Wednesday, January 09, 2008

Profitable Trading: Focusing on What Works

I've posted many times, on the blog and in my book, about the importance of identifying and building upon strengths. Nine times out of ten, traders who come to me for help want to discuss their problems. Often, if they'd just cut out what isn't working and build upon their profitable markets and setups, they'd turn their trading around.

There are two occasions that prompt me to review what I'm doing:

1) Losing Money - Given my strict risk control, a 2% drawdown peak to trough requires me to stop trading and review markets, ideas, and my trading. This single rule has been the most important factor in a relatively smooth, upward equity curve over the past several years. I don't resume trading until my review is complete and I have some confidence and conviction about what I'm doing. Similarly, I'll stop trading for the day if my portfolio is down more than 50 bps. This, too, prompts a nightly review and specific goals for the next day.

2) Hitting New Equity Curve Highs - When my portfolio makes a new high, I will generally review what's been working and where my profits have been coming from. In the past, I used to get sloppy when I was making money, taking marginal trades. By thoroughly reviewing the trades that are making me money during a profitable period, I remind myself of core strengths and redouble my efforts to stick with those.

I hit an equity curve high today, so am beginning a review of recent "best practices". Here are a few:

* Sizing - I enter trades with one unit and wait to see how the market behaves before putting on a second and third unit. Many, many of my losing trades go under water very early, so I want to get stopped out when my size is smallest. If the market moves against my trade but can't hit my stop, that's when I put on the second unit; the same process will have me adding a third unit. What that means in practice is that I can be stopped out on a couple of trades, have one winning trade, and still end the day nicely profitable. It's the few trades that I nail with larger size that contribute a good portion of my profits.

* Waiting - Many of my losing trades have occurred early in the morning. By waiting for the market to show its hand--and by waiting to see how much action we're getting at the market bid vs. offer--I generally find higher percentage trades. I also find that starting my day with a losing trade makes me overly risk averse later on. I'm much better off waiting for those high percentage trades; that's when I can be most confident and aggressive later on.

* Dancin' With the One That Brung Ya - My indicators, many of which I post to this blog regularly, are my old friends. I've watched their behavior on a daily basis for years and have a pretty good sense for their patterns. If we're not seeing weakness in the NYSE TICK, the Market Delta, the number of stocks making fresh intraday lows, etc., I won't sell. If we're not seeing the reverse, I won't buy. Aligning my trades with the trend of the indicators has kept me out of many bad trades.

* Execution - I can't begin to describe how important this is. I've worked at it for a long time, and I still get into trades too early. But I don't chase strength if I'm buying, and I don't chase weakness if I'm selling. If I miss a trade that way, too bad. There will be others. But I've learned to buy on pullbacks in the NYSE TICK and sell on bounces. I've also learned to be patient and enter trades as close to my stop level as possible. That easily adds a point or more of profit to each winning trade.

In football, we often focus on the big plays: the long passes from the quarterback, the thrilling kickoff returns for touchdowns. What wins the game more often than not, however, is the blocking and tackling that make the big plays possible--and that prevent the big plays from opponents. My "best practices" aren't sexy--they're not home run trade ideas--but they're the blocking and tackling that make profitable trading possible over time.


Solution-Focused Trading


Aaron said...
This comment has been removed by the author.
Sandor Tucakov Caetano said...

Hi Dr. Brett

I'm a trader from Brazil who bought your book and since then has been quietly following your posts in my rss feeder.

This week I faced one of the worst problems in Brazilian markets. Execution problems.

You stressed how important execution is, but how a swing trader (who has to work 8 hours a day but DO his homework daily) bear with opening gaps???

For instance...I trade a breakout system which proved very good for some years (specially in our 5 year bull market), but one in 3 trades I miss because the markets go too fast, and the ones I get in have a higher probability of turning into loosers since they lack the strength to go on.

Do you have any advice on that? I think entering on the market open would kill my win/loss ratio since I can never know when to trade the breakout and entering a MoT (market on touch) order can also kill me because of the spreads... :(

Brett Steenbarger, Ph.D. said...

Hello Sandor,

Opening gaps are a part of the risk/reward equation for the swing trader. It's important to analyze the gaps by themselves, almost as if they're a separate market, to see if there's a trend that you might not want to fight. Holding short positions overnight in the U.S. stock market, for example, has--overall--been a losing strategy.

I personally deal with holding overnight through position sizing. My overnight size is at most a third of my normal daytrading size. This helps me deal with tail events--large gap moves that go against me.


Sandor Tucakov Caetano said...

Tks Brett,

I'll run some tests for the opening gaps to see how they relate to my strategy (buy breakouts)and try to test some ways to anticipate or to fade those gaps...

tks again for your help...

BirdMan said...

Your comments on sizing indicate that you may add to a losing position if it looks like your stop will hold - adding to a losing position seems to go against conventional wisdom? In a future post I would love to hear more about your method.

Brett Steenbarger, Ph.D. said...

Hi Dave,

Yes, I do think adding to a position at a better price is different than adding to a position that has proven itself wrong by breaking through a stop level. Just about all portfolio managers operate this way; they can't possibly enter a position all at one time due to their size--