Chapter 19
Developing Strategies Now to Avoid Pain Later
In This Chapter
Choosing what to trade and understanding how to trade it
Keeping those profits coming
Checking and practicing trading strategies
Timing your markets for entry and exit points
Checking your trade results and adjusting for success
A solid trading plan consists of developing a broad understanding of what you’ll be trading, getting a handle on your emotions, finding out about different strategies, and tempering your expectations of and interactions with the market. It also takes in the more methodical nuts and bolts of actually putting together a step-by-step detailed plan in which you microscopically map out your strategies and rules.
In this chapter, I give you the background needed to create a more specific trading plan than you ever imagined.
Deciding What You’ll Trade
I have no secret here, no magic rules or revelations. I can tell you only that you need to trade what you like and use what you already know to your advantage as much as possible. So when preparing a trading plan, take the following into account:
Use your experience. Use what you know to focus on areas in which you’re already an expert, but trade what feels right and what you have success in.
Get specific and get good by applying and refining your knowledge. It’s great to be a one-trick pony. Of all the currencies, I prefer the euro/dollar pairing. I find that for me, it makes sense for two reasons:
• European monetary policy moves at the pace of molasses, and the European economy usually is slow-moving at best. In other words, the news from Europe is less likely to move the markets directly. Instead, the euro is a reactionary currency that tends to move in a slow, steady, one-directional trend, as opposed to other currencies that can be more volatile, such as the Japanese yen, the Swiss franc, and the British pound.
• The dollar, despite the rise of China and other emerging markets, is still the world’s reserve currency. The United States still has the most transparent markets and the most reliable economic data and communications infrastructure.
Study the markets. See which ones appeal to you the most and make the most sense. If you enjoy trading stocks, you may do well with stock-index futures. If you like a particular sector, such as energy, try a few paper trades (practicing without money) with oil, natural gas, heating oil, or gasoline.
If you’re a political junkie like me, the bond and currency markets may suit you well because they’re the markets that move the most with politics and world crises.
If you’re in real estate and construction, consider copper and bond futures. Interest rates are the fuel for mortgage rates, while copper is one of the key building materials in home building. If you know one city or region’s real-estate market well enough, consider trading futures for that market. Real-estate futures and housing futures are now available also, but may take some time to become mainstream trading vehicles for the public.
If you own a gas station, you probably have a good understanding of supply and demand in the energy markets.
If you work in produce, you may have a leg up in grains and seeds.
Remain flexible. If you discover that you have a penchant for trading well in the soybean markets, even though you’re not in the business and you never knew anything about it before, add soybeans to your trading arsenal.
Adapting to the Markets
A major part of your trading success is your ability to adapt. Even if you’re a specialist trading primarily one or two markets, you still encounter periods when those markets trade in difficult patterns.
The major point to understand is that no plan works for all situations. However, you can rely on these realities of the markets. They trade in threes:
Three market directions: Up, down, or sideways
Three trading styles: Trading the reversal, momentum trading, and swing trading
You need to be familiar with the three major trading directions and styles. I cover these in the following sections.
Trading the reversal
When trading the reversal, you’re looking for the market’s turning point, when either a bottom or a top is being made. To find that turning point, you need to keep an eye on the current trend and watch for a significant trend change.
Use moving averages, trend lines, and oscillators to predict and pinpoint as precisely as possible the meaningful trend changes. I describe how to use these indicators in Chapter 7, which is about technical analysis, and in the numerous examples of individual trades throughout this book.
Set your entry points just above the breakout if you’re going long, and below the trend breakdown (a switch by the market to a downtrend) if you’re going short. See Chapters 7, 8, and 20 for more trading tips. Use a sell stop for long trades and a buy stop to cover your shorts when you’re betting on a breakdown.
Trading with momentum
Trading with the trend or with the momentum of the market is a classic style of participating in the markets. In fact, it’s something that I always recommend you do. It works the same way in uptrends as it does in downtrends. Just keep the following in mind:
If the market is trending up, your position needs to be long. Even if you’re day trading, your primary goal needs to be to look for opportunities to trade when the market is rising.
If the market is falling (trending down), you need to be short.
As with any other trade, protect yourself by using stops. Stops are preset instructions that direct your broker to sell your position when a certain price is reached and keep your losses from expanding beyond control (see Chapters, 7, 8, and 20).
Use the market as your guide in momentum trading. You need to let the market help you make decisions for buying and selling.
When you’re going long, you need to look for breakouts as entry points.
Breakouts are generally signs of market strength.
When you’re going short, you need to look for breakdowns to enter your short position.
Breakdowns are generally signs of market weakness.
Swing trading
Swing trading is the best method for trading in markets in which prices are moving sideways, neither going up nor down. For more information about swing trading, see Chapter 8.
Managing Profitable Positions
One of the most important aspects of trading is deciding what to do when you’ve earned a nice profit, and you’re getting antsy about cashing in. This situation may occur during the course of a normal market or one that is reaching the irrational exuberance, or blowoff, stage.
You must watch for several important indicators during a blowoff, or in a market that seems unstoppable and experiences short-term corrections. That can mean that sometimes the market sells off in the middle of the day, and buyers are waiting for the market to drop so they can buy at lower prices.
In this kind of market environment, especially when you’ve earned big profits, taking profits is a good idea whenever the market drops for two consecutive days.
On the other hand, if the market opens down significantly without news, take it as a sign that worse things may be coming. And if the market fails to set a new high after a short-term correction, it’s pointing to an important sign that a significant top is developing.
Building yourself a pyramid (Without being a pharaoh)
Futures traders add to profitable positions by pyramiding, or adding more contracts to existing profitable positions. When you pyramid a position, you’re adding to your existing holdings, not selling your holdings and starting a new position. Check out the example at the end of this section, where I detail how to pyramid a position in which your initial buy is ten contracts.
Use a pyramid strategy only during the early stages of a move, such as the breakout and subsequent early stages of the breakout. If you try it when the market has been moving in one direction for a long time, you’re likely to lose money.
Preventing good profits from turning into losses
When you trade and the market turns on you quickly, you obviously have to get out with whatever you have left. But when your positions show nice profits, don’t let the market take away your hard-earned gains.
Stay on top of your profits by setting protective sell stops as the market moves. For more details about stops, see the previous section and Chapters 3, 7, 8, and 20. With protective stops, you can (at all costs) make every attempt to at least break even on nice big profits, especially when you’re trading markets that move quickly and can change at the drop of a hat if you’re not paying attention.
For example, say you establish a position in the euro at 8 a.m., the market rallies, and by 11 a.m. you have a nice profit. In the middle of the day while you take a lunch break away from your trading screen (bad idea), news breaks, and the euro tumbles, taking your profit with it. If you had set a (protective) sell stop and had adjusted it higher as your profits accumulated, you would have gotten stopped out with more money than you started.
Never adding to losing positions
When the market goes against you, it’s time to get out. If you average down, or add to positions at lower prices in the futures markets, you’ll get hurt badly.
Back Testing Your Strategies
Back testing is the practice of using historical data to test how well your indicators work in a particular market. Software programs enable you to look at past markets and test how different methods and indicators have worked in the past, but it’s a tricky practice. These capabilities amount to a double-edged sword in a chaotic universe because although your indicators may back test well, you still can get a false sense of security. Similarly, what didn’t work in the past may somehow start working.
In other words, no trades ever work exactly the same way twice, so you have to take your back-testing results with a grain of salt. Back testing can, however, help give you a broad feel for how markets behave under certain conditions and help you spot important characteristics of the market, such as the following:
Seasonal trends: Seasonal trends work best when trading the energy, grain, seed, and livestock markets, because those markets are dependent on well-established planting and harvesting cycles, as well as the demand for energy during summer and winter. In other markets, such as bonds and currencies, seasonality is often less reliable, except during short periods of time. For example, stock prices tend to rise at the end of every month and the first few trading days of a new month, because institutions put new money to work during that time frame.
Market tendencies: The amount of time that a particular market tends to run in a certain direction is a great example. If you look at a long-term chart of the U.S. dollar index, you immediately see that its trend lines tend to last for months to years after they’re established (see Chapter 11).
Indicators: Use your indicators wisely after you confirm their accuracy by back testing them. Get the big picture. For example, if you’re testing a moving average crossover method, remember that the one you’re studying now may not work as well later. However, if your testing shows that moving average crossovers work in the market you’re testing, get a handle on several combinations and then monitor them in the current market to find out which ones work best.
Setting Your Time Frame for Trading
The aspects of trading that are most often mismatched are the trader’s personality and the time frame of the trade. Some people are just more patient than others. To be a good trader, you have to find that delicate balance between your level of patience and the reality of the market. If you try to impose your personality on the market, you’re going to get hurt. At the same time, you have to let your general tendencies guide you toward your trading style.
Day trading
Day trading is a misunderstood and oft maligned term. Day trading is the practice of holding positions open for short periods of time during the trading day with the goal of accruing small, but numerous, profits. Usually it means that you exit all positions at the end of the trading day and return to the market with a fresh slate the next day. What it doesn’t mean is that you trade every day or that you open positions at the open of the trading day no matter what.
When day trading, you still need to keep basic trading principles in mind, such as picking good entry and exit points, placing protective stops, managing your money, and using technical analysis. And you still need to keep an eye on the news and on the overall trends of the markets.
Intermediate-term trading
Traditionally, intermediate-term trading means that you hold a position for several weeks to several months, which ultimately is impractical in the futures markets, where volatility can lead to margin calls and where leverage makes holding positions for extended periods extremely dangerous.
So in the futures markets, intermediate is more likely to mean several days and is more often referred to as position trading, where you use a longer-term time frame as your reference point for keeping a position open.
One way to participate in the overall trend of the futures markets for the intermediate term is to use exchange-traded funds. See Chapter 5 for details.
Long-term trading
Long-term trading is impractical in the futures markets, unless you’re extremely well capitalized, and you’re hedging your business. When that is the case, however, you can use contracts that are several months to even years ahead as your positions as long as you’re mindful of expiration dates and other parameters. ETFs can help here as well because they let you trade the trend without worrying about expiration dates and contract rollovers, such as when you’re trading straight futures. Don’t be fooled, though. ETFs, such as the U.S. Oil Fund (USO) are just as volatile as the market which they mirror. That means that a big loss in oil futures can be a big loss in USO.
Setting Price Targets
Setting price targets is a useful strategy, especially when you’re swing trading, which is where you ease into and out of positions by closely watching a market’s trading range. Setting targets in momentum markets, however, may do more harm than good because you may sell a potentially huge profitable position too soon.
Adapting your strategy to the market’s overall trend is the better approach, but Fibonacci levels and support and resistance levels can help you set targets for taking profits.
Reviewing Your Results
After each trade, finding out why you did well or why you failed is a good idea. Checking your trading data from the time you enter a position to the time you exit it on every single trade can be tedious, but it also can be extremely useful. Here is a fairly good overview of the kinds of information and questions you may want to check and answer after good or bad trades:
Exit and entry points: Review your exit and entry points and then ask yourself whether you adapted the right strategy to the right market and whether you used the best possible method to protect yourself.
Did you give yourself enough room to maneuver? For example, was your sell stop too tight? Should you have given the market more room?
Your charts: Go back and look at the charts you used to make your trade to find out whether the market you were trading is acting similar to the way history shows it has acted in the past. If it isn’t, try to figure out what’s different about the market.
Fundamentals: Did you really understand what the fundamentals of the market were telling you? Did you understand the nuts and bolts of the industry? For example, did you pay attention to the part of the livestock cycle that the market was in when you traded hogs? Or did you check the weather reports before you shorted soybeans?
Market suitability: Are you really suited for trading in a given market? Does it move too fast or too slow for you? If you’re trading currencies, for example, can you handle moves that last for several days and keep your positions open overnight? Or does that frighten you and make you lose sleep? If you lose sleep, you’ll be flat-footed when you wake up, and you’re thus bound to miss something. A 20-minute gap in a chart can be closed in an hour because the bad or good news that moved your currency turned out to be a false alarm, and the market moved briskly beyond (above or below) where it was trading before the news hit.
Technical analysis: Did you let your own personal judgment ruin your trade because you thought you knew better than the charts? Always trade what you see and not what you think you know. You may eventually be right, and then you can trade the other way, but in the present, trade with the charts, follow the market’s response to the news that hit today, and forget what the talking heads are saying.
Market volume and sentiment: Did you consider the market’s volume and the overall sentiment before you bought that top and got stopped out in a hurry? Low volume and high levels of pessimism often mean that a market has bottomed, while huge volume and a feeling of invincibility are the hallmark of a pending top.
Subtleties: Don’t miss the subtle stuff. Did you pay attention to your indicators? Did you look at your RSI and MACD oscillators for signs that the market’s bottom that you missed came on a lower low on the charts but a higher low on the indicator?
Remember Your Successes and Manage Your Failures
When things go well, you need to remember the moment in your gut, your mind, and your being. If you fail, do the same. That way, if you’re ever faced with a similar set of situations, you have a visceral and mental archive that will let you react in the correct manner.
This strategy is tailor-made for trading. For example, when you make a big profit, you need to sear the particulars of that trade into your mind. Try to remember how you did it, what you saw, what you felt, and what decisions you made along the way.
Following your trading plan all the way down to your checklist always is the better approach to trading, because then you already have a road map with which to evaluate your performance.
When managing your failures, avoiding the markets that you just don’t understand is best. For example, I don’t trade gold. It just doesn’t work for me, so I manage it by avoiding it.
In the rare instances when I do consider trading gold stocks or other gold-related instruments, I always ask myself really tough questions, such as whether I can stand the lack of sleep. The result: I rarely trade gold.
Making the Right Adjustments
After evaluating your successes and your failures, you can make changes that keep you out of trouble by
Avoiding markets that you don’t understand or that make you uncomfortable.
Not adding to positions without planning your strategy before pulling the trigger.
Having your road map ready and not deviating from it unless you’ve previously decided how you’ll do it and how far you’re willing to go.
Not making the same mistake twice. If you get nailed in the oil market, don’t trade oil until you’ve figured out why you got hammered.