Thursday, March 27, 2008

Trade Rules

Considering Don’s and Bruce’s prep-talk I changed my layout to include a 10 tick chart complementing my 2min and 30min charts

Here is the current Setup:


I will try to summarize my trade rules as I understand them now. Maybe some of you can add to the list or make corrections, so we get a list of rules, which will help all of us.

1. Trade pullbacks with the trend
That means:

a. Never sell a low

b. Never buy a high

c. You go long a test of a higher low in an uptrend

d. You go short a test of a lower high in a downtrend (see 10 tick gold chart)


2. Control

a. Buyers are in control as long as the market is making Higher Lows

b. Sellers are in control as long as the market is making Lower Highs

3. Support and Resistance

a. Resistance will be found, when the market is in an uptrend but is unable to make Higher Highs. As long as you see Higher Lows being made you might expect that resistance to be taken out eventually

b. Support will be found, when the market is in a downtrend but is unable to make Lower Lows. As long as you see Lower Highs being made you might expect that support to be taken out eventually

4. Trend

a. You see identical chart patterns develop on all timeframes.

b. Uptrend: Market is making higher Lows

c. Downtrend: Market is making lower Highs

d. To determine the trend you take a higher timeframe and then take the entry signal from the shorter timeframe

e. The longer the timeframe giving the entry signal, the stronger the move. (See example on the Chart I posted above) (30min chart showed a 50% pullback on the Easter Gap

5. Consolidation versus Trend

a. Markets swing between trend phases and consolidation phases. What looks like a trend in one timeframe can be consolidation in another usually higher timeframe.

b. Markets go from equilibrium to equilibrium. Usually the range covered in a trend phase stays constant within limits. If you know the contract you trade, you know when it has reached an extreme of a move. Take the Euro for example: A trend move usually goes 100 to 120 ticks. If on any given day a trend goes beyond that to say 150 to 200 ticks, you should expect a consolidation phase to start. That does not mean you blindly take a counter trend trade, but if you see Resistance not taken out and say a Double Top forms or even better price is unable to retest the former High, then you go short with a Stop above the highs in case the trend resumes.

c. Consolidation in a longer timeframe trend usually retraces 50% (minimum 33%, maximum 66%) of the previous move, before the trend resumes. If you see a smaller retracement, expect the trend to resume strongly.

d. What is an extreme move in one contract, might be just normal in another. So you need to know the contract you trade.

6. Stops

a. Trading without stops and instead adding contracts at a loss to get the average nearer to price works, as long as you are able to get the average entry price within the next consolidation price range. Say Euro makes a 100 tick move. You can expect Euro to eventually retrace 40 ticks from that high, so you need to get your average entry to less than 40 ticks below the high. But that means you are staying in a losing trade, which becomes more expensive with every tick against you. Even if eventually you might close the trade at a small profit or breakeven, you will have invested huge amounts of emotional energy. Not talking about the missed profits, because you stayed in that losing trade

b. Trading with Stops hurts immediately, something most traders like to avoid. But it has advantages:

  • You are emotionally free to step back and take a new look at the market
  • You get immediate feedback whether you are in sync with the market. I have as a rule: 3 Stops in a row and I’m out for the day. Tomorrow is another day and it will provide fresh opportunities.
  • You make sure you stay in this profession for the long run by protecting your account.

c. The disadvantage is, that you can bleed your account to death by a 1000nd Stops. To avoid that problem, you have to make sure, that when your Stop is hit, the entry signal was not a valid trade setup, meaning the possibility that the trade will come back is remote.

  • The better a trader you are, the smaller your stop can be without the risk of getting thrown out of a valid trade. (At least that’s what I assume)
  • The less wiggles the contract you trade shows, the easier it is to define where a stop needs to be placed to be sure a trade signal is no longer valid.
  • If you are still on the path to the expert level, you need to stack the cards in your favor to make sure you have a very high probability of the individual trade to be a winner. Only then will you be able to pay the unavoidable stops and still come out a winner.

7. Profits

a. Let the profits run.

b. Don’t give profits back.

c. Say you are long, the trend is up and the trade is showing you a profit. Where do you exit? Buyers are in control until Sellers are able to take control from them. That means you exit

  • at Resistance on a longer timeframe, because resistance usually is not taken out on a first try, or it would be no resistance.
  • If the market is making a Double Top. That means you need to sit through a pullback first. This pullback should have its low above your entry. That’s why we have the rule: Never go long at a top. If the market is unable to take out the previous high, you exit
  • If you trade (just) 1 contract, you take profits at certain targets, which have been proven in the past to be the average maximum range a trade goes before you see a pullback. It’s better to build your account step by step. The home runs are for a time, when you have mastered trading 1 contract.

d. I use an achievable daily goal of 375$/day per contract traded. Once I reach that, I stop trading,

  • if I’m at it for more than 6 hours,
  • if I have taken already 5 or more trades,
  • if I feel like I want to do something else. I trade to have free time for other things, so you need to take that time or the ultimate goal is not a real goal.

e. If I make my daily goal in one or two trades, I continue trading and see what the day will bring further. I limit my loss in that case to the profits made so far. A day in green, where you made your daily goal already should never end red, as that’s a big emotional blow to your trader psyche. It’s like a contract making a new all time high and then reversing to close below yesterdays lows.

8. Number of contracts

a. If you can’t trade 1 contract profitable, why do you assume you will be able to trade multiple contracts profitable?

b. With 1 contract you can achieve a daily goal of 500 to 1000$ / day by taking 3 to 8 trades a day. To build your account that’s for sure good enough. On the other hand you protect your account from overleveraging yourself in case something goes terribly wrong. And it teaches you to trade for bigger gains, which makes it easier to pay for the unavoidable losses.

c. I use an internal Margin of 7500 $ / contract traded unless the contract needs a higher intraday margin, then I use at least that margin (eg: the DAX is traded with an internal margin of 17000$. So I allow myself trading a second DAX contract only when my account statement shows at least 34000$)

9. What to trade

a. Trade what speaks to you. It really doesn’t matter what you trade. You need to be comfortable with the contract you trade, you need to know it in and out.

b. Trading different contracts is fine. But it will extend the learning curve as you need to learn not 1 contract in and out but multiple contracts. Each has its own quirks, each his own personality. Compare a Bond chart with an oil chart. It’s something totally different. There are groups of contracts which behave similar. Most indexes will move in a similar fashion, most currencies, a lot of commodities show comparable moves. But just because one contract is rising another must not fall or rise in sync. If you trade different contracts be sure you know the correlation between these contracts or you will be fooled by the markets.

c. If you trade Forex or currency futures be aware how each currency trades against each other. There is no longer 1 major currency in the world. We have 3 major currencies (US Dollar, Euro and Yen) and moves in one pair can be expressed in the other two as well. You might take a EUR/USD trade, but you might as well take a EUR/YEN and USD/YEN trade to get the desired position. The cross rates (major ones are EUR/YEN and GBP/YEN) need to be watched these days, as the carry trade was and is made or unwound in these currencies (If the interest rate differential between the EU and the US widens the new carry trade will be the EUR/USD, something we are already starting to see in the high Euro / USD exchange rate)

That’s it for now I think