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Entries don’t mean anything unless you know your exit and position size. Entries are just prices.

Entries, exits, and a position sizing algorithm are the 3 crown jewels to a basic trading system.

Don’t look at intraday charts – they are worthless and contain the most random data compared to Daily, Weekly, or Monthly charts – in that order. You need either AI or an HFT system to win in the shorter time frames. Doing it “by eye” is a game of losing and frustration. Love yourself enough to play a game that you can win.

Trading is a game of failure – like baseball.

You simulate your trading rules to a) see if they would have been profitable; and b) give you an idea if you have strong feelings about the frequency of losses and the drawdown.

Trading is systematized attrition of your capital until a winner hits.

Risking 1-2% per trade is insane. Start with 0.10% or 1/10th of 1%. Break your capital up into 1,000 units.

Get Tony Saliba’s new options book – FREE

Don’t trade size in your initial entries. Wait for the market to show you which way it’s going to go before you add more.

Forget price targets. That’s ego talking so that you can be “reasonable” with yourself around greed and fear.

How do you know that what is a 3-bagger can’t become a 10-bagger?

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Chart reading is not a trading system – it’s a foundation to learning how to test various conditions to develop your own set of trading rules that include Entries, Exits, and position sizes.

All of these must be simulated so you can learn what the expected value of a trade is.

David Sklansky writes good books on poker and betting. “Getting the Best of It” is one of his best.

A great source to learn learning chart reading is Brian Shannon of AlphaTrends.

He can be found at @alphatrends on Twitter and StockTwits.

Trading is hard and expensive. Good teachers and simulators have a comma in the price.

Backtesting has to be done at the portfolio level, not by testing a single security, one at a time.

Get Tony Saliba’s new book – FREE

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By Jason Pearce

Exit Stage Right

So many traders spend the bulk of their time thinking about how to enter a trade, to the point of even obsessing over it.

Which fool-proof indicator will put them into the trade of the year?

What magical chart patterns are the keys to the kingdom of untold wealth?

How can one be positioned to rake in millions of dollars from the markets over the next few weeks?

For those seeking the Holy Grail on when to get into a trade, there’s a plethora of different books, websites, newsletters, trading gurus, etc. out there that are willing to accommodate paying customers.

But here’s the thing: It’s the novice traders who spend all their time and energy on finding that perfect entry signal.  Professional traders don’t spend too much energy trying to perfect their entries.

After all, they know it’s not where you enter the market that determines your profit or loss on a trade; it’s where you exit the market.

Professional traders have a Stoic attitude towards the market.  They believe that you cannot control the market; the only thing you can control is how you respond to the market.  That means deciding when and where to get out after you get in.

To that end, let’s discuss a few methods that traders can use to exit a market.

Kill the Losers

The winning trades take care of themselves, but the losing trades have to constantly be managed.  You can’t turn your back on them for a minute.  As a matter of fact, a good synonym for a professional trader would be a risk manager.

Victor Sperandeo said that “the single most important reason that people lose money in the financial markets, is that they don’t cut their losses short.”

Before a trader even puts a position on, they need to figure out what the largest acceptable loss would be.

This is accomplished by determining where you to get out of a trade if it doesn’t work out as expected and placing the stop loss at that level, then implementing the correct position-sizing rule.

Once the position is entered, the trader’s primary job is to make sure that they stick to the initial exit plan.

After that, they can start to look for opportunities to reduce the risk on the trade through trailing stops, profit targets, rolling option hedges, etc.

Bad Stop Placement

There are a few ways to determine where to place the initial stop loss to bail you of a losing trade.  One method that’s a popular rookie mistake is setting a dollar amount stop on a trade.

I’ve seen new commodity traders come in and buy a cocoa futures contract and say “place my sell stop $500 below my entry price”, which is the equivalent of 50 ticks on a 10-ton cocoa contract.

They then gets knocked out with a $500 loss before lunch…

And the market recovers by the close and proceeds to go even higher the next day!

The problem is that the $500 stop completely ignores the market’s current behavior.

What if cocoa is flip-flopping in a trading range of $800 a day for the last couple of weeks?  Then that $500 stop loss acts more like an open invitation than an open order and has a high-probability loss of being filled.

A Better Way

A better way to determine the dollar amount for the risk-per-contract on a trade would be to measure the market’s volatility and use something bigger than that.

This method is not a guarantee, but it greatly lowers the probability of getting the stop hit by a silly random daily swing.

Suppose cocoa has had an average trading range of $800 a day for the last couple of weeks.  The trader could use a protective stop of two to three times that amount instead of an arbitrary $500 dollar amount stop.  In that case, the stop order would be $1,600 to $2,400 away from the entry price.

The Average True Range (ATR) comes in handy for measuring the volatility.  It takes into account the difference between the daily highs and lows and, in the instance where the market has made a gap move, it measures from the prior day’s close to account for the gap.

To accommodate the wider stop and keep the risk size on the trade consistent, a trader simply buys less cocoa contracts.

Instead of buying five cocoa contracts and placing the sell stop $500 below the entry price, the trader might buy only one cocoa contract and place the sell stop $2,400 (three times the ATR) below the entry price.

Support/Resistance

Volatility is not the only way to set an initial stop loss.  It can also be something as simple as placing sell stops just below price support at a prior low.  Conversely, you would place protective buy stop orders on a short position above price resistance at a prior high.

In the case of a breakout move, initial protective stop orders can be set at the place where the breakout would be invalidated.

For instance, Nvidia Corporation (NVDA) had a couple of price peaks that marked price resistance back in December 2016 and February 2017 at $119.93 and $120.92.

If a trader bought on the breakout above these old highs in early May when the price reached $121.82, he could consider setting the initial stop loss order just under the $119.00 level.

The day that the breakout to $121.82 occurred, NVDA established the low for the day at $114.02.  So perhaps a smarter approach for setting the sell stop order would be to place it just below $114.02 to give it more breathing room.

You need to keep in mind that you are not going to be the only trading setting their stops just beyond support or resistance.  Everyone’s looking at the exact same chart as you.

That means the stops can sometimes get run and then market turns right back around.

So what do you do?  Decide to not place a stop and just cross your fingers?

That’s certainly a bad idea.  You’d be jumping out of the frying pan and into the fire.  It only takes one really bad trade without a protective stop to wipe out your account.

There are a couple of possibilities for remedying this situation.

First, be prepared in advance to reenter the trade if you get stopped out and the market reverses.

I encourage you to create your rules for this reentry strategy in advance.  You don’t want to be left on the sidelines and making an emotional decision in the heat of battle.

Second, consider setting the stop order beyond support or resistance by an amount that is meaningful.  Perhaps something that’s at least bigger than the 20-day ATR.  It could even be a multiple of it.  That way, it will take more than just a random daily fluctuation to trigger your protective stops.

Going Out On Top

We’ve talked about a couple of ideas on where to exit a losing trade.  But what about exiting a winning trade?  That’s the next order of business.

To simplify it, there are really only two ways to exit a winning trade: Cashing out as soon as the market hits a pre-determined target or liquidating the position when the winner starts to give up some ground and moves against you.

I do want to point out that a trader can also use a combination of the two styles.  Remember, trading doesn’t have to be a binary outcome where you are either “all in” or “all out”.

Many traders combine different levels of exposure and position sizes, so why not combine different exit criteria, too?  Trading is not like the Yankees vs the Red Sox where you have to choose a side!

Profit Targets

Some traders know where they want to take profits as soon as they get into a trade.  Therefore, they will place limit orders to liquidate their position at a profit target if the market reaches it.

The advantage to this idea is that, if the market does meet your objective, you are not going to sit around and give back the profits that you’ve made on the trade.

A perfectly executed trade with this strategy is the one where the market reaches your maximum expectation so you can ring a bell and cash out at the top.  You don’t care where the market goes after that; all you care about is that it hit your target.

Do It Right

There are different ways to set profit targets.  First, let’s address what you should not do.

For the same reason that it doesn’t make sense to use a set dollar amount for setting a protective stop, it also makes no sense to use an arbitrarily set dollar amount for a profit target.

After all, if the cocoa market is normally making advances of $1,500, then why in the world would you want to cash at as soon as you have an arbitrary profit of something like $500?!

You’re almost guaranteed to leave a lot of money on the table when you trade this way.

The solution for the profit objective is the same as the solution for the protective stop: set the price objective based on the market’s volatility or exit when it reaches resistance/support at an old high or low.

If your market research shows that cocoa is making advances of $1,500, then selling out with a profit of just under $1,500 is congruent with what the market is doing.  A successful trader tries to stay in sync with the market.

This also means that if the price volatility dies down and cocoa is only swinging around and making advances of $900, the profit targets would be scaled back from just under $1,500 to something a little less than $900.  Otherwise, you may not get any of your profit objectives hit.

Markets are fluid so you must be ready to adapt and change with them.

Play the Range

This concept of trading the range is pretty obvious, so we won’t spend too much time on it.  Simply put, the objective is to buy when a market nears the lower end of the range and sell when the market nears the upper end of the range.

This applies to both the entry and the exit on a trade.

Since markets seem to trade in congestion at least twice as often as they trade in a trending environment, don’t overlook this concept because of its simplicity.

I’ve seen range traders bag respectable amount of profits in trading ranges when the Buy & Hold crowd and the trend followers were either treading water or getting whipsawed.  There’s definitely merit to this strategy.

That being said, you need to make sure that you have rules that tell you when a market is no longer in a trading range.

Once Elvis has left the building, so to speak, you need to abandon the market or have a different strategy to implement.  Range trading is a mean reversion strategy.  You better know how to tell when a market is in reversion mode and when it’s not (i.e. a trending market).

Harvesting Trend Profits

When the markets are in a trending mode, profit targets can still be implemented.  But the difference between taking profits in a trading range and taking profits in a trending environment is that range-bound profit objectives should more or less be at similar levels while profit objectives in a market that’s trending should be at progressively higher levels in an uptrend and progressively lower levels in a down trend.

Bollinger Bands can be useful for setting profit objectives in a trending market.  The Bollinger Bands plot a standard deviation (2 standard deviations is the popular choice) of a market above and below a market’s designated moving average.

When a market touches a Bollinger Band, it’s considered to be at a short-term extreme.  Think of it as being similar to a rubber band that’s been stretched where the market should either snap back or else breakout.

To use this tool as a profit target, a trader would be long in a market that’s trending higher and then sell the position if/when it tags the upper Bollinger Band.

Once the market has pulled back some and perhaps tagged support at the moving average, the position would be reentered.

The inverse applies for a short position, of course.  The trade would be liquidated if/when the market drops to the lower Bollinger Band and then re-shorted on a bounce back up to the moving average.

The drawback to using this Bollinger Band idea for bagging profits in a trending market is that there’s a good chance that a trader would miss out on some serious profits if the situation turns into a parabolic move.

You need to either be OK with being on the sidelines when things go parabolic or you need to develop some rules to get back in if it occurs.

Indicator Extremes

Another useful strategy for determining profit objectives is to use an overbought/oversold oscillator.  Presuming that a trader is positioned with the market trend, profits would be taken whenever the oscillator reaches and extreme reading.

Popular tools for measuring when a market is in overbought/oversold territory include the Relative Strength Index (RSI), Williams Percent R (%R), and the Directional Movement Index (DMI).

Just as the different types of moving averages (simple, exponential, displaced, etc.) generally end up showing the same thing on a chart, it seems that the different overbought/oversold oscillators usually end up in the same territory as well.

Also just like moving averages, overbought/oversold oscillators should be applicable on multiple timeframes.  This is what makes it a robust tool that works just as well for the day trader as it does for the long-term trend follower.

Study the different nuances of each to see which makes the most sense to you.  In the meantime, let’s look at an example of how one could be applied.

Williams % R

Long time trader and systems developer Larry Williams created this indicator that shows where a market’s closing price is relative to the price range between the high and low of a set time period.

In other words, the %R will show you if the market is in the upper end, lower end, or mid-part of the price range of the last X number of days, weeks, months, etc., indicating if it’s overbought, oversold, or neither.

The %R shows a range of 0 to -100.  You can Google the math for the formula if you want it, but the important thing is to know that a market is considered to be overbought whenever the indicator reaches a level of -10 or higher and it is considered to be oversold whenever the indicator drops to a level of -90 or lower.

So how would a trader use it to take profits?

You exit a long position as soon as the %R hits the overbought level of -10 or higher and exit a short position as soon as the %R hits the oversold level of -90 or lower.

Once a profit has been booked, the trader can monitor the market and watch for a reentry setup to get back in after the %R is out of the overbought/oversold territory.

Beware: markets can hit oversold or overbought and stay that way for quite some time, especially when they’re in a fast moving environment.  Exiting a long position when an oscillator hits overbought will then leave you on the sidelines while the market continues to run.

American financier Bernard Baruch once said, “I made my money by selling too soon.”

It obviously worked out OK for him…but can you live with getting out of a trade too early?

More to Come

We’ve covered a few ideas for exiting both losing and profitable trades.  There are a lot more ways to skin the cat, though.

In the next post, we will discuss even more ideas that traders could incorporate into their exit strategies.

Make sure you put at least as much time –if not more- into designing your exits as you do your entries.  It’s where you get out of a position that determines if you’ve made or lost money on the trade.


More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part 2

Building Pyramids for Asymmetric Trading Gains Part I

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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By Jason Pearce

Full Court Press

In a prior post, we discussed the topic of pyramiding.  This is where you take advantage of a winning trade by continually adding more and contracts or shares as a market trends in your favor.  The objective is to increase the size of your winning trades without a substantial increase in the risk on the trade.

First, we discussed an aggressive strategy of adding futures contracts just as soon as the open profits on a trade provide enough financing to do so.

Most traders initially learn about pyramiding this way.  As a matter of fact, I can recall a trading book that I read as a teenager that taught how to turn a $5,000 grubstake into $250,000 by simply following this easy path to “unlimited riches” while working a mere 15-20 minutes a day.

This is the absolute worst possible way to go about it.  It nearly always ends in tears.  The post explains why and shows a vivid example.

Next, a more sensible method was demonstrated.  This pyramiding method relies on the market’s price structure to determine where and when to pyramid a position.  There’s a delicate balance between pursuing profits and managing risks.  If you want to trade like a professional, this is the way to go.

In this post, we are going to touch on a couple of the more lesser-known pyramiding techniques.  These ideas will give you more options to work with.  This allows you to find and customize the pyramiding method that best suits your personal trading style.

Turtles, Pyramids, and Volatility

In full disclosure, what I know about Richard Dennis’ famous group of Turtles is only second-hand and third-hand knowledge.  When the Turtles were busy building their trading fortunes in the early 80s, I was busy doing my schoolwork, riding a BMX bike, and listening to my Def Leppard and Van Halen cassette tapes.

That being said, several of Dennis’ protégés have shared the secret sauce of the trading system that he taught them.  I feel like there’s enough information out there now that I can relay and comment on it.

The Turtles used volatility to determine their position sizes.  More fitting to out topic of discussion, they also used volatility to determine where they would add to their positions (i.e. pyramid).

They measured market volatility via the Average True Range (ATR), which is a tool that many professional traders still utilize today.  Specifically, they used the 20-day exponential moving average of the True Range as their volatility yardstick.

Once the Turtles bought a market on a breakout above a 20 or 55-day high, they would place their initial protective stops and then place order to buy more contracts at progressively higher prices.  These pyramid orders were designed to ramp the position size up as quickly as possible.

The 20-day ATR that they measured volatility with was referred to as “N”.  To pyramid, the Turtles would add to their long positions in intervals of ½ N higher as the market moved up.  So if the 20-day ATR of a particular market is 160 points, then ½ N is 80 points.

Importantly, the intervals were based on the actual fill prices.  So they would buy another round of contracts 80 points (½ N) higher than the last fill price.

The amount of entry points that a Turtle could take on one particular market was limited to four.  So after the initial breakout purchase was made (entry point #1), the position could be pyramided up to three more times at entry points #2, #3, and #4.

The protective sell stop for the contracts bought on the initial breakout was set at 2N below the entry price.  Also, the protective sell stop for each pyramided position was set at 2N below the entry price.  The thinking behind this is that the stop would be out of the way of random market swings since it’s double the average volatility of the last one month of trading (there’s typically twenty trading days in one month).

For example, if the 20-day ATR of a particular market is 160 points, then 2N is 320 points.  So the initial protective sell stop was place 320 points (2N) below the entry fill price.

Most of the time, when a new entry point was made, the protective sell stops on all units were raised to 2N below the most recent entry price as well.  The Turtles had a couple alternatives to this, but this was the standard method they used.

So there you have it: the pyramiding technique used by one of most famous and profitable trading group in the world.

Turtle Troubles

Before you take this Turtle pyramiding idea and apply it to your trading, there are a couple of potential drawbacks you should take into account.

First, recognize that the risk on the trade actually increases as more contracts are added.  Risk does not stay static or decrease the way that it does with the methodology we discussed in the prior post on using price structure to pyramid.

Suppose the 20-day ATR for gold is $13.00 and you went long a single 100/oz. futures contract at $1,240.00.  With the Turtle method, the initial protective sell stop would be set 2N or $26.00 below the entry price at $1,214.00.  This sets the initial risk at $2,600 on the trade.

If gold rallies ½ N higher ($6.50) you would purchase a second contract at $1,246.50.  The initial protective sell stop for this first pyramided contract would be set 2N ($26.00) below the entry price at $1,220.50.  Additionally, the protective sell stop for the initial purchase would also be raised to $1,220.50.

Here’s the rub: The risk on the pyramided contract is initially $2,600.  The risk on the initial contract, although reduced, is still $1,950.  So the total risk on the trade has now increased to $4,550.

Once you’ve extrapolated this out to the Turtle’s maximum position size of four entry points on the trade (the initial entry and three more pyramided entries), the total trade risk has jumped to $6,500.

That’s two and a half times the initial risk on the trade.

See the problem here?

Like I said, this is a potential drawback.  It doesn’t have to definitely be one.

If you know beforehand that the trade risk will increase as the pyramid is built, you could elect to initiate the trade with just a fraction of your maximum risk-per-trade.  Then as more contracts are added via the pyramid rules, your trade risk gets closer to your maximum risk-per-trade levels and finally reaches it when the last entry point is triggered.

In other words, you put a toe in the water and build up to your targeted maximum risk-per-trade as the market proves itself.  There’s certainly nothing wrong with a strategy of scaling into a position.  Many smart and successful traders do this.

A second potential drawback to this strategy is that the initial entry order and all three of the pyramid buy orders can get elected and filled all on the same day.

Worse yet, they could all be entered and then liquidated on the very same day!

If you’ve been trading for even a short length of time, you may have seen or even been caught in one of those “long bar” market spikes on the charts where prices rocket higher.  These sorts of moves happen on the downside as well.

As a matter of fact, the downside spikes seem to be more severe.  Anyone remember the Flash Crash?

One way you could offset this risk is to modify the pyramiding rules and limit it to one entry point per session.  That way, you will never be full loaded and then knocked right back out all in one fell swoop.

However, there is a potential downside to implementing a time limit rule like this.  If a market spike happens to be the start of a parabolic runaway move, you could miss significant chunks of the move and/or not get all the contracts you want.

There’s a tradeoff with everything in life, though.  You have to determine what is best for your own emotional makeup and capital risk.

Climbing Ladders

Now I’m going to show you a different twist on how to pyramid by incorporating both price structure and volatility.  I call this strategy a price interval ladder.  This is a method I’ve used many times, particularly with spread trade positions where I only track the closing prices, to build small positions into large positions.

You need to know up front that this pyramiding strategy is not something that I feel is compatible with a day trading or swing trading system.  (Why in the world are you day trading anyway?!)  This strategy is to be used in a campaign trade where you want to ride the trend for as long and as far as it will carry you.

In a nutshell, price interval ladders are evenly-spaced price points that are set in a market where contracts will be entered at progressively higher levels as the market advances.  Think of it as climbing a ladder and each higher price point interval is like a rung on that ladder.

The same set points of these price intervals are also where the protective sell stop levels will be trailed “up the ladder” until the market finally reverses trend and all contracts are liquidated.

Although the price interval ladders are based on price structure, it’s a different application than where we discussed trailing protective stops and adding after the market reactions against the trend.

Instead, we will measure the sizes of the countertrend moves in a trend.  Then the entry and exit points are set in price intervals that are larger than the size of the preceding countertrend moves.

The objective in spacing the intervals is to make them wide enough to be able to withstand any countertrend moves that are similar in size to what has already been occurring.

High-Tech Ladder

Let’s look at the NASDAQ 100 futures contract for an example of how a price interval ladder could have been applied during this run over the last few months.

In September and October of 2016, the NASDAQ 100 futures market prodded and poked at the 4,900 level a couple of times and stayed stuck in a trading range.

The election happened on November 8th and stock futures went absolutely nuts.  First it plunged to multi-month lows and then it rocketed back up to the highest level in several days.  The pullback from the preceding high in the all-session high was as much as 361 points.

At the end of the month, volatility had settled down.  The NASDAQ 100 had once again neared the 4,900 level and backed off one more time.

This time, the pullback was about 196.25 points in size.  This was larger than the 147-point pullback that the market experienced off the early October high, but not too different from the 207.75-point pullback that the market experienced off the August high.

In mid-December, the NASDAQ 100 finally cleared the 4,900 barrier.  With a breakout above the trading range and new all-time highs, anyone who looks at charts has to be bullish.  Therefore, let’s assume that a trader will want to get long.

We’ll be patient and wait for a bit of a pullback before jumping in.

The pullback finally occurred at the end of December when the market retraced 144.50 points from the December 27 record high of 4994.50.  Therefore, we can put in an order to buy a breakout to 5005.

Now let’s build a price interval ladder!

Due to the unusual volatility surrounding the election, we are going to disregard the pullback that occurred at that time.

With that in mind, the pullbacks that preceded the breakout ranged in size from 144.50 points to 207.75 points.  Therefore, we are going to set an interval ladder of 210 points to trade the NASDAQ 100.

This means that once the buy stop order at 5005 is filled, a protective sell stop will be placed at 4795.  Also, additional buy stop orders will be placed every 210 points higher at 5215, 5425, 5635, 5845, etc.

Every time a buy stop order is filled, the protective sell stop orders for all contracts will be placed 210 points lower than the most recent entry, which is one “rung” lower on the price interval ladder.  This process will carry on until the entire position is liquidated either by a sell stop getting triggered or a profit objective being met.

Here’s how this strategy would have worked out in 2017:

January 6, 2017 – NASDAQ 100 rallies to 5005 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 4795 and a buy stop order to buy more is placed 210 points higher at 5215.

February 9, 2017 – NASDAQ 100 rallies to 5215 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5005 for both long contracts and a buy stop order to buy more is placed 210 points higher at 5425.

March 15, 2017 – NASDAQ 100 rallies to 5425 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5215 for all three long contracts and a buy stop order to buy more is placed 210 points higher at 5635.

May 1, 2017 – NASDAQ 100 rallies to 5635 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5425 for all four long contracts and a buy stop order to buy more is placed 210 points higher at 5845.

June 2, 2017 – NASDAQ 100 rallies to 5845 and fills buy stop order.  A protective sell stop order is placed 210 points lower at 5635 for all five long contracts and a buy stop order to buy more is placed 210 points higher at 6055.

June 12, 2017 – NASDAQ 100 declines to 5635 and elects the protective sell stop orders for all five contracts.  The trade results in a profit of 1,050 points, which is a 5-to-1 return on the initial risk.

The beauty of measuring the sizes of the countertrend moves in a particular trend is that it is relative to the current market conditions.  It works just as easily in currencies…and crude oil…and grains…and bonds…and any other market you can think of.  This is a robust strategy.

Ladder Modifications

Once you get the hang of this price interval ladder strategy, there are a couple of ways that a trader could build a better mousetrap and modify it.

First, the trailing exit stop or “lower rung” on the ladder can be trailed as the market makes new highs for the move without having to wait for the higher pyramid entry orders to get elected first.

Since the size of the countertrend moves off the highs were measured and the price intervals were placed in increments that are larger than the typical reaction, this is a smart trailing stop strategy that works to reduce risk at a faster pace.

Another modification is to update the size of the price intervals based on the most recent couple of countertrend moves.  If the pullbacks are getting bigger, the wider price intervals will provide more breathing room.

Conversely, if the pullbacks are getting smaller, the tightening price intervals will reflect that and reduce the risk on the trade.  This can have the positive effect of increasing the reward-to-risk ratio on a trade.

Know Your Limits

Do some noodling on these pyramiding ideas and figure out what sort of strategy makes the most sense to you and what gels with your own trading system/methodology.  Once you’ve decided on what you’re going to do, though, you’re homework isn’t complete.

You will still need to determine just how big you’re willing to build your pyramids.

Even though you’re trailing the protective stops as you pyramid a winning position, you still need to set a limit on how big you will go.  This is because there is no iron-clad guarantee that your protective stops will be executed and filled at the exact price of your order.  Price slippage –especially after a big run- tends to be the norm.

I’ve seen a reversal in the silver market only take twenty minutes to destroy one-third of a profit on a trade that took weeks of pyramiding to build…and that wasn’t even the final top for the market!  Traders beware.

Nasty slippage is not even the worst thing that can happen.

If a market suddenly makes a limit move against you, there’s no guarantee that your stop order will even be executed at all!  You could be stuck in a lock limit situation for days at a time.

This lock limit scenario is a worst case scenario.  It rarely happens.

But the fact that it’s possible means that you have to build it into your contingency plan.

It only takes one of those to put a trader out of business if the leverage is too high.  You’ve heard the story of what happened to those geniuses who ran Long Term Capital Management, haven’t you?  It was the leverage that killed ‘em, not their being wrong about the market.

So if you’re going to build pyramids, make sure they aren’t big enough to crush you when they occasionally topple over.


More Articles by Jason Pearce:

Building Pyramids for Asymmetric Trading Gains Part I

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

Continue Reading...

By Jason Pearce

Reward vs Risk

George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

His comments address the subject of the reward-to-risk ratio on a trade.  If the payoff of a winning trade is multiple times larger than the risk and subsequent loss on a losing trade, then you can net out a profit even if you have a lot more losing trades than winning trades.

This is why Paul Tudor Jones only takes a trade where he expects to get a minimum of a 5:1 reward-to-risk ratio.

Jones said, “Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile.  I can be wrong 80% of the time, and I’m still not going to lose.”

Simple Math

To calculate the reward-to-risk ratio on a trade, you have to know where the position is being entered, where the initial protective stop is being placed, and where you expect the market to go if the trade is successful.

The difference between the entry price and the initial protective stop tells you the risk on the trade.

The difference between the entry price and the minimum price you expect it to get to if you’re right is the potential reward on the trade.

Just divide the potential reward amount by the initial risk amount and, voilà, you will get the targeted reward-to-risk ratio for the trade.

Building the Great Pyramids

Now that you know how to determine the reward-to-risk ratio on the trade, I want to discuss a strategy that one can use to potentially increase the reward side of that ratio for any given trade.

Unlike in poker, where you have to up the ante and increase the amount of money you must risk in order to stay at the table, this strategy can allow a trader to keep the initial risk size the same –in some cases, even lower the amount of risk on the trade- and capture even more of the upside of a winning trade.

What I’m talking about here is building a pyramid.  No, this is not some new MLM scheme like your dead-beat cousin Eddie is trying to get you to sign up for.  This is a legit way to ramp up your profits on a winning trade.

Pyramiding a position simply means that you continue to add more and more contracts or shares as the market moves in your favor.  You increase your position size as the trend proves itself and your profits grow.

No Averaging Down

It is important to understand that pyramiding a position is not like the traditional strategy of dollar cost averaging where you continue to add a predetermined amount to your investment in time increments like the guy who socks away $500 each month into his mutual fund portfolio.

It’s certainly not where you average down on a position and buy more and more shares of a sinking stock, either.

Quite the opposite.

In pyramiding, you only add to your position when you’re in a trending market that is moving in your favor.

Furthermore, when more contracts or shares are added, the protective stop orders for all the previously acquired contracts should be moving up as well in order to reduce/eliminate the risk on these contracts.  At least, that’s the right way to do it.  Otherwise, all you are doing is taking bigger risks with bigger positions.

From my point of view, adding more contracts without trailing the stops on the other positions is not pyramiding; it’s simply engaging in bad risk management.

Rookie Pyramid-Builder Mistake

Unfortunately, a lot of new commodity traders first learn about pyramiding with the worst application possible.  This is a financial nuclear meltdown just waiting to happen.

The novice trader might read a get-rich-quick trading book or talk to some sleazy broker that teaches them to buy a futures contract and add more just as soon as it has a big enough open profit to cover the margin for another contract.

This sort of pyramiding is the most aggressive way to apply the strategy…and the most incorrect way to do it!  So let’s go ahead and talk about this misapplication first and put it to rest.  Knowing what not to do is just as important for your trading success as knowing what to do.

Recipe for Disaster

The margin for a 5,000 bushel wheat futures contract is currently around $1,500.  This represents a price swing of 30 cents (5,000 bushels * 30 cents = $1,500).

Suppose a trader has $50k in his account and he buys a September wheat contract on a breakout at $5.40.  He could put in a buy stop order to buy another one when it rallies 30 cents to $5.70 as the initial contract purchased at $5.40 would show an open profit of $1,500 and provide the financing for an additional contract.

This all seems harmless at first.  A single contract with fifty grand to back it and one more contract when the market moves in the right direction.  But watch how crazy and how fast this can escalate…

The trader can place an order to buy another contract just 15 cents higher at $5.85 instead of 30 cents higher at $6.00.  This is because an additional 15-cent gain on two contracts is $1,500.

Or the trader could elect to be a little more patient and instead put in an order to buy two futures contracts at $6.00 instead of one at $5.85.

If the trader were to use the latter and more “conservative” choice, he could simply put in buy stop orders to double up every time the wheat market moves an additional 30 cents higher.

Let’s suppose our wheat trader gets “lucky” and catches a weather market in the grains where the market just shoots to the moon and makes hardly any pullbacks along the way.  That’s the sort of trade that fortunes are made of.  What happens if wheat rockets north of $8-per-bushel like it did in the summer of 2010?

The trader would have purchased one contract at $5.40, one additional contract at $5.70, two contracts at $6.00, four contracts at $6.30, eight contracts at $6.60, sixteen contracts at $6.90, thirty-two contracts at $7.20, sixty-four contracts at $7.50, and (gasp!) one hundred and twenty-eight contracts at $7.80.

That’s a total of two hundred and fifty-six wheat contracts that the trader is holding, folks.  I hope they’re not gluten-intolerant…

Oh, and when wheat touches eight dollars the account would be sitting on an open profit of $638,500.  What trader doesn’t dream of that?!

Jenga!

This nearly thirteen-fold increase in account size, brought about by an aggressive pyramiding strategy, is the siren song that lures the novice traders into the markets.  They only pay attention to the profit potential and hope to match Soros’ net worth with just a few trades with their $50k trading stake.

Here’s what they are not taking into account.  With two hundred and fifty-six wheat contracts on, every one-cent move in the price of wheat creates a profit or loss of $12,800 on their trading account and a mere ten-cent hiccup would rip an astronomical $128,000 from their account.

Notice what happened when wheat finally cracked the eight dollar mark in August of 2010: It rocketed to $8.41…and then promptly fell apart, like a high-stakes game of Jenga gone bad.

Wheat closed ‘limit down’ at a price of $7.25 3/4 that day.

From the day’s high to the close, this huge pyramided position dropped in value by $1,475,200.  (That’s nearly one and a half million dollars, just in case the commas aren’t registering in your brain.)

By the way, once wheat traded to $7.46 1/4 the account value hit zero.

By the day’s close of $7.25 3/4, the account was in a deficit to the tune of $261,900.  The trader is completely on the hook for this amount.

And that’s assuming he could have gotten out at the limit price.  If it was locked limit, the trader would have exited in the next trading session at an even worse price when the market gapped lower.

What?!

Although this is what the September wheat contract actually did in the summer of 2010, the pyramided trade is a theoretical example.  However, I can testify to the fact that scenarios like this can and do happen with alarming frequency.  I watched a trader run $20k into $100k in a matter of weeks and then crash it into a deficit of $20k in a matter of days.  It was accomplished during a good old-fashioned weather market in soybeans.

I also know of a mailman with a $50k net worth who ran a $25k account up to nearly $500,000…and then down into a deficit of nearly $1 million by aggressively pyramiding in the silver market this same way.

With a net worth of just $50k, it’s quite a burden to owe a clearing firm $1 million.

I could go on, but you should get the point by now.  This sort of aggressive pyramiding scheme that increases your account exponentially on the way up will decrease it even faster on the way down.  Don’t even think about it!

Trade Smart

A smarter and better way to build a pyramid is to wait for new entry setups to materialize in a market that you already have a position in.  In other words, you trade the market’s price structure.  This is not about calculating how much it takes to finance the next contract; it’s about waiting for the market to show you when and where to add to your position.

A very simple way to implement this is to trail the protective sell stops below each reaction low after a new high for the move is made.

You can also use the new high of the move as an entry signal for more contracts and place the protective sell stops below that same reaction low where the other stops are set.  That way, you’ve reduced you risk on all previously purchased contracts and you have a well-defined price structure pattern to add more.

The inverse works for short sales, of course.  After a market bounces and then hits a new low for the move, protective buy stops can be relocated to just above the bounce high and more contracts can be sold short.

There are two important rules you should adhere to:

First, only take new setups if the current position has an open profit.  You should never add to a position that’s currently a loser.  Even a breakeven trade has not earned the right to get bigger yet.

Second, wait until the initial protective stop has been moved enough to significantly reduce or even eliminate the initial risk on the trade.

That’s it.  Very simple to understand, very simple to and implement.  This is the KISS principle at its best.

Test Drive

As an example of pyramiding with market structure, let’s look at how this might have been applied to a short sale campaign trade in the July 2017 cocoa futures contract.  Keep in mind that one contract controls 10 metric tonnes of cocoa, so each tick ($1) is worth $10.

Also, let’s assume an account size of $100k where we’re behaving like reasonable traders and risking just one and a half percent (1.5%) of our equity per trade.  None of that crazy “pyramid-your-$10k-into-$1-million-in-two-months” garbage going on here.

We will cap the risk at $1,500 (that’s 1.5% of $100k) so that no losing trade or string of losers can ruin the account or take us out of the game.

Now, there are some who will say that you can’t make any real money when you’re risking such a small amount.  Like the saying goes, “No guts, no glory”, right?

Not when it comes to risk management and pyramiding.  Just watch and learn.

July cocoa made a double top last summer between the July and August highs of $3,077 and $3,069.   The lowest point between these two lows was the July 29th low of $2,800.  When this low was broken on September 9th, I think most technicians will agree that a short position could have been entered.

The initial protective buy stop order for this trade could be placed above the double top high of $3,077 or it could be placed above the bounce high that preceded the break at the September 7th six-session high of $2,907.

To keep things simple and low risk, let’s assume a short sale was initiated at $2,790 (ten ticks below the July 29th low) and the initial protective buy stop order was placed at $2,917 (ten ticks above the September 7th high).  This sets the initial risk on the trade at $1,270 per contract, which is a bit under our $1,500 risk target.

So here’s a price structure pyramiding plan that could have been implemented:

1 Once cocoa has bounced to at least a five-session high (this would be a one-week high since there are five trading days in a week) and then drops to a new low for the move, lower the protective buy stop for all contracts to ten ticks above the bounce high.

2 *After the protective buy stops on the prior contracts have been lowered, short another cocoa contract ten ticks below the most recent low for the move and place the initial protective buy stop ten ticks above the bounce high as well.

*There is a risk management contingency for the pyramided contracts: it can only be done as long as the total risk on all the prior positions are equal to or less than the initial risk on the trade and the new stop placement eliminates 50% or more of the open risk on the most recent contract added.

Here’s how the cocoa short sale campaign trade may have worked out:

September 19, 2016 – July cocoa rallies to a six-session high of $2,849.

September 29, 2016 – July cocoa drops to a one and a half year low of $2,693, breaking the prior low for the move at $2,729.  The protective stop on the initial short contract is lowered to $2,901 (ten ticks above the recent bounce high).  The risk is reduced to $1,110, which is not enough to allow for a new short contract.  Remember, the new protective stop placement has to cut at least half of the open risk on the most recent contract.

November 3, 2016 – July cocoa rallies to a nearly three-week high of $2,661.

November 4, 2016 – July cocoa drops to a three-year low of $2,539, breaking the prior low for the move at $2,585.  The protective stop on the initial short contract is lowered to $2,671 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$1,190 locked in.

Also, a second contract is sold short at $2,575 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,671 (ten ticks above the recent bounce high).  The initial risk on the second contract is $960.  Cumulatively, this locks in a net profit of +$230 on the entire trade.

November 21, 2016 – July cocoa rallies to a five-session high of $2,447.

December 2, 2016 – July cocoa drops to a new multi-year low of $2,334, breaking the prior low for the move at $2,363.  The protective stop on both short contracts is lowered to $2,457 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$3,330 locked in and the second contract entered at $2,575 now has a profit of +$1,180 locked in.

Also, a third contract is sold short at $2,353 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is also set at $2,457 (ten ticks above the recent bounce high).  The initial risk on the third contract is $1,040.  Cumulatively, this locks in a net profit of +$3,470 on the entire trade.

January 5, 2017 – July cocoa rallies to a six-session high of $2,244.

January 11, 2017 – July cocoa drops to a new multi-year low of $2,103, breaking the prior low for the move at $2,108.  The protective stop on all three short contracts is lowered to $2,280 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$5,100 locked in, the second contract entered at $2,575 now has a profit of +$2,950 locked in, and the third contract entered at $2,353 now has a profit of +$730 locked in.

Note that a fourth contract was not sold short.  This is because the prior low for the move at $2,108 was not broken by at least ten ticks.

January 17, 2017 – July cocoa rallies to a six-session high of $2,240.

January 27, 2017 – July cocoa drops to a new multi-year low of $2,100, breaking the prior low for the move at $2,103.  The protective stop on all three short contracts is lowered to $2,257 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$5,330 locked in, the second contract entered at $2,575 now has a profit of +$3,180 locked in, and the third contract entered at $2,353 now has a profit of +$960 locked in.

Once again, a fourth contract was not sold short because the prior low for the move at $2,103 was not broken by at least ten ticks.

January 30, 2017 – July cocoa drops to a new multi-year low of $2,088, breaking the prior low for the move at $2,103.  Therefore, a fourth contract is sold short at $2,093 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,257 (ten ticks above the recent bounce high).  The initial risk on the fourth contract is $1,640.  Cumulatively, this locks in a net profit of +$7,830 on the entire trade.

February 16, 2017 – July cocoa rallies to a seven-session high of $2,060.

March 1, 2017 – July cocoa drops to a more than five-year low of $1,899, breaking the prior low for the move at $1,901.  The protective stop on all four short contracts is lowered to $2,075 (ten ticks above the recent bounce high).  The initial contract entered at $2,790 now has a profit of +$7,150 locked in, the second contract entered at $2,575 now has a profit of +$5,000 locked in, the third contract entered at $2,353 now has a profit of +$2,780 locked in, and the fourth contract entered at $2,093 now has a profit of +$180 locked in.

A fifth contract was not sold short.  This is because the prior low for the move at $1,901 was not broken by at least ten ticks.

March 2, 2017 – July cocoa drops to an eight and a half year low of $1,879, breaking the prior low for the move at $1,901.  Therefore, a fifth contract is sold short at $1,891 (ten ticks below the most recent low for the move) and the initial protective buy stop for this contract is set at the same place as the others at $2,075 (ten ticks above the recent bounce high).  The initial risk on the fifth contract is $1,840.  Cumulatively, this locks in a net profit of +$13,270 on the entire trade.

March 13, 2017 – July cocoa rallies to an eleven-session high of $2,023.

March 15, 2017 – July cocoa rallies to a multi-week high of $2,081.  This triggers the buy stop orders on all contracts at $2,075 and liquidates the entire position with a net profit of +$13,270 on the trade.

Price Structure Pyramid Performance

So how did this more conservative price structure pyramiding strategy affect the reward-to-risk ratio on the cocoa trade?

Well, the initial trade was entered at $2,790 with a risk of $1,270 per contract and the profit was +$7,150.  The profit was a little over five and a half times the initial risk, yielding a reward-to-risk of 5.6:1.

But…

The total profit on the trade was +$13,270 and the pyramiding and risk management rules made it so that the cumulative risk never exceeded the initial risk as more contracts were added.  That means the total trade risk was never more than the initial risk of $1,270.

So the +$13,270 profit was nearly ten and a half times the initial and maximum risk on the trade, yielding a reward-to-risk ratio of almost 10.5:1 in the $100k account.  That’s nearly double what the non-pyramided trade would have returned.

Consider the fact that the trade initially risked 1.27% and made a +13.27% return in six months without being hyper-aggressive.

Annualized, that’s a +26.54% return on the entire account with a single trade that risked about one and one-quarter of a percent.

Yes, Virginia, there really is a way to make good money on small risks!

Obviously, this cocoa pyramid trade is one of those best case scenarios.  They don’t all have this sort of outcome.  Most trades don’t.  But the example does show you the possibilities of what can happen when you take advantage of a sustained trend by pyramiding the smart way.

Many Ways to Win

In trading, there are many different paths to success.  Different timeframes, different setups, different entry signals, different kinds of systems, etc.

The same goes for pyramiding.

In this post, we discussed a wrong way to pyramid and one smart way to pyramid.

But this merely scratches the surface.

In the next post on the subject, we will discuss how volatility can be used for pyramiding.  I will also show you a different way to use price structure to build a pyramid.  Both of these pyramiding methods can be implemented in a systematic, rule-based manner.  So if you’re interested in learning how to potentially turning a single hit into a grand slam home run, stay tuned!


More Articles by Jason Pearce:

How Much Leverage is Appropriate in Your Account?

US Dollar: The New Bear Market?

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

Continue Reading...
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