If You’re a Trader – You’re a Trader

There’s a Difference between Failure and Fiasco!

One of the advantages of living in Chicago is that from time to time you can run into successful traders willing to talk to you.

In fact, in our office of a hundred or so, there are quite a few of those traders. Andy, the founder of Daniels Trading, has a Gulfstream and a few multimillion dollar houses, all paid for from trading. Trading success is not foreign to me.

However, what I want to talk about in this post is about one of the more unique traders I’ve come across over the last several decades.

This trader, we’ll call him Steve, is a net options seller. This means that he sells premium and is looking for time and interest decay over the period the option is active. What attracted my attention was the fact that he was consistently successful. Month after month, year after year, his results were predictable.

When asked what the “trick” was that allowed him to be so consistently successful, his reply astonished me. His answer was simply this, that he was “willing to be wrong 90% of the time”.

This was certainly a new answer and one I hadn’t heard before. I’m sure you’ve all seen the ads that say their system is 80% accurate and promises to make a fortune with little or no money invested and here was a guy that I knew was making money – and a lot of it – and he was telling me that he was doing it and being wrong 90% of the time. This was just too good to pass up so I begged him to tell me more. He did.

Steve went on to tell me that the vast majority of options expire worthless so the odds were inherently on his side on any given trade. That I understood and knew but then he went on to tell about an experience that happened in 1988 that forever changed his approach to the markets and it’s one that warrants retelling.

In 1988, the implausible and the impossible happened. The good ole’ U. S. of A. had an honest to god drought. Global warming worked that year, unlike this one. I can remember driving to work at 6 AM in the morning and it would already be 85 or 90 degrees. It was hot. It was also dry and it was early in the growing season.

The effects were predictable; the grain markets went up – a lot.

Steve had his customary positions on – short both puts and calls – naked, meaning he had no protection in case he has wrong, because he had the statistics and odds on his side. Besides that, it was too early in the season to have a sustained rally of any substance to go against him for any period of time.

Well, here’s what actually happened.

The market not only went against him, it went way against him. The impossible happened and the Soybean market went to $1.099 ½ in late June before topping out.

As Steve told it, the move nearly bankrupted him. And for all I know it may have, he wouldn’t be the first trader to go bust and won’t be the last but here’s what he came away from the experience with which is more valuable than all the money in the world.

“Kid” – he told me – “plan for the impossible”. “What I learned from 1988 is that if I’d simply adjusted the position accordingly I’d have been okay”. “I didn’t and it nearly killed me”.

“So today almost every time I make an adjustment I’m wrong. I’d say 90% of the time”. “It’s hard to do knowing you’re probably doing the wrong thing and taking money out of your pocket at the same time. But what I’m doing is insuring against possible catastrophe, like the one that happened in 1988 in the Soybean market”. What he told me was he was willing to accept failure to avoid fiasco. “The moral to the story is that if you can stay in the game, you can win the game”.

Steve’s point was well taken, what he meant was that during periods when you’re dead wrong in the markets, you need to be able to manage and control it. And accept failure to avoid fiasco. The implausible/impossible happens all the time and it has to be planned and accounted for.

Again – If you can stay in the game, you can win the game. That’s the Treasury Income Engine motto and what I learned from a guy that makes 90% bad decisions by accepting small failures to avoid fiasco.

Handling Market Drawdowns

How a trader or a system handles market drawdowns is vital to long-term success in the markets.

I know this because I’ve been through my fair share of them over the 20 or so years I’ve been trading. However, through experience, I’ve learned a few things about how to deal with and mitigate them.

But before we get into the tips, let me explain my position. I am a member of a trading team that created a system called Treasury Income Engine. Essentially it’s a collection of five separate algorithms that change logic and trading approaches as underlying market conditions change for trading Treasury Bonds & Notes. Basically, the trading system works like a transmission system in a car and adjusts to underlying market conditions change.

Walking into this, I knew that the system would struggle when markets would shift back and forth rapidly from one trade state to another. It’s kind of like having to shift back and forth between reverse and first gear rapidly. In a situation like that, it’s pretty easy to understand that you’re going nowhere fast, so the best thing to do: try to make sure you don’t strip the gears or burn the clutch out.

Let me show you what’s happening and how we’re handling a market drawdown. Here are a few tips for surviving them.

That chart above is of the 2 – Year Treasury Notes and late last week we had the largest single one day move in the history of the market. The single largest one day jump in rates in recent history.

Even though I trade only the 10 Year Notes and 30 Year Bonds I do keep in touch with other markets that may affect them. To illustrate the point I want to show you a weekly chart of the same market.

Looking at the weekly chart it’s pretty easy to see that we had a one day move that was equal to or greater than the largest weekly move over the last six years and in percentage terms, was several times larger than anything in recent memory, possibly in history. This begs the question, what’s going on? Those that know me well know that I don’t exactly phrase it that way, but it’s a nice way to put it.

Here’s the point, when markets are in transition, their internal behavior changes. Institutional traders are adjusting positions according to yield curves which in turn changes general market behaviors, essentially they are switching from reverse to first gears rapidly and this will cause almost any trader or system short-term problems or draw downs. Behavior becomes irrational respective.

So here’s what we did to handle problem situations like this. With this in mind, please understand that we had no idea what the issues would be, only that there would be issues from time to time when the system would struggle due to change and it would take it time for it to “catch up” and during these times, we wanted the rate of decent to be manageable.

So here are 3 tips to keep drawdowns manageable and keep you in a position to win.

3 Tips for DrawDowns

Tip #1 – One of the summer jobs I had growing up was working in a steel-fabricating plant and some of the old timers there would say – “you boys have three speeds – slow, sleepy and stop”. And a lot of that was true and it needs to be true of your trading or trading system as well. If things aren’t going well you need to resist the reaction to correct things immediately. We live in a world of immediate gratification but the markets don’t work that way. They gratify us when they choose, not when we chose; so when things are going poorly, either slow it down or stop. This will keep the rate of decent manageable and keep you in the game. This is an essential component of the Treasury Income Engine.

Tip #2 – Keep notes on the system you’re trading. For example I know that the largest drawdown for the Treasury Income Engine over the last several years has been about $3,800 and recent drawdowns have been in the $1,200 to $1,500 range which is relevant because it represents current market behavior.

To illustrate the point, let me take you back a few years:

Back in the 90’s I wrote a simple system that worked like magic for quite a while. It was a diversified system that day traded 5 markets with a negative correlation which means when one didn’t work the others usually would and pick up the slack.

The system would however have regular $8,000 drawdowns, but like magic, snap right back to make new highs. It truly was amazing. Once in a while the drawdowns wouldn’t occur and then it would have a large spike in equity, but the one constant was the $8,000 drawdowns. Never understood why, but that was the way it worked.

Then one day, it was 1998 I think, and we had a currency crisis – or better yet Malaysia and then Russia and that was that. Price behavior changed, the drawdown was breached, and fortunately we had the good sense to quit while we were ahead. But that was only because I was so intimately familiar with the price action that made the system successful in the first place.

The Treasury Income Engine was designed to deal with 5 separate types of price action to give it maximum flexibility. If it runs into a situation it doesn’t recognize, it will eventually automatically “stand down” and stop trading.

To sum it up, if you don’t recognize what you’re seeing then stop trading until you do.

Tip #3 – Never, ever mortgage the long-term to save the short-term. I don’t care if your technique works 99 times out of a hundred. Sooner or later, that one time could break you. And here’s the kicker, the longer it takes that one to come around, the uglier it will be.

Here’s what happened to a friend of mine. He started with a pretty good idea that matched current market conditions. He’s a bright guy, an MBA from DePaul and was a desk mate of mine at the time.

He basically started from zero and the strategy was to sell high and buy low based on Bollinger bands. If it went against him, he’d just sell or buy more.

After about 3 weeks, he was up about $32,000 and pretty happy. I would’ve been too.

But he didn’t quit and the day of reckoning came.

Following the exact same strategy, one day the market trended; it was up I think. You can guess what happened next. Having negative actions reinforced by short-term positive results he gave it all back – and then some – in a single day. Pretty devastating that day was for him.

Summary

To summarize, the good times will take care of themselves, it’s the bad times you have to sew up. By understanding what you’re doing, why you’re doing it, and eliminating the urge for short-term gratification, you should be able to achieve long-term success in the markets.

As my buddy Diego would say – “It may be simple, but it’s not easy” – and he’s dead on the money with that comment.

Later-

Joe

Don’t Let the Markets Trade You!

You have to learn to Trade the markets –Not let the markets trade You!

The difference between an average trader and a very good one is how the trader handles the scenario that I will later describe. It’s one that I’ve seen played out so frequently that I can not even begin to count the number of times.

Every good trader has to have a solid approach to the markets or they will have no chance of sustained success. With that being said, that alone is not enough. Sad to say, but true; what really separates the real winners in the markets from those that achieve “so-so” results, is the ability for the winners to consistently impose their “will” over the markets.

It begins with a “good” idea.

What happens is the trader begins market operations with a good idea. This could be an idea about using a particular trading style or possibly a good analysis about the duration and direction of a coming move. It doesn’t matter which idea; the point is that they begin with a good idea that will be correct. They must also have a good initial plan of attack and tactical approach.

In the beginning, they are very observant looking for evidence they are wrong in their approach or analysis. This is a very important part of the trading process and you should pay special attention to it.

A good trader will never go into any type of sustained market operation assuming they are correct. In fact just the opposite is true, a smart trader looks for flaws within the parameters of the approach and learns he or she is correct by positive P&S statements or Open Equity. That’s the litmus test; negative results or a negative Open Equity means you’re wrong, it’s that simple. This is how you cut your losses short.

If rewarded with positive results, a very curious thing happens. They stop doing what was making them successful in the first place. It’s an amazing thing to watch, but it’s just human nature. People, corporations, and even countries tend to stray from what was working.

In fact, a psychologist and friend of mine was once a consultant for struggling businesses in Florida and he shared many interviews of clients with me. The interviews would go something like this; he would ask them to detail what they did when things went well. Then he would ask them what they were doing now. If it was different, then he would tell them to go back to what they were doing when things were going well. And the amazing thing is nobody had realized what he or she was doing wrong.

People tend to make small, but significant changes without realizing it. Start in one spot and end up in another without even realizing it and for a trader it can drastically alter his or her results.

This happens to the average trader all the time but seldom to the professional trader. While the average trader gets sloppy and falls in love with his or her positions,  the pro remains sharp and critical at all times.

The net effect is that when you start rooting, thinking, and talking your position, you lose the edge you had in the first place; the markets start trading you instead of the other way around. The results are predictable and usually do not have a happy ending.

When certainwords start popping in your vocabulary such as: wish, want, hope, or you start praying for a position to go your way – exit right away because you’re not thinking clearly. Take a break and get your head clear and then try again later. That’s the only cure.

One possible solution for avoiding this phenomenon is to keep detailed notes and a trade log for constant review. Most traders don’t like to do this, but it’s the only way you can really keep track of what and why you’re doing what you do.

Another good idea is to keep track of significant highs and lows of the markets you follow along with the dates or times of the day they were made.

Again, most traders don’t like to do these things because they take time, but I can assure you that the professionals do do this and this can help take you to that first step of becoming a professional trader.

Till next time!

Joe

Why You need a System – or Systematized Approach

Last Friday was one of the best examples of why you need a system, or at least a systematic approach to the markets.

Over the years, I’ve done extensive research into market behavior through computer analyses. I can tell you off the top of my head what is likely to happen given the number of closes, either up or down, where a market closed in its range, where it opened and any other number of factors such as whether the preceding day was an inside or outside day or whether the day in question was a gap or not. To put it succinctly, I know what I’m talking about, I’m not guessing.

The one glaring statistic that came to the front when I was doing these analyses was the fact that when a market deviated from its norm, extraordinary events occurred.

For example, if a pattern produced positive results 65% of the time and returned a 5 point gain on average, the other 35% of the other time the results would be on track to produce a 10 point loss. This amazed me at first, but after a little thought I began to understand it, because I’ve personally participated in it.

Let’s say you’re sharp enough to pick up on what I call the “Eager Beaver” effect; the early false breakout I’ve described before. The typical good trader will get used to this and rely on this pattern because it works for him or her most of the time.

Here’s what happens, the typical “good” traders get conditioned to react a certain way. Can’t blame them, we tend to react to what typically rewards us, if we’re smart traders anyway.

So let’s say we get accustomed to the “Eager Beaver” effect. We have a pattern we get used to the works about two thirds of the time.

We as people will tend to “believe” that what we are doing is correct. The operative word here is “believe”. Why that is important is that once we “believe” in something, we go to our grave defending that belief. It’s human nature.

Having a good system can help you take advantage of that trait.

Here’s how…...

Looking at the chart below it doesn’t take a genius to see that the early breakout was to the downside. What makes the difference between a good trader and a great trader is the ability to do what is difficult. What you not typically rewarded for.

Having been conditioned lately to the “Eager Beaver” effect it almost killed us to take a straight breakout sell knowing that it was certainly to be wrong.

But there were two factors that differentiated this pattern from the others.

The first was the length of time the market traded in a fairly tight trading range and we do take time into consideration.

The second was the fact that the market offered no attempt to reverse direction, none at all. Now as hard it is for us to trade against proven strong tendencies, we also know that when markets deviate from known previous behavior that extraordinary moves typically occur.

Here’s why.

The previous known good traders will do what is known as “Cannon Balling” or trying to average their position or buying down in this case.

The reason they do this is because they “Believe” in their trading rationale because it usually works most of the time. But when it doesn’t, it’s a train wreck.

Here’s what happens. A normally good trader will defend his or her position, but more importantly his or her belief system. They add to the position, average a loser and Why not if you truly believe the market’s eventually going go your way.

Well, when it doesn’t work out, the losers playing the percentages eventually “puke” which will exaggerate the daily range and cause a close near the high or low of the day.

Been there and done that. Completely understand the psychology and mindset behind it. But as time goes by you, if you have a brain, eventually learn how to avoid this self destructive behavior and eventually how to take advantage of this phenomena.

That’s why it’s important to have a system to avoid some of the emotion and, keeping you from adding to bad trades and to force you to do the trades you don’t want to. If there is one thing we learned over the years it’s that some of the best trades you make are the ones you don’t want to make. They’re the hardest to pull the trigger on and often the best ones.

In the example shown – we got out too early. But we believe a bird in the hand is worth two in the bush and good enough is good enough.

We hope you feel the same way too.

Trading Breakouts and the Eager Beaver effect – Part 2

What we call the  “Eager Beaver” effect has been the norm in the treasury markets lately and by eyeballing it I’d say it’s been occurring about two thirds of the time, which by the way, is a statistical norm.

While we claim to trade breakouts, we do it a little differently than most do and I’m going to illustrate that to you now.

If you’ve read the web site, you know that we use 5 different algorithms that adjust to what we consider to be current market conditions.

Looking at the 10 Year Treasury chart above we can easily see that the early move was to the upside creating a fake out again, no surprise there.

However, the ensuing break exceeds our entry point so we’re not participating in the move and not very happy about that at the moment. But one thing here is significant; the market stopped just short of what would have been the Profit target.

The market then rallies back into our trade zone which at point “A” were we enter short and exit about 10 minutes later with a 4 point profit.

So far so good, but day isn’t over.

Four points is only $125.00 but it’s better than a loss.

A subsequent rally takes the market back to the original breakdown area – folks you really should pay attention to this –and then the market begins to trade into the previous trading range.

We eventually Sell again at point “B” and get another 4 points or another $125.00 – that leaves us with about $218.00 after cost.

So let’s take a look at our Sister market – the 30 Year Bonds

In the 30 – Year Bonds we had a similar situation however the program handles it completely differently and at different times.

It’s not so easy to see that the 30 – Year Bonds have been behaving differently than the 10-Year Notes, similar, but not quite the same.

This is where the computer comes into play, the computer points out what the eye will miss..

The Sell eventually comes at point ”A” and eventually exits with about a 16 point profit.

Does the “Eager Beaver” work all the time? Absolutely not. In fact the next feature will be about that exact topic and will illustrate what happens when the unexpected occurs to the supposed professionals.

How to take Advantage of the “Eager Beavers” and Early “False Breakouts”!

Trading volatility breakouts has been around for a long time, and if you think about it carefully that’s really what you’re trading regardless of what you think you’re trading.

Volatility, assuming it’s in the direction of your position, is what validates your decision. Lack of it almost assuredly means your assumptions are incorrect.

At the moment, I’m almost entirely consumed by the Treasury futures markets and I’ve noticed a simple pattern that, for lack of a better term, we’ll call it the “Eager Beaver”.

“Eager Beavers” are the eternal optimist of the trading world; all they see is sunshine and rainbows at the beginning of each day. “Eager Beavers” want to enter early and ride the wave for the big profits that will come at the end of the day.

Well folks, it happens that way some of the time, in fact just enough to keep them coming back to the trough and believing in the Easter Bunny, but not as often as you may think.

What I want you to do is focus on the highlighted area of the chart above. There are a couple of things to notice. First, we opened lower and immediately traded to the end of the previous day’s range and then went into a consolidation phase establishing a range 128-28 for a high and 129-17 for a low. At the moment you’re looking at both buyers and sellers at a standstill neither having the upper hand and are waiting to see what will happen next.

Now we can see that it was the sellers who were on the wrong side as the market breakouts to the upside and begins to head higher, obviously you don’t want to be short this market at the moment and this where the trap is laid. The buyers are happy and confident at this point.

Most traders think in directional terms, they either want to buy or sell. They have a bias for one side or the other. There are a few that want to play both sides repeatedly during the day, but they are a minority.

Here’s what happens next: the breakout buyers are neither rewarded nor punished by their decision. They’re either up by a few or down by a few ticks. There’s no urgency on either side.

Once the apex is broken off the consolidation phase, the breakout buyers start to run for cover plus new sellers start to come under 129-24 – of which I’m one.

Here’s what’s happening: the pros are smoking the retail trader’s with this gimmick. Somehow, someway the ordinary folks get tricked into a position early in the day by a false breakout.

Then later in the day they get caught equity wise because they HAVE to run for cover for margin reasons.

That’s where the opportunity is now, trading against the guy who HAS to trade because of his limited capital.

That’s the antimony of trading against a “False Breakout”.

(c) 2009 Capital Research & Trading, LLC All Rights Reserved

Hello Trading World!

This blog is about using a combination of technical analyses and statistical probabilities to trade the Treasury futures markets on an intraday basis. The approach sponsored by this page requires that no overnight positions be held and that reasonable profits be taken when available. Oh, and one other thing is that the trading algorithms used work; they work on a walk forward basis.

One thing you will never hear me say is, oh look here and if you’d have done this or that you could have made a lot of money. It doesn’t work that way today, and it never did in the past.

Occasionally, I may write about statistical probabilities and trading approaches applicable to them.

Or I may write about current market environments and how to adjust trading styles accordingly.

Or maybe about risk/reward relationships and how to accurately calculate them so that they become relevant in a trading strategy.

Less frequently, I may write about how markets tend to manipulate the psychology of traders and how to avoid the pitfalls that destroy most traders.

And finally, some real life stories – drama if you will – about situations I and others I know have gone through. Some with happy endings, some not, they will be real and something you should be able to learn from. Up to this point, this has been the most requested of all topics. Seems to me that people like to hear stories, and I have a bunch to tell.

Put another way, this Blog is about telling you how to win – not simply justifying an approach or a method, because that will simply not work. No single sided method works over time and that’s what this is about. Seeing adjustments being made as they are being made and really learning how to trade are key, provided that you can pick up on the subtleties. If you can, fine! And if you can’t, then there are other options for you.

Someone once said that a wise man learns by others’ mistakes and a fool learns by his own. Folks, I can tell you that this is very true. Over time I’ve witnessed many a colossal screw-up and many great successes, I’ve experienced the agony of defeat and the elation of victory.

This isn’t an economic Blog or a Forecasting blog; it’s blog about trading in the real world, the issues, problems and solutions to those problems and more specifically a Blog about trading the Treasury markets and how I approach the business of speculation and how it may benefit you. Happy Trading!

My next issue will address the current environment.