LAW OF LARGE NUMBERS

Besides loving to trade and possessing an extremely compulsive personality, I am ardent subscriber to the theorem, the law of large numbers, and on an occasion when I have too much too drink, a literal believer in the infinite monkey theorem.

In probability theory, the law of large numbers (LLN) is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

A great deal of traders interpret this law in a negative way, reasoning that the more they trade, the greater the chance they will have losing trades, which would result in exacerbating current losses, or giving back current profits. What they don’t take into consideration is that the law is postulated on the premise of random events, i.e., a coin flip or the spin of a roulette wheel. Obviously, if you flip a coin 6 times, you may see 6 consecutive heads or 6 consecutive tails, but if you flip that same coin 100 times, you will probably realize app. 50 heads and 50 tails.

However, while trades are statistically independent events, and one trade has no bearing on another trade, they are not simple random events. Trading decisions may appear to be binary; either buy or sell or up or down, but they are not. There are a critical variables which must be accounted for, such as how much higher or lower is the market is going to move, or in other words, what is the risk/reward of the trade and how do I manage the trade. So, there is something other than chance that comes into play when trading, and that is skill and technique.

It stands to reason then, that the better your skills and technique, the more you should trade. While LLN is important because it "guarantees" stable long-term results for random events, it follows that it is also important that your sample of trades is large enough to maximize the number of successful outcomes from your skillful trades and therefore maximize your earning potential.

You can't find yourself subscribing to the theory that " you're only as good as your last trade. " If you are going to trade for a living, there is no last trade, only the next trade. Whether, your last trade was a winner or a loser, it has absolutely no bearing on the outcome of your next trade. Look forward to taking your next trade, because it's going to be the best trade you have ever made. At least, that's how you should be approaching it.

Unlike gambling, a winning streak by a trader will NOT eventually be overcome by the parameters of the game, unless he somehow convinces himself that this is his inevitable outcome. Trading is not gambling where the house has the edge; trading is a performance based activity that requires skill, technique, experience, and practice. Most important though, the trader must have the right attitude, focus, patience, and self-confidence, and then the trader will be the one who possesses the edge.

THE ETERNAL DICHOTOMY

If Dickens were writing a book on trading it would probably begin; it is the best of times, it is the worst of times, the market can go up, the market can go down, we make money, we lose money, it is easy to do, it is impossible to do, we are full of hope, we are full of despair.

Such is the dichotomy that is trading. You must be confident, but ego-less. You must be objective, but subjective, mechanical but analytical, focused but relaxed, and disciplined but flexible. Your decisions may appear to be binary, buy or sell; but they are infinitely more complex.

Acquiring the knowledge of trading mechanics, tactics, strategies, and risk management is a relatively easy and finite process. Developing the mental skills of focus, discipline, objectivity, and self- confidence are much more demanding. In fact, it’s the one area of trading performance that is a continuous learning experience, and for some a continuous struggle.

The problems and challenges we face trading are not due to a lack of knowledge, but are due to a lack of patience and self-confidence. Improvement begins with changes in how we choose to think, act and be. Positive changes that will only be realized when we make a decision: a choice to learn to let go of the selfish and self-defeating side of our emotions which blocks our minds and clouds our decisions.

The journey to becoming a successful trader is a winding and bumpy road, filled with great triumph, and frustrating sorrow, but everyone has the talent to succeed and the power to create value in their lives. We have all made money, and we have all lost money, but somehow we have all survived and continued along the path to greater knowledge and practice.

APPROACH TO TRADING

This article is intended for the edification of all who are interested, but is especially intended for those who are just starting out. There is not any information in this text that experienced traders haven’t seen before. In fact, everything that is mentioned here is in the public domain, and has probably been discussed at one time or another in this forum and/or practiced by it’s participants. However, this is the routine that I follow, the charts and indicators that I look at, and the thought process and philosophy I employ, so in that sense it is proprietary.

While I look at and consider a multitude of factors, my overriding determinant for initiating and exiting a trade is what I have always referred to as my “feel”. Feel is an intuitive sense a trader develops about the direction of the market, after continuously having watched and studied price action and market behavior. It is not an end state but a dynamic goal, always adapting to changing and evolving market conditions and drivers of price.

For the most part, my trading is not mechanical in nature, although there are certain rule based trades that I take because of their high probability of success. I would like to think that the majority of my trades are still predicated on thoughtful analysis and feel, even though I pay serious attention to the signals generated by my charts and indicators. At times visceral input may generate a trade while the technicals confirm, and at times the converse may be true.

In the most general way, I classify market action as either trending or range bound and my trades as either proactive or reactive, and as either breakout, continuation, or reversal trades.

Algorithmic and high frequency trading has forced traders to transform from “momentum chasers” to “mean reversion” traders. Buying new highs, and selling new lows, rarely works now as passive algorithms are programmed to buy the new low and sell the new high. Even before AT and HFT, the markets traded in ranges about 80% of the time while trending only 20% of the time.

Due to these factors I find myself making a lot of reactive, reversal trades. When I traded at the CBOT, I always felt more comfortable taking the other side of retail stops and fading the rest of the pit, rather than trading with the market, and being the same way as the rest of the locals.

This contrarian strategy is perfectly suited for today’s algo driven and range bound markets, and is luckily already in my trading DNA. The 4 days or so a month that the markets have a trend day, I will adjust my hold times and position sizing upward, but I will still initiate my trades by buying weakness and selling strength, although they will be in the direction of the prevailing trend.

I do make proactive trades based on leading indicators, such as pivots, trendlines, support/resistance, pattern set-ups, etc. which may be also be continuation or breakout trades, but it is far more natural for me to fade extreme moves.

My trade/risk management and position sizing is not mechanical, but is predicated on my on-the-fly assessment of price action and volatility. The broad risk reward parameters and trade plan is outlined, but the final draft has not been finished. Price action is dynamic, and so is my decision process. However, I hope to know within a relatively short amount of time, if the market has me by the balls, or I have the market by the balls, or if it’s just a ring-the-register kind of trade.

What I am very adamant about, and what I feel is a very overlooked topic, is position sizing. Especially on trend days, I am looking to add to good trades. It is critical that you press on these days, because there are so few of them. Adding to, and milking your winners is one of the most, if not the most, important techniques you can employ for making money.

While the opening has progressively become less of a factor and it’s importance continues to become increasingly diminished, I will use it as a general reference point for this article.

FIRST THING IN THE MORNING

I break out the journal and begin to make entries. They begin with cognitive or psychological remarks that continue to the trading session where commentaries about the markets are added. Educational entries are usually made after trading hours as they are made evident.

The idea is to use the cognitive journal to keep a real time record of what I’m thinking and feeling while I’m trading, so that I can become a better self-observer. This helps me to identify problems as they occur, so that I can keep them from affecting my trading. The sooner in the day I begin to assess my emotional status, the better. Therefore, my best practice calls for writing in my journal, first thing in the morning. This initiates the process of clearing my mind for the remainder of the day, and better prepares me for the trading session.

MORNING CALL

This where I bring myself up to speed on overnight developments in Europe, Asia, and the U.S., check the financial calendar for upcoming reports, and try to get a feel for what the market will be focusing on today. As a rule I always have charts up for the Bonds and Dollar, but if something else is in play or is being emphasized that correlates to the e-minis, it will need to be added. Barchart.com has a very good morning call newsletter which summarizes all of the above.

I then begin to make my:

INITIAL APPRAISAL OF TRADING DAY PRIOR TO OPENING

Where is the market trading relative to:

• VWAP
• Overnight Range
• Previous Day’s Range
• Value
• Developing Value
• 200 MA
• Pivots

As it gets closer to the opening, I start to formulate an opinion about what kind of opening it’s going to be:

OPENING STRUCTURE

• Opening Range relative to price benchmarks above
• First Bar and Second Bar - Range (doji) or Trend ( big body)
• Opening’s Structure

a) Open Drive

b) Open Test Drive

c) Open Rejection Drive

d) Open auction

INDICATORS

I am checking the following indicators for reference:

● VIX

● SPX Cash

● Cumulative Adjusted Tick

● Cumulative Delta

● Advances/Declines

● Relative Volume

● Delta Volume

I am now starting to formulate an idea of the potential structure of the day and after the first hour(initial balance) I am getting a better idea of the probabilities for the size of the day’s range, and what kind of day it will be.

● Range Day - The market will oscillate around an average price value with relatively low volatility through the day, likely ending the day not far from its opening price level and/or its volume-weighted average price (VWAP);

● Upside Trend Day - The market will open near its low price for the day session and build its way higher through the day, closing near its high price. The market will tend to stay above its VWAP for most of the day;

● Downside Trend Day - The market will open near its high price for the day session and work its way lower through the day, closing near its low price. The market will tend to stay below its VWAP for most of the day;

● Upside Breakout Day - The market will open within a range, but will build volume and attract participation at the upper end of that range, leading to a price break above the range, and further acceptance of price above the range with solid volume. An upside breakout represents a transition from range to upside trending conditions.

● Downside Breakout Day - The market will open within a range, but will build volume and attract participation at the lower end of that range, leading to a price break below the range, and further acceptance of price below the range with solid volume. A downside breakout represents a transition from range to downside trending conditions.

● False Upside Breakout Day - The market opens within a range and moves above the range, usually with limited participation and volume that wanes with higher prices, only to fall back into the range and return toward VWAP. A false upside breakout represents an extension of range trading conditions.

● False Downside Breakout Day - The market opens within a range and moves below the range, usually with limited participation and volume that wanes with lower prices, only to bounce back into the range and return toward VWAP. A false downside breakout represents an extension of range trading conditions.

TYPES OF TRADING DAYS - MARKET PROFILE STYLE

CONSOLIDATION 80%

● Normal

● Non Trend

● Normal Variation

● Neutral

TREND 20%

● Trend

a) Trend from Open - open, trend

b) Spike and Channel - spike, channel, reverse to prior range

c) Trending Trading Ranges - trend, range, trend, range, trend

d) Trend Resumption - trend, range, fbo, trend-symmetrical

● Double Distribution

Concurrently, I am checking various charts that give me a macro-economic perspective of the markets:

INDICES

● SPX

● COMP

● DJIA

● RUT

MACRO ETF INDICATORS

● VIX - Volitility Index

● UUP - Dollar

● TLT- 30yr bond

● GLD - Gold

● DBA - Commodities

● USO - Crude Oil

GLOBAL MARKETS

● VGK - Europe

● FXI - China

● EWZ - Brazil

● EPI- India

● RSX - Russia

● EWJ - Japan

BONDS

● TLT - 30YR

● IEF - 10YR

● SHY - 2YR

● LQD - IN. GR.

● AGG - AGGR.

● TIP- INFL.ADJ.

STOCKS

● NFLX

● GE

● BIDU

● GOOG

● AMZN

● RIMM

● AAPL

● CME

This is how I break down the trading day, and intra day tendencies I’m looking for

9:30 AM -10:30AM Opening - Initial balance 10:00-12:00 Contra- trend

reversal- Fed open market operations

10:30 AM -12:00PM Morning - The !0am move may continue till Noon

12:00PM - 2:00PM New York Lunch Hour 12: 00 - (1:00 - 2:00)

Consolidation or slight contra- trend move

2:00PM - 3:30PM Afternoon 1:00 - 2:00 - 3:00 ABC Move

3:30PM - 4:00PM Close 3:30 Linear Move

REAL F.E.A.R. - FED ENGINEERED ASSET RAMPING

Short-term traders and the 2-and-20 crowd may be able to take advantage of the current asset ramping perpetrated by the Fed, but long-term investors will continue to lose money in real terms. On a constant-dollar basis, or inflation-adjusted basis, investors will lose value on their investments in terms of the purchasing power of their assets.

 12 Month Performance

• SPX - UP 8.5%
• DJIA - UP 11%
• COMP - UP 12%
• GOLD - UP 30%

12 Month Performance Relative to Gold

• SPX - DOWN 22%
• DJIA - DOWN 19%
• COMP - DOWN 18%

 Future economic conditions/inflation expectations are being priced into the 30 year while the current state of the real economy is being priced into the short end. The long end of treasury curve is selling off while traders/investors are still chasing the short end.

Chasing returns by buying U.S. stocks , (especially at current levels), because the Fed is destroying the dollar may be one of the most irrational exuberances we have ever seen.

ARE WE NEARING A CYCLICAL TOP IN THE S&P?

ARE WE NEARING A CYCLICAL TOP IN THE S&P 500?

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Are we nearing the top of the March 2009 cyclical rally, which is part of the secular bear market that began in 2000?

Monthly chart of the SPX, it is approaching major resistance at the 50MA at about the 1200 level.

Daily chart of the SPX , both the rate of change and money flow index, started to fall about mid September, as the market continued to rally. This suggests that the "smart money" was selling into the rally.

Daily chart of the VIX w/ 5period RSI, the VIX is approaching 6 months lows and very oversold readings.

LESS IS MORE...MORE OR LESS

Technology was supposed to make life simpler, but as Alvin Toffler warned in 1970, in his prophetic novel "Future Shock", rapid technological change has made life even more complicated and increasingly stressful. After having stared at my 10 chart workspace, replete with a varied sampling of custom indicators, I remembered a quote from Mark Twain. “Civilization is the limitless multiplication of unnecessary necessities.” I realized that in my quest for the perfect workspace, I had inadvertently overwhelmed myself with too much information. The immediate corollary of my actions had left me feeling disoriented and disconnected from the markets.

 
There is an abundance of information in the public domain, and a multitude of brilliant people whom never cease to amaze me with their knowledge and experience. Collectively utilizing their ideas, I devised an integrated system comprised of traditional candle charts, Market Profile, Market Delta, DeMark indicators, Fibonacci confluence zones, VWAP/SD, and various indicators and chart formats, in search of the “perfect” workspace. After having weeded out, the charts and indicators I felt were ineffective, I was left with what I believed was necessary to keep me on a level playing field with other traders.

 
While I do utilize every chart in my workspace, they do detract from what should be a visceral experience, so in this case-more may be less. There has been much debate as to the importance and potential benefits of “keeping it simple”, and the competence to objectively analyze price action, and it is my belief that this arcane ability is perhaps the “key to the kingdom”, and the quintessential prerequisite for trading success.

Too much emphasis and reliance has been placed on what is perceived as being technically necessary, rather than concentrating on the art of observation and perception and objective analysis of market behavior and price action. Sometimes less, really is more. 

However, while simplicity may be easy to attain, it is much harder to maintain, because the temptation is always there to try to do more. Therefore, simplicity is not an end state, but a dynamic goal. That being said, the time may have come, for simplicity to come full circle from near obsolescence to absolute necessity.

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