarantee investment success. By pursuing ill-considered, idosyncratic policies, market players expose portfolios to unnecessary, often unrewarded risks. While courage to take a different path enhances chances for success, investors face likely failure unless a thoughtful set of investment principles undergirds the courage. — David F. Swensen, Pioneering Portfolio Management
A trend filter helps the trader avoid countertrend trades when there is an emerging trend, or if there is a trend on a larger time frames.
An Intraday Example
Trend filtering can also be used to simplify multiple time frame trading. Let’s use the S&P E-mini.
Assume that the trading range on the 5-minute time frame is large enough to warrant trading at this time. We know many traders apply the 20-period exponential moving average (20EMA) to their charts. Other types of moving averages set at +/- 5 will also cluster around this value.
From a Keynesian beauty contest point of view, we deduce that traders will attempt to buy a dip to the 20EMA in an uptrend; we also know traders will attempt to sell short a bounce to the 20EMA overhead in a downtrend.
We select the 45-minute (405 minutes / 45 minute = 9 even bars) ES chart as the largest intraday time frame and apply the 20EMA. For stocks, I use (390 minute / 65 minutes) = 6 even bars.
When it comes to multiple time frame analysis, my experience is that multiples of three is about right. (45 minute / 15 minute) = 3 x 20 EMA = 60 EMA is the equivalent on the 15-minute chart. We apply the trading system with the TrendFilter set on 60. The system avoids whipsaws by passing trades that are countertrend to the larger time frame.
Traders interested in the 5-minute time frame should do the same calculations with a 15-minute/5-minute combination, but to demonstrate the multiple time frame principle, we can use the 45-minute/5-minute as an example. (45 minute / 5 minute) = 9 x 20 EMA = 180 EMA is the equivalent on the 5-minute chart. We apply the trading system with the TrendFilter set on 180. The system avoids whipsaws by passing trades that are countertrend to the larger time frame.
7. Shorting Policy
Short-Selling Challenges
The management of the short side of the portfolio poses several challenges peculiar to selling securities short. First, investors frequently underestimate the resilience of corporate management. Even when the facts and futures indicate that a company deserves classification as one of the “living dead”, managers frequently find a way to escape the inevitable consequences of their circumstances. Second, the portfolio consequences of adverse price movements require greater diversification of short positions. If a stock moves against a short seller by increasing in price, the position increases in size. To take advantage of the now more attractively prices short-sale opportunity, the investor faces the uncomfortable prospect of further increasing the position. Starting with a modest allocation to a particular short idea allows an increase in position size without creating an uncomfortable concentration of a single stock. Contrast the dynamics of a losing short position with the behavior of a losing long position. As the long’s price declines, it becomes a smaller portion of the portfolio, reducing its impact on returns and facilitating new purchases at the newly discounted, relatively more attractive price levels. The simple math of price behavior argues for running reasonably diversified portfolios of short positions. Short sellers face peculiar challenges from success, as well as from fail lure. When the stock price of a fundamentally troubled company crashes, the short seller benefits, but the short position disappears, requiring identification of attractive replacement candidates. While long managers often run with successful investments for years, short managers hope to operate on a treadmill, with frequent turnover of holdings caused by the exit of winning positions from the portfolio. The combination of of price dynamics and high turnover causes successful short managers to follow and hold a larger number of securities.Aside from a peculiar set of investment challenges, short sellers face some unusual technical problems in managing portfolio positions. …When the market for borrowing a particular security becomes tight, short sellers face a short squeeze. Security borrowers tend to have most trouble with small, less liquid companies, exactly the type of security most likely to present interesting short-sale opportunities. — David F. Swensen, Pioneering Portfolio Management
The demise of the uptick rule does not make shorting any easier. Swensen’s comments still stand. In addition, several quant friends have also pointed out that short positions seem to be more volatile than long positions, making them hard to manage.
Overall, it makes sense to short only a fraction of the position size that we put on for longs.
8. Allocation of Capital
Suppose there are two stocks. ABC trades at $100/share while EFG trades at $20/share.
A trader pursuing an equal dollar strategy with $10,000 in capital would buy $5,000 worth of each one, namely ($5,000 / $100) = 50 shares ABC and ($5,000 / $20) = 250 shares EFG.
While I am aware of methods that can be used to further calibrate position size to achieve “price range parity”, i.e., account for the differences in volatility and trading range between the two stocks, there is no convenient way to do this in TradeStation and eSignal at this time due to a number of technical reasons. In any event, this might only be useful for traders who are trading a diversified (commodity, currency and financial) futures portfolio anyway. Implementing this type of calculation for a stock portfolio might not be a good thing, since low priced, low trading range vehicles would come to dominate a portfolio in terms of dollars utilized.
The best bet for stock and non-diversified futures traders would be to use the equal dollar method of capital allocation.
9. The Signals
The reversal system from Chapter Three provides buy and sell signals for individual stocks. Stock indices are treated separately and will be addressed in later chapters.
Putting it Together
Trading is so much more than just the buy and sell signals.
In this chapter, we examined the logistics of directional trading and identified individual components. While the list looks long, the fact is that leverage, stops, pyramiding, commission, slippage, trend filtering, shorting policy and capital allocation can be incorporated into the same piece of code as the buy and sell signals to form a complete, mechanical trading system.
The more difficult thing, at least for me, is the symbol universe part. I am a trader, not a stock picker. I come from a tradition where the market picks them for me. In Chapter Five, I will show you how I solved the problem by building a stable symbol universe for trading and engineering a portfolio for the long run.