A SPECIAL TRADING REPORT

Transcription

1 LEE GETTESS ON DAY TRADING A SPECIAL TRADING REPORT

2 LEE GETTES ON DAY TRADING A SPECIAL TRADING REPORT THE INFORMATION AND OPINIONS CONTAINED IN THIS REPORT ARE FOR INFORMATIONAL PURPOSES ONLY. THERE IS SUBSTANTIAL RISK OF LOSS IN TRADING FUTURES AND OPTIONS AND YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR PERSONAL FINANCIAL CONDITION. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THE RISK OF TRADING (OR NOT) Any discussion of trading should rightfully begin by discussing risk. The main reason for that is because it is virtually the only aspect of trading that you have any control over. More on that later. Also, the general consensus among most of society is that trading is "risky". When I am out in a social gathering and asked what I do for a living, I am hesitant to say I trade for a living because 90% of the responses are along the lines of "Wow! That's risky!" It is true that there is risk involved, but what in life doesn t involve risk? Most people get in their cars to go to work in the morning because they assume that the risk they are taking (that they will get to work safely no accidents) is worth the potential reward of earning a paycheck. Trading is no different. You assess the risk of any given situation to determine if you feel the risk is worth the reward. Even keeping your money in a bank involves risk. There is the risk that the bank might go bankrupt. There is the risk that the U.S. government might go under. Granted, there are relatively small risks (they are small aren't they?), but so is the potential reward for assuming that risk. Banks are currently paying out about 2.5% interest, and even back in the late 1970's and early 80's, actually passbook saving ratings were only about 5.5%. You could (and still can) purchase Certificates of Deposit (CD's) that will pay higher interest rates. Those CD's, however, have time requirements on them. You have to assume the risk that you will not be in any dire need of that money for the duration of that CD, or pay severe penalties for early withdrawal. You can earn a higher rate of return, but there is more risk involved. That is the general pattern in many walks of life. Another misconception regards the exact form risk takes. Here's an example: I had a local contractor friend, who asked me one day what I thought about the Wheat market. He knew what I did for a living, but he had never discussed any of it with me. I explained to him that I wasn t actively trading Wheat at the time, but I would look at it and let him know what I thought. This was early Wheat had been above 450 within the last year, but was near 350 and heading lower. After some very brief technical analysis, I went back to see my

3 friend. First I asked him why he cared about wheat. He said he had been contacted by "some broker" who wanted him to buy options in wheat because it was "going to go way up!" I explained to him that it didn t look like it wanted to go up to me. In fact, it looked quite the opposite. If he really wanted to impress the broker, he should tell him that he didn t want to buy the options, but that he would be glad to sell them to the broker and take the other side of the trade. That was the last I heard about it. A couple months later (Wheat was at 278), I asked him what he had done about that wheat. He said "Oh, gee, Lee! That was the worst experience of my life!" I asked him if he actually bought the options, and he said "Yeah, I bought them. I lost $30,000! I'll never do that again.that stuff is too risky for me". So, he had asked a professional for advice, but then went against it. where did the risk come from? Risk comes in many forms, but the greatest risk you can ever take in life is the risk of never giving yourself an opportunity. That isn't necessarily a trading-related statement, but it certainly does relate to the "risk" involved in trading. Risk in trading can be defined as the amount of money that one can theoretically lose on a given trade. That risk is absolutely huge.almost infinite. In an attempt to control that risk sufficiently, it is always prudent to trade the most liquid markets, or those with the most volume. The Treasury Bond futures, for instance, often have 300,000 to 400,000 contracts traded during a trading day. That amount of volume almost insures you the ability to get out of the market whenever you want to. That means if you have placed a stop loss order to limit the loss to $500, there is about a 98% probability that your loss won't be more than $500. Another way to quantify risk in trading is to attempt to determine how much risk you might have in following any given trading methodology. That can be a slightly more difficult aspect to corral accurately. Most traders are concerned about the maximum drawdown of any given methodology. Systems are sold with the historical maximum drawdown shown, and are often rated on the basis of how low (or high) that drawdown is. Let me make a statement that I believe is unequivocally true. Maximum drawdown is probably the most unreliable figure you can get from either a realtime or hypothetical track record. It tells you how bad things ever got over the course of the track record. It is not an indication that things will ever get that bad again, nor is it a guarantee that things will not get worse. In short, it doesn t tell you anything about what you can anticipate in the future. Let's look at a common scenario, where "experts" tell you to capitalize your account to expect 1.5 or 2 times the historical maximum drawdown. Now, let's say you have a system that makes $150,000 over ten years with only a $2500 drawdown. If you trade that and suffer a $6000 drawdown, does that invalidate the system? If someone showed

4 you a system that made $150,000 over ten years with a $6000 drawdown, wouldn t that look like a good system to you? Maximum drawdown truly offers you no clue as to what to expect in the future. The only thing you can deal with is the immediate, which to my mind means to attempt to quantify the risk on the current individual trade. In general, you should attempt to keep the risk on each individual trade as a fixed percentage of your overall account. That can be 1%, 2%, 5%, 10%, or whatever you wish. You should understand, however, that the more you risk, the more volatile your return is going to be. More risk should bring about more profits over the long run, but it definitely will bring larger drawdowns, including the potential of a catastrophic one that will wipe you out. Let's assume you have a $50,000 account and decide to risk 2% per trade. Now, this cannot be quantified precisely due to slippage and overnight gaps, but you can maintain rough guidelines. If the trade you are considering has a potential risk of $300 per trade, you can trade 3 contracts since 2% of $50,000 is $1000. You simply divide the chosen percentage of your account by the risk, then trade just the whole number answer divided by 300 is 3.333, which you round to 3 contracts. If the risk was $450, you could only trade 2 contracts, since $450 goes into $1000 twice. If the risk is over $500 you could only trade one contract, and if the risk is over $1000 you have to bypass the trade. While this is not a perfect solution, it does manage to keep you basically out of trouble, and it allows you to trade larger size as your account grows. As a rule, smaller accounts have to risk a larger percentage out of necessity. It is not uncommon for a $10,000 account to risk 10% or more, while the multi-million dollar fund will risk 1/4 of 1%, or less. Who do you think has the greatest potential rate of return? Obviously, the amount you risk and the amount you can make are generally NOT inversely proportional. The more you are willing to risk, the greater your potential return is, but then you also have a greater likelihood of losing it all. If you are in doubt as to how much you should risk, always err on the conservative side. Risking less may cost you money on individual trades, but it greatly increases the likelihood of your account still being around to take the next profitable trade. If you risk your entire wad and lose, you can't trade. And if you can't trade, you can't make any money in the markets. Longevity is a key to success. Using a small percentage will keep smaller accounts out of a fair number of trades, but that has a very interesting benefit; If you are trading a methodology where the risk is defined by market activity, the smallest risk will be when the market is the quietest. That is, trading in very small ranges. Those small, tight ranges tend to be an indication that a substantial move may be imminent. This is a benefit to larger accounts as well, since the smaller risk will allow them to trade more contracts. Smaller accounts simply have to have more patience to survive and prosper.

5 If I had to make a suggestion based on various account sizes, I would suggest a $15,000 account risk no more than $1000 on any given trade; a $25,000 account risk no more than $1250; and a $50,000 risk no more than $1500. This is about 7%, 5%, and 3% respectively. You can risk more or less, depending on your personal tolerance for risk, but those are reasonable guidelines. Additionally, you should also put a limit on the total amount of an account at risk on all trades combined. This can be a fairly liberal figure, say anywhere from 30% to 50%. The chances of having 10 trades, each with 5% risk, all go against you simultaneously is fairly small, but you should always prepare for the unexpected that can't possibly happen and probably will. (I just love that quote!) When approaching this total risk limitation (or margin constraints) you either have to cut out the trade that is performing the worst at the time (has the largest open loss), or not take any additional positions until the limitation enables you to. My preference is to not take additional positions until my risk parameters say I can. Again, there is no magic number for risk per trade or total amount of risk. It has to be based on your own tolerance for risk (and pain) and your own comfort level. Equalizing the risk on each trade is the only logical method of asset allocation. The focus has to be on risk, since it is the only aspect of trading that you have a modicum of control over. Let's say you have decided that you don t want to risk more than $1000 on a trade. Now, there can be overnight gaps; you can have slippage; you have to pay commissions; there are potential execution problems. Within reason, however; you can come very close to being certain that you don t lose more than $1000 on that trade. On the other side of the coin, what if you want to make $1000 on a trade? You can't do anything to ensure that you will make $1000. You simply put on the trade, then hope, pray, drink, curse, or whatever, but it is out of your control. Risk can basically be controlled, and that is our primary job as traders. CREATION OF HIGHS AND LOWS There is an aspect of technical analysis that is often overlooked, which I believe might be one of the most important clues to probable market direction. Almost all technical analysis begins on a bar chart. Each bar represents some unit of time, although many software packages now allow the use of "tick" bars, which are units of activity rather than time. Since those basically function under the same rules as "time" bar charts, we will discuss on the basis of time only. Each bar on a chart could represent one day's worth of price action. It could also be an hour, a 10 minute period, a week, a month, a year, etc. The exact time frame we are dealing with is irrelevant. All of them hold the same basic truth.

6 That basic truth is that each bar has to make both a high and a low. It doesn t matter how active or inactive, or whether the market is going up, down, or sideways. Each and every bar will make a high and a low. It should be equally obvious that one has to make before the other. That is, a bar will either make a low and then go make a high, or it will make the high first and then go down to make the low. Attempting to understand exactly which is unfolding can be a tremendous help in anticipating price action. The direction that any given price bar takes is directly related to when the high and low forms. If a market is going to up for the day, for instance, it will generally make the low first, then spend the majority of the day traveling up to make the high. Conversely, a market that is going down will normally make the high of the day first, then go down to put in the low. How can this information help you? By making you aware of probable direction. When I daytrade, I am always trying to determine if the market has created the high or low for the day. I don t need to be the hero that picks the exact high or low in order to make money. I just need to be aware of what has happened, which clues me in to what should happen. If I can recognize that the low for the day has probably already been created, then I can assume that we need to go up to make the high. I have a firm opinion on what the probable direction should be, so I know which side of the market I want to trade on. The time frame that you trade in is a personal decision. It should be directly related to your personality and temperament. Everyone has a different comfort level, both in terms of risk and length of time holding positions. While I make use of the directional bias for daytrading, there is no reason it can't be used by longer term traders. A monthly bar, for instance, also has to make a high and a low. If you can recognize that the market has probably made a high, you can look to the short side of the market knowing that it has to go make the low for the month somewhere. If you remember that a market going up will generally make a low first and a market going down normally makes the high first, it can also clue you in to problems with a trade you are already in. Let's say you are short some market and you are anticipating that it ought to go down for 3 months or so. If you can recognize that the current month seems to be making the low first, isn't that important information? You could perhaps exit the position and make more money than you would have. You could even go back short once the market goes up to make the high, if you still think your original position is correct. In 1997, the Japanese Yen started the year absolutely falling like a rock. It had been as high as in April of 1995, and had been coming down hard ever since. In early 1997, it reached back down to the levels it had been trading at in it certainly

7 looked like it was making the low for the first year. I am primarily a daytrader, but I told numerous clients that I thought it was making the low for the year around it went as low as 7894 on May 1 (making the low for the month first), and was over 9000 by June 11! These indications can be dramatically profitable! There is no magic way to always know whether the high or low for any given price bar is in. if you can make some reasonable assumptions based purely on recent price action, it will greatly enhance your understanding of the flow of the markets. RECOGNIZING THE HIGHS AND LOWS FORMING For those of you who have seen my Trading in the Trenches video or read my Scorpion method, you know I am rather fond of divergence between price and indicators. Divergence is a subject that is covered in those materials, as well as numerous other writings. The nuances of divergence are beyond the scope of this discussion. The important point, however, is that not all divergences are good. We need some additional clues as to whether a market is making a high or low, perhaps even when there is no divergence set up. Here is a big clue: Watch to see how price goes up when it is going down, and how it goes down when it is going up. Confused? As price is heading down (or in a down trend) it will find support at some point and rally. There will be small rallies during the move down (markets don t move in a straight line), but we want to recognize with a high probability when a more significant low is being made. The key is to watch the rallies during the move down. They will have a magnitude, both in terms of price and time. They will rally for 3 bars, 4 bars, 5 bars, or whatever unit of time. They will also rally for X number of ticks. When these up moves start getting bigger in terms of price, time, or both, we are nearing a significant low. When price makes a bigger move up in both price and time, it will probably make another lower low, but with less momentum. This may or may not show divergence in your indicators, but it is a major clue that the move down may be over. The same is true of resistance. The market will have little sell-offs during a move up. Monitor the magnitude of these down moves, both in terms of price and time. When they start getting bigger.particularly when they are bigger than any other move down during the up trend, there is a good chance that the next high may be the last. If it isn't THE last high, you at least have a clue that the momentum is slowing and the market shouldn t go much higher. This is not foolproof.nothing in the markets is. We can't deal with certainty, we can only deal with probabilities. If you will monitor the countertrend moves, in any market you choose and on any time frame you choose, you will develop a much better understanding of how powerful (or not) the market is. The next probable course for the

8 market to take will be much clearer to you, and it should help you obtain much better trade location for your positions. Of course, the vast majority of traders need to be able to trade on a reasonably short time frame in order to control the risk, but at the same time, don t have real time quotes and the ability to monitor the markets on intraday time frames. There needs to be a logical way to make use of our knowledge of how markets operate without forcing us to become full time traders. Fortunately, such methods do exist. The best way for most traders to participate in probable market moves on a short term basis is probably to use some form of opening range breakout as a trade entry. This involves buying or selling a market once it has moved a certain distance away from the morning opening. For instance, you could have a rule to buy any time the market has moved more than 50% of yesterday's range above the open. You would simply multiply yesterday's range by that percentage (let's say 55%), then add that to the open to place your buy stop. Here is an example: The June 1997 S&P 500 (SPM) on 6/5/97 had a range of 870 points. It had a high of and a low of If you subtract the low from the high ( ) you get 870. Now, we will multiply that 870 by.55 (which is 55%) to give us We always round our answer up to the nearest whole tick increment, and the S&P trades in 05's. That means our answer could either be 475 or 480, but since we always round up, it would be 480. That 480 is the figure that we will add to the next day's open to get our buy price, or subtract to get the sell price. The open on 6/6 was minus 480 equals We would place an order to sell the SPM at on a stop plus 480 equals 84905, which is where we would place our order to buy on a stop. The data for 6/6: open 84425, low 84410, high 86270, close If you had bought at and exited on close at 86250, your profit on one single contract would have been $6725, minus any slippage and commission. Not bad, huh? Buying some fixed percentage movement away from the open makes use of the concept of utilizing the direction in which the daily price bar gets created. Studies by numerous people over the years (Hadady, Crabel, etc.) all suggest that the opening price of any given day is within 10% of either the high or low of the day about 90% of the time. Obviously, any significant move away from that opening price is a good indication that we have started on the basic direction of the day. Exactly what percentage to use is a difficult question. The smaller the percentage used, the earlier you will get into the move. That means better trade location, but it also means more false signals and more losses. As a rule of thumb, you probably want to use at least 50%, with figures up to 100% and higher generating far fewer trades (and less profit) but more reliable entries. There is, however, no universal, magical figure.

9 Percentages aren't the only way to do it. You can also wait and buy a breakout of the first hour of trading. It could be 30 minutes, 45 minutes, 90 minutes, etc it doesn t have to be just the first hour. You wait for the market to create the range for the first however many minutes, then only trade if it makes a new high or low after that. Incidentally, if you had used that strategy on 6/6/97 in the SPM, you would have bought at We are discussing this as if you simply take these positions, then exit on close with Market on Close order. There may very well be good reasons to hold them longer but we are simply discussing daytrading. There are a whole bunch of other little tricks you can use to improve your daytrading performance. You can only take trades that go opposite the direction of the previous close, for instance. Believe it or not, there is a higher probability that a market will close up today if it has closed down yesterday, and vice versa. Fading the direction of the previous close is a pretty good filter! You can also only buy a market that opened lower than the previous close, or sell one that opened higher. None of these are necessities to be profitable, but they are reasonable filters if you want to cut down your trading frequency. Trading too often not only generates more commissions, it also increases the strings of losses, which is never a pleasant experience. IN CONCLUSION 1. Control the risk. 2. Finding a way to get positioned in the proper direction. 3. Understanding the basic flow of the market for direction. These are the cornerstones of good, profitable trading. There is not just one single correct way to trade. It is up to each individual to find both method and a time frame that is suitable to his or her personality and temperament. Hopefully, there are enough clues and good information contained in this manual to at least get you started in the right direction. Remember those three cornerstones, and you should always have a leg up on the competition. Good luck with the journey ~ and may it be a profitable one! Cordially, Lee Gettess