Catching a tiger by the tail
In Golden Rule 1, we discussed the importance of having a robust, quantified and clearly defined exit strategy for each and every trade or investment.
Irrespective of the style, strategy or timeframe, successful trading is very much about understanding and working with probabilities. This has to be so in a world where there are no certainties, unless you are able to forecast the future. In 30 years I have never found a single person ever who is able to forecast the future, so I am prepared to bet that you are in exactly the same position as me – having to work with a statistical advantage and allow probability to make profits for you over the long run.
Consequently our exit strategies must be designed within this same statistical framework and then there is one particular fact to accommodate – the bigger the profit you shoot for the less chance you have of achieving it. This is why the best traders don’t play for home runs. They treat trading as a business of slowly grinding out regular more modest profits. “A day’s work for a day’s pay” is the mantra. Notice how opposite this mentality is to that of a gambler who is constantly thinking that “the next one will be the big one”, only to be disappointed yet again.
With the chances of hitting big home runs being so low, most exit strategies should almost ignore that possibility. But that does not mean that we won’t occasionally find we have caught a tiger by the tail. So we also have to know how to adapt when luck, which is all it is, lends a helping hand. Here is a great example of how we adapt our exits to handle a potential outlier event.
Sweet move in the sugar market
Let’s take a look at the sugar market – usually a pretty dull, boring market that for some reason flew into life this week handing us an unexpected gift. On this chart I have marked up the last four days, Monday to Thursday.
Over the weekend our S-I-R swing trading system flashed up a buy signal in sugar. So on Monday morning we dutifully bought some. We got lucky on the entry buying fairly close to the low of the day. As usual (Golden Rule 1) our exits were predetermined so exit orders were placed as soon as we were filled on the buy order. Monday passed uneventfully for this trade, although I was pleased to see it close on the high of the day. The best trades always work immediately and without giving you any grief so this was a good sign.
Tuesday arrived and blast off! For some unknown reason (unknown to me at least) the whole world must have decided to buy sugar and we had this explosive move that you can see in this huge bar on the chart. Our trades are exited in 3 equal parts and the first two exit orders were both filled during this big Tuesday rally. Each exit has a specific purpose within our trading plan and a predetermined price. Now here is the first trick – It is very unusual for two exits to be achieved the same day, so when this happens I know something unusual is going on.
Because two exits in a day is an outlier event, I switch tactic for the third and final exit. As we potentially have the proverbial tiger by tail here I cancel that final exit order. Instead we switch to using a trailing stop as there is now a very good chance that it will reward us disproportionately for holding on.
Here is the second trick – If the move is for real a huge range like we saw here on Tuesday will not be retraced into very far so the stop can be placed initially around the mid-point of the day’s range, i.e. around 16.50 here in Sugar. This in itself will lock in a nice profit if triggered, so we will do OK even if Tuesday turns out just to be a one day wonder. However the odds favour a much bigger move and as that move unfolds the stop can be progressively raised locking further profits in.
But when trailing a stop with the objective of catching an outlier event, remember to leave the market room to breathe, don’t trail the stop too tightly. Here we saw nice follow through on Wednesday and Thursday, but the chances are that the market will pause and consolidate for a few days very soon. If the stop is too tight we risk getting nicked out too soon. So we will keep it well back for now, still being guaranteed a decent profit. Once the market has consolidated and left behind a new swing low, then we will ratchet our stop up again and just see what unfolds from there.
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Copyright © Simon Townshend Ltd 2009, all rights reserved
Life doesn’t stand still for long
Time to toss a coin !
We have a really interesting and quite rare structure in the stock market right now. This doesn’t occur often at all, which is why it is worth taking a quick looking at. On this daily chart of the S&P, I have highlighted in purple the closing price each day.
I hope you can see how many times the market has closed at almost the same price over the last few days. So what does this mean? It means that buyers and sellers are perfectly balanced, supply and demand are equal at this point in time. Each time the market moves up, sellers bring it back down. Each time it moves down, buyers bring it back up. Then finally the market closes back at the level that both sides agree upon, seen visually by this little row of purple dots.
OK, so everyone agrees that the market is at “the right price”, so what? Well life doesn’t stand still for very long, especially these days and in the markets these balance points alert us to watch out for a sudden shift in the supply and demand equation. At some point, fairly soon I suspect, we will see an impulse – a violent move away from this balance price. Such an impulse usually is the start of a clean and prolonged move as one side takes control. Those on the opposite side of course start to feel the pain of being on the wrong side of the move and as their pain grows they start exiting their positions which fuels the move further.
Interestingly the longer the market rotates around the balance price, the more violent the impulse tends to be when it finally arrives. This is due to complacency on the part of the losing side. The longer the market remains still the more people accept it is “at the right price” and they lower their guard. The more people that get caught off guard the harder the market moves, trapping those people.
That is a lengthy way of saying watch out for a move over the coming days and the longer we wait the better the move we can expect.
Of course you want to know if the move will be up or down, don’t you? Well so do I. But I am afraid that is impossible to know. Plenty of people will guess. Some will be right and some will be wrong. For me, a 50/50 bet has no attraction whatsoever so I will just wait until the market tells us which side is taking control and then work in that direction.
If the market starts making new highs above last week’s highs we will work the long side. If the market takes out the lows of the last few days, i.e. the conservative short entry level we discussed last week, then we will work the short side. Until then we will patiently remain as spectators at this interesting juncture.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend Ltd 2009, all rights reserved
Sell in May ?
OK its a few days late to be May, but this general time period is well known for the stock market to exhaust itself and for upswings to end. It is psychologically tough to look for shorts when the run up has been so strong, but we had a sell signal in the Dax last Wednesday and the S&P closed on Friday with a sell. So it is starting to feel like we are at, or close to, a turning point of some kind.
Our S-I-R system is short the S&P now from 940 but with a tight stop just above last week’s high. That is a purely mechanical trade of course and we should have shorted at that time, but I am never wild about entering positions on the close on a Friday. With the markets closed all weekend the potential for a large gap either way is so much greater. As long as there is no such gap, we will be looking for a suitable short entry on Monday.
Decision time in the S&P - Up or Down?
If you look at this daily chart of the S&P there is the potential for a bull trap to be forming here. The market has pushed up out of its prior range and failed, so far, to accelerate like it would if the bulls were still dominant. The high of the range has held as support so far, which incidentally makes shorts at this level pretty aggressive hence the tight stop. However if the market turns down and takes out last Wednesday’s low, it has the potential to accelerate down pretty hard. So a more conservative short entry would be to use Wednesday’s low as a trigger after the current support has been seen to have failed.
So is this the end of this dramatic upswing? Maybe, maybe not. Not being able to see the future all we can do is take the trades, keep our risk very small and let the probabilities do their thing. We know we wont be right on every trade, far from it in fact. But waiting patiently for good entry signals, keeping risk small and managing trades well more than make up for not having a crystal ball. That is what all professional traders do, so I can’t see any reason for doing anything else!
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend 2009, all rights reserved
Real time trade unfolds
If you happen to have followed this site closely, or have it RSS’d, you may have noticed the update I put out yesterday on the earlier Natural Gas article, “More Gas”. Here we have a nice trade unfolding in real time and it is a good example of how I expect my “Serious Investment Returns” trades to work. I.E. immediately and with vigour.
We bought July Natural Gas early yesterday morning pre-market at 3852. Actually to be precise it was late on Sunday night a few minutes after the electronic session open. We got lucky with the fill, buying just 8 ticks off the low of the day. (Not many people trade Natural Gas I know, but 8 ticks is nothing in this market that had a range yesterday of 415 ticks.) This is how trades are supposed to work; immediately, significantly and without us taking any heat. They dont always work this well or this fast of course, but this is a classic example of how my trades are designed to behave. I dont know whether I am obliged to disclose this or not, but this is a trade we are taking for the fund.
The market closed yesterday at 4249, just off its high for the day, a gain of $3970 per contract. Our first (of three) exits was hit today just a few minutes ago at 4275. With a trailing stop on the rest of trade, we are now going to make a profit on this trade whatever the outcome. Ideally this market will go on to develop a new uptrend, after plummeting for a year. That is what we are playing for anyway. It might just fizzle out and die right here. Or the downtrend (it is still technically in a downtrend) may simply reassert its dominance and take us out. Only time will tell, but from here on it is only a question of whether we make a small profit or something more substantial.
I am not telling you all this to be a smart arse. That is not my style at all. The truth is that we missed out on entering two other long trades yesterday, that both had spectacular days; Bean Oil never reached our entry price and Cotton did but I was too late getting my order in. I am as prone to human error as anyone! So I’m not so smart really!
The reason I am telling you this is simply because properly designed trades do work like this; quickly, significantly and without giving you any grief. If you find in your own work that this is not the profile you regularly see, then it tells me that your own trades need further honing. I know a lot of traders “get away” with sloppy trades by using big wide stops, but that is not really a long term sustainable solution.
I’m also not saying it is easy to find these fast, furious and sweat free trades – but it can be done if you are persistent. This is my real message from this example…
- keep working at it
- keep honing
- keep improving
- understand that Rome really wasn’t built in a day
- and above all have faith that regular decent trades are there to be had
The other reason I decided to update you on this is that we started discussing Natural Gas a few days ago and somehow I ended up disclosing what we were doing in this market. I am not going to make a habit of disclosing in public what we are doing in real time, so this will be a rare example! As they say on Mastermind, “I have started, so I’ll finish”.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend 2009, all rights reserved.
Follow Up: (June 3rd) Wide-scale liquidation in commodities today, took us out of this trade on our trailing stop for a small profit. The odds now favour this market forming a range down here for the time being. Anyway there you have it, a trade that did not go to plan but still made a little money. The first exit was achieved at a good price, the balance at a less good price but for a profit nevertheless. The key here was being patient for the right entry. Being patient is really difficult for many traders, myself included. But as you can see it is worth developing patience and that sounds like a good topic for another time.
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