How to Challenge
Your Knowledge
In either instance, the process of reprogramming oneself away from the easy and comfortable trading decisions involves discipline, patience, flexi- bility, and a commitment to follow through on a plan of action irrespective of its difficulties and distractions.
TIME FRAMES, TRADING SYSTEMS, AND PERSONALITY TRAITS
Although there are almost infinite delineations of time frames and just as many variations of trading systems, I will use the systems and time frames mapped out in Chapter 3, Chapter 4, and Chapter 5 to examine different personality types and how these types naturally gravitate to particular time frames and strategies.
Many of the advantages and disadvantages of these categories overlap.
Wherever possible throughout this chapter, however, I try to introduce unique and previously unexplored aspects of prerequisites for success in each trading methodology and time frame.
Long-term Trend-Following System Trading Typical duration of trade: 5 to 10 months
Example: MACD Advantages:
• Requires least attention to the markets.
• No intraday action required.
• Typically generates largest per-trade profits and enjoys the best profit to maximum drawdown ratios.
• Works with many negatively and/or uncorrelated asset classes.
• Because it entails the fewest decisions, it is often viewed as the least stressful of all mechanical trading strategies (assuming the trader does not find sitting on positions long term without reacting to short-term fluctuations stressful).
Disadvantages:
• Inactivity.
• Inability to capitalize on obvious short-term, event-driven (government reports, news events, etc.) countertrend opportunities.
• Requires overnight margin.
• Typically experiences poor win/loss ratios and a large number of con- secutive losses.
• Often risks larger percentage of equity on a per-trade basis than shorter- term trading systems.
• Because the duration of trades is the longest, reliability of backtested system results is based on fewest occurrences. This makes statistical validity of certain portfolio results, such as maximum drawdown and maximum consecutive losses, more suspect (unless backtested data history is lengthened accordingly).
• Inability to capitalize on short or intermediate fluctuations in the market.
This problem can be countered, in part, by trading around core posi- tion. Trading around the core position entails holding a portion of the core position until the longer-term trend reverses while trading in and out of the remainder of the position to capitalize on short- or interme- diate-term opportunities.
To execute this strategy successfully, capitalization must be suffi- cient. Use of multiple contracts in this manner is prudent only if it does not result in abandonment of prudent price risk management standards (as outlined in Chapter 8).
Trading around the core position often satisfies the psychological need to do something to earn a livelihood as traders. The Puritan work ethic suggests that we deserve wealth only if we sweat each day earn- ing it. Although the extensive research required in formulation and rig- orous testing of trading systems could be viewed as a fulfillment of this psychological prerequisite to deserve wealth, more often traders feel that activity in the markets is the only measure of having earned and therefore of deserving success.
Until we can convince our subconscious that inactivity is hard work and deserving of the reward of wealth, the strategy of trading around the core position can aid us in feeling psychologically worthy of suc- cess. Although this process will commonly result in relinquishing the noncore portion of the position during the acceleration phase of a trend, as long as we can make our peace with the high probability of the loss of our core position occurrence, the strategy is extremely benefi- cial in training us to stick with part of our position longer than we might otherwise be able to bear.
Intermediate to Long-Term Trend-Following Systems Typical duration of trade: 6 weeks to 5 months
Example: Channel breakout Advantages:
• Making fewer decisions than shorter-time frame traders usually equates to less stress (especially since intraday stress has been eliminated).
• Large per-trade profits.
• Works with many negatively and/or uncorrelated asset classes.
• Greater frequency of trades and shorter duration of trades than longer- term systems makes this time frame more palatable to “active” trend traders.
• Backtested results are more statistically significant than those of longer-term systems based on the same length of data history.
Disadvantages:
• As with the long-term trend-following systems, participation in this time frame usually means an inability to capitalize on obvious shorter- term, event-driven countertrend opportunities.
• Typically experiences poor win/loss ratios and a large number of con- secutive losses.
• Positions require posting of overnight margin.
• Often risks larger percentage of equity on a per-trade basis than short- term system traders.
• As with all trend-following systems, it requires the ability to buy recent highs, sell recent lows, and relinquish a significant portion of unrealized profits.
Intermediate-Term Trend Following Typical duration of trade: 2 to 8 weeks
Examples: Moving average crossovers, Bollinger bands, DMI Advantages:
• Greater sensitivity to trend changes often means this time frame has the ability to participate in newly developing trends quicker and sometimes even to participate in intermediate-term trend reversals.
• No intraday action required.
• Works with many negatively and/or uncorrelated asset classes.
• Large per-trade profits when compared with shorter-term systems.
Disadvantages:
• Quicker response to intermediate-term reversals in these systems can re- sult in oversensitivity to shorter-term fluctuation and a higher probability of being whipsawed than in the longer-term, lower-sensitivity systems.
•
• To minimize intermediate-term whipsaws: Introduce a filter that sen- sitizes us to changes in volatility, such as ADX, following the trend of implied volatility of options.
• Positions require posting of overnight margin.
• Typically experiences poor win/loss ratios and a large number of con- secutive losses.
• Still requires the ability to buy recent highs, sell recent lows, and relin- quish a significant portion of unrealized profits.
• Smaller per-trade profits than longer-term trend-following systems.
Intermediate-term Mean Reversion with Trend- Following Filter
Typical duration of trade: 6 to 10 weeks
Examples: RSI extremes with moving average filter; Bollinger bands with moving average filter
Advantages:
• Because these systems capitalize on the market’s propensity to revert to the mean, we can profit in either trending or choppy markets.
• Although they do entail more trading decisions than long-term trend- following systems, they are still relatively low maintenance/less psy- chologically stressful systems than the intraday decision-making process endured by day traders.
• These systems typically enjoy larger per-trade profits than day trading systems.
• These systems traditionally experience superior winning percentages and lower maximum consecutive losses than their trend-following counterparts.
• Because these systems capitalize on the market’s propensity for mean reversion while simultaneously trading in the direction of the longer- term trend, they are often the easiest for traders to psychologically buy in to as a superior methodology.
It is very appealing to simultaneously sell recent highs/buy recent lows while having the confidence inherent in trading in the direction of the longer-term trend. This ease of psychological acceptance suggests a higher probability of sticking with the system during its inevitable pe- riods of equity drawdown.
• These systems sometimes initiate and/or exit trades with limit orders, thereby reducing slippage.
• Portfolio experiences flat periods: Because these systems rarely hold open positions in any particular market for significant durations, traders can benefit from the enhanced performance inherent in trading a portfolio of assets while simultaneously taking mental breaks from the stress of always holding open positions in the markets.
Disadvantages:
• Requires posting of overnight margins.
• Average size of losers is identical or sometimes even larger than the size of winners (and so it requires superior money management and iron- willed discipline).
As stated earlier, fewer opportunities suggest the ability to exhibit unyielding patience and a willingness to watch from the sidelines until these rare opportunities unfold in the marketplace. A lack of discipline and patience often results in acceptance of inferior trading signals (e.g., taking trades with either a lower winning percentage or a poor profit/loss ratio).
• Small number of trade signals means diminished reliability of back- tested results (unless data sample is lengthened accordingly).
• Works consistently on only a limited number of diverse asset classes.
Short- to Intermediate-term Nondirectionally Biased Mean Reversion
Typical duration of trade: 3 to 8 weeks
Examples: Bollinger bands with ADX filter; slow stochastics with CCI filter;
slow stochastics with CCI filter and time exit Advantages:
• Because these systems have no directional bias, they generate a larger number of trading opportunities than systems with trend-following fil- ters.
• Shorter duration of trades means more trading opportunities.
• Increased number of trades improves reliability of backtested results.
• Unlike many traditional trend-following strategies, these systems (like most mean reversion techniques) quantify both risk and reward prior to initiation of the trade. This results in exiting with profits via limit or- ders, which suggests lower per-trade slippage than trend trading.
Disadvantages:
• Elimination of the trend-following filter often results in less confidence in the trading system and higher probability of abandonment during drawdowns.
• More trading opportunities over a shorter time frame means more deci- sions and more stress.
• Works consistently on only a limited number of diverse asset classes.
Trend-Following Swing Trading Typical duration of trade: 1 to 15 days
Example: Channel breakout with 15-day entry, 8-day exit, and 7.5-day time exit
Advantages:
• More opportunities over a shorter duration.
• Ability to profit from the shorter-term trending action unseen by longer- term players.
• Most strategies employ a time-driven exit criterion, which makes entry at recent highs or lows more psychologically palatable to many trend traders.
• Often employs a profit target exit with psychological benefits similar to those of the time-driven exits.
Disadvantages:
• Profitable on fewer assets—requires superior liquidity and volatility to compensate for endurance of identical, fixed transaction costs.
• Smaller per-trade profits.
• Exclusion of 24-hour traded asset classes for all except for institutional traders or trading teams.
• Intraday decisions means traders are married to the screen, which is much more stressful.
Mean Reversion Swing Trading with Trend- Following Filter
Typical duration of trade: 1 to 15 days
Example: RSI extremes with moving average filter Advantages:
• Same benefits as enjoyed by intermediate-term traders, only now more signals are generated.
• Because the system generates more trading signals, vacations are easier.
Disadvantages:
• Works consistently on only a severely limited number of asset classes.
• Intraday decisions mean traders are married to the screen, which is much more stressful.
• Systems require more attention, refinement, and possible reevaluation than systems with longer time frames to ensure robustness. Because longer-term systems are tested over a longer duration and in multiple markets with low correlations, the backtested results are more robust (therefore requiring less refinement and/or possible reevaluation) than shorter-term systems.
Nondirectionally Biased Mean Reversion Swing Trading
Typical duration of trade: 1 to 15 days Example: RSI crossover
Advantages:
• Same benefits as the intermediate-term traders, only now there are more signals generated.
• Because the system generates more trading signals, vacations are easier.
• Can capitalize on virtually any trading environment—trending, choppy, or mean reverting.
Disadvantages:
• Works consistently on only a severely limited number of asset classes.
• Intraday decisions means traders are married to the screen, which is much more stressful.
• Same as for “Mean Reversion Swing Trading with Trend-following Filter.”
Mean Reversion Day Trading with Trend- Following Filter
Typical duration of trade: minutes to hours Example: RSI extremes with moving average filter Advantages:
• Employment of the trend-following filter enables participation in the short- to intermediate-term trend, while still being able to capitalize on intermediate- to longer-term sideways market behavior.
• Trading in the direction of the short- to intermediate-term trend leads to greater confidence when fading recent highs or lows.
• No overnight margins and ability to “clear your head” at close of each trading day.
• More trading opportunities.
• With proper money management, each trade should risk small percent- age of working capital.
• Ability to implement with some degree of success on very short time frames.
Disadvantages:
• More decisions mean more stress.
• Smaller per-trade profits means few vehicles exhibit enough volatility and liquidity to be profitable.
• Must fight tendency to overtrade or risk losing discipline and/or con- sistency.
Nondirectionally Biased Mean Reversion Day Trading
Typical duration of trade: minutes to hours Example: RSI crossover
Advantages:
• Can capitalize on virtually any trading environment—trending, choppy, or mean reverting.
• No overnight margins and ability to “clear one’s head” at close of each trading day.
• More trading opportunities.
• With proper money management, each trade should risk small percent- age of working capital.
Disadvantages:
• More decisions mean more stress.
• Smaller per-trade profits mean few vehicles are volatile and liquid enough to be profitable.
• Must fight tendency to overtrade or risk losing discipline and/or con- sistency.
• Off-floor disadvantage: loss of the bid/ask spread and/or higher com- missions. Because such costs are fixed, as time frames are shortened, the viability of these strategies becomes marginalized.
All truths are easy to understand once they are discovered; the point is to discover them.
—Galileo