4 Key Pillars to Successful Trading

 

In this blog I will discuss. 

  • My current status update.
  • How to generate income over time by day-trading.
  • 4 key pillars to being a successful trader.
  •  4 core tenants for planning a trade with a recent real world example.
  • How to start overcoming psychological problems traders face.

It’s been a while since I’ve posted. Partly because I’ve been swamped with work but also because I haven’t been inspired by much of what’s happening in the broad stock market. The continual upward trend on light volume and weak structure has not given me an abundance of confidence. The bull’s sentiment backed by dovish Federal Reserve banter means there’s a good chance the S&P 500 makes new all time highs soon and that has me questioning being overly short. Contrary to this, I do not feel comfortable putting money to work on the long side for more than a few weeks. Why? Much of the economic news has not been good; i.e. Q1 earnings results, interest rate uncertainty, Brexit fears, China, high student loan debt, employment rate declines, and increasing default rates on subprime auto-loans (similar to the housing crisis in 2007). If the news gets better surely my outlook will change but for now I’m going to play it safe and stick with day trading.

Other than my 401k and IRA, I’ve been mostly in cash, using some capital to day-trade and put on small short-term trades that last a week or two. This isn’t investment advice but a transparent disclosure of what I’m personally doing.  I’m sorry I haven’t been able to share some of my short-term trade ideas but I’m happy to say that my win/loss ratio is well above 50%. An example would be my silver trade (SLV) which I initiated on May 31st and closed out on Friday, June 10th for a 50% gain! I’ve also been cutting my losers quick, perhaps a little too quick as you can see by my volatility trades for 2016.

I’m currently working on a project which I hope will give people an opportunity to participate in my day-trade and short-term ideas. My partners and I are developing a technology that we believe can let more people actively participate in the market without having to monitor their trades each and every minute of the day! It’s been challenging, exciting and fulfilling to get past the concept phase and into testing the software in a real time trading environment with actual money on the line. For now, that’s all I can disclose about this project but I really just wanted to let you know that this work is part of the reason I haven’t had time to post my blog articles.

Chart of Silver from May 31-June 10 (2016)

SLV.PNG

How to generate income over time by day-trading.

I believe day-trading (if done right) can generate more income than investing in the long-term. Average “investors” look to beat the S&P 500. This means that if the S&P goes up 5% in a year and they make 6% they are doing well, or if the S&P 500 goes down 3% in a year and they only lose 2% they are doing well.  As a day-trader, I seek to make between 25%-100% on an annual basis not matter what! This isn’t to diminish long term investing. They are totally different and each has it’s merits. Since the market tends to go up over time most people (reasonably) prefer a long-term buy and hold investing approach. It’s much less risky, but also much less rewarding. Some of the challenges new day-traders face is the ability to do more than just predict the short-term direction of a stock. It is an extremely emotional, psychological and difficult endeavor and one most people fail at. Without a process it can be a futile endeavor. I have had much success and failure in this area and after 13 years of trading have begun to understand what it takes to implement a successful process. I’ve said it before, day-trading is the hardest thing I have EVER done. That is why I want to share with you a process that may help you discover some success in this area.

4 key pillars to being a successful day-trader over time…

  1. Every trade you make is unique and independent of all your past and future trades. Just because a stock has acted a certain way in the past, doesn’t mean it will act the same again.
  2. You must have a plan before you enter a new trade.
  3. You must be correct greater than 50% of the time (I can write another blog on  this point alone but will save that for another day).
  4. When you’re wrong you must not lose more money than you make when you’re correct.

These four keys may be very obvious but implementing them is not as easy as it sounds. Trust me on that! There are many barriers (including subconscious barriers) which prevent even the best traders from implementing what they know to be true. In the next part of this section I am going to walk you through a trade I made, the psychology behind my decisions and the satisfaction I experienced even though I could have made a lot more money than I did. Then I will finish by explaining how this trade was a small piece of a longer term process and how using the four key pillars to being a successful day-trader really work.

On Friday, June 10th I sold short CAT (Caterpillar). This means I was betting the stock would go down. There was nothing special about this trade. In fact, if you look at the minute by minute chart of the S&P 500 ETF SPY (left side) and CAT (right side) they are very similar (see charts below). CAT did however close down more than SPY on a percentage basis. Subtle differences between the price action on CAT and the broader market provided me with clues and an edge, but I probably could have picked any DOW or S&P 500 stock and had similar success simply by implementing the four keys to being a successful day-trader.

CAT&SPY.PNG

Justifications for shorting CAT:

  1. CAT has had a tremendous run and was due for a pull back (42% rise from Feb low to April high).
  2. The broad stock markets around the world were falling, which meant that it would be hard for large cap stocks like CAT to go up without any game changing company specific news. Big companies like CAT usually (emphasis added) go down on days the broad market goes down and up on days the market goes up, so shorting was the most likely direction to be successful for the day.
  3. At the opening bell, CAT had a deeper sell off than the rest of the market.
  4. CAT is closely tied to commodities like oil which was pulling back sharply.
  5. CAT is closely tied to the US dollar and when the dollar goes up, commodity related stocks tend to perform poorly.
  6. An alert I had previously set triggered which implied that Cat had risen to a level which I believed was a good entry and location for a short trade on a market down day.

*disclaimer – I am fully out of this trade and have no intention to go long or short of it again until market conditions justify a trade.

Despite these justifications, I needed a solid trade plan before I established a position. Remember, this is a day-trade so having a lengthy, detailed, mapped out plan is not really a viable or realistic option. The plan should only take a couple minutes to formulate in your head however, the plan needs to be comprehensive enough to consider all possibilities.

4 Core tenants of a good trade plan…

  1. Determine your time-frame for the trade.
  2. Determine potential entry and exit points before you trade. Entry and exit points may be based on the amount of money you are willing to lose compared with how much you believe you can make. This can be based on a percentage increase/decrease, or a specific price point for the stock you’re trading. For me, this tenant is somewhat dependent on tenant #1.
  3. Determine how many entry points you want to have. For me, I typically do not use all my cash available for the trade on my first entry. I don’t want to clue High Frequency Traders (HFTs) to what I’m trying to accomplish. I also want to save some dry powder to see if I can get a better price. When you play poker do you shove all your chips into the pot when you think you have a decent hand? Probably not, if so please tell me where you play at!
  4. Determine how much capital you are willing to use for the trade.

Once you know these four things you can begin implementing the trade idea.

Implementing my trade plan…

  1. Between 7:43 and 7:46 AM (pacific), I sold short 1000 shares of CAT @ $76.42. I divided my first 1000 shares into two separate trades. I usually like spreading out my trades because I don’t want HFTs to catch on to what I’m doing. There is an extra trading cost associated with this strategy but it gives me some extra time to see if I can get a slightly better price, and to see if I really like the trade. If I do get a better price it covers the cost of the extra trade. In this case my first two trades were at $76.40 and $76.44.
  2. The 1000 shares at $76.42 tied up approx $76,500 worth of day-trading buying power (margin), half of what I was willing to place on this trade.
  3. This was a scalp trade from the beginning. I didn’t want to be in this trade for more than 30 minutes. 30 minutes is a personal preference. There is an opportunity cost if our capital is tied up and we cannot put it to work on a trade generated by our trading software program.
  4. With the initial 1000 shares I was looking for a 2:1 win/loss ratio. My stop zone was $76.62 and profit taking zone was around $76.02. So, if CAT hit my profit zone I would gain $400 but I was only willing to lose $200 if CAT hit $76.62.

CAT_t1&2

Within minutes the stock started to move nicely down in my direction to $76.27. I had two separate orders to buy-to-close the 500 shares @ $76.21 and 500 shares @ $76.17. The idea was to take profit early and maybe re-enter the trade on a bounce. At $76.27 my 1000 shares showed an unrealized profit of approx $150 dollars but suddenly the stock bounced up and my profit was gone faster than it had arrived. This is where the ability to adjust your trade plan can increase your chances for success. Remember, some of my priorities are to be in the trade for as little time as possible, realize a decent profit and move on to the next trade.  My target range of $76.02 was not a hard set number. I imagined it as an “ideal” place to take profits. I believed that it could easily reach that number. One thing I’ve leaned about beliefs (the hard way) is that they often interfere with my ability to make money. When your belief is so strong about the future price of a stock and the direction it should go your brain will subconsciously block any negative information that contradicts your belief. This is because our brains are hardwired to avoid pain. Preconceived believes about the direction and future price of a stock will emotionally and psychologically cause traders the most pain because it’s not until they’re in a bad loss that they realize the data has been indicating all along that they were wrong. Instead, we should strive to understand this dichotomy by interpreting the data and accept that our beliefs may be wrong!

Back to the trade at hand…When the stock surged back up to $76.43 I added 1000 shares to my position bringing the total dollar amount of the trade up to $155,000. This was the max amount I was willing to utilize for this trade, which was the plan from the beginning. However, adding 1000 shares changed the dynamic of my trade in two ways…

  1. I was required to re-think my win:loss ratio. Was $76.02 still my sell target and $76.62 my stop zone. If so then the dollar value of my potential gains would be greater than before but so would the dollar value of my potential losses.
  2. Was my time frame still 30 minutes?

There is no right or wrong answer to these questions. It’s depends on the trader and their appetite for risk. For me, taking money off the table and freeing up capital for the next trade was a top priority. I decided because I was adding more exposure, and taking on extra risk, that I would immediately sell the 1000 shares I bought regardless of what direction it went next. For example, if the stock went above $76.50 I would sell half and take a $70 loss but if it went back down to $76.27 I would gladly sell half for a $150. By tightening my profit and loss zones my ratio of 2:1 never changed and neither did my potential gain or loss. Also, after the surge back up to $76.43 my belief that I was right didn’t change. I didn’t let fear change my perception but I also would be carefully monitoring any new data that might suggest I was wrong.

Sure enough the stock dropped back down to $76.28. I tried buying back the shares at that price but I think High Frequency Traders (algorithms) were not letting me get filled so I settled at $76.30 for a $120 gain. $120 in one minute is a great time/profit ratio (for anyone) so I was very please to take half of my trade off the table, free up cash and be more patient with my $76.02 target.

After thirty minutes CAT was still trending down in my direction but the price hadn’t decreased enough for me to realize much more profit than I had previously taken. I decided to be a little more patient and see where the price would go. After 37 minutes I took off another 500 shares at $76.20 and then after 45 minutes I took off the final 500 shares at $76.05. I made slightly over $400 on the trade.

CAT remainder

Not long after I had sold my final shares did the stock reach my $76.02. I guess in hindsight I could have been a little more patient. The stock went as low as $75.38 which would have been a $2000 gain had I covered all my shares near that level. One takeaway that I’ll try to apply next time is to keep a small position which doesn’t tie up much capital. That way if the stock does make a big move in my direction I can reap the benefits or if it goes against me I can cut it without regret and still have plenty of dry powder for the next trade.

The point of this story is not about how much money I could have gained. Nor is the point of the story to impress upon you a 30 minute time frame like the one I applied here. Actually, for most traders, it would probably be wise to be more patient than I was and let the trend play out. The point of this story is to show how I applied the 4 key pillars to being a successful day-trader. I didn’t base this trade on past CAT trades (or any trades for that matter). I didn’t let any preconceived believe about the direction or future price of the stock affect my decisions. The big point is that if I can repeat this process successfully over 50% of the time I will be be profitable in the long run as a day-trader. Consistent winners add up over time, even small ones. The more trades you can make using this strategy the better your results will be. This is exactly what we are trying to accomplish through the technology we are building, and that’s exactly how you can day-trade to generate income over time.

4 key pillars to being a successful trader over time…

  1. Every trade you make is unique and independent of all your past and future trades.
  2. You must have a plan before you enter a new trade.
  3. You must be correct greater than 50% of the time.
  4. When you’re wrong you must not lose more money than you make when you’re right.

Follow me on Twitter @ Jeffreytief

1 minute chart of CAT on June 10th, 2016.

CATday.PNG

 

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