Optimal f - Betting the Farm

Optimal f is the optimal % risk that can be applied to a fixed fractional money management scheme that will yield the greatest net profit. Of course for the net profit of optimal f to be positive the expectancy of the strategy must be positive. This method is also known as the Kelly criterion.

The primary disadvantage of optimizing our risk parameters in this fashion is the high degree of volatility that this will incur in your account. As such, this method utilizes no limiting factors to account for things such as margin calls. Also, it fails to keep risk within human psychological boundaries as when a trader experiences an 95% draw down (which could occur in 5% of all trade sequences) it is unlikely they will be able to keep trading in this fashion. Lastly, and if the above reasons were not sufficient, this methodology assumes a constant statistically verifiable expectancy. In other words - in the real world where trading expectancy is not constant, optimal f is not constant either. Which in layman's terms means that you are constantly trying to catch a falling dagger - drunk, blindfolded, and missing 3 fingers. Hence, it is an interesting theory but of little practical relevance.

LT

The Right Tools for the Right Market

As a drywall contractor you don't show up to a drywall job with concrete cutting tools. As a trader we need to be congnizant of what tools we use on what market. And because in trading, as in construction, the tools often define the trader/contractor, it is important that you bid on the right job (i.e. participate in the right market).

A few years ago a fellow trader asked me what I was doing. He saw me using overbought/oversold indicators and other reversion to mean oscillators. And I was trading Forex. He told me "you gotta fit the right tool to the right market". If those were the tools I preferred then I was trading the wrong thing.

Needless to say that conversation prompted me to investigate the emini Futures (S&P 500, Dow, and Russell 2000). These markets respond well to reversion-to-mean indicators. Another lesson I learned is that what timeframe you trade also determines the right tools for the job. When you're scalping the Russell on a 52 tick chart (about 35 s - 1 m depending on the speed of the market) you need to have the 610 tick (about 5 m) chart up to keep you on the right side of the trend. Just cause you are reverting to the mean doesn't mean you want to ignore the big picture.

Today, whether I'm trading futures, forex or something else I know that I need to fit the right tool to the right market.

LT

Cut Your Losses and Add to Your Winners

You've heard it a thousand times before from experienced traders or even from yourself. Cut your losses short. It's hackneyed and frankly most traders feel they do cut their losses short. I certainly did. I use stop losses (and I don't move them away from my entry). I'm not a crazy man - or am I?

There is a great little ebook I read recently by the "Phantom of the Pits" that talks about this concept. Although there is a lot of fluff in my opinion there are several key points not to be missed:

1) Use a clock when you trade. In other words if you are in a trade you aren't waiting for the market to do "something" (usually take you out at your stop loss) but you are actively looking to exit the market if your trade idea doesn't immediately "prove it" to you. In other words don't sit there and wait until the market does something. Either your trade idea is a "winner" and it moves immediately and significantly in your favor or it is a "loser" and it either moves against you or doesn't move immediately and significantly in your favor. Every minute, hour, day you are in a trade that goes "nowhere" is just that much more likely to hit your stop loss. Don't wait for it - just get out.

2) There is a great quote in "Market Wizards" where Soroes says something to the effect of "when you're right you gotta be a pig - you can't own enough". The second major point of the Phantom of the Pits is that you need to add to a winning position when you are right. You gotta punish the market when you are right because otherwise you won't achieve much beyond break-even.

I have to admit when I originally heard the concepts of cutting your losses and adding to winners I didn't get it. I use a stop loss - isn't that cutting your losers? And adding to winners sounded dangerous - if I was making money the last thing I wanted to do was let it ride. I wanted to grab those profits quickly! So if you are looking for some ideas to increase your trading edge I strongly suggest looking into these. Especially for those folks who are trend traders this can really make or break you.

LT

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ER2 Migration and Re-defining the Edge

If any of you have read "Who Moved My Cheese" by Spencer Johnson then you'll have a bit of an idea of what it's been like for me over the past couple months (and incidentally why I haven't been posting in the blog much).

The long and the short of it is the emini-Russell contract or ER2 is moving exchanges from the CME to the ICE. So what you ask? Well the problem is several fold: 1) I'm not the only one abandoning the Russell and volume is down significantly, 2) the new exchange doesn't support limit orders. And the last CME contract of the ER2 is September 2008. So needless to say I have re-tweaking my short-term futures trading systems to work more effectively on markets that won't be undergoing such drastic measures - the emini-Dow and the emini-MidCap 400.

So what does all this have to do with the price of cheese? Well let's just say that it has reminded me of how traders must not only be able to find one market edge and exploit it but that they must be able to redefine their edge when market changes occur - such as this one. Brett Steinbarger of Trader's Feed has done an excellent job of describing this in his books and on his blog. Basically it means you have to always be hungry and never satisfied with yourself in the market. Never get too comfortable.

Back to re-defining myself.

LT

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Are you fighting Trading Reality?

I found it somewhat amusing to notice the really bullish tinge that we're hearing from some of the "experts" right now. Lehman Brothers and UBS are saying that the S&P is going to go up 18 percent in the second half of the year. Also I keep seeing reports on how the U.S. dollar is at a high with the Euro - for the past week.

To me these reactions to the market mark a state of denial. As many of us know from personal experience (or anecdote) living in denial in the markets is a dangerous state of mind. We all have this amazing capacity in our minds to deny what is right in front of us - what any 4 year old can see. We are in a "long bullish" trade (at least that's how Lehman's and UBS's money is talking) and we are telling ourselves that yes we are currently in a tough spot (ok we're down like 50% in this trade) and that things HAVE to get better. We'll that's not true - it CAN and if it can it WILL get worse - taking all your money with it. The mistake is not getting into the original trade, the mistake is compounding the error by denying that we were wrong and the market is right. The market is always right.

You've probably heard all of this before, you may have even made the same mistake before and vowed never to do it again. But again any of us may slip into this mistake - even the most experienced of traders. So what can we do about it? In my opinion carefully tracking the statistics of your trades and having a drop dead point (i.e. intelligent stop loss and daily/weekly/monthly/yearly stop limits) is the only way. Of course the only way to have confidence in your drop dead point is to test it. And we are doing that - right Lehman?

What Does it Take to Be A Successful Trader?

I can't tell you how many times beginning (or even intermediate) traders asked me how I learned to trade. I wish I could give them a simple answer - but frankly there isn't one.

What I can tell them (and you) is a little bit about my trading journey. Perhaps this may be useful to your own trading journey...

So to sum things up here is how it went:

1) Started talking to a friend who happened to be a Futures Trader. He had some interest in learning Forex.

2) Went to a Forex Trading Seminar in Los Angeles with said trader - cost $1k.

3) Got 2 useful things from the seminar. 1) Learned how to "test" a trading concept
"candle-by-candle", 2) Met Phil McGrew (who helped mentor me) .

4) Spent 6 months (20-30 hours per week) testing different systems from the seminar including some of Phil's old systems. Got TradeStation - cost $200 per month.

5) Wasn't happy with results of testing (my expectations were too high - wanted to make 1000% per year with like no drawdown lol) .

6) Spent another 1 year(20-30 hours per week) testing many different indicators and setups. Basically on the Holy Grail Hunt. Bought probably $500 worth of books, read every forum, website I could etc. etc. Setup account with TradeStation ($5k). Made $20k in 3 months and gave it all back in 3 days. Learned about the toilet stoploss.

7) Decided that automated trading was the way to go and began learning TradeStation Easy Language. Spent 6 months doing that. Bought an automated trading system (grey box) for $3k.

8) Discovered curve fit strategies don't really make money ;) Spent another 6 months learning about The Grail (a genetic algorithm and walk forward testing package) and spending another $1.5K. Finally got some decent results with that.

9) Discovered two important things that forever changed my trading life 1) Money management could make a decent strategy great, 2) I was a crummy programmer and that the main problem I had was that my automated strategies were never as good as my candle-by-candle tested strategies. Spent another 6 months discovering this fact.

10) After 2 1/2 years finally came up with 2 simple non-curve fit swing trading strategies that made money and which I continue to trade today with strict money management.

11) However, I still was not satisifed as I wanted to learn the day trading strategies that allow some traders to make money every day (more like every month). Spent another 1 year(40-50 hours per week) with NeoTicker ($1.5k) and NinjaTrader ($60/mo and $200/mo for eSignal data) discretionarily testing in tick by tick simulation several simple methodologies that I continue to use today. Spent another $5k in market hazing fees to determine what works and what doesn't.

12) Finally came up with a couple of simple methodologies that I continue to use. Finally after 3 1/2 years I had come up with several methods that work, are robust (only require occasional tweaks) and make money.

13) Today (about 5 years after I started) I am still making money and am working on converting my discretionary day trading concepts into automated strategy (no easy feat but one I am confident I will eventually complete. My swing trading strategies average about 80% ROI per annum with no more than a 10% max intraday drawdown. My day trading strategies average about 10% ROI per month with no more than a 10% max intraday drawdown.

Total Time to
Break-even: 2400 hours
Profitability: 3000 hours
Profitable Day Trading: 5160 hours

Total Dollar cost to
Break-even: $15,000
Profitability: $17,000
Profitable Day Trading: $26,000

So there you have it. Adding it all up seems pretty extraordinary. I guess they aren't joking that trading is a lot of hard work and that a good way to end up with a small fortune trading is to start with a large one ;0

Of course those of you just beginning will probably ask was it all worth it? To me it was. I enjoy trading so the hours spent do not seem wasted. Additionally, although the initial cost seems somewhat steep, when you compare this cost to opening a Subway shop (about $300,000) it seems pretty cheap. And my returns have already exceeded my initial investment with a satisfactory ROI beyond that.

The key that a lot of beginning traders forget is that Trading is a business. You don't become proficient at your profession without time and money invested. Hopefully this will help some of you who are still beginning your journey.