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By Matt Blackman, CMT

Ever wondered if you have what it takes to be a really great trader? Your answer may be just around the corner.

Famous commodities trader Larry Williams and his son, Dr. Jason Williams, who studied psychiatry at the John Hopkins School of Medicine, have teamed up to document exactly what traits separate truly great traders from the rest of us. Due to be published in the fall of 2012 by McGraw Hill, the book specifically explores personality trait differences between extremely successful professionals and average traders.  It identifies what personality characteristics are most important in determining our success or failure in this business. According to Dr. Williams, although there are many books that examine trader psychology, this is the first book of its kind to explore how personality traits work to either help or hinter trading success.

Stock trader Dan Zanger, the host of ChartPattern.com and author of The Zanger Report newsletter, was invited to participate as part of the highly successful group of traders studied. Zanger holds the stock trading record with an annual audited return of more than 29,000%. Every year Dan holds his annual ChartPattern.com seminar where traders learn first hand how he does it.

In the detailed 270-question NEO-PI-R personality test developed by two psychologists, traders are asked questions on a wide variety of topics. But the questions provided little insight or guidance about what the test was attempting to achieve, according to Zanger.

“The questions were somewhat contradictory. For example, one question asked if I liked bright colors and flashy items. I like bright colors but don’t like flashy items so how do you answer it? But it was certainly detailed and it will be interesting to see the results,” Zanger commented.

According to the Williams, the NEO-PI-R test is the most developed, validated personality test utilized by researchers and doctors.  Questions may seem contradictory but they are carefully worded to probe specific traits in such a manner that make it virtually impossible intentionally influence the outcome.

We talked to Zanger about the test and characteristics he feels are essential to trading success. His answers provided valuable insights into how he trades and what helped him become and stay successful in this business.

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Matt Blackman: “Do you think it’s worth the time and money for traders to take a psychological test to learn what their strengths and weaknesses are before they start trading?”

Dan Zanger: “It is essential that traders understand the strengths and weaknesses that they bring to the trading table if they want to make money. Since the Williams’ book focuses on trader psychology, it provides a lot of insight about what the test will tell you.

In my experience, there are traders who are determined, focused, dedicated and passionate and there are those who want to be successful but don’t want to do the homework, don’t want to or can’t focus and they just don’t have the mental tools or mental fortitude necessary. But even if you have the focus and determination, without the ability to see patterns, it’s impossible to do what I do. So there a many different factors essential to being successful.”

Figure 1 – A chart from The Zanger Report newsletter showing the powerful basing Cup & Handle pattern in the Holders Trust Oil Services ETF (OIH) in what turned out to be the foundation of a move that eventually took this stock north of $160. Chart courtesy of ChartPattern.com

MB: “One common theme Larry and Jason Williams found in their research was the fact that successful traders all shared a low level of anxiety under stress. Would you say this describes you?”

DZ: “You certainly get a sense of satisfaction from winning. There is a huge amount of winning gratification. Trading is a big game and you play the game to win. Other traders are trying to take your money every day. Knowing that you’re going to take their money instead is very gratifying.

MB: “Would you say that you experience a low level of anxiety under stress?”

DZ: “I’m always leery that my trade will turn into a loss. You always need to know how much you can lose in a trade. What is the risk on this stock? If a stock goes down $3 on a trade how will that affect me? If I can’t handle a $3 loss, then I’ve got too much stock.

Do I have a high degree of anxiety? I don’t believe in stocks, I don’t believe that they can make big comebacks. I’m so focused that when the trade is on, I’m not feeling anxiety. That only comes after the trading day is over.”

Figure 2 – A great example from The Zanger Report newsletter showing the power of a bull flag pattern amid a parabolic run-up in Garmin in 2007. Note the narrowing channel through which momentum slowly increased followed by an explosive break out and $20 run in just 2 months. But chasing a stock during a parabolic move is a bad idea. Chart courtesy of ChartPattern.com

MB: “What do you believe are some of the most important traits successful traders need to possess?”

DZ: “First and foremost, you need a tremendous amount of focus. Next, you need a passion for the business and then it’s essential that you are very visible and are able to quickly pick out chart patterns in whatever time period you are using.”

MB: “In summary, what would you say are the five most important factors to becoming a successful trader?”

Figure 3 – This chart shows the kind of sloppy sideways action that can decimate the account of the trader who tries to trade every move when markets are trendless. Chart courtesy of ChartPattern.com

DZ: “First, you need to do hours and hours of homework after market close on both winning and losing trades and to understand why you made them. You need to be fully aware both what you did right and when you made mistakes so will you do more of the former and less of the latter.

Second, as I mentioned above, a laser-beam focus on the trade during the trading day is absolutely essential. Distractions or mental lapses can be very expensive when you’re in a trade.

Third, I enter every trade with healthy dose of pessimism and exit either when the trade goes against me or when it doesn’t go as expected based on my reason for entering the trade in the first place.

Fourth, it is essential to keep you emotions in check so you trade logically based on what you’ve learned not how you are feeling that day. You need to understand that anytime an emotion takes over, you lose control no matter what that emotion may be, whether its fear, elation, greed or hope.

Last, the ability to recognize patterns in a heartbeat is essential. You need to understand daily short-term patterns and longer term patterns and be able to put them together. Volume is also an important tool because it provides insight into the level of trader participation.”

[Dan provides an excellent overview of the 11 most powerful chart patterns at http://chartpattern.com/understanding_chart_patterns.html ]

MB: “What is the single most common mistake traders including you make?”

DZ: “Continuing to trade a market that isn’t following through on setups i.e. a choppy market with whipsaws, false breakouts, with no leadership (see Figure 3). That kind of market chop can kill you. For a lot of traders including me, one of the toughest lessons to learn is when to stay on the sidelines when markets aren’t cooperating. It’s tough because you never know when the choppy market has ended and the next rally has started till after the fact. It is a natural tendency to jump the gun but getting in too early can be a very costly and potentially destructive habit. So another essential key to trading success is patience.”

MB: “What are some of the other common mistakes traders make?”

DZ: “I’ve seen a lot of traders buying out of the money options and thinking that is the way to quick riches when in fact you get eaten alive by time decay. To a large degree people are outright gamblers, who are just throwing cash at the market with no rhyme, reason or a deep understanding of the market. That approach is what kills so many so fast.

Among stock traders there is the strong need to buy really cheap stocks and that can be equally devastating. They don’t appreciate how the arithmetic is working against them. A one point drop in a $10 stock is a 10% loss versus the same drop in a $100 stock which is a more manageable 1% drop. Besides, cheap stocks are a lot more volatile which makes them riskier. But it’s tough to overcome that desire to buy something that’s cheap hoping that it’ll go to the moon and you’ll get rich. I learned that lesson a long time ago and the sooner you learn it, the more money you’ll make and keep.

Another common mistake traders make is the failure to use established rules. I have ten golden rules that I follow religiously in every trade.” [See Dan’s 10 Golden Stock Trading Rules at http://chartpattern.com/10_golden_rules.html ]

MB: “According to Larry and Jason Williams, one of the biggest surprises in their research was how consistent the personality traits between successful traders were. And the best traders were quite surprised to learn how their personality traits were working for them.”

DZ: “A big part of their success is an understanding that you don’t have to trade all the time, to wait for the right market and the right kind of setups to trade in the right kind of environment.”

MB: “What can traders do to improve their trading? Larry Williams believes that you can’t change your personality but you can adapt to it. Can traders eliminate destructive personality traits?”

DZ: “I would agree with him. You can’t change your personality but you can reprogram yourself with regards to your discipline. It is important to understand when things are working well. But it takes years to understand the charts, the behavior of stocks, learning to read volume, and realizing when stocks get too extended and to learn not to chase a stock.

Traders need to learn to program themselves on how stocks behave so that they know how to overcome their emotions and trade with logic and common sense in various situations. You may not be able to change your personality but your behavior to stock situations can be programmed. And once you’ve programmed your reaction to situations and then fail to react properly to those situations, you’ll realize you’ve had an emotional lapse. When you blow a trade you understand that your emotions have taken over. Then you work on not making that mistake again. Once you’ve programmed yourself this way, it takes constant attention and awareness to maintain logical control. One pivotal question every trader needs to ask him or herself before they enter this business is do I have the persistence, determination and discipline and am I prepared to dedicate the years it takes to develop these tools?”

MB: “In their research for the book, the Williams found that as well as having low levels of neuroticism especially anxiety, highly successful traders shared low levels of excitement seeking [gambler desire]. Would you say this describes you?”

DZ: “Some people, including me get anxious periodically because the stock is not behaving as expected so I’ll trade out. Sometimes I trade out early but I’m looking for fast movers so when they aren’t trading fast, I exit because that’s not what I’m looking for. It’s healthy to always have a deep mistrust of stocks. Traders who are eternal optimists get absolutely killed because they have a habit of staying in long after the trade has turned into a loser. If you can’t learn to control that desire to gamble and give in to that deadly compulsion to “roll the dice” in every trade, you won’t last very long.”

To attend Dan Zanger’s next annual seminar and learn from the master in person, go to ChartPattern.com or go to the direct link at http://chartpattern.com/seminar.htm

A big thanks to Larry Williams, Dr. Jason Williams and Dan Zanger for their time and input!

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Matt Blackman, CMT is the host of TradeSystemGuru.com. Matt’s articles have appeared in publications such as Technical Analysis of Stocks & Commodities magazine, SFO (Stocks, Futures & Options) Magazine, Trader Monthly Working Money, Physicians Money Digest, Laffer Economics, The Wellington Letter, Traders.com Advantage, Traders Mag (Europe) and  Active Trader. Matt is a member of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA). He earned the Chartered Market Technician (CMT) designation and a B.Sc. (Honors) degree from Simon Fraser University.

Follow Matt’s latest trading ideas and market comments on Twitter at http://www.twitter.com/MattBlackmanCMT

At any given time, a lot of the people calling for a top are probably seeking headlines rather than profits. There is no qualification test required to become a market commentator or a blogger, and anyone with an email address can use WordPress to offer market opinions. Some of the sites look sophisticated. One popular site performs a seemingly never ending array of linear regressions and proclaims that nothing ever works to their satisfaction. This site does book reviews using the Amazon free preview function, which is unfair to authors and readers.  In the end, many site visitors will believe what they read because the math looks so thorough. In reality, regression analysis is a technique that has some limited applications in the markets and should always be accompanied by several tests for trading significance. The best tests of whether or not something works in the markets is simply its profitability – if an idea makes money it is good and if it loses money it is bad. Concepts like r-squared and correlation coefficients can’t pay a trader’s mortgage. Yet, they can create subscription revenue for bloggers.

Traders need to ignore the headlines and opinions of others and focus on what the markets are actually doing. Many will find this to be among the biggest challenges they face in trading. It is natural to follow the market opinions of respected analysts. However, there is never a guarantee that any one will be right in the markets.

Bloomberg recently interviewed 88-year old Joe Granville who forecast a 4,000 point drop in the Dow Jones Industrial Average during 2012. Younger traders have probably never heard of Granville who once moved markets in a simpler time. Bloomberg summarized his record in the news article:

“Granville told newsletter readers to “Sell Everything” on Jan. 6, 1981. The Dow fell 2.4 percent the next day. He correctly forecast the bear market of 1977-78 and the burst of the Internet bubble that began in 2000. In March 2008, Granville said the Dow would end the year near 9,000, more than 27 percent below its level of 12,392.66 at the time. The gauge finished the year at 8,776.39.

His predictions proved less prescient during some of the previous bull markets. He failed to foresee the rally that started in 1982 and lasted for five years. He also called for losses in 1995 while the S&P 500 rose every year till 2000.”

Granville has had some amazing successes in a career that has spanned more than 50 years, but he has had some equally disappointing periods of performance. Followers would do best to evaluate his opinion as one of several factors influencing their own strategy. The same general idea applies to the work of any analyst since all of them are likely to have some great calls along with some bad calls.

How can traders avoid letting the news influence them? Discipline is the only answer, and a checklist could help instill discipline into the trading process.

- Follow a routine.
- Follow your indicators, and ideally trade with a set of rules.
- Follow the news, but as a hobby rather than as a trading signal.
- Research new ideas, but don’t act on them until after the research is completed.

This is a short checklist, and it describes the routine of almost any successful professional. A surgeon will follow a routine that is dictated by their schedule. In the operating room, the surgeon will follow their training (the equivalent of a trader’s indicators and rules) and use procedures that are dictated by the symptoms but they won’t really experiment with an unproven idea on a live patient. Many will talk to fellow surgeons about cases (an idea that is similar to following the news), but they will usually never second guess their own strategy. Most will also read the latest journals and attend continuing education (researching new ideas) but will only incorporate new procedures after careful evaluation and planning. Professionalism includes a number of traits, but discipline is always one of them.

Trading is a profession, even for those who only do it part time. If you are pursuing short-term gains in the markets, you are competing against full-time professionals who also have money on the line. Monetary gains are often regarded as the factor that distinguishes professionals from amateurs. In sports, professionals are paid to play. Unless you limit your market activity to paper trading, you need to think of your trading as a professional activity.

Professionals follow a schedule, and even a part-time trader needs to adopt a routine that allows them to accomplish everything they need to do in the markets. This includes checking account balances and trade confirmations, updating prices to check for required trades, and reviewing all open positions. These actions can be done once a day, and even once a week is enough for some traders, but they must be done on a schedule in order to ensure that the trades are being executed properly.

For traders, the idea of a rules-based trading strategy makes the whole concept of a market opinion into a hobby. This is an important step towards profitability. Systems can be traded with small accounts, and systems can be designed with spreadsheet software and freely available end of day quotes. The 20-day rule is an example of a simple and effective strategy that doesn’t require expensive software and can be monitored and updated in only a few minutes every day.

This strategy uses only closing prices to determine whether to buy or sell and works well with futures. It is always in the market, long when prices reach a new 20-day high and short when price falls to a new 20-day low. It can easily be set up in a spreadsheet and traded with accounts as small as $1,000 on a single Treasury note contract.

The problem with a market opinion is that it often creates a mental hurdle to trading. If I tell my friends and family that I am bullish on the S&P 500 for the next six months, they expect me to be buying stocks and holding on to them for at least the next six months. Traders need to react to the market and focus on making money rather being right. A market opinion is less important than trading profits. The problem for most traders is that once they make their opinion public, it becomes a driving factor behind their trading.

The news is interesting, but markets don’t really move higher one day because the price of oil is up. Intermarket relationships change with time and oil may in fact exert a long-term trend that influences stock prices, but no single event usually makes a market go up or down on a given day. News can be quantified and incorporated into a system.

Traders could research the idea that today’s move in oil forecasts tomorrow’s stock market. This idea is easily tested (and in my experience it is practically worthless). Intermarket relationships can be set up in trading software and simple relationships can be evaluated with a spreadsheet. Once the trader has researched the idea and quantified the results, they can incorporate the successful strategies into their trading.

Trading strategies can evolve over time, if the data shows that the new idea is worth using. The news and opinions of others can inspire testing, but disciplined traders will never place a trade based on someone else’s work. Trading psychology is important to winning and these four simple steps can help keep you on track to profit from the markets.

Michael J. Carr, CMT

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Over the years, probably thousands of indicators have been developed as traders spend time looking for ways to beat the markets. Some like the relative strength index (RSI) or stochastics are very well known and widely followed. Others, like Chaikin Money Flow or the Chande Momentum Oscillator, are much less studied. All indicators are developed with the objective of providing traders an edge in the market.  An edge should be quantifiable and to determine whether or not an edge exists, we can look at whether or not the indicator increases profits compared to a baseline trading strategy. This week we will look at two standard and widely followed indicators, saving the less followed ones for a different article.

For testing, we will look at a diversified basket of futures contracts that could be traded with an account balance of about $25,000. Smaller accounts could adapt the strategy to use only a few of the contracts but that increases risk. The futures contracts used in the tests will include crude oil, cotton, the US dollar index, feeder cattle, five-year Treasuries, copper and sugar. Commissions and slippage of $45 per round turn will deducted from each trade to duplicate the reality of trading costs. The test will cover the twelve years ending December 31, 2011.

For the smallest accounts, five-year Treasuries test very well and can be traded with about $1,000 in margin. Of course it is best to have more than the minimum margin available in a trading account. Small traders can also use day trading strategies in futures markets since many brokers allow day trading with even lower margins.

The baseline system will use only prices to determine whether to buy or sell. It will always be in the market, taking a long position when prices move to a new 20-day high and reversing to a short position when price falls to a new 20-day low. Closing prices are used in this study.

The indicators we will test will be MACD and RSI, using the standard default values in each case. MACD is a trend following indicator and RSI is an overbought/oversold indicator. Default values used to calculate the indicators are 12 days and 26 days for MACD and 14 days will be used for RSI. Optimization can be done on these or any indicator but that is a dangerous path for traders to follow. With optimization you are actually decreasing the odds of future success by fine tuning the rules to precisely fit the past which will be different from the future. The value of optimizing parameters is to find out if the indicator is stable. For example, RSI is usually considered oversold when it falls below 30. We could optimize and find that it delivers great results at a value of 28, loses money when it is set to buy at 29, and breaks even at 30. This would show that the past performance is actually due to luck rather than adding any value to trading. If the results with the default values show that the indicator is tradable, an optimization test should be completed to make sure a small change in the parameters has only a small impact on the results. Otherwise, profits in the future are unlikely to be similar to the back tested results.

For MACD, we will be taking long positions when the histogram crosses above zero and going short when the MACD histogram is negative. The RSI strategy will be long when the indicator crosses above 30 after reaching an oversold extreme and short when it falls below 70 after becoming overbought. The results of the three systems tests are summarized in the table below. The initial evaluation of a trading strategy should simply look at the potential rewards and the risks. Returns are presented as the average annual returns because that is the most common way investors look at rewards. Risk is the ratio of the largest drawdown to the account value, a measure of how big the worst loss would be. This is really the way many investors think of risk. As a standard to measure performance against, a buy-and-hold stock market strategy would have a risk of about 60% over the test period and the S&P 500 showed a loss over that time. Buy-and-hold investors in a stock market index fund would have enjoyed a small gain when dividends are considered. Futures do not pay any dividends and all of the returns come from price action.

These results show that trend following strategies like the 20-day rule or MACD applied to the futures markets work well over time. RSI is an oscillator that tries to capture profits when the trend is changing. Using an indicator to buy oversold markets and short overbought markets doesn’t result in profits because trend reversals tend to be sharp moves. By the time the signal is given, a significant part of the move has already taken place. Trend followers are not trying to pick tops or bottoms, they are simply trying to get in once a trend has been identified.

These incredible results were obtained in the futures markets. Trend following strategies do not work as well in the stock market. Testing over the same time period using the S&P 500 gives the exact opposite results – losses are realized with the 20-day rule and MACD while RSI delivers a small gain. RSI actually provides results that are in line with a buy-and-hold strategy and does not offer any benefit when compared to that approach. When tested on a basket of stocks, the results are the same. Trend following strategies lose money and RSI is no better than a buy-and-hold approach.

Given these types of results, the obvious question is why do most individual traders focus on the stock market? Almost all individual traders limit themselves to the stock market with individual stocks or ETFs that track the broad market indexes. This is probably due in part to the perception that futures are risky. I have met individuals who believe that if they do something wrong they will have a truckload of corn, or whatever they are trading, delivered to their front door. Many also believe they could lose their house to a margin call. Fortunately your broker will sell you out of your position before either of those things happen. But the numbers actually show that a diversified basket of futures has less risk than the stock market.

Futures are risky and the leverage does mean that you can lose more than you invested. However with proper risk management, they can be a very rewarding investment. Those MACD test results show that profits are possible and the risk can actually be less than that seen in stocks.

Individual traders, even small traders, should consider futures. Futures and foreign exchange markets can both be more profitable than the stock market. Making big profits and successfully trading for a living requires you to do things differently than the average investor who is not successful and not making a living from the markets. Trade in the markets where you can actually meet your goals.

By Michael J. Carr, CMT

Some common things you should have in your Trading Journal include all factual information on the trade: date of the transaction, the security you traded, how many shares/contracts bought/sold, entry and exit prices, net gain/loss, stops and targets. Most traders include commissions in their Trading Journal as a way to net gains/losses in their account. The Trading Journal will give you a way to answer the most important question in trading: Are you making or losing money? Nowadays, many brokers will provide some sort of online journal, which is also useful come tax time.

This basic information also provides traders with the ability to see their individual Profit Ratio and Success Ratio. Your Profit Ratio is the size of the average winning trades versus the size of the average losing trade. The Success Ratio is the number of winning trades versus the number of losing trades. Many traders use these ratios to plot their growth as traders. As your winning trades get bigger and bigger in conjunction with a increasing percentage of winners, your profits will definitely increase.

After this point, Trading Journals tend to differ from trader to trader. Your specific trading philosophy will help determine what is the relevant information for your Trading Journal. Someone who trades using the Commitment of Traders probably would have more use for information on the COT reports rather than triple tops or some other technical indicator in their journal. The point being to add information on the specific market conditions, in reference to your specific trading strategy which will provide the reasons to your trade. After some time, you will have a reference to see which trading conditions are the best for your particular strategy therefore helping to increase profits. In addition to recording your specific set-ups, it can be useful to include how the market conditions changed during the trade and what influence that had on the outcome. In the end, this part of your journal should provide you with solid reasons you would give someone else to take the same trade.

One thing to remember is that a Trading Journal is supposed to way for you to recode your trading and find any patterns that will help you improve your trading. In this manner, your Trading Journal should be personal. Therefore you should record any information you find relevant. Many traders will include information on how they feel about themselves, the markets or anything else they think is helpful.  Many times this can be cumbersome considering that the markets can change on a dime at any time. One thing some traders do is use a digital recorder, which is a fast and easy to put your thoughts on a trade down to review. Many traders think that they are disciplined traders only to find out different after reviewing their journal. This can also provide you with a way to see if you are executing your plan correctly. Think in terms that you are trading other people’s money, and what would they think of your reasons and execution of each trade. If you can’t defend your trade to someone else then you probably shouldn’t take it.

Make sure to try to identify any feelings of fear or greed in your journal. This will allow you to analyze your decision making process. With your journal, you give yourself the ability to review each and every trade in an emotion-free, calm manner. The basic idea here is to include any insight into your emotions during trading and how to overcome them. This will also show you if you are more affected by outside influences than you realize because these influences can make our decisions less than rational. Furthermore, if you don’t write it down, you will never how and what is making your trading good or bad. A journal provides you with the ability to identify your thoughts and emotions during trading and it is these factors that determine your trading more than anything else.

After compiling all this information, one thing you can do with your journal is to identify your best trades. Being able to see when you are at your best will give you more confidence when that same situation arises. And it is this quality that separates the really great traders from everyone else. You can keep your losses tight and make a living, but in the end it is the traders who capitalize at the right time and make big bets (and win) that separate the men from the boys.  Over time, you want to isolate what you are doing right when you win in order for them to become habits.

A Trading Journal will also provide you with a way to prepare yourself for the upcoming trading day. Although the journal will only include things that have happened in the past, the journal will give you a way to spot patterns in the market. There are certain truths in trading that only become apparent thru the use of statistical information. Information from how corn traders trade on Fridays to the fact that the market has gone down from 11 o’clock to 2 o’clock the past few weeks will only show itself to those who record it. Basically, your journal will give you an idea if there are set-ups that have been working lately and how to use them wisely. Many successful traders look at their journal in the morning to give them an idea of what to prepare for that day.

One of the most widely underused aspects of a Trading Journal is that it gives you a place to outline specific steps for improvement. All traders want to ‘make more money’ or ‘have fewer losers’ but unless you give yourself detailed ways to reach that goal, that usually does not happen.  Many traders will look at losing trades, then write out what they should have done differently and have it handy the next time that trade set-up happens.

One thing I would like to mention in closing is that trading is a lot like driving. What I mean by this is that when you drive or trade, things may look very similar but most often there is something different. Even roads you have driven down a thousand times are always at least a little different each time. From how many cars passed you, to the colors of those cars, to the weather, to what you ate all can have an influence and therefore change the outcome. So in trading, many times trades look exactly the same, but they aren’t. A Trading Journal can help you spot patterns in your trading and the market, which gives a higher likelihood of profitability.

By Henry King

See also: Ideas for Building Your Personal Trading Journal

Why is position trading so important? Ask any trader and they will tell you that a high amount of beginning traders do better when paper trading than once actually live (at least initially). The reason being the realization of losing ‘real’ money after going live versus paper losses. Something happens to a great deal of traders after the money lost becomes tangible. Also, knowing how to deal with profits doesn’t make a successful trader insomuch as being able to handle losses. Being able to think and act clearly and concisely in the face of danger (ie trade going against you) saves more accounts than any other single trait. Remember, there are five outcomes of every trade: big profits, small profits, scratch, small losses and big losses. Being able to take big losses out of the equation will, at the very least, give every trader more bullets in the gun. Position sizing sets the floor on what you are willing to lose on a single trade.

When determining your position size for your trading account, you must take into account two very important things: yourself and the market you are going to trade. Being able to identify your personal strengths and weaknesses will only help you come up with a practical and probable willing trading plan.  In conjunction with knowing yourself, having a firm grasp on the idiosyncrasies of each security or asset will only heighten your success rate.

Let’s take a look at one specific formula for position sizing and proper money management, the Kelly Formula or Kelly Criterion. The Kelly Formula was designed by John Kelly who worked for AT&T and it was originally used for long distance data transmission. Traders got wind of it once it was published and saw that it could be used as an optimal betting system. There are two basic components to the formula: win probability and win/loss ratio. Your win probability is calculated by dividing the number of winning trades by your number of total trades. The win/loss ratio is found by dividing the average gain of winning trades by the average loss of negative trades. After finding these numbers, the Kelly Formula is:

K% = W – [(1 – W) / R]

where W is your winning probability and R is your win/loss ratio. This formula will give you how much you should appropriate per trade. One must remember that this formula takes the trader and the market as a constant, which doesn’t really happen. Many traders will retest their trading on a monthly, quarterly, annual basis to make sure they are using the correct position size.What do we mean by knowing yourself? In the most basic sense, it is knowing what you are good at and what you are bad at while trading, along with knowing your actual account. For example, a person who doesn’t like volatility should not trade a volatile product (the converse would be true as well). Taking account size out of the picture, you should know what things you do well before trading. Knowing if you can make a decision quickly, be able to act fast off news, read charts technically at a glance are just some of the things you should know about yourself before trading. Once you know what things you do well, and what things you don’t do well, you can determine an appropriate stock, bond or commodity to trade.

Besides knowing your strengths and weaknesses, your account size, risk tolerance and belief in a trade will help determine your position size. Obviously, someone with a smaller account has to have different parameters for their account than someone with more funds. The small account can have the same percentage stop loss on each trade as a big account, but being able to be profitable right off the bat is more important for the smaller account than the big, although I would add that it is important to the big account as well. The reason I say this is because the smaller account already has a different attitude on staying than the big account.

Risk tolerance is another important aspect of position sizing you should know before trading. Risk tolerance is the amount of risk you are willing to take in your account. Besides your personality, age and account size will help determine your risk tolerance. Generally, the amount of profit you are looking to get will equal the amount of risk you will be taking on. For example, if you are looking to double your account (a 100% increase), you can expect a complete loss (a 100% decrease) as your risk. It is very rare to be able to find a trade where your risk is 5% and potential profit be 400%, it just doesn’t happen. Many beginning traders believe that they can see a 50% return with little to no risk, which isn’t realistic. Having a realistic view of the amount of risk you want to put on before you trade will help you be ready should the trade go against you. Position sizing helps you pre-determine what risk you are willing to take before initiating a trade. If you know that you are only willing to risk $500 on a trade, you know where to put your stop as well as be prepared to exit, if needed.

Another important facet of effective position sizing is your belief in a trade. Many successful traders have different grades or rankings for each trade. They will use an A+, green light or 1 (or whatever ranking system they use) for each trade and that will determine how much money or what size they want to put on for the trade. The idea being trades that you believe have a higher percentage of working in your favor should be delegated a higher percentage of funds. This works both in fundamental trading as well as technical trading. Some technical traders put on a larger position if they see a triple or quadruple top (or whatever metric that particular technical trader uses) because they believe that has more of a chance of going down than something just with a single or double top. The general idea is trades that you believe in should be a bigger bet than trades you feel less confident about.

By Henry King

In addition to providing similar signals, many indicators will fail to deliver clear signals in some cases. RSI can be used as an example. This indicator is often used as an overbought/oversold market timing tool. Standard settings in most software packages will show that RSI is oversold when it drops below 30 and is overbought when it rises above 70. One way traders generate signals is to buy when RSI crosses back above 30 and sell or enter short when the indicator falls below 70. Unfortunately, markets do not always provide signals by moving through these arbitrary levels. This problem is illustrated in the chart below.

This chart shows the price of SPY, an ETF that tracks the S&P 500 along with RSI in the middle of the chart. RSI has been converted to a histogram in the bottom of the chart to highlight the fact that the indicator gives clear trade signals infrequently. There are several consecutive buy signals shown as green tops of the bars in the left section of the chart and a single sell signal in the center shown as few bars dipping below the 30 level. The timing of the signals would have been ineffective as a trading strategy and numerous tradable price reversals came while RSI was range bound.

While the specific source of many indicators is unknown, that is not the case with RSI which was introduced by Welles Wilder who offered the formula in his 1978 book, New Concepts in Technical Trading Systems. Wilder noted that RSI could be used as an overbought/oversold indicator and he also offered examples where it could be used to spot trading opportunities by analyzing divergences, trend line breaks and RSI chart patterns.

Wilder’s work may be the first example of applying indicators to an indicator as part of the analysis. Some indicators such as the stochastic or MACD are also examples of this technique although in those cases, the indicator on the indicator is part of the calculation itself – stochastics and MACD both use signal lines as an integral part of their construction. Wilder’s work seems to be the first where an independent effort to study the indicator is made.

A problem with Wilder’s techniques is that they are still subject to interpretation. There are almost always several trend lines that can be drawn on a chart and different traders frequently disagree on pattern analysis. Given this subjective approach, the results can not be quantified effectively and the results will differ from trader to trader. When a trader is just beginning to make their living from the markets, a more objective and back testable approach is usually best. With that in mind, we will review different ways to apply RSI based on clearly defined rules.

RSI can be applied to the markets as an “always in” strategy. With this approach, buys are made when the indicator rises above 30 and those positions are reversed when the indicator breaks below 70. Those simple rules identify a large number of winning trades in SPY using all available daily data for the ETF back to 1988 and deducting $10 a trade for commissions and slippage. While more than 60 percent of the trades are winners, the system loses money. Long trades win more than 85 percent of the time and they are profitable. As a long-only strategy, this would be an effective market timing strategy.

An astounding 93.5 percent of trades are winners using a threshold value of 40 to buy the SPY. Sells are still taken when RSI falls below 70. This strategy averages about one trade a year and is invested about 60 percent of the time. Using the higher value of RSI dramatically lowers the risk and this could be a very useful timing strategy for retirement accounts. While this strategy reduces risk, it fails to beat a buy-and-hold strategy. RSI long only provides a gain of about 6.8 percent a year while buy-and-hold averages about 7 percent a year over the test time frame.

To study the use of indicators on indicators, adding a moving average to the RSI could be a useful starting point to understand the concept. This idea is shown in the chart below.

The moving average (the black line in the chart) is calculated on the value of RSI. Signals would be generated when the indicator crosses above and below the moving average. While this idea is useful for showing the idea of how an indicator can be applied to an indicator, it is not a profitable trading strategy in back testing. Moving averages are designed to catch trends and will not work well on oscillators. There are a large number of whipsaw trades with this idea and it catches very few price trends.

Applying the stochastic formula to the RSI can be helpful. The stochastic formula places a value in context relative to its recent range. It is a very useful formula when applied in this manner to a variety of indicators. Larry Williams has demonstrated this technique for many years, as has John Bollinger. Both of these individuals are among the leaders in market analysis and both have come up with many innovative ways to look at market data over the years. An example of the stochastic formula applied to RSI is shown in the next chart.

The signals from the stochastic (the blue line) are clearer and more frequent than they are from RSI (the green line). There are still missed trading opportunities and losing trades but visually, this approach seems to have advantages over the raw indicator.

Testing shows that the stochastic approach reduces risk over the long-term, when risk is measured by the total drawdown of the trading history. Only 60 percent of the trades deliver a gain but the annual gains are equal to what the buy-and-hold earns over the test period. Returns average about 7 percent a year and the reduced risk, in dollar terms, could make this appealing to long-term investors.

Traders could also get solid returns based on this idea with a diversified basket of futures. Using just RSI as a trading tool would result in losses for the futures trader but using the stochastic formula would be a winning strategy. Returns average only about 7 percent a year, similar to the gains available in the stock market over the test period. Futures use leverage and can be traded with smaller accounts, which would be a reason that small traders might consider this strategy. There are better strategies available to futures traders, such as the four-week rule which I have written about before.

An advantage of using a stochastic of RSI in the futures market is that the signal is correct about 60 percent of the time, a fairly high percentage of winning trades for these markets. Combined with other indicators, this could lead to very profitable and low risk trading strategies.

Adding indicators to indicators has the advantage of making the original indicator easier to interpret. This is especially helpful for analysts, or for forming market opinions. For traders, this idea does provide a way to reduce risk, even if returns are only improved slightly compared to a buy-and-hold investment. Risk reduction in a retirement account can help avoid the large losses that delayed many plans as bear markets unfolded twice since 2000.

This is of course only a starting pint for the idea and many other variations and back tests are possible. Indicators can be added to any indicator and this could be used as just one of several rules in a strategy. This is a profitable idea and worth the time for additional study.

By Michael J. Carr, CMT