Simplicity
Attila has kindly invited me by virtue of the competition rules to sound off on whatever topic I like. With respect to my treasured Nazi Box (smuggled out of Germany in 1944 and acquired by me through one of those secret car boot sales that only those in the know are aware of), I suspect that by now most people are: bored to death/reeling in incredulity/can’t afford one/believe it’s a scam. So I won’t mention it again in this piece you’ll be glad to hear. What I would therefore like to bang on about with respect to trading (and it works in many other fields also) is the topic of Simplicity.
Why Simplicity?
Moving to a philosophy of keeping it simple improved my trading no end and although it’s great fun to experiment with all the indicators and EAs, aren’t we into trading to make some dosh? – and don’t mistake that for easy-dosh which is, as far as I can tell, reserved for the Gods of trading (“The Market Wizards”?) of which I’m not one!
How
So what is simple? The simplest thing you can get is price – it doesn’t lag, it doesn’t forecast and it doesn’t necessarily reflect the value of its underlying assets. But it is what we trade and constitutes our raw material. Some people can look at a string of values and mentally interpret them - “tape reading” - (Jesse Livermore was pretty good at that but he ended up blowing his brains out so we won’t go down that route) but most of us find visual interpretation easier. But even then there are ways of making it more complicated – my old and trusty 20th century MetaStock offers me nine different ways of displaying price. So let’s just keep it simple and go for the daily line chart plotting EOD closing prices.
We are keeping it simple – so no indicators (but I’ll let you have just one as a concession, it may well help in the transition to simplicity but possibly not in the way you would think – more about that later). What we will use are straight lines depicting trend, support, and resistance. (If you want detailed instruction on using straight lines, read contributors dbphoenix and The Rumpled One). The only other addition to our chart will be volume – not always essential and not always meaningful but on occasion very useful. Using our lines we can soon identify trends or channels and trade within them – but even that requires a few simple rules:
- Trade long or short in accordance with general market trend. If it’s ranging then you can do either, dependent on the chart of your chosen instrument.
- Most established trends end up being depicted in a channel of some kind. Enter your trade at the channel boundary favouring your direction of profitability e.g. in a trending up channel you would go long when the price bounces off the lower channel. (If you do it vice versa you will reduce your advantage).
- Volume – keep an eye on average volume and note when actual volume deviates. There’s usually a reason and it can reinforce your conclusions of what’s happening to the trend. Yahoo financial quotes average volume but you can easily plot this yourself (65 period sma overlaid on a vertical column chart of volume works well for me). This is a good instance of using an indicator for clarification rather than a forecast – which is what we are trying to avoid.
What are we going to trade? Well, anything that is either in a decent trend (up or down) or has a clearly defined history of ranging – which in itself is a kind of horizontal trend containing mini up and down trends. If when you look at your daily chart you can’t see a trend, then there isn’t one – simply just move on to the next. We need instruments which possess liquidity and volatility enough to generate a worthwhile trade while not being so volatile to cause problems. Forex? – perfectly okay if you can find a suitable candidate, but for me that’s the rub. With a dozen or so major pairs it may not always be possible to find what you want. (On the other hand, just watching a small handful you can get to know them very well and if you are sufficiently patient to wait for the stars to align you may well be rewarded abundantly – that’s all part of practising simplicity). For me, something like the SP500 makes it very simple: there is always a suitable candidate.
When will we enter/exit? In the grand scheme of EOD trend trading, once our straight lines have given us the message to act, it’s not vitally important with respect to time of day and if you are a beginner it may well be simpler to use your scarce (and it is scarce when you are starting out) brain power for other aspects of the trade. However, with a little experience it’s useful to slip down to a much smaller timeframe to refine your entries and exits – with practice you can squeeze extra mileage out of the trade. But the important thing is to act, once the straight lines have told you to do so. Part of our simplicity mode is to normally live within the daily timeframe.
So that’s our modus operandi sorted out! But we need to test it and that’s where the fun starts – and I do mean that in the sense of enjoying ourselves. If we are a beginner we want to learn how to trade profitably and safely without blowing up our account; if we are an experienced trader it would be nice to demonstrate that we can take those aims in our stride.
The Micro Account
In my quest for simplicity I’ve become a fan of the Micro Account. (NB. This is not about day trading which is a completely different ballgame.) Let’s specify a starting capital of £1000. Yes, it’s well undercapitalised and any misuse or bad practice will soon have you in the debtor’s prison. But that’s why it’s a good learning tool and test of your skill: you can only succeed with this account if you do things right. And you will learn that discipline is essential to success. The aim is to double our capital in 12 months. It’s going to take a fair while to accrue even a deposit for the yacht but on the other hand, if you can make this achievement in a calm and regulated manner then you should be able to scale it up considerably. The yacht then becomes a possibility for those who are patient!
This is our game plan: we’ll start off paper trading – when we can do that properly we can go live. We’ll take our entry/exit prices from the broker’s live feed – if we use spread betting (SB) we can forget commissions et cetera but will still need to take account of dividends and other minor costs. When paper trading SB we will need to deduct appropriate margin from our capital – that’s easily calculated by opening a trade ticket without actually executing it, otherwise you can calculate it yourself.
If we are to trade safely and not wipe out our account then it’s essential to have some safety rules in place. Just as in the aviation world where pilots have limits to ensure safety (break them and you will surely end up in serious trouble) we must do the same. Here are the safety limits I recommend for the Micro Account. Note: I define risk as the amount of money that will be deducted from the account if that limit is breached.
- Maximum risk on any one trade = 10% of account capital. This fits in quite nicely with a guaranteed stop loss (I use IG and 10% is their usual). Do note that this is a nominal stoploss only, used for purposes of risk management (it also shields you from opening spikes and other suchlike shenanigans). Your practical stoploss (the place where you know the trade is no longer viable) is known only unto you & your maker – so you won’t be able to blame the broker!
- Maximum risk on all open trades = 50% of account capital.
- Maximum drawdown allowed = 15% of account capital.
You may think that these limits are very restricting. Well, they are and they are designed that way to keep you in business. You would have to be completely reckless to trash the account. It should become apparent fairly early on if you are not trading well and the idea of the limits is to make you realise that, before the situation gets seriously out of hand.
I did say previously that you would be allowed one indicator as a concession. (My favourite would be the Welles-Wilder PSAR which is ideally suited to trending situations. It gives nice confirmation of a trend and even suggests an adaptive stop.) However, that’s not the point. Just plot your favourite indicator and observe it – don’t use it in your trading. You will then see firstly, that you don’t need it and secondly, that it can give erroneous messages or inappropriate timings. Look carefully and you will see its limitations. Ironically, once you reach that stage that is the very time when you will be able to squeeze some little use out of the indicator despite not needing to do so!
You will have to be patient to be successful with the Micro Account as I’ve postulated. But hopefully it will make you cautious and think very carefully about what you’re doing with each trade. If you can double your money in 12 months without going bust, without having sleepless nights and develop a feeling of confidence and control, then I think you’re probably doing okay. I know that the aims of the Micro Account can be achieved because I’ve done it myself. Expert traders will be able to do a lot better.