Really was a game changer for me, helped my find the courage to investigate what i was already suspecting.
by stevespray
88
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Hi LM, Great thread – I am very much enjoying watching the subject develop.
I hope that I might be able to add a few points to the many that have already been made.
Early in the thread several references are made to Jesse Livermore and his trading techniques. Several questions are then raised by his comments. I’m fascinated by Livermore and have been so for many years.
My feeling is that Livermore’s comments were perhaps cloaking a greater understanding of the markets than most of us perceive. Our ‘perception’ of what goes on is limited by our self imposed rule structures which we may consciously or sub consciously apply to ourselves. My feeling is that Livermore attached absolutely no value to index or stock values other than to acknowledge that each stock or index had to trade at a particular price. Naturally in a bull market prices tended to trend higher whilst a bear market would lead to an overall decline in prices.
Livermore’s techniques were not based around moving averages or any other indicator – this is important to understand since it is this understanding which paves the way for us to understand things beyond our current perception. The basis of this thread is an attempt to develop a largely mechanical trading system of sorts. The trigger to trade being a move away from a predetermined level. I would question everyone who feels the need to use a ‘rule based’ trading system. Most people choose a rule based system because they are looking to absolve themselves of trading responsibility – sub consciously life has taught them to do this – I guess you could call it ‘human nature’ of sorts. Most people will not make money from these systems for many reasons.
What I like about LM’s system are the comments regarding the trade going the right way from the start. This is the kind of ‘taking responsibility’ which makes a system potentially profitable. There is a massive reason for this which I will mention shortly.
Just getting back to Livermore and his techniques – These were, for the most part, based around what we would term as ‘tape reading’. As I said before, the level of an index or stock was not important, what Livermore saw as important was how the prices reacted to the activities of the larger market participants. He would examine how the market ‘absorbed’ buy and sell orders. His key tactic was to try and identify the key areas of what today we call ‘distribution’ and ‘accumulation’. Livermore would record findings in his various journals for later reference. The reason that Livermore was so successful was because he was able to uncover longer term trends right from their outset. The reason that most ‘mechanical’ trend following systems don’t make money is because they spot the trend late. Having ‘spotted’ a trend you join it and hope that the trend continues. Often this happens. The problem is however the exit from a trend. Again a mechanical system falls foul of apparent ‘lag’ – by the time the systems calls an end to the trend the price has retraced significantly and therefore a large percentage of the profit has been eroded. Likewise if we manually intervene, and close it ourselves, the trend will carry on much further and again the profit is missed out on!
Potentially profitable trading....
My own studies have uncovered what I feel are pretty important aspects of trading if one is to become and remain profitable. I feel that these ‘theories’ tie in very nicely with LM’s proposed trading system. This is because I feel that the sudden / rapid movements which LM is looking for are of a particular nature and caused by a particular set of events. People have questioned whether there will be too many false entries (“death by a thousand cuts”) – this is certainly going to be a problem and I would suggest that a volume study is going to be needed either as a set up or a conformation tool.
In my opinion it is important to understand that these types of breakaway techniques are only going to work when there is a significant level of ‘speculative money’ within a particular market. This is because speculative money tends to be ‘fast in – fast out’ in nature meaning that the speculative punter is easily persuaded to alter his market position and this is generally caused by the price movement itself. If the amount of speculative money in a market is low then the reactions to price movements will be very much more damped in nature – this leads to a marked increase in ‘false breakouts’ and the like and a more ‘random walk theory’ starts to prevail.
These theories are backed up by theories such as ‘reversion to the mean’. Someone mentioned earlier about the ‘true value’ of something – this is a very valid point since the true value of something can become vastly distorted by an increase in speculative money. Livermore talks in a number of his books about how certain commodity traders ‘cornered the market’ in certain things. In fact Livermore lost some large sums of money betting against these traders. Livermore commented that ‘no price is so high that it cannot double again in a month’ (or words to that effect). Likewise ‘no price is so low that it cannot half in a week’ (I hope no Northern Rock shareholders are reading this now!).
So, as speculative money enters the market the price can potentially move further and further away from its ‘true value’. In the markets price movements and bigger volumes in turn attract more speculative money which often creates small self perpetuation cycles. Mean reversion shows us that as volumes drop back off the market will return back towards its area of ‘true value’ – ie a fair value which is established by market participants who trade on much longer timeframes and are not persuaded to alter their positions by price movements in the shorter time frames.
As an example you can often spot this in the FTSE in the last 30 minutes of trading. Quite often the FTSE will move independently of its US counterparts (in that last 30 minutes) as the days speculative positions are unwound – this is a reversion towards true value.
So back to profitable trading....
In order to trade profitably on an intra-day basis one has to examine the habits of losing traders. This is, at times, much harder than it sounds. Most of my theories on this subject come about after studying my own unprofitable trading periods. In particular I had a period, about six years back, of intra-day trading on foreign exchange (USD/GBP to be exact) which was of particular annoyance to me since my trading was so consistently bad. By ‘consistently bad’ I mean that I was consistently able to ‘donate’ cash to the markets on a daily basis. As it was I was only trading with £1 per point whilst I ‘got the hang of it’ but it didn’t stop me losing, on average around £120 per week over the course of about 3 months. Statistically I was averaging just under two trades per day – say eight per week. This meant that with a spread of two pips my trading costs were only 16 pips per week which obviously meant that my net market losses were around 104 pips per week. This quite frankly amazed me and, once analysed, lead me to conclude that consistently profitable trading was very possible given that I could show (and indeed demonstrate live!!) that consistent losses could be achieved over and extended 3 month period. I continued studying my failings but to no avail. I could not place any logical reasoning behind this ‘consistency of losses’.
My ‘eureka moment’ came when I was relaxing whilst lying on a beach in Spain. My girlfriend at the time was most amused to see me scribbling away frantically with my demented ramblings. So what had I stumbled across??
What it all comes down to is ‘Stops’! Of course everyone will tell you that keeping good stops is the key to profitable trading but it simply isn’t as straight forward as that and I can now (attempt to) demonstrate why.
I would ask these following questions;
What is a stop and where is it generally placed?
What has happened once a stop has been tripped?
I will attempt to answer my own questions in an attempt to demonstrate my theory. Firstly, stops are generally placed at price extremes in terms of current market action. That is to say that when a stop gets activated the price will have moved to a point of local extremity (at the split second it is triggered) – if the price wasn’t at an extremity then the stop would not be triggered.
Secondly, once a stop has been triggered you are exchanging ‘piece of mind’ (that you loss cannot get any bigger) for a price which is very likely away from ‘true value’ (which is consistently to your detriment). I therefore consider that stops consistently triggered (due to price movements) will always represent bad value from a trading perspective because each and every time a stop is triggered you will be trading at a point in time where the price is least favourable to you in terms of deviation from true value.
Likewise when we think about wining trades – how often do we let winning trades reverse on us before closing? This is the second part of the theory. With stops we set ourselves up to trade at unfavourable price extremes and then compound the issue by only closing winning trades once the price has regressed a good way back towards true value. So, as you can see, we are trading in a manner which is a reverse of what is required.
In my opinion to trade successfully intra-day we must adopt a policy which takes advantage of the theory. This simply means closing bad trades on a regression whilst only ever taking profits on prices of local extremity. By trading this way we will only ever be exchanging ‘value’ at points which are beneficial to ourselves.
End of part one!
Steve.
