Many traders will randomly set daily or weekly performance targets.
Such an approach is very dangerous and you have to stop thinking in
terms of daily or weekly returns. Setting yourself daily goals creates a
lot of pressure and it usually also creates a “need to trade”. Instead,
here are some ideas on how to set trading goals the right way:
Short-term (daily and weekly): Focus on the best possible trade execution and on how well you follow your rules/plan.
Mid-term (weekly and monthly): Follow a
professional routine, plan your trades in advance, obey your rules,
journal your trades, review your trades and make sure that you learn the
correct lessons.
Longer-term (semiannually): Review your trades,
focusing on how well you executed your trades to get an understanding of
your level of professionalism. Find weaknesses in your trading and
adjust accordingly. This will lead to profitable trading inevitably.
The Turtle traders were a legendary group of traders coached by two
successful traders, Richard Dennis and William Eckhardt. They selected
10 people (turtles) with little to no prior trading experience and
turned them into winning traders by providing them with a set of very
precise trading rules.
The building block of the turtle traders’ success was their advanced
risk and money management and their position sizing approach. The
following 5 principles explain the most important risk and management
principles of the turtle traders’ strategy.
Volatility based stop loss orders of the turtle traders
The turtle traders used a volatility based stop loss order, which
means that they determined the size of their stop loss based on the
average ATR indicator (Average True Range). This also means that for every trade, they used a different stop loss size to react to changing market conditions.
The charts below show why this stop method is so powerful. Both
charts show a breakout scenario with very different price dynamics.
Whereas the left chart has very small candlesticks and a low ATR (low
volatility), the right chart shows larger candlesticks and a higher ATR
value (high volatility). How much sense would it really make to use the
same stop loss technique on both breakout trades? Correct, it wouldn’t
make any sense. A trader should use a small stop loss for the trade on
the left chart and a wider stop loss on the right chart to maximize his
reward:risk ratio and to minimize the chances of getting stopped out
during insignificant retracements.
Low volatility results in closer stops (click to enlarge)
High volatility results in wider stop (click to enlarge)
Setting a stop further away in times of higher volatility and
closer when volatility is low, allows the trader to react to changing
market conditions and optimize his reward:risk ratio and risk profile.
A maximum position of 2%
Although the stop loss size (in point distance) changed for every
trade, the risked always stayed the same. The maximum allowed risk
(position size) on any one trade was 2% of the current total account
balance. The table below shows two examples of how the turtle traders
would adjust their stop and position size based on volatility.
Volatility
Entry Price
Stop Loss Price
Stop Distance
Account Size
Risk per trade
Contracts to buy
LOW
$ 100
$ 96
$ 4
$ 100,000
2% ($ 2,000)
500
HIGH
$ 100
$ 90
$ 10
$ 100,000
2% ($2,000)
200
The numbers are for illustration purposes only
Although the risk is identical (2% or $ 2,000), the turtle traders
have to buy more contracts during lower volatility because the stop loss
is set closer.
Always determine the stop loss distance first. Most amateur traders
start by evaluating how many contracts they want to buy and then set
their stop loss order so they can achieve a random risk goal. Never
start by thinking how many contracts you want to buy/sell before you
know your stop loss.
Correlations and risk
If the turtle traders want to enter two trades in different
instruments, they had to look at the correlation between the two markets
first.
A quick reminder: correlations describe how “similar” two
markets move. A positive correlation means that the two markets move in
the same direction and a negative correlation means that they move in
opposite directions.
High positive correlation. Two markets move together (click to enlarge)
Negative correlation. Two markets move in opposite directions (click to enlarge)
The two charts above show two different scenarios. On the left, you
see two price charts with a very high positive correlation (the two
graphs almost move identical). On the right, you see two charts with a
negative correlation (they move in opposite directions).
A trader who enters two trades in the same direction (two buy or two
sell trades) on positively correlated markets increases his risk because
it is more likely that the two trades end up the same. A trader who
enters two trades in different directions (one buy and one sell trade)in
positively correlated instruments will probably (not guaranteed) not
have the same result.
(click to enlarge)
When trading positively correlated markets, your risk increases. When
trading negatively correlated markets, you can lower your risk.
The turtle traders did not come up with this strategy, but it has
been used by professionals as long as trading exists. It is the
irrefutable law of how financial markets work and understanding
correlations is of great importance.
Adding to a winner
The turtle traders usually did not enter the full position size on
the first entry. Remember that they were allowed to use 2% per trade,
but they usually split their order across multiple entries and added to a
winner. Their first position would be 0.5% and after the trade has
moved into profits, they would add another 0.5%. They would keep adding
to their trade until they reached the maximum of 2%. At the same time,
they moved their stop loss behind price to protect their position.
The advantages of adding to a winning trade:
You limit your losses. The turtle traders’ strategy
was a breakout and trend-following strategy. On a false breakout, when
price immediately reversed on them, they would usually only have a very
small position and not yet have scaled in. Thus, the loss they take is
only a small portion of the 2% maximum risk.
You can catch large winning trades and protect your position. You would only reach your full position size during high momentum breakouts and once you had reached the maximum exposure of 2%, the initial stop loss orders would already have locked in some profits.
You have to minimize your losses and try to preserve capital
for those very few instances where you can make a lot in a very short
period of time. What you can’t afford to do is throw away your capital
on suboptimal trades. – Richard Dennis
Adjusting position size during losing streaks
Dennis and Eckhardt understood that the most important thing during a
losing streak is not how fast you can recoup your losses, but the
degree to which you can limit your losses. Their rule to limit drawdowns
during losing streaks shows this principle:
If your account drops 10%, you then trade as if your account has lost
20%. If you lost $10,000 on a $100,000 account, you then trade as if
your account only has left $80,0000.
This means that even though your account is now $90,000 and your 2%
would be $1,800, you only trade as if your account is $80,000 with a
maximum risk of $1,600. This strategy will greatly reduce the losses
once a trader enters a significant losing streak and it takes away a lot
of emotional pressure as well.
This sounds like a lot of rules for just money management and position sizing. Let’s briefly compare that to the turtle traders’ rules for trade entries:
You enter a trade when price breaks above its 20-day range
You enter a trade when price breaks above its 55-day range
You are right, not a lot of trade entry rules, although there were
small variations and exceptions to the rules. The point is that the
professionals understand that entry rules only have very little
importance and that the most important cornerstone of any trading
strategy is position sizing and risk management. This is a major reason
why so many amateur traders struggle; they focus all their energy and
spend all their time on the least important factor.
A few days ago, Credit Suisse did something profoundly
unexpected: its Trading Strategy team led by Jonathan Tse released a
report titled "High Frequency Trading - Measurement, Detection and Response"
in which the firm - one of the biggest flow and prop traders by equity
volume in both light and dark venues - admitted what Zero Hedge has
been alleging for years (and has gotten sick and tired of preaching),
and which the regulators have been unable to grasp and comprehend: that
high frequency trading is a predatory system which abuses market
structure and topology, which virtually constantly engages in such
abusive trading practices as the Nanex-branded quote stuffing, as well
as layering, spoofing, order book fading, and, last but not least, momentum ignition.
This is Credit Suisse, an entity whose incremental
input we are confident will be very much welcome by Congress and the
regulators, not some fringe, tinfoil hat blog.
While we we cover the full report in the next few days and
all its SEC-humiliating implications, it is the last aspect that we wish
to focus on because while all the prior ones have been extensively
covered on these pages in the past, it is the phenomenon of momentum
ignition that goes straight at the dark beating heart of today's zombie
markets: momentum, momentum, and more momentum, in which nothing but stop hunts and even more momentum, define the "fair value"
of any risk asset - i.e., reflexivity at its absolute worst (in
addition to Fed intervention of course), where value is implied by
technicals and trading patterns, and where algos buy simply because
other algos are buying. Behold robotic stop hunts: HFT-facilitated "Momentum Ignition." From Credit Suisse: MOMENTUM IGNITION What is Momentum Ignition?
Momentum ignition refers to a strategy that attempts to
trigger a number of other participants to trade quickly and cause a
rapid price move. Why Trigger Momentum Ignition?
By trying to instigate other participants to buy or sell
quickly, the instigator of momentum ignition can profit either having
taken a pre-position or by laddering the book, knowing the price is
likely to revert after the initial rapid price move, and trading out
afterwards. Likelihood and Rapid Price Moves
Momentum ignition does not occur in the blink of an eye, but
its perpetrators benefit from an ultra-fast reaction time. Generally,
the instigator takes a pre-position; instigates other market
participants to trade aggressively in response, causing a price move;
then trades out. We identify momentum ignition with a combination of
factors, targeting volume spikes and outsized price moves - see Exhibit
18 for a example of this pattern in Daimler on 13th July, 2012:
To pinpoint momentum ignition, we search for:
Stable prices and a spike in volume (Box 1 in Exhibit 18)
A large price move compared to the intraday volatility (Box 2)
Reversion (Box 3)
Though we cannot conclusively determine the intention behind
every trade, this is the kind of pattern we would expect to emerge from
momentum ignition. We use this as a proxy to estimate the likelihood
and frequency of these events (further details are provided in Appendix
4).
Likelihood and Rapid Price Moves
As shown in Figure 19, we estimate that momentum ignition
occured on average 1.6 times per stock per day for STOXX 600 names in Q3
2012, with almost every stock in the STOXX600 exhibiting this pattern
on average once a day or more.
In addition, we note that the average price move is 38bps
(but over 5% are more than 75bps, with some significantly higher – see
Exhibit 20), and the time it takes for that move to occur is
approximately 1.5 minutes (see Exhibit 21).
While 38bps may not sound like a big move, it is a bit more
significant when compared to the average duration of these events (1.5
minutes) and the average spread on the STOXX600 (approximately 8bps).
Though not all momentum ignition events result in massive
price moves, those that do can cause significant impact. Percentage of
volume orders that would normally execute over hours may complete in
minutes on the back of “false” volume ( one of the causes of the 2010
flash crash was a straightforward percentage of volume order). AES
offers a variety of protections to help mitigate this kind of
dislocation, including customised circuit breakers, active limits (that
kick in when the stock decouples from a specified index) and fair value
limits.
Today I’d like to talk to you about stop hunting. And I want to thank reader, Russ, for dropping me a note to spur me on to this piece.
Russ and I agree on two key points.
One: You should always have a stop loss.
Two: we both know stop hunting is not just a ‘bogeyman’ myth to scare traders. It really exists and can trip up your trading. Question: Has this ever happened to you? You get
stopped out of a trade… only to see the market reverse right afterwards
and move in the direction you predicted?
Chances are, you’ve been the victim of stop loss hunting. And it happens all the time.
The good thing is, there are a few tricks you can play to try and help you avoid it. And it’s those I want to talk about today.
How brokers steal your pips
Stop hunting is pretty simple. It’s an easy way for a market maker,
broker or financial institution to make a nice tidy sum scalping some
profit at your expense.
If they know where the orders are in the market, they can target key
areas of bunched up retail orders (e.g. you and me) in order to make a
small amount of profit.
Once those stops are hit, the big player can then make the market move in the direction retail traders were placed originally.
This is dead easy for them as they can directly see where orders are placed in the market. Easy money.
Now these guys are never going to go after your single stop on its
own. But if enough retail traders all place their stops in the same
place, it’s easy pickings.
However, there are a couple of tips for how to avoid this.
1. Stop placing stops on round numbers.
It may look neat and tidy, but stop bunching stops on large round
numbers. Anything ending in two or more zeros is a definitely no-no.
2. Everyone looks for swing highs and lows.
These are the highs and lows over a given period. It’s a really
common place to stick stops exactly (or even within a pip or two) of
swing highs and lows.
So you should always ensure that your stop is placed above this (if
you’re short) or below (if long), with enough room to breathe.
I know you’ll want me to be more precise. But it will depend on your
stop strategy. We’ll come back to this in more detail and look at
specific strategies another time, though.
For today, let’s get on to the good stuff and something Russ also pointed out.
Let’s assume markets are in a downtrend. We get a retracement and price moves up.
Look at where retail trader stops are likely to be for those trying
to trade the down turn. You can almost bet money that market makers,
financial institutions or smart money will be looking for that level.
They want to clear those stops out and give themselves a great price. Then the market will drop back down again.
It’s a trick many traders use, and a great way to get a nice entry price. Let me show you.
Put your short limit order (assuming a downtrend) just at the beginning of where the orders are likely to be placed.
Then, instead of sticking your stop in amongst all the other retail
traders, stick it higher up, but complying with the rules above.
To see what I mean, have a look at the chart below of a trade I did
personally. I was shorting the Aussie dollar. My stop was at 1.05067
exactly – above the bunched orders. My entry on the trade was 1.0480.
See that big circle? By that time, I already knew it was a key level
because of the previous move lower from it (back on 27 March).
This time it tests, pulls back from the pivot line
and then pops higher to break that level and test stops. It knocks a
lot of those stops out and we get a dimple in the order book (you can
see it in the indicator at the bottom – that small circle).
Then the price hovers as a few retail buyers step in to go long on a “breakout”-style strategy. And then it drops.
The instant reversal of the pop higher was a big clue and it only found minor support for buyers once it had broken that level.
And then it gave way.
So a nice trick for finding an entry point. And it can be a great little way to capture a decent move.
A few key areas to look out for
• Swing Highs and Lows; lots of orders are bunched at these.
• Round numbers.
• Exactly on pivot lines (or exactly 5/10 pips above or below).
• Exactly on Fibonacci retracement levels.
• Any points which hit multiples of these.
At these areas, we start to get bunching of orders and stops. So think about how you can use them to your advantage.
Another way to find out is to check out some of the pro traders on
Twitter or in a Live Trading Room. They will often let people know of
order book positions as most of them will have access to a feed or an
order book to give you a view.
Follow these guys for a while and get a sense of whether they are accurate, and you’ll get some valuable trading insights.
See that big circle? By that time, I already knew it was a key level
because of the previous move lower from it (back on 27 March).