Return relative to risk

Below we have our previous 30 days of trading results.

They look similar to the last report regarding gain and percentage win. But in reality, are very different.

Such summaries provide useful figures but often not the important ones. It is nice to know the overall gain. After all, that is our purpose. However, I would like to know how we achieved that gain, or more accurately ‘what was our return relative to risk’?

The amount of leverage we can use is about to change significantly with the European regulation on margin to be introduced at the end of next week.

I have tended to trade on margin rather than on a firm stop. That is, if a trade went against me I would often hold and look for a suitable scale-in point to provide a break-even opportunity or, quite often, a profit.

All well and good until we are caught out with a massive move against us. That happened to us this period on not one but three currency pairings simultaneously.

Our return relative to risk was poor this period. And that has to change. Not only are such trades overly difficult to manage they are likely to create an excessive loss. In any case, the new regulation and change in margin will make such a strategy untenable.

Setting hard stops that provide a planned reward to risk of not less than one to one will offer more (albeit smaller and controlled) losses but also free us early to reenter with a new trade; rather than sometimes being locked into a scaled-in extended detrimental equity trade.

Stats for the last 30 days of trading.
The stats often don’t tell the whole story.

Why momentum strategy and how have we done recently?

We consider a momentum strategy. How distraction coupled with an uncertain approach usually does not go well. The European regulation effects our methodology, oddly in a right way. Our statistics, how did we do over the last 31 days?

We have two strategies that we have employed successfully over the previous month. One of which, however, in an earlier month gave us a loss.

The strategies are mentioned in our recent blogs.

(1) ‘Price value’ trading is where we look to buy or sell at the extreme value of a price. We do this by assessing trend and channel lines.

(2) In probability or ‘momentum’ trading we read the price action of the bar(s) and with measuring tools determine entry points, stop and target positions.

I learnt the lesson some months back that I cannot mix strategies and, of course, timeframes. I did this when on a visit to my elderly mum. (Don’t tell her she’s elderly!) With my daughters dog in tow and tried to trade through the distraction. I ended up mixing my strategies and my timeframes and took a well-deserved hit for my troubles.

With the European regulation coming into force very soon we need to think carefully about how the new rule may or may not affect our tactics while trading within a strategy.

As a reminder, the regulation significantly increases margin required. The margin is the ‘good will’ of a broker to allow a trader to leverage a trade. Without the leverage, other than institutions, few would be able to trade the currency market.

Margin does not affect the mechanics of a trade in any way. It does, however, change the amount of cash needed in our accounts to place a deal; and, more importantly, be able to correctly manage a trade when price often, and inevitably, goes against us.

For this reason, we (Slow Trader) are trading exclusively via our momentum strategy. We have increased our accounts so that we can bet as we have been before the regulation. That is, reward and risk remain the same.

We have chosen the momentum strategy because of the regulation but also as the procedure provides control and has a reduced average duration of trade compared with our value strategy.

Below are our statistics for the last 31 days (19th May to 19 June 2018).

Notice the reward graph at the bottom of the statistics; the shape of which is the desire of all traders.

How we did over the last 31 days.
How we did over the last 31 days.

To scale-in, or not?

To Scale-in is an excellent technique if used correctly.

A few moments ago we exited our USD/CHF trade in profit. See the last blog post.

We all make poor trade entries from time to time; often they are not poor but merely a bet admission that goes against us for no particular reason that we can determine.

Our priority is to protect our account and to let any profits take care of themselves. Our last trade warranted, to us, a scale-in trade. To do so correctly takes some practice as to get it wrong compounds any loss.

However, to get it right provides a trader with options. Either to minimise loss or ambitiously take a reasonable profit.

From our previous blog post, we entered short yesterday afternoon from a reasonable trend entry bar. Unfortunately, this was not correct, and the trade went against us and back to the top of the trading range.

However, the head of the trading range provided an opportunity to scale-into the trade. Our aim here was not to breakeven but achieve a satisfactory reward to risk return.

A consideration was the USD interest rate decision later this evening (UK time). With that pressing, we would not want to be delayed in the trade allowing a pullback as we would typically do.

Scale-in to minimise loss or maybe achieve a profit.
Scale-in to minimise loss or maybe achieve a profit.

Trading range management, can we get out of the woods?

Trading range management, a lesson as it happens live.

As we write we do not know the outcome of our trade in USD/CHF that we started yesterday.

We’re hopeful that this trade will become a suitable lesson in trade management. Having entered our bet short in the chart below at the red circle price quickly goes against us. (the second chart is the same but zoomed-in).

My initial entry of the bar (lower chart) within the red circle was a reasonable bet short; however, lower wicks to the left reduce the probability and what quickly became apparent was that the entry was against a trading range of which we’d taken the worst position!

Having established the trading range, the many lines on the chart attempt to do this, we now ensure that our stop is at least ‘a measured’ move above the trading range.

We see that we have two possible trading range top lines of which we scale-into the trade at each. We are now at maximum risk for this trade, and with a turn in our favour, we may still achieve a successful reward to risk return.

However, any further assent in price will necessitate the management of a breakeven (and therefore, overall, an unsuccessful reward/risk trade).

We have one additional consideration. At 7 pm UK time this evening we have a USD interest rate decision. We do not want to have any trades open, based on hourly bars, at this point as price volatility with such an announcement can exceed our stop positions.

Chart perspective of trend and channel lines.
Chart perspective of trend and channel lines.
Bar by bar perspective of price action and the traded channel lines.
Bar by bar perspective of price action and the traded channel lines.

Price action strategy – the whole chart

To trade the price action of a chart rather than the price action of the bars is an assured strategy.

Take a look at the chart below. Individual bars in this strategy are secondary to the context of lots of bars. Maybe 600 bars on one screen from which we can identify price channels.

A price action chart strategy identifies channels, support and resistance levels and trends.
A price action chart strategy identifies channels, support and resistance levels and trends.

The chart above is hourly bars, but the same is achievable with any timeframe. Hourly bars provide a trade lasting from a few hours to a few days.

We need to check for scale-in opportunities at the close of each bar, in this instance every hour. In the chart above the lower blue arrow represents our first entry short point; this worked well in the previous two touch points marked by the green circles to the left.

However, this strategy is not always plain sailing. As we can see, the price climbed some 60 pips above our initial entry. Stops have to be at least the width of the channel and ideally beyond a significant premise point.

A trader also needs to be comfortable being out of the money for most of the trade. From the initial entry to the final scale-in entry we went £2,702 out of the money with a marked increase in our usual margin outstanding.

We had a maximum of three entries in each of the pairings, GBP/USD, AUD/USD and EUR/USD. USD links each trade; we, therefore, have to expect that a failed bet in one could result in a fail in all three.

Each pairing provided a different momentum. GBP/USD, once it turned our way dropped to target rapidly. AUD/USD having stayed in the money for much of the trade duration casually moved to target but tempted, which we took, an early, albeit profitable, exit. (The only part of the overall trade that was poor on my part).

EUR/USD, on the other hand, went out of the money more than the other pairings and took longer to turn. Holding all pairings until target would have provided a profit more than £4,000. Or 67% above actual risk.

However, we exited EUR/USD at breakeven. That is when the aggregate position of the trade went positive we exited. Eventual price of this pairing went some 40 pips below our breakeven position but as we write has not made our original target.

As we had a lower than an ideal entry point for EUR/USD in debrief we consider the decision to exit at breakeven was correct and within our criteria. Our actual profit was £1,782. Or 34% below actual risk.

A well-understood strategy, trading in such a way is not without its issues, trade management being high among them.

(1) Stop positions being too close is probably the principal reason for failure. Moreover, (2) trading above our means makes the inevitable loss occasion far exceed many win opportunities. (3) Not scaling-into a trade, or trading at maximum from the initial entry; either due to a limited trading account or entering from the outset at a maximum bet size. And finally, (4) exiting too early due to fear or too late due to greed.

Below is the outcome of GBP/USD.

Target against the trend, so profit taken before the trend line.
Target against the trend, so profit taken before the trend line.

As we are against the trend, our pre-planned exit was at the yellow arrow. Price did hit the channel line at the red circle.

The European regulation coming into force within a couple of months and thereby significantly increasing margin rates will exacerbate the usual reasons for failure mentioned above for the retail trader. For example, stop positions will be shortened rather than positions reduced.

Retail traders may thus be encouraged to move from a ‘price action chart strategy’ to a more difficult ‘price action bar strategy’.

Accurate measurement of bars – measure, and measure again

Accurate measurement of bars and the like.  Not appreciated by many retail traders, but accuracy provides the clue.

We are continually looking for that measure. It may be an explicit support or resistance level, or one that is not so obvious.

It may be within a channel, or a trading range may define the boundaries.

My favoured measuring tools are a simple mirror rule and an edited version of the Fibonacci retracement to provide a quick way to find the middle of something.

Below is an example from yesterday and this morning. Although we show only one measure per chart, in reality, many tests would be performed to find, what we think is, the best clue.

Our point of interest is the last significant bear bar (seven bars from the end). We feel this bar strongly supports the probability of a further reduction in price.

The question is at what point do we enter the trade? The bear-bar we are measuring is a trend bar but has a  prominent tail; this indicates either buyers below or, and more likely that sellers are buying back their trades – taking profits.

It provides some uncertainty and a stop immediately above our measured bar would be vulnerable. We, therefore, look for the workable trade solution that the majority of ‘institutional’ computers will employ.

We consider that the next premise point (marked by the red arrow) is a candidate. To provide a traders equation of reward and risk, we measure the halfway point between stop and target and determine our entry level; this we have marked with a yellow arrow.

Contextually it makes sense. In other words, we like what we see if we stand back and take in the bigger picture.

Below is how the trade developed over several hours.

From this morning we have an early, but a viable consideration. In this example, we are against the trend but contextually a probable scalp of 26.9 pips.

After the close of the third of the last four bull bars, we take our entry as marked by the yellow arrow.

Our measure is from the third bull bar, from the bottom of its tail to the close providing a measured extension above.

However, as before we feel that a viable stop position is the base of the recent low. Again our reward/risk is satisfied if we enter at the yellow arrow.

The trade concludes as shown below.

A point on the spread. As retail traders, we have to consider spread in our bets. That is, we allow for half spread on trade entry – if we had not in the last example we would not have been successful with our entry.

Our measurements, however, are a determination of what the institutional computers are taking, and they, by-and-large, do not have to deal with anything as distracting as spreads!

Trend indicators, are they needed?

Trend indicators are useful but are in lag? Our method is systematic price action with trend identified through context.

Price action is a good fit for the methodical approach to trading. Relatively easy to establish, back-test and edit. Based on the close of a bar and that bar relative to as many prior bars as is necessary.

Trading range or trend?

The market spends most of its time in a trading range. Trends take up only a small proportion of the demand. Our systematic approach must, therefore, work in both markets. To do otherwise, as many trend-following systems do, is to miss the majority of trade opportunities.

The problem with price action and a systematic approach is the identification or confirmation of a trend. To help, many traders rely on trend indicators. For example, the  MACD is a valid trend indicator when employed in the correct time frame.

Moreover, there are many ‘to buy’ trend systems available that claim to provide a reliable trend identification system; this may be. However, all indicators take their cue from price, and the price has to change sufficiently to give the trend.

A pure price action trader, on the other hand, will read the context of the chart to indicate a trend; this is made to sound natural to achieve by established price action traders. But as with anything after many hours of practice and once mastered will always seem easy from that point.

Let’s take a look at a trending opportunity this week with Sterling.

We can see from the yellow box that we have three bear bars. Our system took the close of the first of the bars within the yellow box short. But we are now flat waiting for more information. We know that the more significant trend supports a sell short but in our timeframe, an hourly chart in this instance, we are at the bottom of a trading range indicated by the red arrow. A reversal is 50/50.

The two bull pull-back bars, however, are weak and support an early entry short at this point, or if uncertain we can wait for an entry bar, which comes next. We sell short for a target equal to a measured move of the yellow box.

Trading range or trend? It's all in the context.
Not yet a trend but the last two pull-back bars are weak.

It is the second move down (the second yellow box) that established the trend short for at least three to four times the distance of the first yellow box.

We need to sell short and join the trend.
Trend short, at least for another measured move, is probable.

We can either hold our second trade (most advisable for intermediate traders) or exit with profit and re-enter for the final leg.

We say most advisable above as many traders once out with profit would not get back into the trade quickly enough to take advantage of the trend.

Take the profit as the trend has a possible three push short already, or hold for price action?
Exit at the measured move or hold until price action says otherwise?

To finish our point about trend identification. The remainder of the day, as shown by the chart below, are tradable pull-back bars. As we are reactive and not predictive, we can trade each appropriate bar or sequence of bars relative to context.

Context does not support a trend long, therefore scalp only.
Context does not support a trend long, therefore scalp only.

Notice there are three possible pushes long with the final bar being an extension driven, probably, by the welcome UK financial news released at the time.

We do not consider this a trend due to the context to the left, the identifiable three pushes already and the news-driven extension or possible exhaustion bar.

We only traded the close of the bull bar, the fifth bar after bar 1, long for a scalp. The imminent release of financial news of significance at about bar 3 kept us flat.

Better to be the active rather than the defensive trader

To be the active trader, always preferable to the defensive trader.

More on Hans Zimmers idea of questions and answers and how it relates to financial trading.

We need to be on the watch for the smallest of hints that something isn’t quite as it seems.

A question or three

The currency markets we trade have been in a bear trend for some time. Meaning that all the ‘answers’ are short trades and all the ‘questions’ are long trades.

We want to be going short where possible. However, this ought not to make us blind to the detail. If we get the detail wrong, this is not necessarily a losing trade if our stop is sufficiently distant.

But getting it wrong can concentrate our efforts on managing the loss which in turn creates missed scalp questions and lost entries to better-placed answers.

Short entry price action but context says different

A couple of days ago from early morning each of the markets provided short entry price action opportunities. Each was answers. Therefore they had swing potential.

However, if we take a closer look at the conversation prior (the context of the chart), we notice a wedge or three pushes.

If we had missed this observation, we would have been distracted, mainly Euro and Ozzie dollar, for some 30 hours managing an out of the money trade.

The pictures below are the same stories for the EUR and AUD. GBP has a similar connotation but is in a trading range and therefore only provides questions.

What kept us as an active trader

AUD/USD wedge probability long but wait for an entry bar.
AUD/USD wedge probability long.
EUR/USD wedge probability is long but wait for an entry bar.
EUR/USD wedge probability is long, but we wait for an entry bar.
GBP/USD wedge and a trading range.
GBP/USD wedge and a trading range.

It is unusual that all three screenshots provide the same clue. A pullback is now probable. In all cases, the ‘actual’ pullback was a 100 pips or so. We wait, however, as these pullbacks are questions and we need an entry bar first to trade a question.

Active trader in EUR/USD

If we look at the EUR/USD in more detail, we see that we have a possible expanded wedge, being three pushes, as well as the embedded wedge; and adds confluence to a low probability short.

Notice the pullback, marked by the green circle, closed slightly above the resistance level of the past half dozen bars; this improves the odds of at least a measured move (a scalp) up to the green horizontal mark.

Three pushes big picture and embedded gives confluence.
Three pushes big picture and embedded gives confluence.

The next screenshot is four hours later. It follows our analysis and more importantly, we are not distracted managing an out of the money trade – we have a win and are viewing price with an active rather than a defensive perspective.

We make the measured move long. Active rather than defensive
We make the measured move long.

 

The music process of questions and answers can help in financial trading

Story and conversation with questions and answers as explained by Hans Zimmer can help the technical, financial trader.

Many traders have their trading ideas that help them win.

Such ideas, however, are not a panacea or substitute for all the hard work that goes into understanding how to trade the financial markets.

They are more to do with a traders discipline and a traders personal way of trend and context identification.

Hans Zimmer and answers

We like the thought process of the composer Hans Zimmer.

In composing his music, he says it can be summed up in one word – Story. For the financial trader, the story is the market cycle.

We apply his methodology in our trades. Conversation is context; question and answer notes are price action.

Below we have a series of ‘trade’ questions and answers. For us, the sequence of bars following the green arrows are the questions, and those within the red arrows are the answers.

We will trade a question but only from an entry bar and just as a scalp. Answers, however, can be taken from signal or entry bars as swings or scalps.

When does a question become an answer?

If the bull bar with the blue circle had closed above the resistance – the next price level that is determined by the bars about midway across the screen – this ‘blue circle’ bar might have premised into an answer.

Questions and answers are a price action.
Questions and answers are price action

We concluded that the blue circle bar would close low and remain a question. Therefore, we shorted the bar at about the centre of the blue circle.

Accurate enough, the answer bar came next and resulted in over 60 pips of profit in less than an hour.

Hans Zimmer’s explanation of Q and A in his music can similarly help a technical trader maintain the all-important market perspective on the chart.

Reactive or predictive in financial trading, what’s best?

Did our career ethos demand reactive or predictive decisions? What about financial trading?

It is right that most professions require predictive decision making. Engineers, doctors, entrepreneurs, lawyers, pilots.

Many of us from these disciplines have a go at financial trading in some form or other.

Why not apply the same predictive philosophy to trading that has always stood us in such good stead.

Mistake

Sorry, but that is mistake number one. To have any hope of success trading the financial markets, we need to change our career lessons of predictive bias to reactivity.

We all find this hard to do, it takes time to relearn, and most will never truly grasp the new concept.

We need to think of probability as the belief in an alternative outcome; it is not about the odds.

Highly probable trades are the essence of our (Slow Trader) strategy and paradoxically the most difficult to trade reactively.

Reactive, always

To do otherwise, to trade predictively rather than reactively, is to mistake possibilities for probabilities.

And knowing when not to trade is as important as knowing what trades are probably worth making.