This page was last modified March 29, 2013

Trading Stocks, Futures, Options, Bonds, etc.

Part I - You probably shouldn't trade

This part is here basically to discourage you from getting to trading if you're thinking about doing it.

There is a very large degree of unpredictability in the markets. Most people don't realize and/or refuse to acknowledge it. But it was actually shown mathematically in the 1960s that asset prices cannot be predicted based on past prices. This is the so-called random walk theory. This means that trading on price patterns or predictive parameters won't work. If you go into the markets believing you can predict prices, chances are very high you won't succeed.

The unpredictability factor becomes increasingly apparent the more number of complete trades (round turns) you do. If your first few trades go nicely for you, you will get a false sense of confidence, not realizing that the results are likely due to chance. You may think the markets indeed are predictable. Not good if you decide to continue trading, because the more trades you complete, the more you see that it becomes a matter of bouncing around the "0" line on your P/L statement. Day traders are simply living this fact on a much shorter time frame than swing traders or investors, but the concept applies equally across all time frames.

In addition to the technical challenge of dealing with price behavior, most people will let their emotional concept of money get involved in their trading decisions. This is guaranteed to seal your fate as a trader. Emotions have no place in a successful trading strategy. The result of trading with emotion is that you make completely the opposite decisions of what you should make. You liquidate when you should hold. You buy when you should sell. You go short when you should go long. You remove from a winning position when you should add to it. Etc.

Most people who first get into trading don't realize that controlled losses are as much a part of trading as wins are. You take losses as often as you make wins. Both are equally important. In industry terms, a "drawdown" is the maximum loss from peak at any particular time during the year. Every trading strategy, every hedge fund, mutual fund, be it mechanical or discretionary, has drawdown. If you begin trading, drawdown applies to you as well. Although your drawdown cannot be known in advance, you may get a good estimate of what it should be, as long as you have done your homework in advance. It is a function of your trading strategy, the type of market you are in (trending, non-trending, etc), chance, and so on. You can get within ballpark expectations based on historical performance (including backtesting) and how well the current and future market behaves accordingly. Certain strategies will provide a certain expected range of drawdowns in certain markets. But as markets are unpredictable so is the amount of drawdown and there, of course, is the rub. People can have a wildly successful time trading strong, trending markets, but once that market changes their strategy is useless.

You also must have the proper concept of money. Money in a trading account is a business resource, but some (most?) people are inclined to view it as tangible money - the same as the spending money they keep in their wallet, which obviously is going to tie into your emotions, which means you will not be able to trade successfully.

Since there is a very fine line between "winning" and "losing" in trading, any of the above difficulties has the potential to quickly make mince-meat of your account. This is why trading is not recommended.

Part II - Guidelines for getting started

According to the statistics, something like 99% of all retail traders fail to be profitable. If you're determined to make a go of it, there are certain things you need to do to give yourself the best chances of long term success. It is important to approach it as a scientific endeavor, quantify everything, and understand what drives asset prices.

Preparatory work

  • Emotions are the kiss of death to a success strategy. Make sure your emotions are under control
  • Realize that trading is a probability game over the long term. The outcome of any particular trade means little to the overall result.
  • Identify something driving prices (see below).
  • Risk/money management is more important than anything else
  • Backtest, backtest, backtest. At a minimum, over a multi-year period with several hundred round turns. Even better 2000 trades. Better yet 5000 trades.
  • Test over all possible market conditions, including outliers. If emotions are the #1 cause of trader failure, outlier events are #2.
  • Quantify your expected drawdown
  • sufficiently capitalized to implement your strategy
  • patience to see it through.
  • willingness to not predict the outcome of trades, timeframes, return on account, etc
  • Do not curve-fit under any circumstance.
  • Do not trade news.

An underappreciated author in the world of trading literature, Art Collins should be required reading for anybody involved in trading. It's also cool that he's a musician, like myself

The Components of a Strategy

You strategy must have the following:

  • rules for trade entries and exits
  • methods for limiting downside exposure
  • results of historical backtesting with as many simulated trades as possible
  • numbers for expected drawdown, net profit, win/loss ratio

Entries and Exits

The setup(s) you use may be based on any number of price driving factors:
  • basic characterstics of price behavior, such as breakouts, retracements, or congestion areas
  • correlation with external events or other markets
  • correlation with some type of fundamentals

Any of these are valid as long as you are faithful to the research: don't let noise or lack of data skew your results and conclusions.

Keep in mind that stocks behave differently than commodity futures. The defining behavior of stocks prices is a result of the accumulation and distribution of the finite quantity of outstanding shares and relationship of these shares to the ownership of the company and the expected earnings. In contrast, commodity futures are contracts and the defining price drivers (outside of speculation or random movement) have to do with supply and demand.

Risk Management and Limiting Downside

Even more important than setups is making sure a series of losing trades does not (a) threaten your trading ability or (b) threaten the long term profitability of your system. Losing trades - including multiple series of losing trades - are an unavoidable part of trading. You must have a good idea of your expected win/loss ratio (see "Backtesting" below).

There are two types of potential losses to consider: those that occur in "normal" market conditions, and those that occur in extreme market conditions (the "outlier" event mentioned above, also known as Black Swans). You need to limit your exposure to both.

The way you protect yourself against extreme events is by buying options.

Limiting your losses in normal conditions is a function of your entry and exit strategy, and normal market orders for stop losses are part of this process. You need to understand that you must design your stop loss strategy in such a way that it does not impair the long term win-side probabilities of your strategy to the point where you have a breakeven net P/L. To this end, realize that:

  • Wide stop losses afford more breathing room to hit the profit target, but incur larger drawdown
  • Tighter stop losses get stopped out more frequently, meaning you are generating more trades and not hitting as many profit targets
  • The trick is to balance profitability with preservation of trading capital. Keeping the probabilities in your favor while ensuring you don't subject yourself to a margin call in the process

Backtesting

Backtesting is critical to understanding your trading strategy and how it holds up under various market conditions. The point of backtesting is to "prove" (as far as that it possible) that your method has a sufficient edge to provide a net profit over the long term, in simple terms: your winning trades ultimately prove greater than your losing trades. At a minimum you need to backtest against two or three years and with a couple thousand complete trades ("round turns.") The reason for the high number of trades is that the more trades you do, the less likely the results are from random chance and the more likely the results are a reflection of the inherent property of your strategy. Since asset prices are not predictable, a small number of trades is not sufficient to provide that.

When you backtest, make sure you account for all possible market conditions, especially extreme ones. Test against all the ways that your trades can go seriously wrong. Do not make the mistake of believing that extreme market events will not happen to you: they will. You need to make sure your strategy + risk management is able to withstand and bounce back from whatever the markets will throw at it.

Unrecoverable losses also take place over time through series of losses that slowly reduce the trading balance or through a "breakeven" method that gives up commissions and fees. If your trading strategy suffers from either of these problems, it must be corrected. There is no point to trading unless your net P/L is noticeably better than the interest rates you can get at a bank.

Measuring Performance and Risk

Backtesting provides you the numbers you need to determine the effectiveness of your strategy and how risky it is. The most important number to look at is your drawdown, which is how much your account is down during a period of losses. You will go through various drawdown periods during the year. It's important that these never exceed your margin requirements. You also want to take a look at how long your average drawdown periods are. Obviously, the shorter the better. A typical drawdown period might last two or three weeks.

There are various other measures of risk and performance, and although you can get really fancy with these (eg. Sharpe Ratio), the basic drawdown number is sufficient. You can go a step further and normalize the performance numbers against volatility.

Besides the importance of drawdown for what it means to your account balance, it is also important to understand what it implies about trading in general: that losing trades are an unavoidable part of trading.

Drawdown is a function of how well your trading strategy matches the type of market you are in. If you have a general purpose method for many markets, this means you will take smaller and less frequent wins, but a better chance of withstanding the evolving nature of any particular market. Most people attempt to design a strategy that works either in a trending market, or a ranging (sideways) market. It is best to try to design one that works in both.