Creating Successful Trading Rules
Learning how to trade Every professional trader has a tale worth sharing which is unique but not identical. This is a description of my journey toward successful trading in automated systems. This is information I wish I had available prior to starting my investment career. That is not to say this would have helped me, because I was too stubborn and too stupid to listen to the stories of professional traders before me. I had to learn the hard way, through the loss of capital and by trusting others who promised much more they could deliver. I am hoping that you do not make the same mistakes, but rather are willing to evaluate and test what I found to be true so that you too, can earn a passive income from your trading and learn a skill that few people can demonstrate they possess. I started my investment career similar to the way that most people start. I spoke to family and friends and interviewed several financial advisors to seek the one I felt could best help me meet my financial goals. I invested primarily in stocks, ETF's and mutual funds in a very conservative manner. Over the next eight years I saw the value of my portfolio rise and fall with no direct correlation to the quality of the investments I believed I held. It became apparent, that regardless of the time and effort I put into the fundamental analysis of the investments I selected, I had no control over the performance of my portfolio. I was told by my financial advisor to invest for the long-term and assume that an 8 to 10% average annual return over the long-term would help me realize my goals. I learned all about dollar cost averaging, rebalancing my portfolio, attended dinners and sponsored events put on by my financial advisor to learn how I could play the game successfully. What I soon realized was that all the rules I was being told to follow put more money in my advisor's pocket and the companies that he represented than it did in mine. I requested a special meeting to speak with my advisor to asking the following question, "Do you make more money from your investments or from the commissions you make from your clients"? After asking that simple question and watching him tap dance around the answer for nearly 10 minutes, I realized I needed to change direction. I wanted to learn how to make money regardless of market direction so I learned about advanced options trading strategies, trade advisors and trading rooms and automated trading systems. For me it was like going back to college in learning an entirely new way to invest in which money could be made or lost regardless of market direction. I also learned that professional traders do not trade the way my financial advisor was telling me to invest. Over the years that followed, I both made and lost money trading the markets. But the process was exhilarating. Rather than waiting and hoping that my portfolio would grow I realized that I had more control and could actually define my risk before trading. What follows is a brief summary of the trading rules I utilize with descriptions of why they're so important. Unlike most trade journals, articles, or books, I will share with you my live trade performance as well as my rules, so that you can verify that the information I am providing you is exactly how I trade.
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I am not a licensed Commodity Trade Advisor, nor do I want to be. The reason for this is I do not want the increased liability resulting from the compliance and regulations inherent in this industry. I want to make the majority of my income through trading not to commissions or subscriptions. I am making this information available to you because I want to help prevent you from making the same mistakes that I have made over the last 10 to 15 years. What follows is a dynamic document which will change as more material is added. I am a manager of the company, Automated System Trader, L LC and a professional trader making the majority of my income through investments like these that will be covered in this document. I am making the same systems that I trade available to you should you decide that these will meet your trade objectives. For a limited time, I will also provide you with my contact information should you decide to speak with me directly.
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DETERMINING YOUR TRADING RULES 1.
DETERMINE WHAT TO TRADE
2.
DETERMINE PERCENTAGE RISK PER TRADE
3.
DETERMINE MAXIMUM ALLOWABLE DRAWDOWN
4.
DETERMINE CAPITAL REQUIRED TO TRADE
5.
DETERMINE ASSET ALLOCATION
6.
DETERMINE GROSS AND NET RISK
7.
DETERMINE TRADE STYLE
8.
PREDEFINED EXIT RULES
9.
CALCULATE FEES INCURRED CONTINUALLY
10.
MONITOR OR JOURNAL FREQUENTLY
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Determining What to Trade It's important to realize that the markets move up and down and sideways. Because of this, it's always amazed me that the majority of financial pundits on TV today only talk about investing in stocks and ETF's. There are too many programs to mention which follow traditional advice, buy and hold for the long-term. Perhaps this is the best advice for the average investor, but the average investor loses money. This might sound hard to believe, but after taking into account the risks assumed, taxes, fees and inflation, even 8 to 10% a year is not enough to break even. This may come as a surprise to you, but I believe that this information is what most financial advisors do not want you to know. You may not believe me, but how often have you heard a financial advisor to tell you to place a stop loss on a trade, or where to take profits, or what to do when the market falls? The reason they don't give you this advice, is because they make money every time you adjust your portfolio. Getting you the traditional line of expecting 8 to 10% return per year over the long-term and to use dollar cost averaging to build your investment portfolio has always made my financial advisor more money than it's made me. One of the first things that I wanted to accomplish in my trading was to be able to make money regardless of market the direction. I used options and advanced options strategies to make this possible. I was successful trading spreads , covered calls, calendar spreads, and other advanced options strategies. However, I soon realized that fundamental analysis could not be duplicated from one person to the next, and the time to talk to analyze each and every trade was prohibitive for most people. I also participated in trade rooms and advisory services but felt that the fees they charged were too excessive totrade a small account using the rules that I had established and will discuss with you in the followingpages. For now, just understand that I like to start with the minimum capital required and seek 100%return on my investments before allocating more to my investments. I will discuss why this is importantin a future lesson. I stumbled onto automated systems trading around 1997 and have been here ever since. However, the learning curve I took in the money I've lost I would not wish on anyone. Again this is the reason I'm sharing my trading rules with you. In determining what to trade I can only recommend that you select an underlying security or currency pair that has high volume in trades around the clock. The reason that high-volume is important is because thinly traded instruments have excessive slip which can be an unreliable cost to your trading. As with any business, having low fixed costs is much better than having high variable costs and the same is true in trading.With regard to trading around the clock, I have found that trying to enter and exit trades within the same trading day only serves to decrease the potential profit per trade over the long-term. I havedemonstrated this through my own analysis and back testing of the systems I've traded and developedmyself. I've ended up trading Forex systems exclusively because of their extremely high volume and the ability to start with the limited amount of capital and scale up gradually with mini lots rather than contracts
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used in futures systems. Individual stocks are out of the question because of the gaps that occur at the end of each day. Most futures systems available today only trade during normal business hours as well. There are systems which may be successful or profitable, but being limited to entering and exit a trade within eight hours understandably limits the profit potential of any day trade system. The Forex systems I trade, trade around-the-clock and only exit positions when a stop loss or profit target is hit. Therefore, I can stay in a trade for less than one hour up to several weeks depending on what the market is doing. If the market is moving up and I'm long a position, I will stand the trade until the automated system takes me out at a profit. If the market is moving down and I'm short a position, I will stand that trade until a profit target is hit. Of course if the market moves against me and I've taken a position opposite the direction the prices headed, I will stay in these trades as well until a stop loss is hit. What most people don't realize is that professional traders take a lot of losses. However the size of their losses as generally much smaller than the size of their winning trades. There are those traders who scalp the market or utilize high-frequency trading, but the fees they pay are too excessive and the risks too high to suit my trading style. Further, in order to achieve their high percentage profitable trades they have to endure larger stop losses which if hit, we'll wipe days or even weeks of trading profits. Their profits are close to their entry price and the stop price is at least 3 to 5 times the size of their profits. This may work for some people, but I feel the risk is too high to hyper trade or scalp the markets. The reason for this is also because to make any significant profits many contracts or lots must be traded which only further increases the risk of loss when looking at percentage risk per trade. What I have found the best way to reduce risk is to start with a minimum amount of capital trading a variety of different systems together in a portfolio product. With Forex, you can trade three different systems with $3000 starting capital trading in mini lots. You could trade with even less, but you better know what you're doing otherwise you could lose it all and more. Don't worry though, this will all become clear as you continue to read and understand what all present and future pages. I have learned that no system performs the same in every market condition. Therefore I feel it is best to combine systems that trade well in a non-trending market with those the trade well in the trending market in a ratio of 2 to 1 respectively. This means that I seek systems with smooth equity curves that handle markets moving up down and sideways preferentially over systems that take a large when only occasionally. Having both non-trending and trending systems to gather in a portfolio tends to reduce risk significantly. Here is a short video that illustrates that what I have written is true. http://www.youtube.com/watch?v=AVDO0Cghxgc
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Determining Percentage Risk per Trade One of the first mistakes I made in trading was over leveraging my trade capital. I began with the scalping system which had over 90% profitable trades and a very smooth equity curve. Looking at the equity curve, I realized I had a system that couldn't lose. Take a look at the image that follows and you can see why I was so excited.
I've removed the underlying security and time frame to protect the interests of the system developer. Looking at this graph, which represents over five years of data, I believed that if I traded a higher quantity of units, that I could replace my income. We'll come back to this later, but for now let me assure you that although I made some money trading this system, I lost all of my gains quickly after taking my first and subsequent losing trades because I had overleveraged my account.
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I had earned nearly $30,000 in profits during my first month of trading this system before I took my first loss. Feeling as if this losing trade was just an aberration, I continue to trade too many units and soon experienced my second loss which nearly decimated my account. Each loss cost me more than I had made in my first month of trading. Too many traders today are seeking systems that never lose without realizing the risks associated with this type of trading. Take a look at several more examples of systems that are been traded live with thousands of accounts of people just like me, who were too stupid to realize the risks inherent in over leveraging their accounts. Please understand that the charts below represent real money from live trade accounts. Adding the two examples below represents nearly $5 million of client accounts from people just like me who were seeking automated trading systems that could not lose. Now I could be wrong, these systems may bounce back, but how much are you willing to risk to trade a no lose system?
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I tell you all of this only to illustrate the devastating effects that over leveraging your trade capital can have on your account. Luckily, I took the time to reevaluate what I had done wrong and started creating a list of trade rules which I'm sharing with you now. The first and perhaps the most important lesson, is to keep your percentage risk per trade extremely low. I say extremely low, because the number scared me when I first heard it. Most professional traders risk no more than 1 to 2% of their total trade capital per trade. When I calculated what I was allocating as a percentage risk per trade, I was risking nearly 50% of my total capital per trade. Of course this is possible with a system that never loses, but when the losses do occur they will devastate your account. Of course draw downs, or holding positions open when the price moves against you is in fact another type of loss. If you've ever received a margin call from a broker you're well aware of what I'm talking about. Now I realize I've spent a lot of time talking about over leveraging your accounts. I do this only because I've seen it happen not only to me but also to many other traders. I want to start with a warning and finish with a solution that is working well for me and many other professional traders. Before trading any system or portfolio, you need to understand what the maximum stop loss is per unit traded. It's also important to know if additional units are added intra-trade. In other words, if you go long one unit and the price moves against you, are additional long positions taken before the initial position is closed? I do not trade this type of system because I'm unwilling to accept the risk. The calculation of determining percentage risk per trade is quite simple. You simply take the maximum stop loss and divide it by the trade capital that you want to allocate to trading that system or portfolio. For example, if you wanted to trade one the mini lot of Forex system or portfolio with a max stop loss of 55 pips ($55 for the EURUSD), and you want to allocate $2000 to that account, you would calculate percentage risk per trade as follows. (Max Stop Loss ($)/Total Trade Capital) x 100 = Percentage Risk per Trade ($55/$2000) x 100 = 2.75% Risk Per Trade Making this calculation can help you understand why I stated that I felt that keeping your percentage risk per trade less than 2% was EXTREMELY low. I will go into more detail on how to control this in my asset allocation rule but for now let's look at another often overlooked way of minimizing the risk as well as percentage risk per trade. Rather than trading a single system, I soon realized that trading a combination of systems together in a portfolio could essentially reduce my percentage risk per trade as well as minimize my risk through diversification of trading different systems with low correlation. We'll get into that in a later lesson, but for now let me illustrate my point. Assuming we wanted to stay with $2000 per mini lot traded but instead of using a single system, we wanted to trade three different systems each with a max stop loss of 55 pips ($55 for the EURUSD) as shown above. If we were to trade three mini lots of the same system our percentage risk per trade would remain the same at 2.75%.
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[($55x3mini lots)/($2000x3)]x100=2.75% Risk per Trade Now if we were to trade three different systems together in a portfolio, the calculation would look like this. ($55/$6000)x100=0.92% Risk per Trade By trading three separate systems with different correlations, we've reduced our percentage risk per trade threefold assuming each system had a max stop loss of 55 pips. This may or may not be the case, so it is important to understand what the max stop loss is in order to calculate your percentage risk per trade accurately. Of course the amount of capital required to trade three systems is three times larger with this example, but your risk is been significantly decreased because each system trades with different logic. This can be demonstrated by watching the following video at 5:40 (you’ve seen this before in “Determining What to Trade”.
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Determining Maximum Allowable Drawdown The next important topic to consider when trading automated systems either individually or collectively as a portfolio is to determine your maximum allowable drawdown in dollars or whatever currency you choose based on hypothetical or real-time data. The reason for doing this became apparent to me when systems started to perform worse than their back test history illustrated. At that time, I had no rule stating when I should discontinue trading system. Therefore this is an important point to consider prior to your starting trading real money in any system or portfolio. There are a few important points that must be evaluated prior to determining this figure. Where possible, I've always put more weight or significance in live trade performance when compared to hypothetical back test data. The reason for this is many developers will maximize the profit potential of their systems based on unknown series of data making their input variables unreliable or unfit when trading in unknown market conditions. Much has been done to minimize the risk of over optimizing data but it is still is one of the biggest problems of trading new systems. In order to illustrate this I want to share a document with you of some of the systems I've traded myself that it failed in real time trading. This does not mean that all systems are developed in this way. I purchased many systems and have found that several work well when traded live. Over time I've come to realize that it is possible to put too much weight on data or performance of the past. I consider this similar to driving down the highway by looking in the rearview mirror to see where you're about to go. Everything looks fine until you run off the side of the road because of the upcoming curve you didn't see in the rearview mirror. The exact same thing is true in trading. That is why these rules have become so important to me to help me preserve my capital and reduce my risk. When I look at maximum allowable drawdown I look for data either real or hypothetical that illustrates past performance over an extended period of time. My preference is to look at data spans at least five years over multiple market conditions. I like to see how the system or portfolio handles both trending, channeling, and highly volatile market conditions. The smoother the equity curve the less capital is risked before corrective action must be taken. However I have also learned that following profits to closely can take you out of a system or portfolio too soon. Therefore I look at the past maximum historical drawdown and multiply that dollar figure by 1.5 to set my maximum allowable drawdown in dollars. You might select a different value or factor but this is the one that I use. So let me illustrate how this value is determined by using a sample portfolio performance report.
This performance report is of a portfolio of systems the trades the Forex market. Fees of $60 per round turn have been added and a maximum drawdown per portfolio lot traded is equal to $9,072.00. This portfolio if it is made up of three different systems or one lot of each system. I have allocated plenty of allowance for slippage and commissions for trading this portfolio of systems which trades multiple time frames on the EURUSD currency pair. Using the factor that I've determined appropriate of 1.5 and multiplying that by the maximum drawdown that is occurred over the previous eight years I get the following. $9,072.00 x 1.5 = $13,608 per portfolio lot traded Now if you can’t afford to lose $13,608 you might consider reducing the factor that I use from 1.5 to a lower value of 1.3 or 1.25. However again I caution you not to reduce it too much because it is not realistic to assume that performance will improve with untested data. Another option unique to Forex is the ability to trade in mini lots which are equal to 1/10 the size of a full lot. That means instead of risking $13,608.00 you could risk only $1,360.80. That makes trading Forex much more affordable than trading futures. In addition to this your ability to control the amount of leverage you use is increased significantly and Forex over futures. The tremendous volume traded in the Forex market around-the-clock is another huge advantage I have found and Forex markets when compared to futures markets which are typically traded only eight hours daily. It is even possible with Forex to trade micro lots although I've never done this. In micro lot is only 1/10 the size of a mini lot. That means that rather risking $1360.80 you would only risk I hundred and $136 and change. Nearly anyone should be able to afford that! Cutting the risk in this case also means cutting the profits realized as well. This is done in the same way as illustrated above. Because of the tremendous volume traded in Forex around-the-clock and the ability to control risk and position size, Forex has become my favorite market to trade. However regardless of what you decide to trade keeping these rules in mind may help save you from making some of the costly mistakes that I have made.