Your assignment for this lesson is to go to Henry Carstens’ Vertical Solutions site (www.verticalsolutions.com/tools.html) and check out his two forecaster tools, using your own trading data as inputs. His first tool will show you how the path of your returns will vary as a function of changes in volatility. These volatility shifts could be attributable to market changes or to your taking more risk in each of your trades. You’ll see clearly how much drawdown is associated with a given level of volatility, which will help you gauge your own tolerance.

The second forecaster tool asks you to input the average size of your winning trade, your average ratio of winning to losing trades, and the ratio of the size of your average winners to losers. Run the forecaster many times with your data and you’ll see a variety of plausible sets of returns. This will give you a good sense for the expectable runs (to the upside and downside) in your trading, as well as the expectable returns over a 100-trade sequence.

Finally, tweak the parameters from the second forecaster to simulate the paths of possible returns if your average winning trade shrinks (maybe due to slow markets) or if your ratio of winning to losing trades declines (perhaps because of misreading markets). Tweak the ratio of the size of your average winners and losers to see what happens to your returns if you lose discipline and hold losers too long or cut losers short, creating poor risk/reward per trade.

All of these what-if scenarios will give you a good sense for what you can expect from your trading. It is much easier to deal with business adversity if you’ve planned for it in advance. When you’re coaching yourself, the more you know about your trading business, the better you’ll be able to make it grow.

COACHING CUE

An important element of success in building a trading career is being able to identify periods of underperformance as quickly as possible, before they create large drawdowns. The more you know about your trading—the average sizes and durations of drawdowns and the variability around those averages—the better prepared you’ll be to identify departures from those norms. Keep statistics on your trading so you can also highlight periods in which you’re trading particularly well and learn from these episodes. The single most important step you can take to further your trading performance is to keep detailed metrics on your trading. These steps will highlight what you’re doing right and wrong, informing your self-coaching efforts.

LESSON 73: DIVERSIFY YOUR TRADING BUSINESS

Suppose you have a passion for coffee and decide to start your own coffee-house as a business. You develop reliable sources for high quality beans, purchase a roaster, and rent space in a well-trafficked area. You furnish the cafe’ attractively and purchase all the cups, saucers, and utensils you will need. Altogether you sink $100,000 into your new enterprise, which is loaned from a bank with your home as collateral. Your average cost to serve a cup of coffee, just based on materials and labor expenses alone, is 50 cents. At $1.50 per cup, you’re making a dollar for each cup you sell. At 300 customers per day, that’s $300 per day or about $90,000 per year. That doesn’t leave you with much to take as a salary once you pay off your overhead.

In this scenario, you can only make a go of the business by increasing the number of customers coming to the cafe’, by increasing the average expenditure per customer, or both. So let’s say you try to increase the average check size per customer by adding something additional to the menu. In addition to coffee, you now also serve tea.

Unfortunately, this doesn’t help your business greatly. A few more customers enter the cafe’ who are tea drinkers, but few customers order both coffee and tea. As a result, you’ve increased your overhead (for tea equipment and supplies), but haven’t greatly added to the bottom line. Tea overlaps coffee too much to add much to the menu; it doesn’t really diversify the offerings of your cafe’.

Suppose, however, you add pastries to the menu, sourcing them from a local bakery. Now you find that many people interested in your coffee also like a pastry to go with their drinks; this increases the size of their checks and enables you to make profits from two sources instead of one: the beverage and the pastry. You also now attract people who are interested in a snack or who just want a bite to eat after a concert or theater. The increased traffic also adds to the bottom line.

What has happened is that you’ve made your business more diversified . You have multiple profit centers, not just one. If you offered evening entertainment, sandwiches, and breakfast items, you would be even more diversified. Instead of attracting 300 patrons per day at one dollar each, you might attract 800 a day at $2.50 each. With $2,000 a day of gross income after labor and materials costs, you now have the basis for a thriving business. Moreover, should a cafe’ open elsewhere in the neighborhood, your business will be protected because of its other unique offerings.

Diversification leverages talent.

The same business principles that impact the viability of the cafe’ apply to trading. When you trade different markets, time frames, and patterns, you generate multiple potential profit sources. This protects you when markets shift and place any single idea or pattern into drawdown mode. It also leverages your trading productivity, as you now can generate profits from many centers instead of a very few.

There are many ways of diversifying your trading business. If you are an intraday trader, you’ll be diversified by trading long and short and by allocating your trades to different stock names and/or sectors. You may also hold some positions overnight, creating a degree of diversification by time frame as well. If you are trading over a longer time frame, you may trade different markets or strategies, each with different holding periods.

The key, for the trader as well as the cafe’, is to make sure that diversification truly adds diversity. Adding tea to a coffee menu did not achieve adequate diversification for the cafe’. Adding a Dow trade to an S&P 500 trade similarly fails to add unique value. Your diversification should provide a truly independent and reliable income stream. When the coffee business is slow, for example, customers may come to the cafe’ for a bite to eat. This keeps the flow of customers strong through the day. Similarly, when one of your trading strategies is drawing down, other ones that are not correlated can sustain the flow of profits to your account.

Of course, when you diversify, you need to make sure you stay within your range of expertise. Adding fresh entre’es to a menu would make little sense for a cafe’ owner who lacked cooking skills. Similarly, it doesn’t help your profitability as a trader to add strategies that are not well tested and known to be successful. Diversification only makes sense when it adds unique value to what you’re already doing.

Many beginning traders think they’ll find a way of trading that is profitable and then trade that for a career. Rarely are markets so accommodating. If a cafe’ brings in a huge number of customers, you can be sure competitors will soon follow. If a trading strategy is successful, it will find wide interest. Successful businesses must always innovate, staying ahead of the competitive curve. Adding new sources of revenue to exploit changing markets is essential to long-term survival.

I cannot emphasize this strongly enough: markets change. Edges in markets disappear. Trends change. The participants in markets change. The themes that drive markets change. The levels of volatility and risk in markets change. I have heard many promoters hype trading methods that they claim are successful in all markets, but I have yet to see documentation of such success. Every trader I have known who has sustained a long, successful career has evolved over time, just as successful businesses evolve with changing consumer tastes and economic conditions. Quite a few traders I’ve known who have been successful with a single method have failed to sustain that success when that strategy no longer fit market conditions (momentum trading of tech stocks in the late 1990s) or when it became so overcrowded that the edge disappeared (scalping ticks on the S&P 500 index by reading and gaming order flow). It’s difficult to learn how to trade; even harder to unlearn old ways and cultivate new ones.

The successful trading business, like elite technology, pharmaceutical, consumer, and manufacturing firms, devote significant resources to research and development: staying ahead of their markets.

When you are your own trading coach, it’s not enough to learn markets. You’re an entrepreneur; you’re always developing new strategies, new ways of building upon your strengths. What products do you have in your pipeline? What markets, strategies, or time frames are you looking to expand to? You can adapt your current trading approaches to new markets or cultivate new strategies for familiar markets. Your challenge is to develop a pipeline: to always be innovating, always searching for new sources of profit that capitalize on what you do best.

Many traders sit down at their stations a little before markets open, trade through the day, and then go home, repeating the process day after day. That schedule is like coming to work at your cafe’, putting in your hours, and then going home until the next workday. That is what you do if you’re the employee of the business, not the owner. Your challenge, as your own coach, is to actively own and manage your trading business, not just put in hours in front of a screen. You need an edge to succeed at trading, but you need to develop fresh sources of edge to sustain your trading business.

COACHING CUE

I find there is value in learning trading skills at time frames different from your own. Short-term, intraday traders can benefit from looking at larger market themes that move the markets day to day, including intermarket relationships and correlations among stock sectors. If you identify those themes and relationships you can catch market trends as they emerge. Conversely, I find it helpful for longer-term traders, portfolio managers, and investors to learn the market timing perspectives of the short-term trader. This process aids execution, helping traders enter—and add to positions—at good prices. The views from different time frames can fertilize the search for new sources of edge: the perspectives of big-picture macro investors and laser-focused market makers can add value to one another.

LESSON 74: TRACK YOUR TRADING RESULTS

You cannot coach your trading to success if you do not keep score. Keeping score is more than tracking your profits and losses for the day, week, or year. It means knowing how you’re performing and how this compares with your normal performance.

Score keeping makes sense if you once again think of your trading as a business. A sophisticated retail clothing firm tracks sales closely every week. Retailers know not only how much they’ve sold in total, but how much of each product. Perhaps the economy is slow, so women’s accessories—which are lower-priced—are hot, but high-priced clothing is not. The company that tracks these trends regularly will be in the best position to shift their product mix and maximize profits. Similarly, if one store is dramatically underperforming its peers despite a favorable location, managers can use that information to see what might be going wrong at the store and make corrections.

Score keeping in the business world can be extremely detailed. There are good reasons for the investments in information systems that we observe among the world’s most successful corporations. Firms may track sales by hour of the day to help them determine when to open and close. Purchasing patterns based on gender and age are factored into advertising messages and promotional campaigns. Score keeping provides the business with knowledge; in the business world, knowledge utilized properly is power.

You can’t properly manage your business if you don’t understand what it is doing right and wrong.

Nowhere do we see this power more dramatically than in quality control. Firms such as Toyota collect reams of data on their manufacturing processes to help them identify lapses in quality, but also to make continuous improvements in manufacturing processes. If you don’t collect the data, you can’t establish the benchmarks that enable you to track progress. It’s not just about ensuring that you do well; the best businesses are driven to do better.

When you keep score in your trading business, a few metrics are absolutely essential. These include:

• Your equity curve, tracking changes in portfolio value over time.

• Your number of winning versus losing trades.

• The average size of your winning trades and the average size of your losers.

• Your average win/loss per trade.

• The variability of your daily returns.

Let’s take a look at each metric in a bit of detail.

Equity Curve

Here you’re interested in the slope of your returns and changes in the slope. As we saw with Henry Carstens’ tools that simulate trading returns, a great deal of directional change in your portfolio can be attributed to chance. For that reason, you don’t want to overreact to every squiggle in your equity curve, abandoning hard-won experience. Too many traders jump from one promised Holy Grail to another, shifting whenever they draw down. A far more promising framework for your self-coaching is to know the equity curve variation that is typical of your past trading, so that you can compare yourself against your own norms. If you have learned trading properly, you will have a historical curve of your returns from simulation trading and small-size trading before you begin trading as an income-generating business. When your current equity curve varies meaningfully from your historical performance, that’s when you know you may need to make adjustments. If the variation is in a positive, profitable direction, you’ll want to isolate what is working for you so that you can take full advantage. If the variation is creating outsized losses, you may need to cut your risk (reduce the size of your trades) and diagnose the problems.

Knowing your normal performance is invaluable in identifying those periods when returns are significantly subnormal.

Winning Versus Losing Trades

This is a basic metric of how well you’re reading markets. Again, the emphasis is not on hitting a particular number, but on comparing your current performance to your historical norms. Let’s say, for instance, you’re a trend follower. You tend to make money on only 40 percent of your trades, but you ride those winners for relatively large gains compared to your losers. If your win percentage suddenly drops to 25 percent, you’ll want to diagnose possible problems. Has your market turned choppy and directionless? Have you altered the way in which you’re entering trades or managing them? The more the drop to 25 percent is atypical of your historical trading, the more you’ll want to enter a diagnostic mode. If, however, you’ve had past periods of 25 percent winners just as a function of slow, directionless markets, you may choose to ride things out without making major changes in your trading simply by focusing on markets or times of day with greater opportunity.

Average Sizes of Winning and Losing Trades

It doesn’t help to have 60 percent winning trades if the average size of your losers is twice that of your winners. Keeping score of the average sizes of winners and losers will tell you a great deal about your execution of trade ideas—whether you’re entering at points that provide you with favorable returns relative to the heat that you’re taking. The data will also tell you how well you’re sticking to your risk management discipline, particularly stop-losses. If your average win size and loss size are expanding or contracting at the same time, you may simply be dealing with greater or lesser market volatility (or you may be sizing your positions larger or smaller). It is the relative shifts in size of average wins and losses that are most important for managing your business. If your winners are increasing in average size and your losers are decreasing, you’re obviously trading quite well. It will be important to identify what you’re doing right so that you can be consistent with it. Conversely, when losers are increasing in average size and winners are not, you want to figure out where the problem lies. Are you reading markets wrong, executing and managing trades poorly, or both?

Average Win/Loss Per Trade

Suppose you make a particular amount of money in January and the same amount in February. You might be tempted to conclude that you traded equally well in the two months. That would be a mistake, however. If you had placed 50 trades in the first month and 100 in the second month, then you can see that more trading did not produce more profit. Your average profit per trade actually declined. This suggests that at least some of your trading is not providing good returns, and that bears investigation. The situation is similar to that of a business that opens five new stores in a year, but reports the same sales volume year over year. The average sales per store have actually declined, an important factor masked by the increase in overall activity. Average win/loss per trade will vary with your position sizing and with overall market volatility. Be alert for occasions in which market volatility may increase, but your average win per trade goes down: you may not be trading as well in shifting market conditions. Many times, traders make as much or more money if they simply focus on their best ideas and reduce their total number of trades. This selectivity shows up as a soaring average win per trade. It’s a great measure of the efficiency of your trading efforts.

When you trade more often, make sure that the incremental trades are adding economic value.

Variability of Daily Returns

If you take your wins and losses for each day and convert those to absolute values, you’ll then have a distribution of your returns. You’ll see how much your equity curve moves per day on average. You’ll also observe the variation around this average: the range of daily swings that is typical for your trading. The variation in your daily returns will ultimately shape the size of drawdowns you experience in your portfolio. Given that you’re going to experience runs of losing days over your career, you’ll have larger drawdowns when those runs are 2 percent each than if they’re ½ percent. Indeed, if you investigate the losing periods that are historically typical of your trading, you can use these to calibrate the daily variability you want to tolerate in your trading. This is central to risk management. If you want to keep total drawdowns in your portfolio to less than 10 percent, for example, you cannot risk average daily swings of 2 percent. Of course, if you’re keeping drawdowns to less than 10 percent, you also cannot expect to be making 50 percent or more per year: risk and reward will be proportional. By calibrating the average swing in your portfolio per day, you target both overall risk and reward. If you’re trading very well (i.e., very profitably) with a relatively low variation in your portfolio size from day to day, you can probably afford to gradually pick up your risk (increase trade size to generate larger returns). If you’re trading poorly and losing money beyond your norms, you may want to reduce your daily variation and cut your risk.

What all of this means is that, when you’re your own trading coach, you are also your own scorekeeper. The metrics above are, in my estimation, an essential part of the journals of any serious trader. The more you know about how you’re doing, the more prepared you’ll be to expand on your strengths and address your vulnerabilities.

COACHING CUE

See David Adler’s lesson in Chapter 9 for additional perspectives on trader metrics. A particular focus that is helpful is to examine what happens to your trades after your entry and what happens to them following your exit. Knowing the average heat that you take on winning trades helps you gauge your execution skill; knowing the average move in your favor following your exit enables you to track the value of your exit criteria. Sometimes the most important data don’t show up on a P/L summary: how much money you left on the table by not patiently waiting for a good entry price or by exiting a move precipitously.

LESSON 75: ADVANCED SCOREKEEPING FOR YOUR TRADING BUSINESS

After the last lesson, you may be feeling overwhelmed by the data you need to keep to truly track and understand your trading business. I’m sorry to inform you that such items as equity curve, average numbers of winning/losing trades, and average size of winning/losing trades are just a start to serious scorekeeping. Professional traders at many firms obtain much more information than that about their performance. Access to dedicated risk-management resources is one of the great advantages of working in such firms. Although it is unlikely that you could duplicate the output of a dedicated risk manager, it is possible to drill down further into your trading to uncover patterns that will aid your self-coaching.

In this lesson, we’ll focus on one specific advanced application of metrics that can greatly enhance your efforts at performance improvement: tracking results across your markets and/or types of trades. This tracking will tell you, not only how well you’re doing, but also which trading is most contributing to and limiting your results.

Of the different types of trades that you place, which most contribute to your profits? These are the drivers of your trading business success.

We’ve already seen how important it is for your trading to be diversified. Among the forms of diversification commonly found are:

• Trading different instruments, such as individual stocks versus index ETFs.

• Trading different markets, such as crude oil futures and stock indexes.

• Trading different setups, such as event trades and breakout trades.

• Trading different times of day and/or different time frames.

To truly understand your trading business, you want to tag each of your trades by the type of trade it represents. You will thus segregate trades based on the criteria above. All your overnight trades, for instance, will go in one bin; all your day trades in another. All our stock index trades will fall into one category; all our fixed income trades in another. If you’re a day trader, you may want to segregate trades by time of day, by sector traded, or even by stock name.

Each of these categories is a product in your trading business. Each category is a potential profit center. When you think of your trading as a diversified business, you want to know how each of your products is contributing to your bottom line. Simply looking at your bottom line will mask important differences in results among your trades.

In practice this means that the metrics discussed in the last section—equity curve; proportion of winning/losing trades; average size of winning /losing trades; win/loss per trade; and variability of returns—should be broken down for each portion of your trading business. My own trading, for example, consists of three kinds of trades: intraday trades with planned holding times of less than an hour; intraday swing trades with planned holding times of greater than an hour; and overnight trades. The short intraday trades are based on short-term patterns of price, volume, and sentiment. The swing trades are trend following and are based on historical research that gauges the odds of taking out price levels derived from the prior day’s pivot points. The overnight trades are also trend following and are based on longer-term historical research that shows a directional edge to markets. These trades comprise different kinds of trades, because they are based on different rationales and involve different positioning in the markets. For instance, I can take a short-term intraday trade to the long side, but short the market for an overnight trade that same day.

You can identify the inventory of your trading business by segregating trades based on what you’re trading and how you’re trading it.

For other traders, the division of the trading business will be by asset class (rates trading versus currency trades versus equity trades) or by trading strategy/setup (trades based on news items; trades based on opening gaps; trades based on relative sector strength). Relatively early in my trading career, I broke my trades down by time of day and found very different metrics associated with morning, midday, and afternoon trades. That finding was instrumental in focusing my trading on the morning hours. In other words, the divisions of your trades should reflect anticipated differences in your income streams. If the returns from the trading strategies or approaches are likely to be independent of one another, they will deserve their own bin for analysis by metrics.

One of the breakdowns I’ve found most helpful in my trading is based on tagging the market conditions at the time of entry. To accomplish this, you would tag each trade based on whether it was placed in an upward trending market, a downward trending market, or a nontrending market. You will want to be consistent in how you identify market conditions; my own breakdowns (because I trade short-term) were simply based on how the current market session was trading relative to the previous one. It is common that traders will perform better in some market environments than others. For instance, based on a different breakdown, I learned that I was most profitable in moderate volatility markets, as tagged by the VIX index at the time of entry. When markets were relatively nonvolatile or highly volatile, my returns were significantly reduced. This was useful to me in knowing when and where to take risk.

Your trading business is most likely to succeed if you play to your strengths and work around your weaknesses.

What you’ll find by breaking your trading down in this fashion is areas of relative strength and weakness in your performance. You will have a historical database of the normal trading in each area of your trading business, and you will have a way to see how your current trading compares with those norms. Thus, for example, you might make money overall, but your event-based trades (those based on fast entries after news items and economic reports) perform much better than your trend-following trades. This may say something about the market you’re in and how you want to be trading that market by focusing more on what’s working than what is not. Similarly, you may find that your average numbers of winners versus losers is fine overall, but lagging in one particular market. This could lead you to fine tune what you’re doing in that market.

The goal of keeping score is to identify your own patterns and use those patterns to your advantage.

When you are coaching yourself, I encourage you to think of yourself as a collection of different trading systems. Each system—each market or strategy that you trade—contributes to the overall performance of your portfolio. Your job is to track the results of each system, see when each is performing well, and determine when each is underperforming. Armed with that information, you can thus allocate your capital most effectively to the systems that are working rather than those that are not. Diversification can’t work for you if you are not diversified in how you view and work on your trading performance. Just as a football coach breaks down his team’s performance into segments—running, kicking, defense against the run, defense against the pass, throwing—and works on each, you want to analyze and refine your team of strategies. Many a drawdown can be avoided if you stay on top of each segment of your trading business.

COACHING CUE

When you add to positions or scale out of them, how much value does your management of the trade provide? What is the performance specific to the pieces that you add to positions? How much money do you save or leave on the table by removing pieces from your positions? If you hedge your positions, how much do you gain or save through those strategies? Are you better trading from the long or short side? Do you perform better when trades are entered at certain times of day or held for particular time frames? If you drill down with metrics you can become specific when you work on various facets of your trading performance.

LESSON 76: TRACK THE CORRELATIONS OF YOUR RETURNS

A department store is an example of a diversified business. The store sells a variety of goods, so it attracts a wide range of customers. If consumers aren’t buying seasonal items, they may come in to shop for clothes or housewares. The departments that offer products for children, teens, men, and women ensure that there will be a mix among customers, evening out peaks and valleys in traffic patterns for any of these individual groups.

In your trading business, diversification provides you with multiple profit centers. You can make money from intraday stock index trades and longer-term moves in the bond market, for example. If you divide your capital among different ideas and strategies, you smooth out your equity curve, much as the presence of many departments keeps traffic flowing to the department store. When any one or two strategies fail to produce good returns, others contribute to the bottom line.

Diversification in your trading enables you to stay afloat when any one of your strategies stops working for a while or becomes obsolete.

But how do you know your trading business is truly diversified? Just because you are trading different setups or markets doesn’t mean that you necessarily possess a diversified portfolio. The only way you can ensure true diversification is by tracking the correlations among the returns of your different strategies.

Suppose you are a day trader who trades two basic patterns: moves on earnings news and breakouts from trading ranges. The idea is that your returns would be diversified because you would be long some names (earnings surprises and breakouts to the upside) and short others (earnings surprises and breakouts to the downside). You would also be diversified across market sectors and perhaps even by the time frame of your holdings. If you follow the logic of the previous lesson, you can track performance metrics for your earnings-related trades and your breakout trades. You can also track performance across your long trades and your shorts.

When you track the correlation of your returns, you take the analysis a step further. You calculate the daily P/L for each of your strategies over a period of time. You then evaluate the correlation between the two number series. If the strategies are truly independent, they should not be highly correlated. A slow market, for example, may yield little in the way of breakout trades, but you could still make money on selected stocks with earnings surprises. Similarly, you may get little earnings news on a particular day, but the market may provide a number of breakout moves due to economic reports.

Many traders think they are diversified, when in reality they are trading the same strategy or idea across multiple, related instruments. This means they’re taking much more risk than they realize.

One stock market trader I worked with had a phenomenal track record and then stopped making money all of a sudden. On the surface, he was well diversified, trading many issues and utilizing options effectively for hedging and directional trade. When we reviewed his strategies in detail, however, it was clear that all of them relied on bull market trending to one degree or another. When the market first went into range-bound mode and then into a protracted bear move, he no longer made money. He was trading many things without much in the way of diversification. His trading business was like a car dealership that sells many kinds of trucks, vans, and SUVs. Once large vehicles go out of favor, perhaps due to high fuel costs, the business becomes vulnerable. It’s not as diversified as it looks.

Suppose you track your performance historically and find that your strategies correlate at a level of 0.20. The outcome variance shared by the strategies would be the square of the correlation—0.04, or 4 percent. That means that results from one strategy only account for 4 percent of the variation in the other strategy—not a high level. Imagine, however, that during the last month, the correlation soars to 0.70. Now the overlap between strategies is close to 50 percent. They are hardly independent.

What could cause such a jump in correlation? In a strongly trending market, the breakouts might all be in one direction—the same direction as earnings surprises. Alternatively, you might get caught with an overall market opinion and select your trades to fit that opinion. In either case, your diversified business is no longer so diversified, just like the car dealership.

Correlations among your strategies and trades vary over time because of how markets trade and because of your own hidden biases.

That lack of diversification matters, because it means that your capital is concentrated on fewer ideas. Your risk is higher, because instead of dividing your capital among two or more independent strategies, it is now concentrated in what is effectively a single strategy. The same problem occurs when different markets or asset classes begin trading in a more correlated fashion, perhaps due to panicky conditions among investors. During those periods of high risk-aversion, traders will often shun stocks and seek the perceived safety of bonds and gold. The three asset classes (equities, fixed income, and gold) will thus trade in a highly correlated manner. Instead of being diversified across three markets, your capital is effectively concentrated in one.

When your trading results are becoming more correlated, your self-coaching will lead you to ask whether the correlations are due to biases in your trade selection or due to shifts among the markets. In the first instance, you can make special efforts to seek out uncorrelated ideas; in the second, you may want to reduce the size of each of your trades so that you have less concentrated risk. What you want to avoid are situations in which all your trading and investment eggs are in a single package. That can produce fine returns for a while, but leaves a trading business vulnerable when market conditions change.

My coaching experience with traders suggests that they most often achieve sound diversification in one or more ways:

• Blending intraday trading with swing trading or blending longer-term trading/investing with shorter-term swing trading.

• Blending directional trading (being long or short a particular instrument) with relative value trading (being long one instrument and short another, related one).

• Blending one strategy (such as trading around earnings events) with another (trading opening range breakouts).

• Blending the trading of one market or asset class (such as a currency pair) with another (U.S. small cap stocks).

For example, a trader might be long high-yielding stocks as one idea. A second idea would have the trader selling the front end of the yield curve and buying the long end, perhaps in anticipation of yield curve flattening ahead of Fed tightening. A third idea would have the trader short value stocks and long growth issues, anticipating that a historically wide spread in performance between the two will revert to its norm. A fourth idea might be a short-term long trade on small cap stocks. The good thing about spread/pairs trades, such as ideas two and three, is that they can work regardless of the direction of the underlying market, providing a measure of diversification. Trading horizons widen considerably when you don’t just ask if a market is going up or down, but start to think about what will go up or down versus other things.

High frequency day traders will tend to achieve diversification and low correlation in other ways. They will demonstrate a relatively even mix of long and short trades over time. They may also manage positions over different time frames or place different trades in different stocks and sectors. The risk for the day trader is getting caught up in fixed opinions about the market, biasing trades in a single direction. If the day trader is diversified, the correlations among returns from his different setups and the serial correlations of returns among trades (and among returns across times of day) should be relatively modest over time. Each trade or type of trade for the day trader should, in a sense, be a separate product in the business mix.

You don’t have to diversify by trading many markets. You can diversify by time frame (longer-term, shorter-term), directionality (long, short), and setup pattern (trending, reversal).

Is your trading business adequately diversified? Is its diversification expanding or narrowing? If you’re like most traders, you don’t know the answers to these questions. The data, however, can be at your fingertips. All you need is to divide your trades by strategy, track the results of each strategy daily, and enter the information into Excel. From there, it’s simple to calculate correlations over varying time periods. And if you don’t trade every day and hold most positions for days? No problem: simply calculate the returns of each strategy as if you had sold all positions at the end of each trading day. That will tell you if your trades are moving in unison or independently. And that will tell you if you have many profit centers supporting your business or only a very limited few.

COACHING CUE

It is not too difficult to turn good directional ideas into good pairs trades. Once you determine that an index, sector, commodity, or stock is going to go up or down, ask yourself what related indexes, sectors, commodities, or stocks are most likely to maximize this move. You would then buy the instrument most likely to maximize the move and sell the related one that is likely to lag. For instance, you might think the S&P 500 Index is headed higher. You note strength in the NYSE TICK ($TICK) relative to the Dow TICK ($TICKI) and so buy the Russell 2000 small caps and sell the Dow Jones Industrials in equal dollar amounts. This gives you an idea that can be profitable even if your original idea about directionality in the S&P Index doesn’t work out. As long as there’s more buying in the broad market than among the large caps in relative terms, you’ll make money. Learn to think and trade in terms of relationships so you increase your arsenal of ideas.

LESSON 77: CALIBRATE YOUR RISK AND REWARD

I recently used Henry Carstens’ P/L Forecaster (www.verticalsolutions.com/tools.html) to simulate possible equity curves under scenarios for two small traders:

1. Trader A has a small negative edge - The trader wins on 48 percent of trades and the ratio of the size of winners to losers is 0.90.

2. Trader B has a small positive edge - The trader wins on 52 percent of trades and the ratio of the size of winners to losers is 1.10.

I viewed the simulation as tracking returns over a 100-day period. The average size of winning days was $100 in both scenarios. That means that, if we assume that the traders began with a portfolio size of $20,000, that the daily variability of their returns was somewhere around 50 basis points (½ percent, or $100/$20,000). If the traders averaged just one trade per day, then it’s plausible that they were risking roughly 2 S&P 500 emini points per trade and making about that much per trade.

By running the scenarios 10 times each, I was able to generate an array of returns for the two traders:

What we see is that small edges over time add up. When the small edge is negative, as in the case of Trader A, the average portfolio loss over 100 days is around 3 percent. When the edge is positive, we see that Trader B averages a 100-day gain of about 3 percent.

Clearly, it doesn’t take much to turn a modest positive edge into a modest negative one: the distance between 52 percent and 48 percent winners and the difference between a win size that is 10 percent smaller versus larger than the average loss size are not so great. Just a relatively small change in how markets move, how we execute our trades, or how well we concentrate and follow our ideas can turn a modest winning edge into a consistent loser.

You don’t need to have a large edge to run a successful trading business; you do need to have a consistent edge.

Had we tracked results every single day, we would have found that Trader A had some winning days and Trader B had some losers. Over a series of 100 days, however, the edge manifests itself boldly. There are no scenarios in which Trader A is profitable and none where Trader B loses money. Just as the edge per bet in a casino leads to reliable earnings for the house over time, the edge per trade can create a reliable profit stream when sustained over the long run. Once you have your edge, your greatest challenge as your own trading coach is to ensure your consistency in exploiting that edge, every day, every trade.

But let’s take the analysis a step further and explore risk and reward. Our Traders A and B are not great risk takers: they are only trading one ES contract for their $20,000 account. This provides them with average daily volatility of returns approximating 50 basis points, which is not so unusual in the money management world. We can see, however, that the 3 percent return for Trader B over 100 days would amount to about 7.5 percent per year (250 trading days). While that’s not a terrible return, it is before commissions and other expenses are deducted. The consistent small edge does not produce a large return when risk-taking is modest.

So how could our Trader B juice his returns? A simple way would be to trade 3 contracts instead of 1. Assuming that this does not change how Trader B trades, the average daily variability of returns would now be 1.5 percent, with an average win size of $300. The return of over 20 percent per year would now look superior. If you take more risk when you have a consistent edge, this certainly makes sense, just as betting more makes sense at a casino makes sense if the odds are in your favor. You simply need to have deep enough pockets to weather series of losses that are expectable even when you do have the edge. When I ran the scenarios for Trader B, peak to trough drawdowns of $700 to $800 were evident. Multiply that by the factor of 3 and now Trader B incurs drawdowns of 12 percent.

But what if Trader B took pedal to the metal and traded 10 contracts with a small edge? The potential annual return of 75 percent looks fantastic. The potential drawdowns of more than 40 percent now seem onerous. That small, consistent edge suddenly generates large losses when risk is ramped to an extreme.

The variability of your returns will tend to be correlated with the variability of your emotions.

In that aggressive scenario, Trader B would ramp the variability of daily returns to 5 percent. Average daily swings of that magnitude, particularly during a slump, are bound to affect the trader’s psyche. Once the trader becomes rattled, that small positive edge can turn into a small negative one. Amplified by leverage, the trader could easily blow up and lose everything, all the while possessing sound trading methods.

The size of your edge and the variability of your daily returns (which is a function of position sizing) will determine the path of your P/L curve. Management of that path is crucial to emotional self-management. Your assignment is to utilize Henry’s forecaster in the manner illustrated above, using your historical information regarding your edge and average win size to generate likely paths of your returns. Then play with the average win size to find the level of risk, reward, and drawdown that makes trading worth your while financially, but that doesn’t overwhelm you with swings in your portfolio.

Few traders truly understand the implications of their trading size, given their degree of edge. If you know what you’re likely to make and lose in your trading business, you’ll be best able to cope with the lean times and not become overconfident when things are good. Match your level of portfolio risk to your level of personal risk tolerance for a huge step toward trading success.

COACHING CUE

Doubling your position sizing will have the same effect on the path of your returns as keeping a constant trading size when market volatility doubles. This process is a dilemma for traders who hold positions over many days and weeks, but is also a challenge for day traders, who experience different patterns of volatility at different parts of the trading day. It is common for traders to identify volatility with opportunity and even raise their trading size/risk as markets become more volatile. This greatly amplifies the swings of a trading account, and it plays havoc with traders’ emotions. Adjusting your risk for the volatility of the market is a good way to control your bet size so that a few losses won’t wipe out the profits from many days and weeks.

LESSON 78: THE IMPORTANCE OF EXECUTION IN TRADING

You can have the greatest ideas in the business world, but if they’re not executed properly, they won’t be worth much. A great product marketed poorly won’t sell. A phenomenal game plan by a top coach won’t work on the basketball court if the players don’t pass well and can’t establish position underneath the basket for rebounds. The quarterback can call a great play, but if the line doesn’t block, the pass will never get off.

So it is with trading: execution is a much larger part of success than most traders realize. The average trader spends a great deal of attention on getting into a market, but it’s the management of that trade idea that often determines its fate. When you are the manager of your trading business, you want to focus on day-in and day-out execution, just as you would if you were running your own store.

A trade idea begins with the perception that an index, commodity, or stock is likely to be repriced. For example, we may perceive that a stock index is trading at one level of value, but is likely to be trading at a different level. Our rationale for believing this may be grounded in fundamentals: at our forecasted levels of interest rates and earnings growth, the index should be trading at X price rather than Y. Our rationale might be purely statistical: the spread between March and January options contracts on the index is historically high and we anticipate a return to normal levels. Too, we may use technical criteria for our inference: the market could not break above its long-term range, so we expect it to probe value levels at the lower end of the range. In each case, the trade idea takes the form: “We’re trading here at this price, but I hypothesize we’ll be trading there at that price.”

What this suggests is that a fully formed trade idea includes not just an entry setup, but also a profit target. Too often that target is not made clear and explicit, but still it lies at the heart of any trade idea. A trade only makes sense if we expect prices to move in an anticipated way to an extent that is meaningful relative to the risk we are taking.

Just as businesses set target returns on their investments, traders target returns on their trade ideas.

It is in this context that every trade is a hypothesis: our belief regarding the proper pricing of the asset represents our hypothesis, and our trade can be thought of as a test of that hypothesis. As markets move, they provide incremental support for or disconfirmation of the hypothesis. That means that, as trades unfold, we either gain or lose confidence in our hypothesis.

Any good scientist not only knows when a hypothesis is supported, but also when it is not finding support. A hypothesis is only meaningful if it can be objectively tested and falsified. The outcome that would falsify our trade hypothesis is what we set as a stop-loss level. It is the counterpart to the target; if the target defines the possible movement in our favor, the stop-loss point captures the amount of adverse movement we’re willing to incur prior to exiting the trade and declaring our hypothesis wrong.

The trader who lacks clearly defined targets and stop-losses is like the scientist who lacks a clear hypothesis. You can trade to see what happens, and scientists can play around in the laboratory, but neither is science and neither is likely to prove profitable over the long run. A firm hypothesis and objective criteria for accepting or rejecting the hypothesis advances knowledge. Similarly, a clear trading idea and explicit criteria for validating or rejecting the idea can guide our market understanding. Frequently, if you get stopped out of a seemingly good trade idea you can reframe your understanding of what is going on in the market. After all, scientists learn from hypotheses that are not confirmed as well as those that are.

With the target and stop-loss firmly in mind, we now have the basis for executing our idea. Good execution mandates that we enter the trade at a price in which the amount of money we would lose if we were wrong (if we’re stopped out) is less than the amount of money that we would make if we were right (if we reach our target). When traders talk about getting a good price, this is what they mean: they are entering an idea with relatively little risk and a good deal more potential reward. A good way to think about this is to think of each trade as a hand of poker: where we place our stoploss level reflects how much we’re willing to bet on a particular idea.

Many traders make the mistake of placing stops at a particular dollar loss level. Rather, you want to place stops at levels that clearly tell you that your trade idea is wrong.

Let’s say my research tells me that we have an excellent chance of breaking above the prior day’s high price of $51 per share. We are currently trading a bit below $49 after two bouts of morning selling took the stock down to $48, which is above the prior day’s low of $47.50. A news item favorable to the sector hits the tape and I immediately buy the stock at $49, with $51 as my immediate target. My hypothesis is that this news will be a catalyst for propelling the stock higher, given that earlier selling could not take out yesterday’s low. I’m willing to lose a point on the trade (stop myself out at $48) to make two points on the idea (target of $51).

Suppose, however, that the stock was trading at $50, rather than $49 when the news came out. Now my risk/reward is not weighted in my favor. If I’m willing to accept a move back to $48 before concluding I’m wrong, I now have two points of potential loss for a single point of targeted profit. While the idea is the same, the execution is quite different. It is difficult to make money over the long haul if you’re consistently risking two dollars to make one. If, however, you’re risking a dollar to make two or more, you can be right less than half the time and still wind up in the plus column.

Good execution means that you calibrate risk as a function of anticipated reward.

Execution provides proactive risk management. If you control how much you can win and lose based on your price of entry, you keep your risk known and lower than your potential reward. You can track the quality of your execution if you calculate the amount of heat you take on your average trades. Heat is the amount of adverse price movement that occurs while you’re in the trade. If you’re taking a great deal of heat to make a small amount of money, you’re obviously courting disaster. When your execution is good, you should take relatively little heat compared to the size of your gains. Your assignment for this lesson is to calculate heat for each of your recent trades and track that over time. This assignment will tell you how successful you are at executing your ideas, and it will provide a sensitive measure of changing risk/reward in your trading.

Good execution, psychologically, is all about patience. To get a good price, you will have to lay off some trade ideas that end up being profitable. Like the poker player, you want to bet when the odds are clearly in your favor. That means mucking a lot of hands. Similarly, a business doesn’t try to be all things to all people. A business owner passes up certain opportunities to sell products in order to focus on what she does best. When you’re running your trading business well, you don’t take every conceivable opportunity to make money; you wait for your highest probability opportunities. The clearer you are about risk and reward, the easier it will be to stick to trades that offer favorable expected returns.

COACHING CUE

A simple rule that has greatly aided my executions has been to wait for buyers to take their turn if I’m selling the market and wait for sellers to take their turn before I’m buying the market. Thus, I can only buy if the NYSE TICK has gone negative and if the last X price bars are down. Similarly, I can only sell if the NYSE TICK has gone positive and the most recent X price bars have been up. This reduces the heat I take on trades by entering after short squeezes and program trades juke the market up or down. Once in a while you’ll miss a trade if you wait patiently for the other side to take their turn, but the extra ticks you make on the trades you do get into more than make up for that.

LESSON 79: THINK IN THEMES—GENERATING GOOD TRADING IDEAS

Notice how successful businesses are always coming up with new products and services to meet the changing needs and demands of consumers. A great way to become obsolescent in the business world is to remain static. If a current product is a hit, competitors and imitators are sure to follow. What was hot at one time—large vehicles during periods of cheap gasoline, compact disc players for music—can go cold quite suddenly when economic conditions or technologies change.

It is the same way in the trading world. For a while, buying technology stocks was a sure road to success. Thousands of day traders gave up their jobs to seek their fortunes. After 2000, that trade vanished with a severe bear market. Now, selected technology firms are doing relatively well, while others languish. Markets, like consumer tastes, are never static.

As we saw in the lesson on diversification, if you base your trading business on a single type of trading—a limited set of ideas or patterns—it is a vulnerable place to be. I recall when breakouts of opening ranges were profitable trades; in recent years, those breakouts have tended to reverse. We all hear that the trend is your friend, but in recent years buying after losing days, weeks, and months has—on average—been more profitable than selling. Market patterns, as Niederhoffer emphasized, are ever-changing. That means that successful traders, like successful business people, must continually scout for fresh opportunity.

The best system developers don’t just develop and trade a single system. Rather, they continually test and trade new systems as part of a diversified mix.

One of the skills I see in the best traders is the ability to synthesize data across markets, asset classes, and time frames to generate trading themes. These themes are narratives that the trader constructs to make sense of what is going on in markets. These themes are the trader’s theories of the financial marketplace. Their trades are tests of these theories. The successful trader is one who generates and acts on good theories: themes that truly capture what is happening and why.

This thematic thinking is common in the portfolio management world, but I see it also among successful short-term traders. The scope of the theories—and the data used to generate them—may differ, but the process is remarkably similar. A portfolio manager might note high gasoline prices and weakening housing values and conclude that a lack of discretionary income among consumers should hurt consumer discretionary stocks. That might lead to a trade in which the manager shorts the consumer discretionary sector and buys consumer staples stocks that are more recession-proof.

The short-term trader may look at a Market Profile graphic covering the past week and observe a broad trading range, with the majority of volume transacted in the middle of that range. As the market moves to the top of that range, the trader sees that many sectors are nowhere near breaking out. Moreover, overall market volume is light during the move, with as much volume transacted at the market bid as at the offer. From this configuration, the short-term trader theorizes that there is not sufficient demand to push the market’s value area higher. She then places a trade to sell the market, in anticipation of a move back into the middle of the range.

Thematic thinking turns market data into market hypotheses.

The key to thematic thinking is the synthesizing of a range of data into a coherent picture. Many traders, particularly beginners, only look at their market in their time frame. Their view is myopic; all they see are shapes on a chart. The factors that actually catalyze the movement of capital—news, economic conditions, tests of value areas, intraday and longer-term sentiment—remain invisible to them. Without the ability to read the market’s themes, they trade the same way under all market conditions. They’ll trade breakout moves in trending markets and in slow, choppy ones. They’ll fade gaps whether currencies and interest rates are impelling a repricing of markets or not. Little wonder that they are mystified when their trading suddenly turns from green to red: they don’t understand why markets are behaving as they are.

There is much to be said for keeping trading logic simple. The synthesis of market data into coherent themes is a great way to distill a large amount of information into actionable patterns. In the quest for simplicity, however, traders can gravitate to the simplistic. A setup—a particular configuration of prices or oscillators—may aid execution of a trade idea, but it is not an explanation of why you think a market is going to do what you anticipate. The clearer you are about the logic of your trade, the clearer you’ll be about when the trade is going in your favor and when it is going against you.

Intermarket relationships are particularly fertile ground for the development of themes. You’ll notice in the TraderFeed blog that I regularly update how sectors of the stock market are trading relative to one another. This alerts us to themes of economic growth and weakness, as well as to lead-lag relationships in the market. These sector themes change periodically—financial issues that had been market leaders recently became severe laggards—but they tend to be durable over the intermediate-term, setting up worthwhile trade ideas for active traders.

Other intermarket themes capture the relative movements of asset classes. When the economy weakens and the Federal Reserve has to lower interest rates, this has implications not only for how bonds trade, but also the U.S. dollar. Lower rates and a weaker dollar might also support the prospects of companies that do business overseas, as their goods will be cheaper for consumers in other countries. That situation might set up some promising stock market ideas.

Track rises and falls in correlations among sectors and markets as a great way to detect emerging themes—and ones that are shifting.

Short-term traders can detect themes from how markets trade in Europe and Asia before the U.S. markets open. Are interest rates rising or falling? Commodities? The U.S. dollar? Are overnight traders behaving in a risk-averse way or are they buying riskier assets and selling safer ones? Are Asian or European markets breaking out to new value levels on their economic news or on decisions from their central banks? Often, these overnight events affect the morning trade in the United States and set up trade ideas about whether a market is likely to move to new highs or lows relative to the prior day.

The short-term trader can also develop themes from breaking news and the behavior of sectors that are leading or lagging the market. If you keep track of stocks and sectors making new highs and lows often, you will highlight particular themes that are active in the market. If oil prices are strong, you may notice that the shares of alternative energy companies are making new highs. That can be an excellent theme to track. Similarly, in the wake of a credit crunch, you might find that banking stocks are making new lows. Catching these themes early is the very essence of riding trends; after all, a theme may persist even as the broad market remains range bound.

As your own trading coach and the manager of your trading business, you need to keep abreast of the marketplace. That means that considerable reading and observation must accompany trading time in front of the screen. On my blog, I try to highlight sources of information that are particularly relevant to market themes. I update those themes daily with tweets from the Twitter messaging application (www.twitter.com/steenbab). Ultimately, however, you need to figure out the themes that most make sense to you and the sources of information for generating and tracking those themes. The more you understand about markets, the more you’ll understand what is happening in your market. Like a quarterback, you need to see the entire playing field to make the right calls; it’s too easy to be blind-sided by a blitzing linebacker when your gaze is fixed!

COACHING CUE

It is particularly promising to find themes that result from a particular news catalyst. For instance, if a report on the economy is stronger than expected and you see sustained buying, track the sectors and stocks leading the move early on and consider trading them for a trending move, especially if they hold up well on market pullbacks. Many of those themes can run for several days, setting up great swing moves.

LESSON 80: MANAGE THE TRADE

Business success isn’t just about the products and services a firm offers to the public. Much of success can be traced to the management of the business. If you don’t hire the right people, supervise them properly, track inventories, and stick to a budget, you’ll fail to make money with even the best products and services.

So it is with trading. The best traders I’ve known are quite skilled at managing trades. By trade management, I mean something different from generating the trade idea and executing it. Rather, I’m referring to what you do with the position after you’ve entered it and before you’ve exited.

Your first reaction might be: You don’t do anything! It’s certainly possible to enter a position and sit in it, waiting for it to hit your profit target or your stoploss level. That reaction, however, is inefficient. It’s like selling the same mix of products at all stores even though some products sell better and some sell worse at particular locations.

To appreciate why this is the case, consider the moment you enter a trade. At that point you have a minimum of information regarding the soundness of your idea. As the market trades following your entry, you accumulate fresh data about your idea: the action is either supporting or not supporting your reasons for being in the market. For instance, if your idea is predicated on falling interest rates and you see bonds break out of a price range, that would be supportive of your trade. If you anticipate an upside breakout in stocks and you see volume expand and the NYSE TICK move to new highs for the day on an upward move, that is similarly supportive. If you track market action and themes while the trade is on, you can update the odds of your trade being successful.

Trade management is the set of decisions you make based on the fresh information that accumulates during the trade.

One way that I see traders utilizing this information is in the way that they scale into trades. Their initial position size might be relatively small, but traders will add to the position as fresh information validates their idea. My trading capital per trade idea is divided into six units. I typically will enter a position with one or two units. Only if the idea is finding support will a third or fourth unit enter the picture. I have found that, if my trades are going to be wrong, they’re generally wrong early in their lifespan. By entering with minimal size, I incur small drawdowns when I’m wrong. If I add to a position as it is finding support, I maximize the gains from good trades. This trade management, I find, is just as important to many traders’ performance as the quality of their initial ideas. Indeed, I’ve seen traders throw lots of trade ideas at the wall and only add capital to the ones that stick: the management of their trades makes all the difference to their returns.

Such trade management means that you have to be actively engaged in processing information while the trade is on, not just passively watching your position. Good trade management is quite different from chasing markets that happen to be going in your favor. It is a separate execution process unto itself, in which you can wait for normal pullbacks against your position to add to the position at favorable levels. If you are long, for example, and the market is in an uptrend, the retracements should occur at successively higher price levels. By adding after the retracement, you gain the profit potential when the market returns to its prior peak, but you also ensure that risk/reward will be favorable for the piece of the trade that you’re adding.

Each piece added to a trade needs a separate assessment of risk and reward to guide its execution.

While I’m in a short-term trade, I’m closely watching intraday sentiment for clues as to whether buyers or sellers are more aggressive in the market. I will watch the NYSE TICK (the number of stocks trading on upticks minus those trading on downticks), and I will track the Market Delta (www.marketdelta.com; the volume of ES futures transacted at the market offer minus the volume transacted at the market bid). These trackings tell me if the balance of sentiment is in my direction. If the sentiment turns against me, I may decide to discretionarily exit the position prior to hitting my stop-loss level. That, too, is part of trade management. To be sure, it is risky to front-run stop-levels: it invites impulsive behavior whenever markets tick against you. I’ve found, however, that if I’m long the ES futures and we see a breakdown in the Russell 2000 (ER2) futures or a move to new lows in a couple of key market sectors, the odds are good that we will not trend higher. By proactively exiting the position, I save myself money and can position myself for the next trade.

What this suggests is that it is important to be right in the markets, but it is even more valuable to know when you’re right. Very successful traders, I find, press their advantage when they know they’re right, and they’re good at knowing when they’re right. This means that they are keen observers of markets in real time, able to assess when their trade ideas—their hypotheses—are working out and when they’re not. They are good traders because they’re good managers of their trades.

Your assignment for this lesson is to assess your trade management as a separate profit center. Do you scale into trade ideas? Do you act aggressively on your best ideas when you are right? If you’re like many traders, this is an underdeveloped part of your trading business. It may take a return to simulation mode and practice with small additions to trades to cultivate your trade management skills. It may also mean that you structure your time while you’re in trades, highlighting the information most relevant for the management of your particular idea. Most of all it means cultivating an aggressive mindset for those occasions when you know you have the market nailed.

As your own trading coach, you want to make the most of your assets. It’s easy to identify traders who exit the business because they lose money. It’s harder to appreciate the equally large number of traders who never meet their potential because they don’t make the most of their winning ideas. A great exercise is to add to every position at least once on paper after you’ve made your real-money entry. Then track the execution of your added piece, its profitability, the heat you take on it, etc. In short, treat trade management the way you would treat trading a totally new market, with its own learning curve and need for practice and feedback. You don’t have to be right all the time; the key is to know when you’re right and make the most of those opportunities.

COACHING CUE

Track your trades in which you exit the market prior to your stops being hit. Does that discretionary trade management save you money or cost you money? It’s important to understand your management practices and whether they add value to your business.

RESOURCES

The Become Your Own Trading Coach blog is the primary supplemental resource for this book. You can find links and additional posts on the topic of coaching processes at the home page on the blog for Chapter 8: http://becomeyourowntradingcoach.blogspot.com/2008/08/daily-trading-coach-chapter-eight-links.html

Jim Dalton’s books are excellent resources when it comes to developing a conceptual framework for trading. I recommend Mind Over Markets as a first read, then Markets in Profile. Both books are available on the site where Jim and Terry Liberman offer training for developing traders: www.marketsinprofile.com

An excellent book on risk and risk management is Kenneth L. Grant’s text Trading Risk (Wiley, 2004).

Exchange Traded Funds (ETFs) are an excellent tool for achieving diversification. Two good introductions to ETFs are David H. Fry’s book Create Your Own ETF Hedge Fund (Wiley, 2008) and Richard A. Ferri’s text The ETF Book (Wiley, 2008).

I receive a number of questions regarding seminars, courses, and other resources that are offered for sale under the general rubric of trading education. My impression, and the feedback I get from blog readers, is that these offerings are often expensive and of limited relevance to the particular strengths and interests of individual traders. Similarly, I receive many inquiries into proprietary trading firms, which allow traders to trade the firm’s capital in exchange for a share of profits. Some of these firms are quite professional and ethical; others are not. I strongly encourage due diligence: talk to a number of people who have taken these courses or who are trading at these firms. If you cannot get direct feedback from actual users (not just one or two stooges), move on. Don’t pay thousands of dollars for something unless you know exactly what you’re getting.