More on knowns, unknowns and risk

The recent passing of Donald Rumsfeld caused me to reflect again on his (in)famous "known knowns, known unknowns and unknown unknowns" speech (see here), but the truth is that we always have such instances possible in the markets, at any time.

Stick or twist?

"We have a saying here: "It is incredible how rich you can get by not being perfect." We are not looking for the optimum method; we are looking for the hardiest method. Anyone can sit down and devise a perfect system for the past." - Larry Hite

A trader is always evolving, in terms of his ideas, beliefs and his method. As an example, you often read about how young 'fearless' traders learn to appreciate the importance of risk control - often after blowing up an account or two, or at the minimum having an emotionally demoralising experience associated with a major drawdown. Even some of the Market Wizards went through this.

Occasionally, a trader moves away from their original ideas and beliefs about how to make money. Again, some of the most successful traders have done this.

Some thoughts on varying your position size

In my own trading, I use fixed fractional position sizing - that is, while the monetary value of risk per trade varies as my equity goes up or down, I risk the same amount in percentage terms.

A while back, a good trader friend of mine experimented with varying the percentage risk per trade based on a look back period of performance. 

Both methods have been used by successful traders and Market Wizards. Both have strengths and weaknesses.

Jerry Parker on volatility

It's been a while since I read Michael Covel's The Complete Turtle Trader - the story of the famous Turtles experiment with Richard Dennis and William Eckhardt and their band of trend followers in the mid-1980's.

Whenever you read an old favourite after a while you tend to discover some little nugget that you may have previously overlooked. As an example, today I came across the following excerpt featuring quotes from Jerry Parker:

Improving your emotional control

A few weeks back, a trader friend of mine sent me the following message: "Just had my best ever trade...well, was a full -1R loss in record time!"

When I read this I thought he was being sarcastic, however he went on:

"There were f*** all emotions. Didn't hesitate on the exit, didn't think - just acted".

I've known my trader friend for a few years now. He actually has more experience in the markets than me, and has developed his own method, but he is continually learning and trying to develop himself as a trader. He has also been consistently profitable.

So why did he think this was his best ever trade?

The starting point for any trader - what are your beliefs?

I've talked in the past about the importance of constructing your own trading method which is based around your beliefs.

But how do you start this process?

Playing great defence

As a trader, I am always more concerned with how much I could lose on a trade than win. Good risk control certainly helps you with that, but there are some other ideas that can help you keep losses as small as possible. 

Here are some examples of playing 'good defence', as Paul Tudor Jones would call it, which have helped me as a trader.

Combining technicals and fundamentals for investing

Recently I had the opportunity to review an investor’s portfolio. This was valued in excess of £1m. The allocation of the funds was entrusted to a well known brokerage. I was asked for my opinion on the performance and allocation of the fund.

What I learned from two Market Wizards about volatility

Given that the markets have taken off to the downside so far in 2016, readers may be wondering why I have not taken any positions so far this year.

What's there not to like?

It is not often that I post up a potential set up before it decides whether to trigger an entry or not. It is even rarer for me to trade one of the major indices. However, I was struck by the current set up on the chart of the Dow (see below). The S&P and Nasdaq are also showing similar characteristics and price structure.

Paul Tudor Jones - Is there a contradiction here?

"My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out." - Paul Tudor Jones

The above excerpt comes from PTJ's interview with Tony Robbins, which appeared in the book Money: Master The Game. I've not read the book, but I've seen this paragraph quoted enough on social media.

When you are wrong, don't stay wrong!

In this recent post, I referred to Ocwen Financial Corp, a US stock that had been on my watchlist, and which broke out to new highs just ahead of earnings, triggering a possible entry.

Now, as I have mentioned numerous times, I do not initiate positions just ahead of such releases - the potential for price gapping against me is a risk I choose to pass on. My own belief is that is gambling, not speculating.

In this particular instance, price did gap down, which, had I taken the trade on the breakout, would have caused a loss greater than my initial risk.

But what if you did take the trade?

Losses, your mindset and risk

Most unsuccessful traders fall into the trap of assuming that the next trade will be a winning one. They can only see the potential profits – not the potential losses and the subsequent reduction in their equity.

To avoid this mindset, I recommend assuming that every trade you take will generate a full 1R loss. I do this, even though 99% of my losing trades end up being closed for a loss smaller than that.

Intellect, theory, risk taking and reality

From the outside, trading opportunities within the big financial institutions or investment banks seem to be a closed shop. I took a look at job opportunities in the City of London this morning and all of them seemed to want people who were educated to a degree level, and/or who already worked in a financial institution. This obviously rules out bozo's like me, who left school and didn't proceed into further education, or who have never worked within the industry.

Why I don't rely on fundamentals

There are undoubtedly a lot of traders, as well as the investing community, who place great faith in researching, analysing and interpreting the underlying fundamentals of a company. This information is then used to assist them make buying and selling decisions. However, some traders (like myself) place no reliance whatsoever on what the fundamentals are telling me.

Frankly, I don't care how many widgets they are making, whether the directors are buying or selling, or what the price to earnings ratio is. I'm far more interested in what price is doing, because ultimately the company's stock price and its movements is what generates a profit or a loss for a trader.

A plan on how to get over a major drawdown or price shock

It is an unfortunate part of trading that people can suffer the traumatic experience of losing a significant part of their equity in one go. In extreme examples, some traders may even blow up their account. This may be as a result of some major unexpected news coming out. It may be as a result of your broker putting most of your money in a downtrending stock. It may be because you took a big position just before earnings were released which then gapped against you.

When something like this happens, your mindset will take a battering, and before you commit any fresh funds to the markets, you need to step away for a while and regroup. As hard as it may seem, how you deal emotionally with what has happened is of paramount importance, and may even determine whether you can make money in the future.

How I use volatility as part of the selection process

I don't use any of the classical indicators or oscillators that you see on many chartists screens. The price channels you see denote where entries and exits should be taken. To me, price is and always will be the ultimate indicator. Price and its movements will tell me when a trend is starting or finishing.

Price is the sole factor for a trend follower

People who read this blog will know that I focus solely on price rather than fundamentals. However I also know that people are successful focusing on fundamentals.

Quotes from Market Wizards

Here's a small collection of quotes from the Market Wizards interviews, that relate to trend following, or the beliefs that trend followers have. These may provide food for thought for those who do not believe in following trends. The people quoted here are amongst the most successful traders of their time, so anything they say should be listened to. I have purposefully avoided quoting two famed trend followers who have been interviewed in the book, namely Ed Seykota and Larry Hite, as I have referred to them extensively in previous posts on here.

Paul Tudor Jones:

"We have tested every system under the sun and, amazingly, we have found one that actually works very well. It is a very good system...(under the realm of) trend following. The basic premise of the system is that markets move sharply when they move. If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try and fade that price move. When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion."

"The most important rule of trading is to play great defense, not great offense."

"I don't really care about the mistakes I made three seconds ago in the market. What I care about is what I am going to do from the next moment on. I try to avoid any emotional attachment to a market."

" I always believe that prices move first and fundamentals come second."

Gary Bielfeldt:

"The best thing that anyone can do when starting out is to learn how a trend system works. Trading a trend system for a while will teach a new trader the principle of letting profits run and cutting losses short. If you can just learn discipline by using a trend-following system, even temporarily, it will increase your odds of being successful as a trader."

Richard Dennis:

"You should expect the unexpected in this business; expect the extreme. Don't think in terms of boundaries that limit what the market might do. If there is any lesson I have learned in the nearly twenty years that I've been in this business, it is that the unexpected and the impossible happen every now and then."

"A good trend following system will keep you in the market until there is evidence that the trend has changed."

"The correct approach is to say: 'This structure is up, and this structure means no more, but never that this structure means up this much and no more'."

"I could trade without knowing the name of the market."

"The market being in a trend is the main thing that eventually gets us in a trade. That is a pretty simple idea. Being consistent and making sure you do that all the time is probably more important than the particular characteristics you use to define the trend. Whatever method you use to enter trades, the most critical thing is that if there is a major trend, your approach should assure that you get in that trend."

All of the aspects referred to directly or indirectly above form the cornerstone of both a trend follower's thought processes, as well as the nuts and bolts of their trading system. As a result, they are all covered in my own system, the rules of which are described in my e-book,or are fully covered in my training sessions with other traders.