Financial Market Fisherman

Feb 19 2009

What Is Your ‘R’ Factor and How to Stop Yourself Cutting Winning Trades Short

Published by Dean under Backtest, Financial Market Fisherman, Mechanical System, Mindset, Money Management, Psychology, Trading Plan, Trading System

In trading there is a factor known to many as the ‘R’ factor or risk factor. Traders determine their average or base risk per trade they’re willing to take and name it ‘R’, and then measure profits as a multiple of this ‘R’. For example, a 3R profitable trade means the trader has made 3 times the amount they risked. The idea is to determine the ‘R’ factor early on in the trading system building stage and keep it consistent, whether it is a fixed dollar amount or a percentage of available capital.

The benefits of using an ‘R’ factor include measurability, especially during back testing, which helps to determine a systems potential, and being able to track your trades from a systematic point of view rather than a monetary point of view. However it is the monetary point of view that I would like to address as I feel there could be another angle or point of view that could aid struggling traders, especially those that find themselves cutting winning trades short (breaking their systems rules).

First, let’s do a quick demonstration of the use of ‘R’. A trader has $20,000 in capital, and decides he wants to risk $200 of his available capital per trade. After much back testing, he finds that out of 100 trades, 40 were 1R winners, 10 were 3R winners and 50 were 1R losses. He now knows that after 100 trades he system will provide an estimated 20R profit (40R plus 30R minus 50R = 20R), and if ‘R’ is $200, then that equates to $4000. This trader can now use this information to help determine what he needs to do to reach his goals.

Now, when determining the ‘R’ factor, there is one element this trader has missed, and that is, what is his ‘R’ factor from a personal point of view? Why did he choose $200 and not $300 or $100, or some other figure? This in my view is a serious question that needs to be asked and then answered, and in order to do that, one must look at their personal finances and spending habits.

In your every day life you have small, medium and large expenditures all of which fall into the categories of either tangible or intangible. For the most part, most of us have no problems with medium to large tangible expenses, such as house or car payments, or a new TV as these are things we can see or touch. Medium to large intangible expenses are much harder, such as a seminar or course fee where the results are not guaranteed. Small expenses on the other hand are a different breed altogether.

How often will you go and spend money on something small and intangible and think nothing much of the actual expense? An example would be some lunch on the go; where you buy some food and drink and know that the cost won’t change things much for you so you don’t concern yourself with it too much. But let’s say you get home that evening and decide you like the idea of eating out for dinner. Do you now think twice about where you will go and how much you are willing to spend? If so, you have a threshold on the amount of money you are willing to spend (as most of us do), especially on intangible items or items quickly consumed.

This threshold or level of expenditure where you change from not thinking to thinking twice is a perfect example of where your comfort zone currently sits when it comes to the value of money relative to you. Go over it and you get uncomfortable and have to think twice.

In trading, it will be no different. You will find it much easier to take losses where the amount, or ‘R’ factor, is under your threshold, than if it is over. I know many people will respond to this comment with the issue of, by risking so little it will take too long to make any decent amount of money or even the fact that brokerage costs etc will start to become a heavy burden, and these are fair responses. However, the fact of the matter is, the act of trading is not going to change the way your brain responds to such losses because there is nothing to show for the loss (intangible), and if the loss is out of your comfort zone then your brain is not going to like it.

What’s more, imagine you are sitting on a nice paper profit which is in excess of your threshold; an amount that if you were to spend on something intangible would cause you to think twice. Your brain is way out of its comfort zone because a) it’s a lot of money to you, and b) you can’t realize the profit and thus bank it until you actually close out the position! When you are in such a position all sorts of justifications for breaking your rules start flooding your mind.

Both of these instances of not being able to take losses well and cutting winners short are major hurdles traders face all the time and much of the issue lies in their personal relationship to money and the value they place on it. If you have a low relative value of money, it doesn’t matter what the system you use is or how well it performs for others; you are only able to extract from it what your relative value to money is. If you don’t believe me, check out the free e-book and video at this site www.reprogrammingthemind.com and see for yourself on how and why we behave the way we do with money.

You should spend some time assessing your spending habits and determine where your threshold lies. If it is too low to even consider making substantial money in the markets, then you are faced with the tough decision of either looking for a different career or changing your threshold level. Much of the problem lies in the belief that money is something we generally lack, and that there never quite seems to be enough. Unfortunately, it doesn’t matter which way you look at it, this is a fundamental issue for most people, and it is no wonder 95% of trader fail.

Once again, you should check out the free e-book and video at this site www.reprogrammingthemind.com and see for yourself on how and why we behave the way we do with money.

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Jun 26 2008

Using candlesticks to signal reversals

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Fundamental Analysis, Mechanical System, Money Management, Technical Analysis, Terminate, Trade, Trading, Trading Plan, Trading System, Trend, Trigger

Candlesticks in trading have two main purposes;

One is to tell the trader the open, low, high and closing price of that particular time period, and two, whether the close was higher (green bodied), or lower (red bodied) than the open.

However they can alert the trained eye to pending reversals offering the chance for a trader to get a head start on a possible new trend, or to alert the trader who is already in the markets that the trend is ending and to tighten stops or take profits now.

The two candlestick patterns we are demonstrating here is the hammer (& hangman), and the tweezers (also known as railway tracks).

When looking at either pattern, they look quite different, however when it comes to what is going on in the market place, the same thing is happening. So let’s see what that is.

After a significant run up in price, the market will exhaust itself or be overbought; however this is when the most action usually takes place. The reason is because towards the end of the trend, the misinformed public are still buying, not wanting to miss out on what is probably a well talked about market and trend. However at the same time, the professional traders are the ones selling to the misinformed public.

This activity creates a resistance to any higher prices because all the late buying is being absorbed by the professional selling. On a candlestick chart, this will often be shown by either a bearish pair of tweezers or a hangman. Essentially price moves up and then moves all the way back down again, in the space of one or two candles (see diagram below).

Likewise, after a significant move down the market will exhaust itself or be oversold; the misinformed public are the ones selling because they can’t handle their losses anymore, and the professionals are the ones buying from them.

Again, this activity creates support for price and the candlestick patterns will show price move down and then all the way back up again. This is shown by a bullish pair of tweezers or a hammer.

The bearish tweezers pattern and the hangman show the same activity, price moves up, and then moves back down roughly the equivalent amount. The bullish tweezers pattern and the hammer show the same, price moves down and then moves back up roughly the same distance.

If you look at the diagram below, you’ll see this in action. The main difference between the tweezers and the hangman or hammer is the time period. The tweezers are two candles, but the activity is the same. The other difference is that the colour of the hangman or hammers body is not relevant because the open and close are very close to each other.

Two things that make these candlestick patterns more powerful is when the range of the candles are longer than the average range, and there is higher than average volume to go with it.

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Jun 16 2008

Using Oscillators to get a feel for the market

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Mechanical System, Technical Analysis, Terminate, Trade, Trading, Trading Plan, Trading System, Trend, Trigger

Oscillators are great tools when used wisely. They offer many ways in which they can be used, divergence, over bought/over sold, crossovers to name a few.

They can also be used to get a feel for the markets, whether trending or in a range.

If a trader wants to use oscillators to get a feel for the markets, what they need is some recent price action and a belief that the current trend or range will continue long enough to create some more opportunities.

For example, if you believe you are in an uptrend, and the trend has quite a way to go, you can then use an oscillator such as the ‘stochastics oscillator’ to tell you how deep the corrections are likely to go, based on how the oscillator behaved recently.

All you need to do is adjust the oscillators variable until the indicator produces a repetitive signal and one that you feel you can use.

Take a look at the chart below.

This is a daily chart and what has been added is a stochastics with a 25,5,5 setting. The most important variable was the first number, 25. Not because 25 works better than any other number, but because for this market, during this trend, 25 offered simple triggers as to when the corrections were likely to end and the trend continue, as shown by the arrows.

All you do as the trader is determine what number gives you the best signals or triggers for a possible trade.

When in an uptrend, look to use the oscillator as a signal that a correction is ending, and not when the trend itself is ending. Likewise, in a downtrend, use the oscillator as a signal that a bear market rally is ending, and not the downtrend itself.

However, when in a ranging or sideways market, you can use the oscillator as a way to signal when the top and the bottom of the range have been made.

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Jun 11 2008

Using MACD to ‘clip’ the trend

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Mechanical System, Technical Analysis, Terminate, Trade, Trading, Trading Plan, Trading System, Trend, Trigger

Do you use the MACD or even moving average crossovers as a way to determine the overall trend in your analysis? One thing you may have come across in the past is that although these are great methods, they always produce drawdown periods for you when the market is correcting or consolidating, and sometimes these periods can last for months.

One way to eliminate or reduce the effects of these consolidation periods is to ‘clip the trend’, and here we’ll demonstrate how to do this using the MACD indicator.

If you are in an uptrend, when the leading MACD line crosses below the trigger line, the uptrend is now clipped, leaving you with a decision to either not trade this market, or to look for shorts. Once the leading line crosses back above the trigger line, you can once again trade this market or now look for longs.

Likewise; if you are in a downtrend, when the leading MACD line crosses above the trigger line, the downtrend is now clipped, leaving you with the decision to either stay out of this market or look for longs. Once the leading line crosses back below the trigger line, you can once again trade this market or now look for shorts.

On the chart below, we have an up trending market which is being shown by both the MACD being above zero (one method for determining a trend), and a moving average crossover, where the short mav is above the long mav (the red line above the green line on the upper part of the chart).

The black arrows are showing you where the trend is being ‘clipped’ by the action of the MACD crossover (leading red line crosses below green trigger line), and as you can see on all occasions, a consolidation period forms, which is not ideal for a trader wanting to trade the trend.

The red circles are demonstrating when the leading MACD line crosses back above the trigger line and where the trend once again resumes.

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Jun 05 2008

Using Bollinger Bands to signal tops or bottoms with divergence

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Mechanical System, Technical Analysis, Trade, Trading Plan, Trading System, Trend

There are quite a few uses for Bollinger Bands in trading and today we’ll look at one of them: Divergence.

Divergence is a common element of oscillating indicators such as stochastics, MACD and RSI to name a few, but the Bollinger Bands can display divergence too.

When divergence takes place several things will happen. In this example, we’ll discuss price making a top and the bollinger bands alerting us to this.

1. First, price will make a high and break above the upper band, and usually quite significantly.

2. Second, price will then head back into the bands, retreating from the high.

3. Third, price will then make a new high but will NOT break out of the upper band.

When you see this series of events, you have bollinger band divergence.

The picture below will give you a visual example of the three events that I have just described. Whether you already use bollinger bands or not, this can be a very useful tool to add to your tool box.

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May 30 2008

Your exit strategy determines your profits

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Mechanical System, Money Management, Psychology, Technical Analysis, Terminate, Trading Plan, Trading System

Getting back to basics part 2

In my last article I spoke about getting back to the basics of trading when you find yourself struggling. I also mentioned that it was not the complete picture and that an exit strategy is more a function of the trader themselves. In this article I explain why.

There are many ways to formulate an exit strategy. Other than an initial stop loss, which is there to get you out of a bad trade, exit strategies are used to achieve a goal. A lot of traders don’t understand this concept and therefore pay little attention to it, spending more of their time worrying about entries.

Those that do consider the exit strategy important may still place more importance on finding the exit strategy that proves to be the most rewarding when back-testing. Although this is important it is only half the picture. An exit strategy also needs to support you the trader and help you achieve your goals.

An example: The three most popular methods for exiting a trade are to use profit targets, trailing stops, and indicators; some people may even use a combination. If you use a profit target as an exit strategy, there must be a reason. A long term investor, or someone who trades medium to long term has less need for profit targets and more need for catching trends; therefore trailing stops are more suited.

Someone who uses profit targets is more likely to be shorter term, someone looking to use the markets to generate income, or even be a novice looking for consistency to build confidence. You see if your goal was to generate some sort of long term result such as a decent return on your capital over 5 years, then profit targets are a waste of your valuable time. What you need is to catch trends, and an exit strategy that uses profit targets is not going to allow you to do that, because you never know how long the trend will last.

If you take the time to assess what it is you want from your trading, you’ll find that the exit strategy you employ is either going to fit or it isn’t. If your shorter term and looking for income, what’s important to you is knowing what your goal is for the week or month, knowing your average win to loss ratio, knowing your average profit to loss ratio, and setting profit targets based on that.

For example, if your goal is to generate $1000 a week from trading and your system has a 60% win to loss ratio, and you always set your profit target to the same as your risk (this means you have a 1:1 profit to loss ratio per trade), then each trade would have a $500 risk, and a $500 profit target. Let’s do the math here…

10 trades; each trade we risk $500, and we set a profit target of $500 (after commissions). We have 6 winners totaling $3000 profit. We have 4 losers totaling $2000 loss. Result - $1000 profit. In this situation, your exit strategy has helped you to achieve your goal.

Now let’s say you didn’t understand the concept of exit strategies and thought that the best way to exit your trades was to use trailing stops. This is fine if your goals are longer term, but if your goals are to create income, or even to create confidence in yourself as a trader, then using trailing stops takes away any short term certainty; something that you need if looking to generate income or gain confidence.

Let’s look at longer term exit strategies. If your goal is to build your wealth over a certain period then your more than likely looking to catch trends; the reason is because at any given time, some market some where is trending.

The Turtles made a name for this sort of strategy where their goal was not some monetary figure every month but merely to make sure they caught every trend that presented itself. In order to do this, they had to employ the right exit strategy. See how I said exit strategy and not entry strategy. Although important, the entry was merely a set of rules that ensured the Turtles entered every market that looked like it could trend, even if no trends eventuated for many months. The exit strategy was the system that allowed those markets that did trend to pay handsomely. One trending market was all it took in one year to more than offset all the many losses, and return a profit that most fund managers would frame and place on their walls.

The actual exit strategy the Turtles used is not the point; the point is to find a strategy that suits you and your goals. Worrying about whether to use a trailing stop, or a volatility stop that works out some weird percentage of the daily range, or even some indicator cross over is fine if you’re longer term, but most traders are not long term and so must pay special attention to their goals and what they are trying to achieve.

I firmly believe that all exit strategies if tested over a long enough periods will produce similar results. It’s how practical they for you and your trading business that is more important.

My suggestion is to assess where you are. If you’re looking for short term results such as income, use profit targets. If you’re new or even struggling, but are not too concerned with income right away, using a profit target is still the better option as it helps you build confidence. Only move to the longer term exit strategies such as trailing stops once you have gained confidence in yourself to let trades run, and have less need for the income.

Exercise:
Assess what you are trying to achieve and select exit strategies to suit. Then test them out over a decent sample of data along with your entry techniques you created from the last exercise.

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May 30 2008

Your trading system and building on the basics

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Fundamental Analysis, Mechanical System, Technical Analysis, Terminate, Trade, Trading, Trading Plan, Trading System, Trend, Trigger

Getting back to basics.

All professions whether it be sport, business, or trading have what are called the basics and if you’re starting out in a new profession, the basics form the foundation or the core. However if you’ve been practicing your profession for quite some time and feel you’ve gone off track or are not hitting your goals, usually the best thing to do is just get back to the basics: and trading is no different.

This is not an article based on emotional discipline or psychology, it is based on the basics of a trading plan, and it really doesn’t matter if you’re long term or short term, the basics apply to most market participants. Some may have trading plans that are quite different to the basics however for the majority who are relatively new to trading or are struggling, the basics are by far the best approach to adopt.

The basics are split into three and are:

1. Determine the trend
2. Wait for a pullback
3. Enter on an event or pattern

1. Determining the trend can be a discretionary or mechanical decision. For example, a lot of traders can pull up a chart and instantly determine it’s going up, down, or it’s sideways and choppy, and if it’s the latter it is best left alone; this is a discretionary approach.

For other’s they need some tools to make that decision for them such as moving averages, MACD or trend lines to name a few. All have their pluses and minuses and it usually helps to use a couple of tools or to add some discretion.

I’ll give you an example of a completely mechanical approach to determining a trend.

Set up a 200 day simple moving average (200 SMA) on your chart. Also add the indicator ATR (average true range) and set it to 100. If you take the current 200 SMA reading and the reading from 50 days ago, the difference needs to be greater than 4 times the current ATR(100) reading.

For example, if the current 200 SMA reading is 60 and the reading from 50 days ago is 50, that’s a difference of 10. If the current ATR(100) reading is 2, multiplying it by 4 gives you 8, and as such means you are in a mechanical uptrend. The opposite applies to down trends or bear markets.

2. Waiting for a pullback simply allows you to get on board a trend at a cheaper price. It can become somewhat of an issue for many as it’s hard to time when the pullback has ended or to determine if indeed the trend will continue. It could end up being that the trend has ended.

Keeping it simple is the best policy. Oscillating indicators are great tools for this very purpose, such as Stochastic or RSI to name a couple. Oscillators such as these have what are called over-bought and over-sold zones which you should become familiar with. When in an uptrend, a pullback in price coupled with an over-sold reading on your indicator is telling you it may be time to look for a possible trade to go long.

Using an RSI (14) is a popular method for determining if a pullback is over-sold when it reaches or goes below the 30 level.

Many will want more than just one indicator and will prefer a confluence of events to occur. Other tools will include trend lines, Bollinger bands, old support and resistance levels, volume, Fibonacci levels and so on. My suggestion is to just pull up some charts and look at what pull-back cause your indicators to do regularly. It doesn’t have to be all the time, but if it does it enough, you have your tools for measuring a pullback.

3. Entering your trade should probably be the most mechanical of the three basics. The reason is because it is the point where emotions can run high and traders can get twitchy. It’s also a time when someone will start to question whether they have the first two basics right.

If you have determined that the trend is up, and a pullback has occurred you’ll need a way to get in and this is best done by waiting for some event or pattern.

Events can be that price has exceeded a certain number of price bars, or it crosses over a short moving average. If the pullback made lower highs and lower lows, you could wait for a higher low to be made which could signal that the pullback is over and enter after a break of the most recent high.

Once again, by looking at a few charts you can get a feel for what could work and what wouldn’t.

A simple and popular method is to wait for price to close higher than the previous 3 bars. In other words, the closing price of the current price bar must be higher than the 3 previous bars highs.

So there you have what I call the three basics of a trading plan or system however it is not the complete picture. It’s ok to get into the market but how do you get out? And it is this part of trading that I believe goes beyond the basics because everyone is different. Different goals, different risk profile and tolerance levels, different resources such as time and capital and so on. Because of this, an exit strategy needs to center around the trader themselves.

Exercise:
If you feel the basics I have just spoken about make sense to you, then look for ways to determine each of the three steps based on your preferred method of trading (mechanical, discretionary, technical, fundamental or a combination).

Use the members area, search on forums, seach on Google and ask other traders.

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May 30 2008

Your most important asset in trading

Published by Dean under Backtest, Discretionary System, Financial Market Fisherman, Fundamental Analysis, Mechanical System, Mindset, Money Management, Psychology, Technical Analysis, Trade, Trading, Trading Plan, Trading System

How much time a week can you devote to trading?

Also, what are those time slots? For example, if you can spare 10 hours a week to trading, what are those exact times? Are they evenings, mornings etc?

Now comes the heart breaker. What is your yearly ROI goal? Write it down. Now next to that, write down the number of hours you can allocate to trading. Now compare your results to the table below. Do they match up?

Hours a week available - A reasonable expectation ROI% PA

              0-5                -                     0-10%

             5-10               -                     10-20%

            10-15              -                     20-30%

            15-20              -                     30-40%

            20-25              -                     40-50%

            25-30              -                     50-60%

            30-35              -                     60-70%

            35-40              -                     70-80%

These are just rough guidelines. They are mainly presented in this fashion to drive home an important point, and that is trading involves a lot more than just trading!

For example, as a beginner you not only have to physically trade, you need to do the following;

Learn the system; learn the jargon; learn the particular market you are trading; learn the software, the brokers platform, the data provider; learn the laws and taxation laws that affect you; learn your own strengths and weaknesses; assess you skill level; learn any necessary computer skills and so on.

It’s exactly like any other business. You need to learn the ropes. Someone who only has 5 hours a week to devote to trading can not be expected to learn all of the above and successfully out-perform fund managers who employ teams of full time staff and traders with years of experience.

However, if you have the desire to achieve great results, it will need a commitment from you. Allocating more time to your start up now, can lead to less required time from you in the future. For example, someone looking to make 60% per year and achieve this in 12 months may look to devote more than 25-30 hours per week, in fact more like 45-50. However the pay off is that this extra devotion may lead to finding a system that does indeed generate 60% returns with only a 10-15 hour a week commitment.

Exercise:
Determine how much time a week you can allocate to trading and then
split it into the following:

1. Actual trading (should be the least time)
2. Analyzing and seeking opportunities
3. Working on yourself and your trading business (should be the
most time).

Number 3 should be your biggest priority. Ensure you have at least
1 hour plus, to every one you spend on seeking opportunities.

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Apr 09 2008

I am a bit confused about the trailing stops employed

Published by Dean under Backtest, Financial Market Fisherman, Forex, Mechanical System, Money Management, Technical Analysis, Trade, Trading System, Trigger

Claire asked me to clarify the use of trailing stops in the 4T’s system. I think this is a great chance to demonstrate the uses of exits as they are more dimensional than most realize.

In the 4T’s system I use a trailing stop that moves up (I am referring to longs - just think opposite for shorts), every time a new low forms. As I am using an ‘isolation low’ as my point of reference (after a trigger has taken place), to look for a trade, I suggest using the same when trailing the stops. The reason is because if you are looking for isolation lows after a trigger, you’ll become more familiar with the pattern, and thus making it easier to spot them during the trade to trail your stops.

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Financial Market Fisherman

Fishing the Markets for Opportunity - Only when you have peace within can you be in harmony with the markets

Archive for the 'Backtest' Category

What Is Your ‘R’ Factor and How to Stop Yourself Cutting Winning Trades Short

Using candlesticks to signal reversals

Using Oscillators to get a feel for the market

Using MACD to ‘clip’ the trend

Using Bollinger Bands to signal tops or bottoms with divergence

Your exit strategy determines your profits

Your trading system and building on the basics

Your most important asset in trading

I am a bit confused about the trailing stops employed