Chapter 20
Executing Successful Trades
In This Chapter
Preparing to place a trade by observing a full range of details
Planning an entry point to place a trade
Comparing your market’s relationships with others and confirming your plan
Placing the trade and managing your positions
Deciding when to close out your positions
Evaluating your trade so you can benefit from your mistakes.
This chapter is all about putting together the analysis, the execution, and the management of a trade. Although the information throughout this chapter generally is hypothetical, it nevertheless relies on real-life examples of trading. It starts with your pre-trade analysis and then details the actual execution of the trade through a phone conversation with your trading desk, managing the position, and then closing out the trade.
The trade I outline chronologically in this chapter obviously is idealized, but it isn’t meant to be a Pollyanna-like exercise. Instead, it’s an exercise of discovery that uses a real-life example in an active market — the oil market — during a crucial period of time.
Setting the Stage
Here’s the scene: The oil market has been consolidating since October 2007, with prices ranging between $82 and $95. As Figure 20-1 shows, the May contract for crude formed a double bottom between January 11 and February 12, 2008. Note the “W” formation, and also note the clumping of prices around the 20-, 50-, and 200-day moving averages (labeled 20, 50, and 200), as the right portion of the “W” forms.
Figure 20-2, confirms your analysis, as the Bollinger Bands around the 20-day moving average are squeezing the prices. When Bollinger bands squeeze prices and there is consolidation around moving averages or key support or resistance points, such as in these figures, that’s known as compression, and it is usually a prelude to a big move. And that’s when you should start making plans to trade this market. Three scenarios are possible:
A move to the up side is possible, which is an opportunity to go long.
The market might go nowhere, which means that you have to wait some more.
Or the market is about to fall. In this case, the chart clearly shows that the $85 or better area has held at least two times, as marked by the asterisks.
This kind of chart formation suggests that the market is most likely to rise.
Your three major goals are to
Analyze the situation. Combine your knowledge of technical and fundamental analyses with the psychology of a market in a multiyear bull market.
Design a trading strategy. Based on your analyses, you must design a well-crafted, step-by-step, careful plan that either makes you some money or gets you out of the position with as little damage as possible (if you’re wrong or the market turns against you).
Put the plan into action. Make the trade, establish the position, and then manage it as you take the plunge into chaos.
You wake up, get your coffee ready as your computer boots up, and survey the landscape. As you sip coffee while going through your stretching routine, you scan the latest news on CNBC, in the Wall Street Journal, or on Google News or the Dow Jones Newswires. You probably ought to check Reuters and Bloomberg, too. As you scroll through all that information, you have only one goal in mind: watching the different markets as they set up for trading.
What you know for sure is that the date is February 8, 2008, a bull market is raging in oil and has been for several years, and the market is clearly at a critical juncture, because crude oil futures have been consolidating for months and the weekly release of supply data is in about five days — February 13. As you scan the news, you note that there is a big energy conference in Houston next week and that leaks and comments from experts are starting to make the wires.
Most of them are concerned about the effects on the economy of $100 oil, which is still $18 away from the prices you see in electronic trading.
You take another sip of coffee, and scan the markets. The dollar is flat but looking a bit wobbly, and stock-index futures are flat, a couple of days after having gotten hit fairly hard. Bonds are also flat.
That means that you’re focused on oil. It’s the one market that looks ready to jump and it’s the one that suits your style and the one where you’ve had your share of success.
Getting the Big Picture
As you pour yourself another cup of coffee and grab a roll, you realize that you have some time before heavy trading in crude oil gets going in a couple of hours, but you note that the price has steadily crept higher in the overnight markets. Aside from the news on the upcoming conference in Houston, there is little going on at first glance.
Then the news hits about Exxon Mobil winning a court battle against Venezuela and the price starts to move. Exxon got a court in London to freeze $12 billion worth of assets of Venezuela’s state-owned oil company, PDVSA, and the Venezuelan government started making threats about halting oil sales to Exxon. The markets needed a spark, and this seemed to be it.
Viewing the long-term picture of the market
You review your one year chart of crude oil, and the RSI indicator (Figure 20-2). See Chapters 8 and 13 for more about the RSI oscillator.
A perfect example is shown in Figure 20-2. A look at RSI is very encouraging, as it is confirming the “W” bottom on the price. More important, the second bottom in the RSI is higher than the first one, which shows that the selling on the second “V” of the “W” was not as strong as the first “V.” This is often an indication that sellers were exhausted during the second bout of selling in “W” formation.
You’re all set now. You have the background from which you’ll approach your trade. Until proven otherwise, a bottom is in place and this market has to played from the long side.
Doing a little technical analysis
Check out the technical status of the oil market by
Examining the long-term trend: The crude-oil contract are consolidating just below the 20-, 50-, and 200-day moving averages. The long- and intermediate-term trends clearly are moving sideways, but look ready to turn up. You want to be there when they do. (See Chapter 7 for more about market trends and support.)
Watching the behavior of the market in relationship to the Bollinger bands: During this consolidation the Bollinger bands — both upper and lower — have served as support and resistance for crude oil (see Figure 20-2). Notice that every time oil prices tag one or the other of the bands, the result usually and eventually leads to a reversal and a tag of the opposite band. Most recently, though, the price of crude came off of the bottom band. This is another clue that a move up is likely.
Noticing that the 20-day moving average also provided fairly good resistance during the recent rally attempt in crude. You want to make sure that prices stay above that key level before making your move.
Analyzing what the price does above the 50 and 200 day averages: Figure 20-1, shows all three averages. You decide that you want to make sure that you don’t get whipsawed, so you’ll put your initial buy point above the 200-day line, at 91.55, just above the 200-day line.
Stalking the Setup
You’re now waiting for the setup, or a key set of developments that need to come together almost simultaneously before you pull the trigger and make the trade.
As you wait for these circumstances to occur, run through the following checklist to get ready for the trade:
Check the status of your account.
Review the key characteristics of your contract.
Fine-tune your strategy.
Review your plan of attack.
Checking your account
Always know how much money you have in your account. You can check your account status online. Say, for example, that you have $100,000 worth of equity. Your margin check shows that you need an initial margin of $7,763 per May contract and a maintenance margin of $5,750. See Chapters 3 and 4 for details about margins.
You have $100,000 of equity in your account. By consulting the margin requirements for the May contract for crude oil, you quickly calculate that you have enough in your account for going long on one or two contracts because the margin is $7,763 × 2 = $15,526. Your rule is that you don’t want to risk more than 10 percent equity in any one trade, but given the margins, and your analysis, you may want to risk an extra 5 percent in this one. In order to follow your rules closely, though, you decide to only buy one contract during your initial purchase. Let your experience and risk tolerance guide your decision.
You want to figure in how much to limit your losses to, so you have $2,013 per contract that you can play with before you start getting worried about a margin call ($7,763 – $5,750).
|
Figure 20-1: Crude oil, moving averages, and buy points. |
|
Reviewing key characteristics of your contract
As you formulate this trade, reviewing the characteristics of the crude-oil futures contract is a good idea. A barrel of oil holds 42 gallons and trades in U.S. dollars per barrel worldwide. The minimum tick of $0.01 (1 cent) is equal to $10 per contract. A single futures contract for light, sweet crude oil is in the amount of 1,000 barrels, or 42,000 gallons of oil.
That means that each penny you gain or lose is $10 worth of gain or loss in the contract, so you figure that $1 in price movement in crude oil is $1,000 worth of gain or loss.
You have $100,000 worth of equity in your account, so you have a good cushion. But you’ll get a margin call if your equity drops a little over $2,000. That means that you’ll have to work out your sell stop to be somewhere in between those two numbers. You decide that placing your sell stop just above where the margin call would get you is a good idea, so you settle on the initial stop being at $89.05. The margin call would be at $88.53.
See Chapter 17 for the details about trading plan and money-management rules. You need to follow the rules you establish, or else you’ll eventually get into trouble.
Regular open-cry trading hours at the NYMEX are from 10 a.m. to 2:30 p.m. (14:30) eastern time. After-hours futures trading takes place electronically via NYMEX ACCESS, an Internet-based trading platform, beginning at 3:15 p.m. Monday through Thursday and concluding at 9:50 a.m. the following day. On Sundays, the session begins at 6 p.m.
Reviewing your plan of attack
After you come up with a plan, review it just to be on the safe side.
Here’s what you’ve accomplished:
You were attracted to the oil market (the right one for you) because it’s where the action is. You understand the oil market, so it’s okay to trade it.
You’ve figured out the technical side of the trade, and you’ve identified the catalyst for the trade, the news of Venezuela’s spat with Exxon Mobil.
You’ve waited patiently for the right setup.
You’ve calculated your risk, and you’ve decided on your entry point and your sell-stop placement.
|
Figure 20-2: A 30-minute chart for crude oil for Aug. 17–19, 2005, zooms in on the action shown in less detail on longer-term charts like Figure 20-1. |
|
Jumping on the Wild Beast: Calling In Your Order
As more traders come in, you see that the action is heating up, so you decide to make your trade because the price is moving swiftly toward your entry point of 90.55.
You have good trading software, but you decide to call your broker because she’s been good about giving you good fills, and the guys at the trading desk are good at making sure that you, as a fairly young trader, get the kind of order that you want executed.
1. Say who you are.
“This is Tom Smith.”
2. Say what kind of order you’re placing.
“This is a futures order.”
3. Give your account number.
“My account number is 8648642.”
4. In a clear voice, say what you want done.
Buy one October crude oil, $89.05 stop.
5. Ask for a reading of your order before you agree to have it sent to the floor.
The desk usually does this automatically, but it doesn’t hurt to remind the person with whom you’re working that you need confirmation.
If for any reason you’re unsure about your order or unsure whether the desk understood it, make sure that you either cancel it or confirm that the trading desk person knows exactly what you want to do.
You just told the trading desk that you wanted to buy one October crude oil contract at the market price and that you wanted to place a sell stop at $89.05. The desk reads the order back to you, and you agree. The order then gets transmitted to the trading floor, and the desk informs you that you’re filled at $90.75 and gives you your order number.
Riding the Storm
As the day progresses, the market continues to move and it closes at $91.62.
You have some gains after all that waiting — hurrah! And you’re still protected by your stop. Now, you raise your stop to $89.92, just slightly below the gains you made,. As the regular trading close nears, the market is rallying even more, so you raise your stop to $65, and you’re nicely ahead now, with a guaranteed paper profit of $870 per contract if your stop gets hit without a major catastrophe that knocks prices below your sell stop in a gap. A good rule of thumb in a market that is moving rapidly is to raise your stop by 50 cents for every 50-cent rise in the market. If you make more than 50 cents, you can raise your stop more. Although I’m giving you guidelines here, the more you trade and the more you become familiar with the way each individual market trades, the more likely you’ll develop your own guidelines. The message here is that as the market rises, you need to raise your sell stop to lock in gains.
Now you have a decision to make. Your overall profit is $870 at the close on a Friday. Your options prior to the close are
Selling your contract and reentering the market on Monday: This strategy makes sense because you never know what’s going to happen over the weekend.
Tightening your stops: This strategy can get you stopped out of the market, which means that your sell stop is triggered, your position is closed, and you’re out of the market. That would be good if the market crashed or lost ground, and it may cost you some money if you no longer have a position and the market rallies again. Remember, you want to let your profits run.
Knowing If You’ve Had Enough
Presented with the two trading options in the preceding section, I’d choose to leave the position open and see what happens during the weekend. I’m a cautious trader, and I don’t like leaving large positions open during the weekend. But, the rally was very strong, and the Exxon news looked as if it had legs.
By managing my sell stop, I’d accomplish two things. First, I would have locked in my profits on a good trade, and second, I’d leave myself with a reasonable and tolerable risk over the weekend, with the potential to gain more.
By February 19, prices had moved nicely and the price of crude was getting close to $100, a price area that would likely lead to volatility, given the inevitable hype from the media.
On that day, as the price of crude jumped over $4 by the close, there was plenty of opportunity to sell. If you sold somewhere above $99, say $99.25 you bagged $8.50 in profits, or $8,500 minus commissions per contract.
Reviewing Your Trade
After your trade is completed, you need to review what you did right and what you did wrong. One way to conduct such a review is to answer these questions:
Was this market the right one for me to trade? If you understood the fundamentals and you knew that the action was here, then you traded the right market.
Should you have bought into this market sooner? More than likely your answer is no. By waiting for the right setup, and managing your sell stops, you had a fantastic trade.
Did you risk the right amount? You followed your own rules by risking no more than 10 percent of your total equity in one market, and you used the right amount of protection as you set your stops. Best of all, you profited.
Were you patient enough? Yes, indeed. You didn’t jump into the market until you were convinced that the odds of a bounce back to the top of the range were on your side. Then you waited until the trend was clearly established before adding to your position, and you raised your stops at a steady and patient pace.
Mastering the Right Lessons
The trade outlined in this chapter probably is a good prototype for a beginning trader. I tried to make it easy to relate to and used easy-to-follow indicators.
This example is as much about approach as it is about the tools traders use. You can make trading as simple or as sophisticated as you want, but in the end, the only thing that counts is whether you make or lose money by using those tools.
Other books may offer different approaches, and as you gain more and more trading experience, you’ll develop your own methods. Nevertheless, at the end of the day, trading is all about knowing your market, setting up your strategy, being patient, executing your trading plan, managing your position properly through vigilance, and following your strategy as well as the market will enable you to.
Finally, remember that a two- or three-day time frame in the futures markets can be a profitable time if you understand how to trade for short periods of time and how to use technical analysis.