Tharp's Thoughts Weekly Newsletter (View On-Line)
Tranform Your Trading Ideas into Profitable Trading Systems
My Favorite Edge in System Design by D.R. Barton, Jr.
Trading Tip Developing a Market Classification System that Fits Your Style by Ken Long
A Memorable Experience at Ken Long's Discretionary Workshop
2010 Fall Workshop Line-Up
My Favorite Edge in System Design
This past weekend, I watched a true master practice his craft.
As I watched, I noticed the edge that separated him from others who are very good in his field. Put into practice consistently, this edge repeatedly made the difference between success and failure. And so I was reminded of trading systems (no surprise there!) where this same concept really matters. The consistent application of an edge, even a small one, can make all the difference between trading success and failure (or mediocrity).
The master I watched was Peyton Manning, the quarterback of the Indianapolis Colts football team. Manning is an absolute lock as a future Hall of Famer. He has been league MVP a record four times, holds numerous other records, and has a Super Bowl win to his credit.
Manning has earned respect for numerous aspects of his game. He’s certainly one of the best thinkers and strategist to ever play the position. He’s the only quarterback in the league who calls many (if not most) of his own plays. He’s also among the all-time league leaders for passing accuracy.
Manning possesses at least one other ability he has developed over time that gives him a true and important edge. I’m not talking about a major component here (e.g., his strong and accurate arm or his knowledge of the game). This edge is subtle while, at the same time, highly effective and valuable.
During a pass play, Manning rarely looks at his ultimate target until the last moment. Manning knows his plays and players so well that he doesn’t have to watch his target’s passing route develop. Instead he surveys the whole field and even looks away from his target to confuse the defense. At the last instant he glances back and throws the perfect spiral to a receiver who had full confidence that the ball would be in the right place at the right time.
Manning’s edge makes a huge difference and contributes to his successful performance in the highly competitive world of professional American football.
In a similar manner, often the less conspicuous areas of a trading system give a strategy an edge in the markets. Today I’ll talk about the one that has made perhaps the biggest difference in strategies that I’ve designed or reviewed.
Finding an Edge
Digging into trading strategies is one of my favorite pastimes. I’ve had the pleasure of doing it for household names in the trading industry as well as for traders and investors just getting started.
A useful trading strategy has several parts that work together:
- the system’s beliefs about the market (i.e., why it works),
- market conditions—where it works well and poorly,
- set-ups, entry, stop loss, profit taking exit, and
- a position sizing strategy.
A weak link in any one area will render the system ineffective. (Next week, we’ll dig into each of these components).
For today’s discussion, we’ll focus on entry and how to gain an edge there. Entry is the part of the system that tells us to pull the trigger now. (For clarity, the set-up is the part of the system that tells you to get ready to enter).
One entry strategy has paid bigger dividends in system design for me than all of the others. I love it because it’s truly effective and beguilingly simple.
It’s All About the Direction
The concept for gaining an edge with your entry is straight-forward: require the market to move in your desired direction before entering. Some readers may be thinking that this is too simplistic to be useful; however, my research and practice show otherwise. Let’s look at some proponents of the practice and some examples of when and why it works.
First, Van published the results from a study based on this concept in our book Safe Strategies for Financial Freedom. Van looked at a series of trades that Steve Sjuggerud recommended as investments for the Oxford Club.
With just Steve’s recommendation and no other entry criteria, the picks were quite good, averaging a gain of 2.5 times the initial risk or 2.5R. When Van added the entry condition that required the stock price to move up for one month before entry was allowed, the results were dramatic. Rather than earning 2.5R, the trades with the directional entry requirement returned a whopping 6.4R or 6.4 times the initial risk!
We felt that this entry strategy was so compelling that we made it one of the “six keys to investment success” presented in the book.
My good friend and systems maven Chuck LeBeau has always been a big fan of requiring the market to move in the direction of your trade as a requirement for entry. On several occasions Chuck helped me to improve already profitable trading systems by applying this simple concept.
A directional entry works not only for longer term trades like those that Van cited in our book but also in short time frames. We also reviewed an intraday trading system called the 10-Minute Trader strategy in the Safe Strategies book. It produced excellent results in large part because of the requirement that price moves in the direction of the trade on an intraday basis before a trade could be entered.
As with almost all trading system design choices, the trader has to consider the tradeoffs for a directional entry requirement. Waiting for confirmation of a price move in your favor means that your initial stops have to be a bit wider (farther from entry). Still, my research has shown that for most cases, this “disadvantage” is more than made up by the avoidance of strong momentum moves against the trade. It basically ensures that you won’t try to catch a falling piano for long trades (wait for it to bounce first!) or step in front of a freight train for short trades.
I hope you can use this simple edge in your trading and investing. If you’d like to understand how to apply this valuable concept and others, remember that there is a How to Develop a Winning Trading System That Fits You workshop coming up in October. You’ll explore different types of trading system concepts and find the ones that align with your beliefs. You study in-depth each trading system component as well as the entire system development process so that you’ll be able to transform trading ideas into profitable trading systems for any type of market.
I’d love to hear your thoughts and feedback on this entry edge or about system design in general at drbarton “at” iitm.com. Until next week…
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Developing a Market Classification System that Fits Yours Style
A market classification scheme is a high payoff strategy for improving your trading results. There are a few things for you to consider as you look to take advantage of your edge in market classification.
Remember that you are not in search of eternal truths for all times and places, for all traders and styles. You are just trying to make a reasonable, risk-adjusted return on your invested time and money to achieve financial freedom. This will take you down different paths than those of the pure academia, with the intent of adding value to your bottom line.
- Focus on your time frame for trading. This is especially important if you are looking to supplement your income initially and have not yet made the leap to full time, professional, independent market trading for a living. You will have constraints placed on your time by the competing demands of work and family and there will be some styles that are simply not within your reach. No sense trying to develop a classification scheme for a style that will not fit you.
- Identify interesting markets and targets for you to specialize in. You want these to offer you the kind of volatility you can trade while remaining in your tolerance for excitement. As a trader you must trade on volatility, the fluctuation of price around the idea of “fair value.” It will be important for you in the early years to focus on markets that you find appealing and interesting and about which you will develop a feel and an expertise that will give you an edge. It is these markets where your classification scheme can be informed by both art and science.
- Look for a blend of art and science in your classification scheme. Find elements of the market’s behavior that may be expressed as rules, like seasonal volatility cycles, time frames that seem to repeat, and typical patterns and express those elements quantitatively. Find those patterns and themes that seem to emerge in the course of your trading to add an element of qualitative description to your scheme. By blending the best of both worlds you will have a market classification scheme that leverages the two primary domains of your cognition: art and science, qualitative and quantitative reasoning.
Your classification scheme will help you to interpret price into useful meaning, which can be placed into favorable risk-managed action.
Finding an Edge
When you peel back the onion a little and examine the traders who seem to have an edge not completely explainable by luck and the law of large numbers, there are many who have focused on their ability to link an assessment of market conditions for their selected targets to an appropriate strategy designed to exploit their particular edge.
Crucial to this strategy is the development of a market classification scheme that is related to the underlying dynamics of the chosen market and in tune with the average length of holding positions so that favorable moments that are actionable can be identified.
Individual traders who have found a sweet spot for their edge can apply this idea to improve their average returns, and identify moments of higher than average expected returns.
One of the most common quests for trading excellence early in a trader’s career is the search for an all purpose, robust trading secret that can be used to guide the trader through all markets, in all time frames, in any conditions, regardless of the instrument being traded, the size of the position, and your goals and objectives.
In some ways this is a legacy of the increasingly academic pursuit of truth in the marketplace fueled by the need for institutional money and those charged with a fiduciary responsibility for the money of others to employ only the most rigorously tested and objectively powerful strategies. The combination of sizeable management fees and the seriousness of the legal implications of being a fiduciary certainly are compelling reasons alone, but part of me believes that there is also a commitment to the scientific pursuit of objective truth there. Almost every sound piece of academic research establishes that there are no enduring edges that an individual trader can take advantage of and we are advised to follow efficient market theories in various forms to ensure we get the average market returns.
And yet there are traders who consistently make better than average returns. Many are simply lucky and have confused a “to-be-expected” run of luck with skill. They find themselves running out of luck when they are at their maximum exposure level and are never heard from again except as an admonition to avoid timing the markets or aiming for more than average.
It is a paradox, of course, since only by having individual actors striving for abnormal returns will the market mathematically achieve the efficiency required by academic theory.
A Memorable Experience at Ken Long's Discretionary Workshop
Having worked on Wall St. for over 30 years and having sat through more than my share of conferences, meetings, seminars, workshops, etc. on investing and trading, I can say without question that your workshops are some of the most valuable.
The discretionary workshop has surpassed them all. Not only did you present the material in your usual excellent manner, not only did I walk away with useful, actionable ideas that I will put to work Monday morning, but the quality of the ideas and contributions of my fellow attendees made this seminar one of the best ever.
Meeting, speaking with and swapping ideas with traders from Germany, Spain, China, Switzerland, etc. as well as from all over the U.S. was memorable and fascinating, and added to my experience. What a great bunch of people and not a bad vibe in the place.
Thank you very much.
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