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.

My personal trendfollowing "A-ha" moments

Every trader on their own journey will encounter some lessons which are critical to their long-term development and ultimate success.

These will differ from trader to trader, as their own personality, beliefs, strengths, weaknesses and experiences are unique to them.

Below is a list of ten "A-ha!" lessons which I personally have learned from and helped shape my own beliefs about how best for me to trade:

New testimonial

Just before Christmas I received the following from Stefan, an aspiring trend follower based in Germany:

Focus on your own trading and the trends you are looking to profit from

We know that markets can move from a trending to non-trending state, or vice versa, at any time. But as Ed Seykota says, there is no such thing as 'the' trend. 

Also, different traders will have different interpretations about the type of trend they are looking for - one person's long-term trend may be another person's short-term trend.

The important point here is that how anyone else defines a trend is irrelevant to your own trading and performance.

Some words of wisdom from David Druz

David Druz is a long-time trend follower who was the first mentee of Ed Seykota. He has run Tactical Investment Management since the early 1980's. Here are some of his nuggets of wisdom:

Current market volatility and staying the course

In the last couple of weeks we have seen an ever-increasing level of volatility within the context of a sharp drop in price in the major market averages.

We have also started to see intervention in the markets by governments and regulators - additional liquidity being provided and interest rate cuts, as well as market trading halts (up and down) being triggered and the introduction of short selling bans on certain stocks.

New testimonial

This week I received the following testimonial from Stephen, who I have now known for a number of years and has been an active member within our small group of traders:

Trend following and Epictetus

The stoic philosopher Epictetus once said that “We have two ears and one mouth so that we can listen twice as much as we speak.”

In the world of trading however, plenty of participants seem to think they have two mouths and one ear. They aren't interested in listening; they are simply wanting to speak - often over the market itself.

Using volatility contraction to increase your profits (part 2)

Following on from my previous post about the use of volatility-based position sizing, here is a little wrinkle you may want to consider:

Typically this type of position sizing method is calculated using a multiple of Average True Range over a specified 'look back' period, and is normally expressed as a pure monetary number. So, in the second example in the previous post, Stock B priced at $20 had a 2ATR reading of $1.

Using volatility contraction to increase your profits

Often you see people talking about a winning trade, and how far in percentage terms price moved in their favour after entry.

But on its own, this doesn't tell you anything - to me, it is a worthless metric when evaluating performance.

As a trader, I'm far more interested in the size of the profit (or loss) generated when expressed in terms of R.

How do you define a trend?

The past has happened. The future doesn't exist.

Therefore, we can only react and respond to what is happening in the moment of now.

So, for traders the question is, what is price doing now?

The tricky bit is how you define "what is price doing now".

Using Bitcoin as an example of why I love volatility contraction

On my last post, I talked about the recent big winning trade in Bitcoin on the long side from earlier this year,which generated a +21R profit. Yesterday, Bitcoin gave a short signal as price dropped. 

Would I have taken this signal? 

No. 

Let me explain why.

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.

Jack Nicklaus and trading - part 3

A couple of my more popular posts from past years relate to Jack Nicklaus, where I listed a number of quotes from his extensive writings and interviews over the years. 

Below I've pulled out a few more of nuggets of wisdom from The Golden Bear, which again may require some thought on your part, but the underlying message can easily be applied to your trading and mindset:

Trading the downside - remaining faithful to the process

The last couple of months have been very positive as profitable downtrends have appeared in a number of stocks, both at home and abroad. Fortunately, I have been able to profit from some of these (while suffering small losses in a few others!), and while some which developed into downtrends have now triggered their exit signals, prices in others have remained in a downtrend.

This has potentially meant I may have been able to profit from the downwards move while those who trade longer-term trends have had to suffer an erosion of open profits, or even suffering losses, from a pullback or retracement within the context of a prevailing longer-term uptrend.

Recency bias, and labelling markets as easy or hard

I've seen it said that one of the goals you should have as a trader is to try and make money when things are easy, and that you should be more defensive and protect what you have when things are hard.

That is all very laudable, but from a trend follower's perspective there is a problem with that.

You think the markets are volatile? Think again...

I've mentioned a few times this year, both here and on social media, that the current levels of volatility may seem quite high (certainly compared to the more 'normal' recent levels), but these are nowhere near the levels seen in 2008.

To show what I am talking about, at the bottom of this post I've shown the monthly chart of the Dow going back to the early 1970's. And then, I created a simple measurement to show the change in volatility, by taking the typical 2ATR measurement calculation and expressing this as a percentage of current price.

Trading the line of least resistance

A lot of the people who were profitable in 2008 became unstuck the following year. They seemed to get in their head that, once the markets started rallying, they were anticipating a further, more pronounced price drop.

In the summer of 2009, they got their chance. There were numerous trading blogs of the day talking about a 'head and shoulders' pattern which had formed on the indices between May and June, and they were going to use this as a trigger to go short the market, and really make a killing.

Another example of a nasty price gap

If you subscribe to the Mark Douglas theory that in the markets anything can happen, at any time, then you will know and accept the potential effect that sudden or unexpected announcements can have on price of a stock or instrument.

Seemingly you can be comfortably sitting in profit on a trade, even with your trailing stop above your entry price, only for a price gap to occur against you, resulting from the reaction to such an announcement.

It is for this reason why I never take into account open profits for position sizing purposes. A profit or loss on a position is not known until the trade is closed. Open profits can disappear - seemingly overnight with little or no warning, and your trailing stop may be rendered worthless.

New testimonial

A couple of weekends back, while on the train to London, I posted this up on Twitter:

The traders I was going to meet were Craig and Aaron, and our catch up marked the end of working closely together for three years.

Following that, Craig has now kindly forwarded the following note: