5.01 – Building Your Trading Rules
Indicators are notoriously unreliable. The true secret to successful trading is to accept indicator unreliability and to take steps to offset that unreliability with disciplined trade management practices.
The indicator system doesn’t exist that always results in gains and never results in losses. You will take losses. Indicators are like the raw materials for baking a pie – the oven, the pie plate, the flour, the filling. Indicators are about price changes, or things. Trading rules are about the process of trading, involving you and your money. Managing the trade is like becoming a skilled baker; you need to massage the pie dough but not too much, thicken the filling, and bake the pie for the right amount of time at the right temperature. Some trade management skills are mechanical (set the oven temperature at 450 degrees), and some involve more judgement and nuance (the right amount of water to add is a function of the humidity in your kitchen).
In this chapter, I talk about developing trading rules that reflect your risk appetite. The emphasis is on the stop-loss rule – don’t leave home without one.
Talking about managing the trade before I talk about indicators may seem a little strange, but I have a good reason for it. After you find a few indicators you like and you’re fairly well convinced you can do trade on technical signals, you’ll be champing at the bit to get going. Don’t take the plunge just yet! You’re only halfway there.
A trading rule is the specific action you take when certain conditions are met. At the most basic, a trading rule instructs you to buy or sell when an indicator meets a preset criterion (like the moving average crossover in the case in Chapter 4). Many indicators have a buy/sell trading rule already embedded in them, as I describe in each of the chapters about indicators.
But technical trading is a mindset that goes beyond using indicators. Trading rules improve your trading performance by refining the buy/sell signals you get from indicators. Trading rules tend to be more complex and contain more conditions than raw indicators, such as “buy after the first 45 minutes if x and y also occur” or “sell half the position when z occurs.”
Finding your risk profile . .. not yet
Every trade you take needs to meet a simple goal: Your expectation of gain is higher than your expectations of a loss. This is a fancy way of saying you want to get the highest return for the lowest risk. In this context, risk refers to the risk of loss. And that’s as far as you need to go right now in determining your own personal risk profile. How much are you willing to lose in order to have the opportunity to make how big a gain? You may think today that you’re willing to risk losing $500 for the chance to win $10,000. However, this trade-off is unrealistic. How about being willing to risk losing $500 for the chance to make $1,500? This trade-off is more realistic in real-world conditions, but you have no way of knowing upfront if the indicators you come to like will deliver that win-loss ratio.
In a nutshell, you need to develop your indicators and your trading rules dynamically with constant feedback from one to the other in a process of self-discovery as to your risk profile. You don’t set your risk preferences first and then choose your indicators. Risk preference emerges organically from the process of developing indicators and trading rules. And it may surprise you. You can start out imagining you’re a buttoned-down, ultra-conservative type with a low tolerance for risk, but you discover you’re darn good at using quick-time, short-term indicators that have you in and out of trades far more often than you expected upfront and that deliver a high gain/loss ratio that arises more from hewing to disciplined trading rules than the indicators themselves.
Adhering to the no-guru rule
Trading rules are intimately intertwined with indicators. You can easily find the “trader’s top secrets,” “magic indicators,” and the “trade of the day” on websites. Many promoters even explain their techniques. But you aren’t doing yourself any favours adopting somebody else’s indicators – because those indicators embed that guru’s trading rules. He may be willing to swing at every pitch and able to accept big losses that will freeze your soul. Instead you need to tailor the indicator to your risk appetite and not the risk appetite of the guru selling the trade or the program. The fault lies not in the indicator but in the execution of the entry and exit that suits your risk appetite. Good trading isn’t about the securities you trade or about indicators. It’s about planning the trade ahead of time to suit your personal risk tolerance, and following the plan. Managing the trade isn’t exclusive to technical analysis. But all successful technical traders manage their trades.
The no-gurus rule does have one exception. If the guru discloses all his indicators and has a long-term (more than five years) track record of completed trades that you can verify, you may find his style suits you just fine. But remember, the absence of indicator disclosure is a fatal flaw. The absence of a long-term real-time track record is a fatal flaw. Hardly any guru can meet these criteria, however charming and seductive his presentations are.
Creating your trading plan with five easy rules
At each step you have to decide which indicators or combinations of indicators to follow, and your exact specifications for them.
Each rule has its place. You shouldn’t follow just one or two of the rules. You need to follow them all. Here’s what your rules need to do:
- Determine whether a trend exists.
This rule may seem obvious, but keep in mind that trend-following indicators are going to fail when the security isn’t trending.
- Establish the rules for opening a position.
Some advisors say this rule is the most important. Like buying real estate, getting the house at the lowest possible price is the benchmark for ending profit, given average price ranges in the neighbourhood.
- Manage the money at risk by scaling up or down (adding or subtracting the amount of money in the trade).
This rule is the most important step named by professional futures fund managers, which is logical. It’s more profitable to increase funds in the currently winning trades and to withdraw funds from the laggards.
- Establish the rules for closing a position – set stops and targets.
Professionals always observe this rule. For the individual whose mind may still hold vestiges of value-investing and buy-and-hold ideas, this rule is the most important. The paramount rule in technical trading is to control losses.
- Establish a reentry rule after being stopped or after the target is hit.
This rule is my own contribution. Most technical analysts consider each buy/sell situation as a stand-alone case. After you’ve exited a position, you need to start all over again at the top and determine whether the security is trending. They say a reentry is the same as an entry and takes all the same amount of work. But when you’re looking at trading within a big macro trend, the reentry is a different process.
Say your security has been in an uptrend for many months. As in every uptrend, it corrects downward from time to time, exactly as Edwards and Magee described decades ago. You want to take profit at the first sign of a pullback and reenter at a relative low (refer to Chapter 4). You want to be the swing trader who takes the eight trades in the overall move, or four if you’re unable to take the short side. You already know the security is trending. Your re-entry rules are inherently different from entering from scratch and will most likely involve additional indicators.
The technical trader plans the trade from entry to exit. This is the opposite of traditional investing, where you buy a security for an indefinite period of time without a stop or profit target. But if you want to increase your stake or preserve capital, it’s when you sell that counts. You sell for one of three reasons – you met a profit target, you met a loss limit, or you chose to increase or decrease the risk of the trade.
You can pick so-so securities and apply so-so indicators to them, and if you’re trading systematically, you can still make a decent net gain if you only control losses.
Combining indicators with trading rules
The key to technical trading success is being doubly systematic – systematic in identifying what are for you tradable trends and conditions and systematic in applying your trading rules.
Trends can be defined by dozens of different criteria, as I show you in Part 2. A trend defined by a simple measure, such as two or more touches of a support line, gains credibility when you can add confirmation from a second indicator, such as volume, momentum, or relative strength. All indicators fail sometimes, so a trend can be deemed more reliable if it’s confirmed. By the time you add a third confirming indicator, your confidence level should be pretty high that this will be a winning trade.
But price series seldom cooperate and deliver confirmation after confirmation from multiple indicators. In fact, by the time everything lines up perfectly, the trend is probably ending! It drives some people nuts to have three indicators saying buy and one saying sell, but trust me on this, that’s exactly what you’ll face, almost all the time. Depending on what indicators you choose and how well they tend to perform on your securities, you should rank trendedness by your own measures of reliability from real-life experience. You can take guidance from statistical work on reliability by analysts like Bulkowski (see Chapter 9), but you need to remember that even though history repeats, it never repeats exactly.
This is why book authors and other gurus who claim to have ideal indicators for their securities aren’t necessarily lying – maybe they did, for their securities and in the time frame they were working. That doesn’t mean their magic formula will work for you on your securities going forward and with your risk preferences. It’s therefore better to master the principles behind many different indicators and understand why they work so that you can be flexible in choosing the ones that work for you. It took me 20 years of looking at it every blessed day to get the Fibonacci retracement concept. It’s now on my list of must-haves, and I still look at it ahead of every trading decision.
Ranking your indicators as to their value in meeting your trading rule criteria is a personal job. Not all indicators are created equal. The zippy indicator that yields good gains for the high-frequency trader may entail too much risk for you. The reliable slow-poke indicator that’s hardly ever wrong may get only minor gains as well as put you to sleep.
Trading styles
There are as many trading styles as there are individual traders in the world. I propose a way of looking at trading styles that aims to blend indicators with rules, but it’s very general.
System-mechanical trading
Truly systematic traders take every trade that their indicator system dictates. Indicators are selected because they deliver the desired risk metrics, but after the design phase, the indicators rule. The actual trading is not only mechanical but also literally can be done by a computer. Two major system designers are Keith Fitschen and Perry Kaufman, each of whom has written an excellent book on building trading systems. See the Appendix for additional resources. If you’re a computer whiz, you absolutely, positively need both books.
System design that blends indicator choices with risk management rules is very advanced stuff. But after the system is built and tested, you can sit back and let ‘er rip. In the system-mechanical world, especially if indicators are adaptive to changing conditions, you apply no judgement after the design phase. You don’t sit around contemplating noise versus Event (see Chapter 4) or worry about contingencies. A successful system should be robust across all conditions.
System-guided trading
Say that you’ve developed a set of indicators that delivers the mix of percent gain, gain/loss, and so on, that you prefer, but sometimes it fails to live up to expectations. This generally occurs during retracements but also when trendedness collapses into lack of ‘trendedness’ – the dreaded sideways movement. It’s very hard to modify indicators to be adaptive in both trending and non-trending situations, and it’s equally hard to identify precisely when trendedness is giving way to ‘non-trendedness’ so that you can change to a different set of indicators.
Not all trends are created equal.
In system-guided trading, you want to apply additional techniques, usually from the nonmathematical collection (like candlesticks and other patterns) to help you modify your trading style to preserve your trading rule goals. In other words, your trading rules are more important than your indicators to lasting success. You don’t discard your indicators, but you have a healthy scepticism about their usefulness in untrended conditions.
How does this work, exactly? You have three tactics to consider:
» Embrace the idea that you don’t have to take every trade. When your chart is a mishmash with no obvious directional bias, your indicators are still pumping out buy/sell signals that are mostly wrong. Don’t hate your indicators – it’s not their fault. Just accept that they aren’t reliable under these conditions and because your priority is to preserve capital, don’t trade. This doesn’t include cherry-picking, meaning taking some trades and not others. Doing so is almost always self-defeating and causes confusion to boot; you start thinking your intuitive feel for the security is better than the indicators. It’s not. Once in a blue moon it may be, but don’t count on it. Just stop trading until you see ‘trendedness’ return.
» Change your time frame. Say you consider yourself a position trader with a holding period of months, but along comes a choppy chart with high volatility, meaning a wide high-low range. Instead of sitting it out twiddling your thumbs until a trend emerges, trade the choppiness on a swing basis using patterns or other techniques. This proposition is also iffy. It entails changing horses in midstream. Again, you can easily get confused.
» Adapt your risk management rules – stops and targets and perhaps scaling in and out – to the new conditions. If you’ve been setting profit targets as a function of average range and stops just below support levels, but support levels are broken or can’t be found in the new environment, devise new stops that still preserve your gain/loss ratio.
Guerrilla trading
The term guerrilla trading is mostly used by one school of analysts that specialises in sideways-market, special set-up situations, but it can be used in other contexts. In military terms, a guerrilla engages in irregular fighting, meaning he is the one to choose his time and place, not the enemy.
Guerilla trading is the least systematic method of trading and relies on special pattern setups and/or an astute eye or intuitive feel for crowd psychology. An example is stipulating a buy-entry order below the current level (but still within the normal range) because the desired target would be outside the normal range and therefore not likely to get hit. In other words, the market isn’t offering you a profit opportunity at current levels but could easily go to your preferred levels while you aren’t watching. If the price falls to the guerrilla entry, you have a fighting chance to hit the target, but the trade isn’t otherwise worth doing on a gain/loss basis.
A parallel guerrilla tactic is seeing with blinding clarity where a stop should be placed and determining the entry as a function of the stop. Again, if the entry isn’t hit, the guerrilla trader doesn’t care. The trade was worth doing only on his terms. Individuals can’t tell markets what to do, of course; you and I are always price-takers. But if a better entry is possible using average range or other concepts, why not try? In non-system trading, you don’t have to take every trade.
Guerrilla trading comes in at least two flavours:
» Guerrilla trading can take the form of entering and exiting an existing trend multiple times, each with a deliberately short time frame (like a few minutes) but staying out of the market or reducing the stake (scaling out) when the ‘trendedness’ ranking is low or medium. It may also entail tactics like specifying nonmarket entries as I describe earlier in this chapter. To a certain extent, using a trailing stop (see the following) is a guerrilla tactic, although trailing stops can be system-mechanical, too.
» A subset of guerilla trading is setup trading, in which trades are inspired by a Shock that results in specific bar configurations, especially in candlestick form or patterns like gaps. The Shock, especially if it’s noise (see Chapter 4), is expected to be short-lived and so the exit depends on time, usually a very short holding period, or dollar gain/loss, rather than an indicator.
