FAQ #2
This week marks the anniversary of my second appearance on Friends and Quinto.
From last weeks feedback it sounds like newer subscribers who have not previously heard these interviews want to hear more. So here is the second one, that Jeff refered to in last weeks recording.
In this interview Jeff and I discuss the process to moving from trading your own account to handling other peoples money. I know this is a transition that many traders will eventually make. But it is not without some hidden pitfalls that I discovered the hard way. So hopefully this will help you avoid making the same mistakes.
Just click on the icon above to hear this 11 minute broadcast.
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Copyright © Simon Townshend Ltd 2010, all rights reserved
My First Anniversary
Time certainly flies. I find it incredible that a whole year has past since my first appearance on Friends and Quinto.
If you missed it then, here is another chance to hear Jeff and me discussing the strange volatility extremes we had been witnessing in the markets. This may be a year old, but it is every bit as valid today as it was then – now that is something that we would never have believed possible!
Just click on the icon above to hear this 8 minute broadcast.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend Ltd 2010, all rights reserved
The storm clouds are gathering
I want to start this article my pointing out that I am no economist, just a humble engineer with a half logical but inquiring mind. Not that I place much faith in the predictions I have seen from proper economists over the years!
Anyway having recently been studying the copper market where we missed a very nice short trade, I was suddenly struck by something unusual – a huge divergence between copper and gold has been developing over the last month:
Notice how these markets usually follow a very similar path? Sure the amplitude of each swing varies, but the general direction tends to be the same. Until all of a sudden about a month ago this changed fairly dramatically.
When an established pattern suddenly changes my interest is aroused as it means that “something” is going on and the market is trying to tell us something. Well actually the market is probably trying hard not to reveal its secrets to us mere mortals, but it cannot avoid leaving its footprints behind for those that are looking.
What do we know about these two markets? Well gold is a long established hedge against inflation. For decades it has been the place for people to put money when they fear inflation which is of course a mechanism for devaluing cash. (In practice it turns out that this gold instead of cash strategy doesn’t actually perform anything like as well as we might believe, but that is another story altogether.)
The copper market has become something of a proxy for economic activity over more recent times as our lives have become ever more dominated by consumer and electrical goods, computers, phones etc. Everywhere you look these days, you will find copper. Actually I would argue that it is more a proxy for discretionary spending rather than the purchase of essentials like food. But that is probably a mute point.
So what might this sudden divergence between these markets be hinting at? Gold continues its upward march reminding us of the looming inflation threat that clearly in not abating but becoming an ever closer reality. Indeed UK inflation figures just released showed CPI already at almost double the 2% target figure and RPI at a 20 year high at well over 5%. So here at least the penalty for all this printing money madness is no longer a threat but already becoming a reality.
Of course economists and politicians made a big thing about this recession being so different from the past due to the absence of inflation and how much pain we were spared as a result. So no doubt these oracles will be relieved to be out of recession (apparently!) now that inflation is set to strike?
Well not so fast please, let’s not forget this copper market. If this proxy for economic activity is to be believed (and who knows?) this market seems to be seriously pricing in a fall in economic activity. A 20% decline in copper prices in a month is more than just noise. Most of the traders I speak with (and what the heck do we know!) have been taking a double dip for granted. The debate that rages here seems to be “2 dips or 3?”.
So let’s see then – we have:
- no jobs (and unemployment still rising)
- no growth (and quite possibly negative growth ahead)
- inflation (at some point interest rates will have to be raised)
- debt of unimaginable scale (and no realistic prospect of reducing it currently)
Forgive me for being pessimistic but this looks to me like the perfect storm brewing and it is not just the markets hinting at this possible scenario. Uncanny isn’t it that yesterday we had the SEC proposing tightened circuit breakers in the stock market to prevent crashes (like limit moves don’t suddenly become targets for traders!) and today Germany implements a 10 month short selling ban (which they will also try to rollout across the rest of Europe too).
Do you think maybe these guys are trying to get ahead of the game this time? An interesting few months ahead of us I suspect.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend Ltd 2010, all rights reserved
Why Are You Using a Stop?
If your answer to this question is “because I have to use a stop”, then that is the right answer. But it is not the answer I am looking for.
As far as I am concerned a protective stop can be used to serve two very different purposes. It is important to know which of these purposes is the reason for using the stop. Without knowing this it is impossible to select the optimum place to put that stop.
The two uses for a protective stop are:
- As an emergency exit
- To close all or part of a position
I am not talking semantics here – these are very different propositions for very different circumstances.
The Emergency Exit
Here a stop is placed a fair distance from the current market price at a position that the market should not even get near if the hypothesis for the trade was to remain valid. This is your classic “get the heck out of here” type of order. The trade has failed and you are on the wrong side of the market, so you take your loss and move on to the next opportunity.
Such an exit may be used in any and all markets, even the thinner markets where you may experience a few ticks of slippage. That doesn’t matter for a couple of reasons – Firstly you need to get out as the probability is that losses will accelerate from this point. Secondly such stops don’t get activated very often so a few ticks of slippage won’t make any difference to your overall performance.
Closing a Position
In this case a stop order is used to close out all or part of a position. The stop is very tight to the market and is actively used as part of your trade management approach. It is often a trailing stop as well – progressively reducing risk and then locking more and more profit in. Here you are on the right side of the market, but seeking to ensure you capture the bulk of an open profit in the event of the current move ending.
This exit may only be used in deep liquid markets, where slippage is unlikely. Such an exit will be activated regularly so slippage is important and if used in markets prone to slippage the impact on your bottom line can be considerable.
Conclusion
So whilst it is easy to think of all stops being equal, they really aren’t. They are very different. Unless you are clear which one you are using it is impossible to place it in the ideal location. As you can see the two types of stop are almost total opposites. By definition this polarisation means that there must be an area in between in which you never place a stop. There is and it is a big wide area too. So if you find yourself placing a stop in this vague middle ground, you know it is the wrong place and that you have not thought through where the right place is! There is no room for:
- “I’ll give this one a bit more room” when you know it should be much tighter
- “I’ll give this less room to reduce my risk” when you know you should give the market room to breath
In both of these cases the purpose of the stop has been overlooked and both trades will suffer in the long run – the first one will dilute profits by giving up bigger losses and/or locking in smaller profits, the second will dilute profits by decreasing the percentage of winning trades by getting tagged in the noise too frequently.
How I Use Stops
In my work I use stops in exactly the two ways described above and each time I place the order I know its objective.
In short term trading in liquid markets, such as the S&P and Euro my stops are used as managed exits. I only allow any trade just a few ticks of initial risk – either the trade works or it doesn’t so I am not going to give up much on the losing trades. As the trade starts moving I will tighten the stop. When my first profit target is achieved the stop on the balance is at breakeven already. When my second target is achieved the stop on the remaining 1/3rd locks in a few ticks. On that final piece I keep tightening and tightening and I am quite happy if my final exit is achieved with that trailing stop.
My second program is swing trading in 30+ markets, some of which can be relatively thin especially at night. Here I use an emergency stop which is a long way from the current price. If something dramatic changes I want to be taken out. I must have that stop in place just in case of emergency as I also do not watch these markets intra-day, nor when I am asleep either! However when a multi-day swing trade fails to perform I try to manage the exit by working limit orders to scratch the trade or to accept a smaller loss. It is extremely rare to be stopped out of these trades with a full sized loss as the stop is there to cater for emergencies only.
So on your next trade as you place your protective stop, just check with yourself “exactly why am I placing this stop?” Without absolute certainty in your answer, the chances are the stop is in the wrong place.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend Ltd 2010, all rights reserved
Spontaneous reversals – impossible to predict?
In theory if something is spontaneous then by definition it is impossible to predict. But that doesn’t mean that we cannot spot the telltale signs that often precede “the unpredictable”. As always with the markets the key is in understanding what lies behind that which is visible on the surface.
So let’s look at a spontaneous reversal, or as most people refer to them – the V-reversal.
In Financial Physics we specify 3 ways in which a new trend may be born. Of these the least common (by far) is the V-reversal – where a market just spontaneously turns ending one trend and instantly starting a new one in the opposite direction.
As well as being rare such new trends are extremely difficult to anticipate. Difficult yes, but not totally impossible 
. That is why a few days ago I included the following excerpt in my daily update sent to members of my S-I-R service:
So we were all on notice that the stage was set for one of these unusual events and hence in our shorter term trading to switch to playing the short side of the market. I also promised to write an article explaining more about this situation. So, here I am going to show you how we knew to switch to the short side days in advance of this rather impressive, and theoretically unpredictable, spontaneous reversal:
The What, the Why and the How
I don’t have room here to explain why this works, but I will show you exactly what to look for – the telltale signs, so that you will know in future what to watch out for. My suggestion for how you might use this insight is mainly as a filter rather than as a trade setup. So next time you see this you will know NOT to consider buying pullbacks etc.
As well as knowing when not to buy pullbacks, there is also a way to use this to trade against the prevailing trend – shorting in this case. But this is only for those who are highly experienced with this technique and I am not able to share that here. It is extremely aggressive and you have to know exactly how to play it.
But if this insight just keeps you out of one losing trade in future than I will regard it as being worth my time writing this. (For my S-I-R members I will elaborate further next weekend on both why this works and how to actually trade it, as I promised you previously.)
Right. What we need to look for is a market (any market and any timeframe) where a trend is underway that meets these criteria:
- A low volatility trend (lots of small overlapping bars moving strongly in one direction)
- No swings within the trend (just a single, painfully slow straight line crawl)
- The whole trend taking place displaced from its mean (see chart below)
Here we can see a simple Keltner channel added to the same S&P daily chart. (The parameters are largely irrelevant but as I know I will get asked – 21 period exponential moving average and 2.25 ATRs are the settings used here.)
Notice how this trend consisted of a single low volatility crawl along the outer band. This is not the usual series of swings and waves, but one single move. Note that moving along an outer band is critical here – this means that the move is displaced from its mean. If it was just a crawl along the moving average the situation would be totally different.
This action is rare, yet whenever you see it you will find that it very frequently ends with the hitherto totally unpredictable V-reversal – hence you don’t want to go buying pullbacks!
Have a rummage through your charts – look at different markets, various timeframes, etc. You won’t find many examples but you will be amazed at just how many of them end in a spontaneous reversal.
Disclaimer, risk warning and copyright notice apply to all articles published on this site.
Copyright © Simon Townshend Ltd 2010, all rights reserved
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