The Most Common Mistakes Traders Make

Here’s a simple guide to losing money in the financial markets. These are the most common mistakes traders make. Most traders make all three, but making even one is a recipe for losing.


Poorly Defined Exit Conditions

Before you enter a trade, you must have already defined your exit conditions. Every trade has at least three exit conditions:
  1. A Stop-Loss exit – this is the price that tells you, “my thesis is wrong, I need to close this trade at a loss.” The stop-loss order doesn’t have to be in the market, but it has to be a precise number, and the professional trader must make the commitment to close the trade once that price is hit.
  2. A Profit Target – this is the price you expect to reach to make a profit on your trade. Lacking a clearly defined profit target, you don’t have a clear idea of when to close the trade at a profit and will often let those profits melt away.
  3. A Trailing Stop Trigger – Once price begins moving in your direction, you want to have a strategy that will protect you so that a small profit doesn’t turn into a loss. You should pick a price somewhere between your entry and your profit target that – once hit – triggers your trailing stop strategy. (You do have a trailing stop strategy, right?


No Thesis

Successful traders can clearly state their “reason why” for the trade. They know how much profit they expect to make if their thesis is correct, how they will know if their thesis is incorrect, how much money they will lose if their thesis is incorrect, and how long they will leave the trade open before they know one way or another if their thesis is correct. Losing traders merely hope.

The five characteristics of a valid trade thesis are as follows:

  1. It has clearly defined entry conditions. These can be any combination of prices, indicators and/or external conditions that you wish, but they must be clear and unambiguous. You must know exactly why you are entering the trade, or – lacking all the conditions being met – know exactly why you are choosing not to enter the trade.  For example, “I will enter this trade long on the first day after the price closes up after having fallen below its 20 day moving average.”
  2. It has a clearly defined profit target. If you don’t know how much money you expect to make, you have no way of knowing how much money you can afford to risk.  For example: “I expect the price to reach the top of the 50 day price channel as of the day the order was opened.”
  3. It has clearly defined risk. You know how much money you will lose if your thesis is wrong. For example: “I will close this trade if the price drops more than eight percent from my entry price.”
  4. It has a defined expectancy. You know how much money you will make on average every time you execute this strategy. You will know roughly how many times you will win and how many times you will lose for a given number of trades. You will know your average expected loss per losing trade and your average expected win per winning trade.
  5. It has a time limit. Sometimes a trade hits none of your exits. In those cases, you also have a time limit set for your trade so that you can close it and move your money to something more profitable. For example: “If none of my exits are hit within 14 calendar days of my entry, I will close the trade.”


Failure to Test

Many traders will define their exits and their strategies, but never actually test those strategies before putting real money at risk. Any trade strategy that is clearly defined can also be tested against historical data. In fact, without such testing, it is impossible to know the expectancy of your trade strategy.

Maximum Value, Minimum Risk

When I trade, I am always looking for a combination of Maximum Value and Minimum Risk. That means not only making profitable trades, but also protecting my downside against loss and being in cash as much as possible.

This morning  I tested several DOW 30 stocks using my Touch SMA strategy. (See here, here, here and here for other studies I’ve already published.) In about half of the stocks, Buy & Hold outperformed Touch SMA. 

Here’s an example:

I tested Caterpillar (CAT) using my Touch SMA strategy.  The optimal strategy I found grew the portfolio about 40% since March 2009. In comparison, Buy & Hold would have grown it almost 60%. That’s a ton better.

But look deeper:

Touch SMA was in the market only 442 out of possible 1962 days. The P&L per day was a little over $31 for Touch SMA compared to just over $8 per day for Buy & Hold. The maximum drawdown on Buy & Hold was almost 39% compared to a max drawdown of 10% for Touch SMA.

There is no clear winner here. If you prefer making more money while taking bigger risks, then Buy & Hold would’ve been the right strategy in CAT the last 5 years. The upside is a 60% gain in value. The downside is that your money was tied up 100% of the time and you suffered a 39% drawdown.

But Touch SMA, while not generating the same profits, was in the market only about 20% as long as Buy & Hold, which means that money could have been put to use in other trades as well.

I don’t trust the market, I don’t trust my emotions, and I don’t trust the past. But I do trust systems that are built to protect my war-chest and slowly, consistently collect profits. Touch SMA is proving to both protect and profit.



Bubble Markets and Back Testing


I saw a question on the Reddit /r/algotrading forum about back-testing and how much data one “should” use. As far as I am concerned, the only rules are “whatever works”, but within that framework, I do have some rules I follow. Bubble markets and back-testing affect one another profoundly.

When running back-tests on the strategies I build, I don’t test anything prior to January 2, 2009. I don’t go back any farther than that because of my beliefs about the market. (Remember, you don’t trade the market, you trade your beliefs about the market.) What I believe is that we’ve had 4 entirely different markets in the last 20 years, and the only one in which I can perform valid testing is the most recent.

The Internet Bubble Market: 1994-2001

The first market we had was the internet boom period – more accurately called the Internet Bubble – that started around 1994 and ended with the Dot Com Crash of early 2001. In fairness, this was merely the last 7 years of the Great Bull Market that started with Reagan and ended with the reign of Bush II. This was the time when millions of peoples thought they were genius traders because all you had to do to make money was buy some stock. This was also the heyday of the day-trading craze where everyone who could install highspeed data lines in big room could open their “day trading” company and sell seats. Any back-testing that is performed during this period is highly suspect, because the conditions that prevailed in that market simply don’t exist today.

The Real Estate Bubble Market: 2001-2008

The Dot Com Crash led to a wide-spread despair that Happy Days were never gonna Be Here Again. This was clearly unacceptable, so the Fed does what the Fed does best: goose the market. The Fed decided to slash interest rates in order to spur borrowing. That led to the Great Real Estate Bubble that topped out in October 2007 and ended with the collapse of Bear-Stearns in March 2008.

This was the period when any stock that had anything related to “Real Estate” in its name or prospectus exploded off the charts. This was also the period where “financial engineering” gained ascendancy, which also led to the gross over-valuation of financial stocks. Tech stocks were as shunned during this period as they were embraced during the Dot Com Boom. Any back-testing that covers this period is suspect, especially if  it includes real estate, finance or tech stocks. Like the Dot Com Boom period that preceded it, the conditions that existed then do not exist now.

The End of the World As We Know It Market: March 2007-March 2008

The period from March 2007-March 2008 was dominated by the collapse or  near-collapse of all the Too-Big-To-Be-Allowed-To-Fail financial institutions, the bankruptcy of General Motors, TARP and assorted bailout games, and Bernie Madoff’s $50 billion fraud. It was a time of overwhelming panic, when fundamentals were irrelevant and technicals no longer worked. I don’t consider anything that happened during that market to have any bearing on the current market.

The QE/HFT Bubble Market: March 2009-Present

When the S&P500 bottomed out at 666 in March 2009, the Fed resorted to the the only tool they had left: create money out of thin air. That was the advent of “Quantitative Easing” which utterly changed the nature of the market. Vast quantities of brand new cash came pouring into the market by way of the Fed’s largesse. Not only did fundamentals no longer matter, (most of the big financial institutions were technically insolvent during the time leading up to the QE era), not only dud technicals no longer work, but now the high-frequency traders were starting to take over the market.

Due to the advent of QE and the takeover of the markets by HFT, this market is completely unlike any that has come before it. We are now trading in a market where the dominant realities are not earnings or the promise of future earnings, but by the quantity of newly created money flooding in, and the success of competing trading algorithms. The only period that matters is this one. Don’t bother back-testing data prior to March 2009 because it is no longer relevant.

Build Your Own Expectancy Calculator

In this video, I show you how to build your own expectancy calculator.

If you just plug all your trades into this calculator, it will give you a raw, unbiased measurement of your skill as a trader. If you plug into it only those trades which were executed under a particular trading system, it will give you a way to objectively measure one trading system against another.

If you’d like a copy of this spreadsheet, just sign-up for my newsletter.

[vooplayer vooid=’MjY2OTY=’ width=’543′ height=’408′]

Q&A from a Reader

I received a long list of questions from a reader about my trading, so rather than answer him privately I decided to answer via this “Q&A from a Reader”. ES 03-14 (30 Min)  2014/01/13

Q. Do you use technical information before market opens and then plan out your day?

A. Not really. At the end of every trading day, I update my support and resistance lines on my daily chart. I also make a note of the 14 Day Average True Range (14D ATR) and of the Volume for the day compared to the 20 Day Average Volume. At the start of the trading day, I will mark the overnight Highs & Lows on my 1000-contract chart, but that’s it.  (I use a 1000-contract chart rather than a 5-minute chart because volume to me is as important as price – and way more important than time.)

Q. How are you utilizing ATR?

A. It’s important to understand what ATR is before I explain how I use it. Check the definition here. I currently use a 14 Day ATR. It tells me what the Average True Range for the instrument has been over the previous 14 trading days. With that information, I know what the likely range is for the upcoming trading day. I compare the 14D ATR to the horizontal Support/Resistance (S/R) lines I have drawn on my daily chart, and with that information, decide where my entries & exits will be for the upcoming day.

For example, if the 14D ATR is 15, and I have S/R only 10 points apart, I will likely select one of those S/R prices as an entry with the other as an exit for the upcoming day. In other words, a 10 point range between S/R points is within the current “normal” range of the instrument. OTOH, if my S/R lines are 20 points apart while 14D ATR is only 15, that tells me I am not likely to get a full move between S/R points during the trading day. I’m okay with that; it’s just nice to know that I will have to plan to hold a position overnight.

Q. How tight are your stops?

A. Set your stops too tight, and you get bounced out of good trades by “noise”, right? But set them too loose, and you lose too much money when you’re wrong. So how do you know the “right” size stop? The reality is — that is unknowable. However, there are some ways to make some educated guesses. I try to not trade on sideways, choppy days because even if my stop is large enough to avoid getting chopped out, there’s a likelihood I also won’t hit my target. Not much point in being in a trade if I’m not gonna make money, right?

So I first try to determine if I am in a “trend” day or a “sideways” day. Typically, the way I do that is to check other indices. I trade the ES so I check the NQ for confirmation. These two tend to trade in tandem, so if they aren’t trading in the same direction, it’s a pretty good bet we’re in a sideways day. If I’m not sure, I also check the DOW Transports, the XLF (financials ETF) and the XLK (tech ETF). If I think we’re sideways, I stay out. If I think we’re trending, then I have to decide my stop size. This is typically a function of the amount of money I expect to make on a trade.

I try to risk an amount of money that allows me to keep trading if I am wrong about the trade. My personal rule is that I want to be able to be wrong three times for every time I am right. That means when I am right I make enough money to recover from the times I am wrong. If I am wrong thrice as often as I am right, then I need to risk a little less than 33% of the amount I expect to make on any trade.

An example: suppose I expect to make 10 points on a trade. With my “wrong three time / right once” rule, I set a stop of 3.25 points. That means I can be wrong on a trade like that 3 out of 4 times and still not lose money. (In practice, if I’m wrong much more than 50% of the time, I need to re-examine my trading plan.

Q. How many trades do you make a day? (not too many right, you swing trade, right?)

A. I prefer to trade no more than once a day. My experience is that it is easy to over-trade. If I am absolutely convinced that I am right on a trade but get chopped out of it, I might try the same trade a second time in a day. (This does happen, but if  I make the same trade twice and am wrong both times, that’s the sign  to stay out.) But I know I am better off trading less than trading more.

Q. Thoughts on the current ES market?  Seems like we kinda in a choppy portion and I think we are due for a correction?

A. As I look at the chart from the last 2 weeks, it is screaming at me that a correction is due. The average volume has plummeted even as we’ve made new highs on several consecutive days. We’re green 10 of the last 11 days, even though volume is averaging less than a million contracts a day. This is not the sign of a bull market gathering steam; it’s the sign of a market running out of steam. I’m still looking for a retest of 1868.

Q. What pieces of info do you rely on most?

A. Volume compared to average volume, closing price, high price on high days, low price on low days, extreme price on swing days and ATR. That’s about it.

Q. What was the price action journey like?  Did you use Technical and got comfortable with movements and then move to price action? 

A. I think I did what most traders do when first starting out: I tried every combination of technical indicators available: moving average crossovers, fibonacci extensions and retracements, MACD, stochastics, bollinger bands, CCI – you name it. None of it helped me be consistently profitable. (I do think Volume Profile is very helpful, but frankly, now that I am “seeing” support and resistance, I’ve realized that Volume Profile just confirms what I already know. I keep a Volume Profile open on my desktop, mostly because it is a default on my trading platform.) Technical indicators look at the past. Price is the present. And every trade is a coin flip.

Q. Do you use candlestick?

A. Yes, I keep two charts open on my desktop: a daily candlestick chart and a 1000-contract volume candlestick chart. I  will occasionally flip over to a 10,000-contract volume candlestick chart when I want a view in between daily and 1000-contract volume.