90 Chapter Four In Figure 4.03b Elliott Waves 1, 2, 3, and 4 all bounce of FRLs. The 2nd and the 4th waves do not exceed the start of Wave 1. Given that Wave 5 was at 23.6% Fibonacci Ratio July 5th 2018, a reversal may occur. If a reversal occurs, possible support levels are US$1,256 (the 38.2% Fibonacci Ratio), US$1,255 (the 50% Fibonacci Ratio), or US$1,254 (the 61.8% Fibonacci Ratio). 4.2 Evaluating the Trading Strategy Traders should evaluate their trading strategy to determine its success, and where improvement is needed. Such an assessment requires that the trader records the following information: x the average profit or loss daily; x the size of the average win; x the size of the average loss; x the average risk which is taken per trade; x the win to loss ratio; and x the number of round-trips taken in a day. A trading strategy can only be evaluated properly only when its profit, loss, and risk have been measured accurately. The average profit will indicate the profitability of a retail trader on a daily basis. If the profitability is low, or if there is a loss, the trading strategy should be adjusted. The average size of the win provides insight into the optimal time the trader is holding the position to closing the trade. Assuming the financial capital traded is held constant, the size of the winnings can indicate whether the trader is closing their winning positions too early or not. Likewise, the size of the average loss also indicates if the trader is holding losing positions too long. With such information, the trader may amend their strategy and opt to hold winning positions for a longer period of time. Also, the may utilize a more stringent risk management strategy to limit their losses. As part of the evaluation, a trader could review their trades over the past day/ week, and ask themselves the following questions: x Was there a strategy for opening and closing positions? Is so, was it followed?
Trading Strategies 91 x Was any technical or fundamental analysis tools used to inform trading decisions? x Was there a target for wins/ losses? x Were trades closed/ canceled early? x Were losing positions held longer than outlined in the strategy? x Did human emotion influence any of the trading decisions? The answers to the simple aforementioned questions can provide insight as to why a trader may be experiencing losses. Of course, more complex methods such as the Sharpe Ratio, and Monte Carlo simulation can be used to more rigorously assess the trading strategy of a trader. Such complex strategies may be used by an advanced trader with a background in financial economics, however, they are beyond the scope of this book which targets the novice trader. 4.3 Summary Insight It is difficult for a trader to successfully earn a profit on a long-term basis with the implementation of an objective and winning strategy. This chapter first reviewed the basic features that a trading strategy should contain. These include the entry and exit rules, risk management rules, and position sizing rules. Then this chapter explored a number of simple trading strategies. Crossovers, momentum trading, and reversal trading were identified as the main strategies. However, they could be supplemented by information from Moving Average Envelopes, Bollinger Bands, and Heikin-Ashi charts. While trading strategies may rely on indicators it is important to note that an indicator is not a trading strategy. Finally, this chapter considered a basic framework to evaluate the performance of utilized trading strategies. Simple trading strategies are relatively easy to build, implement, and evaluate. Conversely, complex strategies are more difficult and time-consuming to build, test, and optimize. The same principle applies to evaluation methodologies. As previously mentioned, this book focused on the simple approaches as the target audience is the informed reader seeking to increase their financial knowledge. The next chapter, Chapter Five, probes risk management in greater detail as it is a crucial element of a trading strategy.
CHAPTER FIVE RISK MANAGEMENT 5.0 Introduction Trading is the practice of trading strategies and managing risk. Successful traders carefully assess and justify their risk whenever considering making a trade. In other words, they need to be mindful of the loss they can make while entering trades. They may intensely use limit orders to open and close positions so that their trades are executed at target prices. As a risk management strategy, a trader needs to know when to enter trades, how long to hold the position, and when the exit the trade. Such information would be beneficial to a trader as it would prevent them from buying into a profitable momentum too late, holding a loss position too long, and selling a profitable position too early. Retail traders should only trade based on money that they can afford to lose. This is suggested since there is a potential for the trader to lose their money from engaging in the practice of trading. Money for essential consumables such as food, rent, utility bills, educational expenses, health care, etc. should not be risked by the market participant in trading. In fact, if the retail trader fears to lose their money they may find themselves holding profitable positions too short, or selling losing positions too early, which in turn can result in the trader realizing unnecessary losses. This of course could result in the retail trader operating a negative profit to loss ratio. Thus, as a recommended rule, if a person can’t afford to lose the money that they risk in trading they should stick to demo trading until their financial position improves. This chapter considers a number of strategies to manage risk. It reviews the various types of risk, the optimal point to enter and close trades respectively, and strategies for position sizing.
94 Chapter Five 5.1 Types of Risk Market participants on a stock exchange face different risks. These risks include: x Market risk; x Liquidity risk; x Concentration risk; x Credit risk; and x Inflation risk. 5.1.1 Market Risk Market risk is that a market participant incurring a negative return or a drawdown due to a change in the market. The main market risks are price risk, interest rate risk, and currency risk. Price risk is the chance that the price of the asset can go in an unfavorable direction. For example, if a trader went long on a stock, the price risk would the chance that the price of the stock declines rather than increases. Alternatively, if the trader short-sells the stock, the price risk would be the chance that the price goes up rather than down, resulting in a loss for the trader. Stock prices are marked to market daily, subsequently, their prices can change on a daily basis. In fact, stock prices can fluctuate within a day. Thus, price risk is inherent in all stocks that are public traded on exchanges. Another price risk that a trader can face is a stock halt. A market-wide stock halt is when the price of all the stocks on an exchange is suddenly frozen. This may result from a technical glitch of the online platform of several brokers, or a direct intervention of a central authority to freeze the market. Non-market-wide stock halts can also affect specific stocks. Stock halts, in general, are risky to market participants, as they can be accompanied by huge jumps in the stock price at the end of the halt (Lahaye et al. 2011). 73 73 Stock halts are not to be confused with limit moves. Limit moves are limits set by Exchanges to confine the price movement of assets within ranges. For example, the daily price of soybeans on an Exchange may be allowed to fluctuate $0.50 above or below the previous day closing price.
Risk Management 95 Price risk can be addressed with Limit Orders or the utilization of options. Limit orders are discussed later in this chapter. Options give an economic agent a right, not an obligation, to partially counter the effects of adverse price movement by the execution of a strike price. Options can be a useful tool for investors to hedge against the risk of adverse price movement. Interest rate risk is the chance that the market participant can experience some loss in the value of their asset due to a decline in the interest rate on the asset. Interest rate risk is relevant to bonds since bonds have coupons attached to them. However, interest rate risk is not relevant for stocks since stocks do not bear interest. Currency risk is the chance that the market participant from country A trading assets in the currency of country B, may incur some loss due to a change in the floated exchange rate. For example, on Thursday January 3, 2017, the price of First Citizen’s Bank’s stock (FIRST) was TT $34.98 on the TTSE. The exchange rate between the US and Trinidad and Tobago (T&T) on that day TT$6.7563 = US$1. By January 9, 2017, the exchange rate between T&T and the US depreciated to TT$6.7976 = US$1. However, the price of FIRST was still TT$34.98. A market participant from the US trading in TTSE would experience some loss from the depreciation, even though the price of FIRST did not change.74, 75 5.1.2 Liquidity Risk Liquidity risk is the risk of the market participant being unable to sell the asset when they desire. It can also be considered as the risk of the market participant being unable to sell the asset at a fair price when they want to liquidate their assets. 74 At the TT$ 6.7563 = US $1 exchange rate, the value of the assets would be US$5.18 per share. At the TT$6.7976 = US$1, the value of the assets would be US$5.15 per share. The depreciation would cause the market participant to incur US $0.03 per share in loss, or a 0.6% downturn. 75 Note: the TTD/ USD currency pair would be considered an exotic rather than a major currency pair, since the TTD is not traded or demanded in high volumes, relative to the currencies of major developed countries, or emerging economies (e.g. Brazil and China). Moreover, T&T’s currency can be also be consided as a weak currency relative to the currencies of the countries that are relatively large players in international trade. Futhermore, it is highly unlikely that the TTD would become a majour currency within the short-term to medium-term.
96 Chapter Five Liquidity risk is a common feature of inefficient exchanges. On the TTSE liquidity risk is a real issue, as there are some days in which there may be no trades, even for popular stocks. For instance, between Wednesday July 27, 2016, and Tuesday August 9, 2016, there were no trades for FIRST on the TTSE. Thus, a market participant seeking to liquidate the shares of FIRST over the aforementioned period may find difficulty in doing so. Liquidity risk may not be an issue on exchanges in developed countries as the Market Maker would be available to buy or sell stocks to facilitate liquidity. 5.1.3 Concentration Risk Concentration risk is the risk that a market participant can incur a large loss due to too much of their money being invested in one (1) asset, or one (1) type of asset. For example, assume that an investor purchased only United Continental Holdings Inc. (UAL) stocks prior to April 9, 2017. On April 9, 2017, an incident occurred in United Airlines whereby a passenger was forcibly removed from the airplane and sustained injuries (Bowerman and Aulbach 2017). The incident attracted negative publicity worldwide, causing the stocks to United to decline (Reklaitis 2017). On April 7, 2017, UAL was US$70.88 per share. However, by April 13, 2017, UAL closed at US$69.07 per share. Thus US$1.81 was lost from the market value of United’s stock over the trading week. The investor holding only UAL would lose 2.5% of the value of their portfolio. However, if the investor held other stocks in addition to UAL, once the value of the other stocks didn’t decline, the investor would experience less than a 2.5% loss to their portfolio. The financial economics literature has long recognized concentration risk (Wagner and Lau 1971; Lee and Lerro 1973; Merton et al. 1978; Lütkebohmert 2008). In fact, modern portfolio theory (MPT)76 attempts to address concentration risk. In other words, if the economic agent had 1 asset and the returns from that one asset were negatively affected, then the economic agent would lose from holding that individual asset. However, if an economic agent 76 MPT is a financial economics theory that explains how a risk adverse investor can minimize their concentration risk of their investment by constructing portfolios. The portfolio, which is a group of assets, allows the market participant to earn a given level of return, while minimizing their concentration risk (Markowitz 1952).
Risk Management 97 holds a portfolio of different assets, it is possible even if 1 or more assets in the portfolio are performing poorly, the overall portfolio may still perform well since the weight or contribution of any 1 asset to the portfolio may be small. Thus, concentration risk is addressed by diversification and the construction of portfolios. It is a common misconception that higher risks will generate higher returns. High risks may theoretically provide a probability of a higher return. However, it is not guaranteed to occur. In fact, higher risk can result in higher losses. The tradeoff between risk and return can be displayed graphically via the Efficient Frontier. The Efficient Frontier shows the various returns a market participant can earn given various risk. In Figure 5.1, the Efficient Frontier is the line that displays the maximum return that a market participant can acquire for a given level of risk. A trader seeking to avoid concentration risk by developing a portfolio should aspire for a portfolio that is on the Efficient Frontier. All portfolios below the Efficient Frontier reflect inefficiency as the market participant can earn a higher return for the associated risk. All points above the efficient frontier reflect combinations of risk and returns that are unattainable for the market participant.
98 Chapter Five Figure 5.1: Efficient Frontier Source: adapted from Benninga and Czackes (2000) 5.1.4 Credit Risk Credit risk is the risk that the economic agent that has received credit would not be able to repay in the future. In the context of exchanges, credit risk is the risk that the government or company which issued a fixedincome security, such as a bond, would not be able to repay at maturity. The credit risk is the risk that the government or company would default on the bond at maturity. Both traders and investors trade bonds and fixed-income securities. In instances where governments default on bonds, the government may
Risk Management 99 negotiate debt restructuring with the bondholders. This may involve the granting of haircuts on the bond, and the extension of maturity. Bondholders refusing to accept haircuts77 may holdout on the bond restructuring, and in worst case scenario raise a ligation matter on the government with an international country. 5.1.5 Inflation Risk Inflation risk is the risk that the profitability of investments is eroded by inflation. Inflation erodes the purchasing power of money over time. Inflation risk is relevant for medium-term and long-term investments, as the inflation can reduce the real value of the return on the investment over time. There are other risks that market participants face on stock exchanges. For instance, a market participant from a developed country purchasing securities in a developing country may face some political risk if the government of the country decides to nationalize certain industries, especially without compensating foreign owners. 5.2 When to open a Position When entering trades, a trader should determine the optimal point to make an entry position. As previously mentioned, there should be some preconditions that have been met which provide a trader with the opportunity to make a profit. For example, assume that the price of a stock is currently $20 per share. Assume that the trader expects that the price of the stock to rise to $40 per share within the next 30 minutes, then decline to $20 per share. In such case, the trader should enter the position at $20, wait for the price to rise to $40, and then exit the position. In the alternative scenario where the price of the stock is $40 per share and the trader anticipates the decline to $20 per share, a profit can be made by short selling. The trader could short sell the stock at $40, and then when the price declines they could close the position to cover. 77 A haircut is a discount on the par value of a bond. It is typically negotiated between creditors and debtors that have defaulted or on the verge of default.
100 Chapter Five Ideally, the optimal entry point is the position that allows the trader to maximize the expected profit. This would be the lowest price for the opportunity where a trader can make a profit from going long. Likewise, it would be the highest price for the opportunity where the trader can earn a profit from short selling. Some examples of entry positions include: x If the 5-day EWMA crosses from below to above a 20-day EWMA go long, or if the 5-day EWMA crosses from above to below the 20-day EWMA go short; x If the RSI close below 20 to go long, or if the RSI to rise above 80 to go short; x If the daily close is higher than the weekly close by 5% then go long, or if the daily close is lower than the weekly close by 5% then go short; x If the present day’s close is higher (lower) than the previous 3 days close, as there was an increase in the trading volume over the past 3 days, then go long (short); and x If the price of a stock goes outside of the Bollinger Bands then go long is resistance is broken, or go short if support is broken. Traders should use multiple criteria in an entry filter to confirm market patterns before entering trades. 5.3 When to close a Position After a trader has entered a position, they need to determine the appropriate point to close the position.78 Any trader can enter a position. However, profits or losses are made when the position is closed. If the position is not closed at the appropriate point in time, then profits that were earned could be lost. Furthermore, if the trader anticipated the market wrong, a strategy is required to minimize their loss and move on. A successful trader should have rules for an exit position. There are three exit rules which can be used to minimize losses and protect gains. They are: 78 If a trader went long on the open position, the close position would be to go short. Also, if the trader went short on the open position, the exit position would be to go long.
Risk Management 101 x Stop-Losses to protect the capital of the trader; x Profit-Stops to when gains are realized; and x Time-Stops to exit positions when the market is not moving. A stop-loss is a limit order that is used to limit the loss a trader may incur when the market moves in an unfavorable direction. It allows the trader to close the position and reduce their loss without allowing the market from going too far in the unfavorable direction. As a strategy to minimize risk, a trader can use the current level of support as the stop-loss position. If the trader anticipates the market wrong and the stock moves in the wrong direction and breaks support, then the loss is minimized at support, and the trader may move on. If support is used to determine the stop-loss, then the trader may use Fibonacci Retracement Levels to identify potential support levels. Recall, a rule for the Elliott Wave Theory trading strategy is “Wave 2 should not go beyond the start of Wave 1, and Waves 2 and 4 may frequently bounce off FRLs.” The FRL can be used to identify possible levels of support. The stop-loss could then be set at such price.
102 Chapter Five Figure 5.2: XAU/USD July 5, 2018 – July 6, 2018 Source: FX Choice (2018) For example, consider Figure 5.2 which illustrates a case where FRL has been applied to XAU/ USD.79 The closing price in Figure 5.2 was US$1,258.20. If a reversal occurs, possible support levels are US$1,256 (the 38.2% Fibonacci Ratio), US$1,255 (the 50% Fibonacci Ratio), or US$1,254 (the 61.8% Fibonacci Ratio). Thus, the retail trader may set their stop-loss at one of the FRL levels. The stop-loss can be specified as a fixed dollar amount. For example, assume that the price of a stock A is $20 when a trader goes long. Assume 79 Note: XAU is the ticker for gold. Although XAU/USD is not a currency pair, gold and several other commodities are traded on forex markets just like any other currency pair.
Risk Management 103 that the stop-loss is identified at $19. Thus, if the market goes in the opposite direction that the trader anticipates, then the maximum loss the trade incurs on the trade is $1.80 The stop-loss can also be specified as a percentage of the market price, or a percentage of volatility. For example, assume that after the retail trader went long on a stock at $30, then decided to implement a 5% stoploss. Five percent of $30 is $1.50. Then, then they would set the stop-loss at $28.50. In fact, trailing stops are percentage stop-losses. Trailing stops are effective as the stop-loss position changes as the market moves in the favorable direction. For example, assume the trader went long at $30 and implemented a 5% stop-loss. Assume the price of the stock increased to $50. The stop position would be adjusted to $47.5. Therefore, as the spot price suddenly declines after hitting a new resistance level, the trader would automatically exit the position while earning some profit.81 Consider another scenario, assume the trader wanted to implement a stop-loss at 50% of the market volatility after going long at $30 per share. Assume that the standard deviation, which is typically used as a measure of volatility, was $10 for that day. Then 50% of the market volatility would be 50% of $10, which equates to $5. Thus, the trader would implement a stop-loss at $25. Once the stop-loss has been identified, the trader can similarly establish a stop position for their profit. The trader should calculate the stop profit position based on their profit-loss ratio82. The stop profit position would be the price in which the trader may automatically close the position once the target profit level is achieved. For example, in the example where the price of a stock A is $20, and the trader identified a $19 stop-loss, if the trader has a profit-loss ratio of 80 This is the loss the trader would make, excluding the cost of commission for the broker. 81 Note: This is one of main reasons why limit orders should be used to minimize risk. It allows the trader to automatically lock in traders based on the direction of the market. If only market orders are used to facilitate trades, then a risk adverse trader would have to consistently monitor the market without leaving their computer to manually execute trades when the market changes. 82 The profit-loss ratio is the ratio of the profits to loss that a trader makes. If the profit-loss ratio is 2:1, then for every $2 the trader earns in profit, they lose $1. Thus, even if the trader takes the correct position on at least 50% of their trades they will still be profitable.
104 Chapter Five 2:1, then their target profit would be $2. Therefore, they would desire that the stock price increases to $22 to execute their stop profit order. If the trader is risking $100 per trade but can earn $300 in profit, then they have a 3:1 profit=loss ratio. However, if the trader is risking $100 per trade, but can only make $10 profit, then they have a 1:10 profit-loss ratio. Such setup is unlikely to be profitable on a long-term basis as it would require a trader to be accurate about the market direction at least 90% of the time in order to break even. Many new traders may desire to earn large profits in just one or a few trades. However, the key to success is to earn profits consistently. This may involve the earning of a series of small profits, which add up over time. It is important to note that traders should also ensure that they close their stop order whenever they cancel or close their position. If they don’t perform such action after making profits from a winning position, then when the market turns in an unfavorable position the order will be filled. This could result in the trader making unnecessary losses. Time stops are stop orders that are related to time. The trader implements an order to close a trade, or the close a certain percentage of an order after a certain period of time passes. Time stops are implemented regardless of if the trader profit target is achieved or not. Time stops are useful for traders when markets are not moving. 5.4 Position Sizing and Balancing Risk Successful traders balance their risk. Consider the following scenario, a trader performed a series of fundamental and technical analysis to determine what stocks to trade. Assume the trade took to correct entry and exit positions on the first nineteen (19) of their trades. On their twentieth trade, they took the wrong position. However, as they were investing 100% of all their trading capital in each trade, the twentieth (20th) trade in which they make a loss, they will lose all of their earnings. Such a scenario reflects a trader with a poor strategy to manage risk. Regardless of how much earnings they made previously if they risk all of their earnings in each trade, then the one time in which the trader takes the wrong position, they risk losing everything.
Risk Management 105 Subsequently, a trader should only risk a percentage of their entire account on each trade. The percentage will vary depending on the risk tolerance of the trader. A risk adverse trader would only risk a small percentage of their account on each trade. A trader with a higher risk tolerance will risk a larger percentage of their account in each trade. Position sizing determines the amount of trading capital the market participant risks with every trade. In the example where the trader risks 100% of their trading equity in each trade, their risk was not balanced properly. Although the position sizing would be limited by a market participant’s trading capital, it is still possible to set a target as to how much capital should be risked with each trade.83 This book considers 5 objective approaches to determine the position size. They are: 1. Volatility Adjusted; 2. Martingale; 3. Anti-Martingale; 4. Fixed Sum; and 5. the Kelly Method. Volatility Adjusted Position Sizing specifies the number of shares per trade as a fixed percentage of trading capital divided by the trade risk. Consider an example, assume that the trader had a risk size of 3% of equity, a risk per contract of $100, and an account size of $25,000. The Total Equity to Risk = $25,000 × .03 = $750 Number of Contracts = $750/ $100 = 7.5 Thus, the trader utilizing the volatility adjusted position sizing technique would only take 7 contract positions. Consider another example where a trader had a smaller account of only $2,500. If a 3% risk per equity is assumed, then only $75 would be risked 83 More sophisticated methods can be used to determine the optimal position size for different assets. For instance, in the case of futures, the optimal hedge ratio could be used to determine the optimal amount of futures to be held to offset the spot position to minimize the basis risk to the portfolio. Such advanced techniques are not considered in this book.
106 Chapter Five on each trade. Thus, regardless of the share price, the trader will only spend $75 on each trade. The Martingale Position Sizing Rule is a gambling rule that doubles the size of each trade after each loss and but retains the unitary position after each win (Parado 2011). The Anti-Martingale is a variation of the Martingale Rule. It recommends the doubling the number of trading units after each win but retains the unitary position after each loss. The Fixed Sum Position Trade Rule is where the same size equity is used for each trade. For example, a trader with a small account of $1,000 may risk only $100 per trade. The Kelly method utilizes a formula to determine the optimal position sizing. It is given by ܭ݈݈݁ݕ ൌ ሺௐΨି௦௦Ψሻ ሺ௩௧ ௩௦௦ Τ ሻ (5.01) For example, assume a trader’s strategy wins 55% of the time, has an average win of $350, and an average loss of $125. The Kelly percent indicates that the 3.57% of the total trading capital should be risked on the next trade.84 The aforementioned position sizing methods may not produce the optimal position size for every trader or for every strategy. To more accurately fine tune the trading position sizing would require more complex tools, historical returns, and econometric models to assess the empirical performance of the strategy. Researchers have come to accept that financial markets have a non-Gaussian distribution (Lo et al. 1988; Campbell et al. 1997; Embrechts et al. 2002). Furthermore, some researchers have come to accept the fractal distribution of financial markets (Peters 1994; Mandelbrot and Hudson 2010; Mandelbrot 2013). Such key non-Gaussian assumption suggests that non-linear, regimechanging econometric models are more relevant for the assessment of position sizing. However, such complex modeling is outside the scope of this book. 84 Kelly % = (55-45)/(350/125) Kelly % = 10/2.8 Kelly % = 3.57%
Risk Management 107 It is important to note, when trading shares, a trader seeking to earn a profit need to trade sufficient shares in order to cover the cost of the round trip. The cheapest most brokers will charge for a trade is $5. Thus, the cost of the round trip is $10. If a trader expects the target gain from a trade to be only $1, then the number of shares the trader must trade in order to break even is 10. The following equation outlines the number of shares a trader must trade in order to break even ௧௧ ்ൌ ݏ݁ݎ݄ܽݏ݂ݎܾ݁݉ݑܰ ௦௧௧௨ௗ௧ (5.02) Thus, if the price of the share is $40 per share, and the target profit is $0.50 per share, then the trader must trade 20 shares, and risk $800 of their trading capital in order to break even. 5.5 Common Mistakes Traders that find themselves in a losing position often make a number of mistakes. Some of the more common mistakes include: x Trading without a strategy; x Trading stocks based on emotion rather than technical or fundamental analysis; x Failing to manage risk; x Entering positions too soon; x Closing positions too late; x Holding losing positions too long; and x Missing changing trends, reversals or news 5.6 Summary Insight The cardinal purpose of risk management is to curb losses to trading capital. This chapter examined the various risks that market participants face in financial markets. Market risk emerges as one of the more prevalent risk that economic agents face on markets. In fact, price risk will be faced by every trader. Due to price risk, traders may adopt a number of measures to mitigate losses. This chapter identifies stop orders as a very useful tool to limit losses in the event of unanticipated adverse price movement. Fixed dollar amount stop-loss, Volatility-Adjusted Stop-Loss, and Trailing Stops can all be used by a trader to limit potential loss.
108 Chapter Five Concentration risks may be addressed by market participants creating a portfolio of assets to limit the exposure to adverse price movement. Furthermore, risk exposure can also be reduced by the incorporation of position sizing rules in the trading strategy. This chapter highlighted a number of simple position rules. The trader’s choice of position sizing rules would depend on their risk tolerance, their preference for complexity, and size of their trading capital. Given that the main tenants of a trading strategy have been discussed, Chapter Six will assess the average trading day of a trader.
CHAPTER SIX THE AVERAGE TRADING DAY AND GENERAL CONCLUSION 6.0 Introduction The previous chapters reviewed the basic Technical Analysis tools, and strategies. Given such information, the retail trader will have to decide which combination of Technical Analysis tools to use. This chapter highlights the importance of an objective trading strategy used by a retail trader. Moreover, a mechanical trading system should be implemented by retail traders seeking to systematically acquire more gains than losses. This chapter also presents an example of a mechanical trading strategy that a retail trader can implement for stocks, and another for currency pairs based on Technical Analysis. 6.1 Mechanical Trading Systems Mechanical trading systems are objective systems based on the recognition of patterns of charts, and values of indices and oscillators, which in turn could be used to inform appropriate trades for a retail trader to take. Such trading systems are referred to as ‘mechanical’ since they inform potential trades without taking into consideration human emotion. Many websites claim to have a mechanical trading system that generates profits. Usually, they require a market participant to pay a fee to use their system. Many of these mechanical trading systems actually do work. That is because they are based upon a specific set of trading rules which the system follows without any emotion. Many retail traders can make the same profit from implementing a system, but the fail to do so since their emotions cause them to break their trading strategy. They lack the discipline to trade in an emotionless systematic manner. Rather than paying hundreds or thousands of dollars to use a mechanical trading system, it is possible for a trader to create their own
110 Chapter Six mechanical trading system for free. The thousands of dollars which would have been spent as a membership fee to use a website’s mechanical trading system could be used as trading capital for the retail trader. A retail trader that is developing their own mechanical trading system should aspire to achieve two very important goals: 1. Their system should be able to identify trends as early as possible. 2. Their system should be able to avoid you from getting whipsawed85. If their system can accomplish the aforementioned goals with they will have a much better chance of being a successful trader than a market participant that trades with absolutely no strategy. Notwithstanding, the achievement of such goals is difficult as they contradict each other. A system which is designed to identify trends very early is likely to pick up a lot of false signals. This, in turn, can result in retail trader being misled by trading in the wrong direction. Likewise, a system that focuses on avoiding whipsaws will rely on lagging indicators to confirm patterns. This could result in the retail trader missing out on excellent opportunities to earn financial gains from the market. Thus, a retail trader is tasked with the responsibility of finding a balance between a system that identifies trends early, and a system that would eliminate false signals. Anyone that understands the basic principles behind Technical Analysis can develop a mechanical trading system. While it does not take long to develop a mechanical trading system, it does take time to thoroughly test the system and verify that it produces more gains than losses. A working mechanical trading system can be developed in a number of steps. Step 1: The Time Frame This first thing that a retail trader should consider when developing a mechanical trading system is what type of trader they are. As mentioned in Chapter One, the main trading styles include: position trading, swing trading, scalping, and day trading. Day traders and scalpers tend to hold positions shorter than position traders and swing traders. Thus, they (the 85 A whipsaw refers to a specific movement of an asset’s price. It refers to a situation where an asset’s price is moving in one direction but then quickly pivots and moves in the opposite direction.
The Average Trading Day and General Conclusion 111 day traders and scalpers) would need to look at charts on a regular basis. In fact, they would need to review intra-day charts, such as the 1-minute chart, 5-minute chart, 15-minute chart, etc. This need to visualize shortterm charts is driven by the fact that large price changes can occur for some assets within very short periods of time. In fact, it is possible for an asset to experience over 50% change in price within a minute. Such jumps can be very profitable for retail traders that manage to trade in the correct direction before the jump occurs, while they can generate large losses for retail traders than have open positions on the wrong side of jumps. Step 2: Utilizing Technical Analysis Indicators Mechanical trading systems should also utilize Technical Analysis indicators. The indicators are very useful in identifying trends. Some of the popular Technical Analysis indicators which can be used include Moving Averages, Bollinger Bands, the RSI or the Stochastic Oscillator, the Force Index, and Fibonacci Retracement Levels. The Mechanical trading system may involve a strategy that utilizes the Technical Analysis indicators and recommends specific actions when certain conditions are met. For example, if a 5-day Moving Average crossover a 20-day Moving Average, and the RSI is below 20, the retail trader could use such conditions as a rule to go long on the asset. Step 3: Incorporate Risk Management Recall, Chapter Five emphasized that risk in embedded in the trading of financial assets. There is always the possibility that things do not turn out as how the market participant anticipated, resulting in a loss. Successful traders are the retail traders than manage to implement an effective strategy to minimize their loss. This can be done by implementing rules for the entry and exiting of positions. For example, a trailing stop could be implemented with every order, such that if there is an unexpected change in the price of an asset by 10%, the stop-loss will be automatically triggered to close the position. Risk can also be managed with position sizing. For example, the retail trader may only trade forex with trading factors no greater than 0.05, or they can spend no more than US$100 on each stock trade. Step 4: Back-Testing After specifying a mechanical trading strategy, a retail trader should write down or record the rules. They should also diligently follow their mechanical trading strategy. To verify the robustness of a mechanical
112 Chapter Six trading strategy a retail trader should back-test the strategy will real historical data. The retail trader can also opt to test a strategy on a demo account before proceeding to live trading. 6.2 The Average Trading Day for the Informed Stock Trader Just after market open, there may be high trading volume, and high liquidity. The informed trader should already have a mechanical trading strategy ready to direct them about how to trade. Before entering the market, the informed trader should have a number of tools: x Stock Scanners (e.g. Yahoo Finance, Finviz, Stock Twits, or Trade Ideas); x Stock News (e.g. Yahoo Finance, Trade Ideas, chat rooms); x Charts (e.g. Finviz, eSignal); and x Broker (e.g. FXchoice, SureTrader). The retail trader should start by going to a stock scanner. Traders should consider low float stocks, with high price movements in either direction. Traders may consider stocks with at least 10% change in price. Free scanners such as Yahoo Finance, and Google Finance are excellent for identifying the top movers in a market. Stock scanners should also be used to identify chart patterns. Finviz is an excellent free scanner to reveal chart patterns. Trade Ideas can be used by a trader willing to pay for its patterns. As a recommendation, a retail trader intending to trade on momentum can look for the following patterns for up-trends: x Rising Wedges; x Rising Rectangles; and x Bull Flags. For down-trends, the trader may look for the following patterns: x Falling Wedges; x Falling Rectangles; and x Bear Flags.
The Average Trading Day and General Conclusion 113 The retail trader should confirm the chart pattern by the reviewing of news. Good news should justify bullish movement, while bad news should be associated with bearish movement. On the online platform, the trader can review the level 2 data to acquire information on relative volume. If the trader is using Finviz free services, it can receive information about the overall relative volume from the previous day. If the trader pays for Finviz services, they would be able to access Finviz’s intraday charts. Finviz also provides information about a stock’s RSI, indicating if it is overbought or over-sold. Retail traders using the moving average crossover strategy may also acquire the relevant price information from Yahoo Finance or Finviz. The retail trader can also briefly search stock scanners such as Yahoo Finance and Google Finance for news regarding the stock. Once the trader is confident about the emerging pattern, they may then search for an ideal entry position. The entry position would depend upon the retail trader’s preference and strategy. For example, a retail trader may set the entry position for an upward momentum strategy as the second green 1-minute candlestick after the market opens, once the previous day had a bullish chart pattern, a relative volume greater than 2, a low float, and positive news for the stock. Recall, profits or losses are made only when a position is closed. The informed trader should have a strategy to manage risk. They may use a position sizing rule to determine how much trading equity is risked per trade. Furthermore, they should set target profits. Once the target profit is made they may keep the position open, however, they may close the position after the first pullback of a 1-minute candlestick. With regards to losses, they can initially set a stop loss at 5% lower than their entry price. The trader may engage in a few trades, or complete round trips within the morning period. After the trader completes their trading for the day they may review their profits, losses, and their trading strategy. They may consider ways to improve the returns of their trading strategy.
114 Chapter Six 6.3 A Practical Mechanical Trading System for Trading Currencies The currency trader may trade based on Technical Analysis. One possible strategy involves the use of Bollinger Bands, and the Force Index. The following rules may be applied. 1. If the Force Index is positive, and moving up and the Bollinger Bands are trending upward, then the trader may go long with a position size of 0.10. This pattern must be in both the 1-minute and the 30-minute candlesticks. 2. If the Force Index is negative, and moving down while the Bollinger Bands are also trending downward, then the trader may go short with a position size of 0.05. The same pattern must be in both the 1-minute and the 30-minute candlesticks. 3. The smaller position size is suggested due to the risk of the broker closing the position if the trade goes wrong. Furthermore, a stop loss up to $5 can be applied by the trader. While the target profit may be $10. 4. If the Bollinger Bands and the force index point in different directions, then it is deemed a risky trade. The cautious trader may not place an order larger than 0.01. In such a case, the trade direction should be taken from the price of the currency pair in both the 1–minute and 30-minute candlesticks. 5. If the force index is in a bullish divergence, and the RSI is lower than 20, then it suggests that the currency pair is over-sold and a bottom reversal may occur. If the Force Index is in a Bearish Divergence, and the RSI is higher than 80, then it suggests that the currency pair is overbought and a top reversal may occur. 6. If the 1-minute and the 30-minute candles are indicating different patterns, the trade may also be deemed risky. 7. If the force index is small and close to 0, the risk adverse trader should not enter a position. It means there is a weak price change and volume is weak. Furthermore, the current candlestick should look like a doji. 8. The trader should not trade during weak volatility since they need volatility to cover the bid-ask spread and the commission. Thus, the trader should seek to trade where there is wide Bollinger Bands. The aforementioned strategy is just an example of how a trader may create a strategy based on technical indicators. There is no one strategy
The Average Trading Day and General Conclusion 115 that a trader has to use. A trader can develop their own strategy based upon a combination of technical indicators that they prefer. Furthermore, the trader’s preference for risk will also influence how they choose to manage their risk. Of course, in order to derive the ideal strategy that consistently generates profits, a retail trader would need to evaluate the winnings and losses of previous strategies, and make amendments until they derive the strategy that bests work for them. 6.4 Trading Plan To be successful at trading, the market participant should have a trading plan. The plan should be an objective strategy which has been proven to consistently produce more financial wins than financial losses. If a retail trader performs poorly at trading, even after being informed about the fundamentals of financial markets it may be due to one of only two reasons: either there’s a problem in the trading plan or the retail trader is not sticking to their trading plan. If the retail trader is trading without a plan, then they may unable to determine what they are systematically doing what is right from what is wrong. Thus, the trader may have no way to systemically correct their previous errors in trading. It is analogous to the proverbial saying “if you fail to plan you will plan to fail.” A trading plan doesn’t guarantee success. However, its performance can be evaluated, and modified to eventually help the retail trader achieve success on the market. A trader can make an occasional winning trade while disregarding their trading plan. This can generate short-term satisfaction, but consistently entering trades haphazardly can adversely influence a trader’s ability to maintain discipline in the long term. Trading can be considered as being analogous to running a marathon, as it requires long-term discipline to a trading plan to consistently generate an overall positive return in the long term. Successful traders achieve such success simply by getting the law of averages to work in their favor over the long run. In order to build a trading plan, the retail trade should develop a strategy that suits their personality, their preference for various technical tools, and their tolerance for risk. The practice of trading strategies which are not compatible with the market participant’s profile and personality will drastically lower their chances of achieving success. For example, a trading strategy which involves the risking of a lot of trading capital with
116 Chapter Six each trade may not be very successful for a trader that is relatively risk averse. When the trader sees that a trade is in a high loss they may be tempted to implement a stop loss and prematurely close an order, even though the trade may turn profitable if the market participant were to hold the position for a bit longer. For this reason, every trader should develop their own trading plan and strategies. The actual strategies (e.g. crossovers, news/ event trading, etc.) should be part of a larger plan which specifies what course of action for the retail trader to take when faced with different scenarios. Thus, a trading plan and strategies that may be successful in generating profits for one retail trader may not be profitable for another retail trader. 6.5 Conclusion Many people enter financial exchanges to trade stocks, forex, and other financial assets without first being educated about the fundamental principles behind such markets. The uninformed trader is not cognizant about how to use the wide range of tools that are provided to them by their broker. Subsequently, such market participant trades on the basis of emotion, their preferences, and other subjectivity. This book provided an introduction to day trading. It begins by making the distinction between trading and investing. It also elaborates on various trading styles. This book also informs a reader about how to open an account for trading stocks or trading forex, factors to consider before deciding to choose to trade stocks or forex, and how to find stocks to trade. As Technical Analysis is a very useful technique to inform trading, this book explains the basic principles of Technical Analysis in detail. The Technical Analysis tools considered, such as candlesticks, candlestick charts, Moving Averages, Bollinger Bands, the Force Index, and Fibonacci Retracement Levels are very popular among successful retail traders. Success in trading is achieved by implementing a mechanical trading system incorporated into a wider trading plan. Such an approach takes the subjectivity away from trading, and allows a retail trader to systematically generate more financial gains than losses over the long-term. Since risk is inherent in the practice of trading, this book strongly recommends that a retail trader should implement an objective strategy to manage and minimize risk.
The Average Trading Day and General Conclusion 117 Before trading will real money, this book recommends that a retail trader should trade on a demo account. This would provide a retail trader to test a mechanical trading strategy, and determine its effectiveness. Furthermore, through demo trading, the retail trader can become familiar with a broker’s platform, and can become accustomed to opening and closing market and limit orders while the financial market is open. Only after demonstrating success in a simulated environment, should a retail trader proceed to the market to live trade with real money.
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