As a trading career develops, it may ramble through many stages. Personally, I tried a little of this, a bit of that, educating myself through a process of trial and error.
I had no trading style, and no clear goals. I had no idea which styles suited my personality and which styles would drive me crazy. Sometimes I was a long term investor, sometimes a day trader, sometimes a swing trader.
Sometimes I traded equities, sometimes equity options, sometimes pure futures and sometimes futures options. I was a directional trader, a delta neutral options trader, a seasonal spread trader, an option buyer, a premium seller.
Only in recent years have I focused on the grain futures markets and built the trading style which matches my personality and meets my specific needs.
I learned that I am impatient for results and need quick feedback. I am risk averse and hate being exposed to a leveraged market position one second longer than I absolutely have to be. Above all, I need to win steadily, rather than make money through occasional big wins interspersed with long losing periods.
My main need from trading is to secure a consistent income stream, with the emphasis on consistent.
Trading income is never like earning a salary. There are good weeks and bad weeks, good months and bad months, and with some trading styles there are good years and bad years.
I wanted a solution which had few bad weeks, and where bad months are almost unheard of. I find it almost impossible to maintain good trading discipline when my system is not winning steadily, even though it may be in an entirely predictable and expected drawdown.
All trading systems have losing spells as markets gyrate, change and evolve. During losing spells, account equity goes into drawdown. A system with "positive expectancy", and sensible risk management processes, eventually comes out of drawdown, and equity growth resumes. Quite early on, I realized that if I need a steady income, I need a system which trades frequently.
The logic is simple. Assume your account normally goes into drawdown for an average run of 5 trades. Further suppose you have the choice of three strategies, with the same theoretical returns over the long term, which have average trade durations of 1 day, 3 weeks, and 3 months respectively. Clearly the average drawdown in the first system lasts 5 days, in the second system 15 weeks, and in the third system 15 months!
Think about that! On average, when the third system is working normally, you are likely to have spells of 15 months, or longer, where you make no money! Occasionally, it will compensate with a stellar period, a home run, where the long term profits are made.
That kind of system may suit a patient, longer term investor, but it is of little value to a person hoping to trade for a living, unless they have enough capital to live on during those long financial droughts, and admirably tenacity to sit out long bad spells without losing motivation.
Assuming each system has the same theoretical profit potential, the third (slow) system will make a lot more money over an extended period of years. Why? Because its trading costs will be so much lower than in the higher frequency strategies. Frequent trading costs in the day trading system are likely to consume at least half the potential profits.
Given my personality traits, and my requirement for a consistent income stream, I was more or less constrained to the day trading option.
A day trader can trade more than once a day, potentially shortening the drawdown period further. Imagine a fourth strategy with the same potential as the others discussed above, which trades 10 times per day. The length of the average drawdown is reduced to half a day, which is good, but beware of the probable huge escalation in trading costs that may turn that theoretically high expectancy strategy into a losing proposition.
To cut a long story short, the trading style I evolved for myself was based on placing one good trade each day. I found trade setup patterns which win just over half the time, and I manage trades so that my average win is about twice my average loss. As long as I control risk by not taking too large a position in any one trade, this has worked well for me.
I think of my trading style in this way. It is like being taken to the casino and granted one bet each day where the odds are significantly in my favour. I accept that just because the odds are in my favour does not mean I will never have a string of losses. So I must manage risk in a professional way, to ensure I can weather these little storms. I understand that I must not succumb to the other temptations of the casino, particularly the urge to place unplanned bets. This is sometimes referred to as over-trading.
It is a technique geared to my requirement for a consistent revenue, as near to the notion of a normal salary as I can get.
Using the methods described in my book, I am most relaxed when I start each month with about US30K in my account, risk no more than 1.5% of my capital per trade, and trade whichever commodity (beans, wheat or corn) is in the 400 to 700 price range, with a preference for wheat when there is a choice. My goal is to make a minimum of 10% per month on capital invested. I withdraw profit and reset the capital to US30K at the end of each month.
So I am very much day trading for revenue. I trade to meet my needs. I was fortunate to retire early from a former career with a decent nest egg. My wife has a good job. Trading produces money for luxuries. And, as an added bonus, it allows me to be at home to enjoy and care for our little boy.
Now, there is no reason why these same techniques should not be used for capital gain. In theory, all that is required is to let the profits ride each month, so that the compounding effect kicks in and capital growth is exponential.
In practice, there would probably be difficulties. I cannot say for sure, because I have never done it. But I expect the techniques I use to trade five or six contracts would have to be substantially modified if I were trying to trade fifty, a hundred, or more contracts at a time. I suppose it might be a pleasant problem to experience.
At any rate, even though I’ve never tried it, it seems reasonable to assume that simply compounding my profits should lead to fast capital growth, if I start from my existing capital base.
However, many people are in a different position and have very different needs. They are attracted to trading for its lifestyle benefits, but are undercapitalized. Often they cannot afford to spend a lot of time on their trading. Their need is to build a small stake into a big one. While doing so, they intend to keep working their normal jobs. If successful, they hope to leave their jobs and become full time traders.
It should come as no surprise to find that this is not as easy as it sounds. A few months ago, I decided to use my methods to grow a small account of AUD10,000, into a substantial one of AUD50,000. I planned to trade exactly as I do in my revenue trading model. The only difference was that I would need to increase my acceptable risk per trade from 1.5% up to 5%, because otherwise most trading setups would violate my risk parameters and very few trades would be taken.
Despite an excellent start (up 9% on first day) this account did not do well, and I abandoned the effort when the capital dropped well below AUD6,000.
So what went wrong? Essentially, it was that 5% figure.
Sure, the market did run into a lean spell and losers were more frequent than usual. But with a 1.5% risk figure you can ride out a run of losses with equanimity. That is not the case when you risk 5%. Trading those months with my normal revenue generation style, I would have made acceptable positive returns each month. Instead of which, I destroyed nearly 50% of the equity in the small capital account.
Much of the problem was psychological. I found the extra volatility in the equity curve very difficult to cope with. I very much wanted the project to succeed, so began second guessing some aspects of the system. That is a sure recipe for disaster. Once you stop entering and managing trades exactly according to your predefined plan, you are no longer trading a system at all.
No experience in life is wasted, including this one. I made the fundamental mistake of concluding that the smaller capital base could be compensated for by increasing my risk parameter. But clearly it was not enough to simply take a successful revenue producing system (with its 1.5% risk tolerance), boost the tolerance to 5% so it would still allow me to take the same trades, and plan to let profits ride to obtain compound growth. Before getting back into this project, some research was required.
The small capital account is a very different animal. I had not fully appreciated how much the small equity base needs fanatical, stringent protection.
So, it was back to the drawing board. I remained satisfied with the fundamental elements of my system – the trade setups, the risk management, the placement of stop loss and profit target levels. Eventually, though, I began to see that there could be considerable advantages to developing a more defensive trade management plan.
I researched losing trades to see if there is a good predictor of failure which can be used to trigger an early exit from the trade. (This differs from my current practice, where I let the market trigger the target or activate the stop.) Obviously, an early exit from a bad trade, somewhere near break-even, is going to be much gentler on account equity than letting it hit the stop.
(The flip side is that, inevitably, some trades that go on to be winners will be exited early at break-even. That must be anticipated and accepted as a cost of protecting the small capital base.)
Another area I looked at is the amount of time required for the trading activity. I mentioned that many people are time poor – they cannot spend hours at a screen waiting for a trading opportunity. This is where the grain markets provide some wonderful opportunities. With primary trading sessions of just 3.75 hours there is already a huge advantage over the popular index futures contracts, or currency markets.
Even better, the best trading opportunities in grain markets often occur during the first 30 minutes of the main trading session!
I found that this period (0930 – 1000 US Central Time) provided ample opportunity to meet my goals, especially if I tightened my trading timeframe by using 1-minute trading charts.
In summary, I am now ready to begin the project again.
I have a clear plan based on executing the techniques described in my book.
I must risk more per trade than the 1.5% that I am comfortable with. I will cap it at 3%.
To keep the equity curve as smooth as possible, I have modified the trade management strategy to exit some trades at break-even.
I will trade one minute charts, speeding things up considerably and putting an even greater emphasis on implementation excellence (no mistakes!).
I will confine trading to the opening 30 minutes each day, but not limit myself to one trade per day. In other words, if two valid setups occur within the 30 minute window, I will trade both.
I plan to monitor slippage costs. If they eat to far into profits, I am prepared to use a modified entry technique to eliminate slippage at the entry, accepting that this will cause me to miss some trades.
This project is all about capital growth, so I will not draw any profits from the account until the target is reached.
The account is funded and I am starting the project at once. Not without trepidation, I might add, having been burnt once and fully realising the fragility of the tiny account in a high octane market. But the trading plan is good and hopefully my execution will be up to standard. Whatever the outcome, I will record real-life results in my trading diary, as well as my usual comments on various aspects of the trading process.
[January, 2010: Please note the above project was put on hold while I developed TradeOnAuto software, but is being restarted in February, 2010, with some modifications. Check this post.]
