Mechanical Systems

Everyone who is trading, but not for a living, has probably asked themselves this question. When they ask us, we ask: what is a living? For one person, it is $50,000 a year, for another it is $500,000 a year. We don't know how much money you have or how much you want to make. One trader might risk more and make 100% on his money, but another might risk less and make 30% a year. Some traders may have a losing year -- it happens to the best. The real crux of the matter amounts to what is a living for you, and whether you are able to follow a system to make your goals happen. The answer ultimately depends on your self-discipline and whether you have that needed deep desire to win at all costs.

Most of us don't have the discipline to stay focused on a single goal for five, ten, or twenty years, giving up everything to bring it off, but that's what's necessary to become an Olympic champion, a world class surgeon, or a Kirov ballerina. Even then, of course, it may be all in vain. You may make a single mistake that wipes out all the work. It may ruin the sweet, lovable self you were at seventeen. That old adage is true: You can do anything in life, you just can't do everything. That's what Bacon meant when said a wife and children were hostages to fortune. If you put them first, you probably won't run the three-and-a-half-minute-mile, make your first $10 million, write the great American novel, or go around the world on a motorcycle. Such goals take complete dedication.Jim Rogers

How Much Time is Needed? Not much if you follow a Trend Following system. Trading signals can be generated manually via a simple PC spreadsheet in a few minutes per day. Just keep careful records and a trading log. You can also automate trading signals with products as discussed here.

Orders can be placed before the market opens and do not need hourly monitoring. Most top traders don't spend all day trading. If the markets are not moving there is nothing to do! What do they do? They manage their trades in 10 to 60 minutes per day. Richard Donchian offered the wisdom decades ago:

If you trade on a definite trend following loss limiting-method, you can [trade] without taking a great deal of time from your regular business day. Since action is taken only when certain evidence is registered, you can spend a minute or two per [market] in the evening checking up on whether action-taking evidence is apparent, and then in one telephone call in the morning place or change any orders in accord with what is indicated. [Furthermore] a definite method, which at all times includes precise criteria for closing out one's losing trades promptly, avoids...emotionally unnerving indecision.Richard Donchian

Tim Arnold's Trading Blox software is one of the few software trading packages that traders actually use to accurately test technical trading concepts. While not as well known as many more popular packages, Trading Blox has a dedicated and loyal following. If you can imagine a trading idea, there is a good chance you will be able to "write" it into Trading Blox and backtest your idea. For more information see: www.tradingblox.com.

NOTE: If you want to learn trend following techniques and systems through advanced home study and or seminars for all traders click here. If you want to learn about trend following trading in general there is one definitive text the bestselling classic "Trend Following: Learn to Make Millions in Up or Down Markets" by Michael Covel. If you want to learn about the most famous group of trained trend following traders, the Turtles and their teacher Richard Dennis, "The Complete TurtleTrader" by Michael Covel is the only complete biography (with all of the Turtle rules) available. If you have any questions you can reach us immediately via phone or email.

This excerpt is from Chuck LeBeau. Chuck happens to be one of the pioneers in the field of trading systems. His wisdom should be absorbed by all:

[This] happens to be a true story, which contains a very valuable trading lesson that has influenced my trading for many years now. We thought the story might make an interesting topic...Here is the story: Back in the late 1960s I was a young commodity broker at E. F. Hutton and Company. Our office was a brand new high-tech office (for its time) which was considered the "flagship office" for E. F. Hutton. In this office about thirty brokers and as many clients shared one very large boardroom and there were no private offices. The brokers had elegant and expensive desks and the clients had a comfortable seating area in the front of the office where they could hang out and watch the tapes and monitor our state of the art commodity "clacker board". Sitting at my desk near the front of the boardroom I could read my Wall Street Journal and keep track of the commodity markets without looking at the board. By just listening to the rhythm and tempo of the mechanical clicks as the prices changed I could easily tell when anything important was going on because the tempo of the clicks would increase noticeably. Just in front of my desk were a half dozen comfortable sofas facing a high mahogany paneled wall with the tapes and the "clacker board". A gallery of traders, mostly retired "old timers" who were trading real commodities like grains and pork bellies, lounged around on the sofas plotting their charts and talking about life and the markets. They typically arrived early to get a good seat in their usual spot and then spent the day trading, exchanging commentaries and offering unsolicited advice to one another on any subject. For the most part they were a very sociable group who would take coffee breaks together and greeted each other on a first name basis. These traders enjoyed the elegant atmosphere and treated our well-appointed boardroom as their private men's club. (Were you aware that women were not allowed to trade commodities back in those days? My how times have changed!) However, one of these "old timers" kept to himself and was not interested in becoming a member of the friendly and often boisterous social circle. He usually sat quietly by himself intently watching the price changes on the commodity board and holding an old glass Coca-Cola bottle up near his ear. The vintage shaped Coke bottle had been emptied many years before and now contained only a 12-inch tube of bent and broken radio antennae which extended awkwardly out of the top of the bottle. Keep in mind that in the 1960s no one had yet heard of cell phones so the purpose of this Coke bottle was a real mystery to everyone. When the trader would talk to the bottle from time to time all the heads would turn and the traders nearby would try to listen to the conversation. But the trader spoke very softly and no one was able to eavesdrop on his conversations with the bottle. The traders knew that the fellow with the coke bottle was a client of mine and eventually a representative of the group came to me and explained that they were extremely puzzled about this guy and his Coke bottle and asked me if I knew what was going on. I didn't know the purpose or meaning of the Coke bottle but I was as curious as anyone was and I promised I would find out. The next time the client came back to my desk I promptly placed his order and then politely asked him about the Coke bottle. With a serious expression and no embarrassment he explained to me that the Coke bottle was an inter-planetary communication device that had been given to him by aliens. He said that the aliens were very interested in our commodity markets and they often gave him trading advice from their various observation points on other planets. He said that he had just had a message from Mars and they were buying soybeans so he had also purchased soybeans. After revealing his unique trading methodology he returned to his seat and resumed his whispered conversations with the Coke bottle. As soon as I revealed my discovery of the meaning of the Coke bottle to the other traders, all attention was immediately focused on the Coke bottle trader and the soybean market. The soybean market proceeded to go the wrong way and the trade from Mars was eventually closed out at a loss. The other traders were had no sympathy and were quick to begin ridiculing the the trader and poke fun at his beliefs. The next trade however turned out to be a big winner and the Coke bottle trader went from sofa to sofa telling his story and pointing to the clacker board while waiving his Coke bottle and bragging about the profitability of his most recent message from outer space. Because he was making money now his previous critics had to endure his bragging about his success on the current winning trade. As time went on and a few winning and losing trades later a clear pattern of behavior began to emerge. The Coke bottle trader was ridiculed unmercifully on his losing trades but was able to get his revenge and the last laugh during the winning trades. This trader might have been a little bit crazy but he wasn't stupid. He soon learned that his only defense against ridicule was to hold on to winning trades as long as possible and to quickly get out of his losses. As long as he was sitting on his sofa with a winning trade no one could tell him he was crazy and make cruel jokes about his messages from Mars. In fact while he was winning he was quick to wander around the room and ridicule the methods of the other traders who were not making as much money as he was. He displayed the profits in his trading account as hard evidence of the validity of his methods and offered copies of his statements as irrefutable proof that he was getting valuable advice from his alien contacts. Who could argue when his advice from other planets was obviously working? As a young broker this experience and the first hand observation of the Coke bottle trader who suddenly became profitable gave me my first important lesson about the importance of exits. I knew the entry signals had nothing at all to do with his success. His batting average was not any better than that of any other trader. However, this crazy old trader seemed to be able to make money consistently while other traders with more "sanity" and more valid entry methods were losing. Before long I was able to recognize that this man had become a successful trader simply by his efforts to avoid ridicule. He knew that he was vulnerable during his losing trades so he closed them out very promptly. His winning trades became his shield against the ridicule of the other traders and he kept his winners much longer than before his unorthodox methods were revealed. In the many years since this experience I have encountered many claims of success for entry methods that probably have even less validity than the Coke bottle messages. I have learned to look only briefly at the entries of winning traders and to examine their exit strategies very carefully. I am very fortunate that more than thirty years ago I learned from the Coke bottle trader that success in trading depends on our exits and not our entries.Chuck LeBeau

There's something very reductive about the stock market. You can be right for the wrong reasons or wrong for the right reasons, but to the market, you're just plain right or wrong.John Allen Paulos

Are you comfortable with the concept of right and wrong? The price you analyze everyday is the truth. Price does not lie. The price is always right.

Taking price a step further we can see...

Markets are also the same because of price. All markets are most directly measured by their individual price movements. What do cotton, crude oil, Cisco, SUN, GE, US Dollar, Australian Dollar, soybeans, wheat, Microsoft, JDS Uniphase, EMC and Oracle all have in common? Let's say you know nothing about trading cotton. Moreover, you also know nothing about fiber optic networking (a specialty of JDS Uniphase). Oracle and databases? Let's say you are clueless about them as well. Does it matter that the fundamentals of cotton, JDSU and ORCL are all different? What if you just analyze their market prices?

Trend Following does not require an understanding of the market fundamentals. Take the price data and apply your rules. If your trading is pure trend following, all markets are the same in terms of price analysis.

The Universal Chart

William F. Sharpe
Reprinted from The Financial Analysts' Journal Vol. 32, No. 4, July/August 1976. p. 4, Copyright 1976, Association for Investment Management and Research, Charlottesville, VA
Some years ago, in a land ...

When most people first start trading they often start small. As they get better at it, they trade more. They might start with one contract and then move to ten contracts. As time progresses, they reach a certain comfort level with their trading, but are still afraid to take risks beyond that ...

Consider the following table:

Loss of capital (%)

Gain to recover (%)

5
...

Trend Followers know the trick of letting their profits run is key to trading. Once you learn that to maximize your profits you must be willing to give up some part of your accumulated profits, you are on your way to sustained success. For example, let's say you start with $50,000. The market takes off and your account swells to $80,000. Many people might quickly pull their $30,000 profit off the table. They feel that if they don't take those profits immediately, they will disappear. Refusing to give up a part of that accumulated income due to fear is their big mistake.

Trend Followers understand the nature of the market. They realize that a $50,000 account may go to $80,000, back to $55,000, back up to $90,000, and from there, perhaps, all the way up to $200,000. See the mistake of quickly taking a profit just because you might not like volatility? Those people who took profits at $80,000 were not around to take the ride up to a $200,000 account. Pretend you are one of those people with the $30,000 gain in your account. Instead of simply protecting your entire $30,000 profit, why not be more aggressive with it? Do you think great traders have been successful by taking profits? Or have they compounded their profits?

Letting profits run is tough psychologically. It's counter-intuitive for most people. It feels risky. But, once you understand that in trying to protect every penny of your profit, you actually prevent yourself from making a bigger profit, you have learned an important reason why Trend Followers are so successful.

Money Management

If You Consider Volatility in Your Trading
You Can Adapt and Adjust Your Direction

Quick! Volatility is changing. What move do you make?

What direction do you take now?

Trend Following traders use a philosophy of trading that adapts to different markets and different market conditions. Trend Following is based on keeping things proportional to the market's current volatility. The ability to adapt to changing volatility (the market's daily ups and downs) is built into the core of any successful Trend Follower's trading system. If you don't measure and consider volatility everyday you are missing a core component of trading success.

What do we mean? During a high volatility period, for example, a good Trend Following trading system will dictate that you trade fewer contracts or shares of a given market. During periods of lower volatility, Trend Following dictates that you trade more contracts or shares. In other words, trading commitments are increased during favorable risk/reward periods (low volatility) and decreased during less favorable periods (high volatility). This doesn't mean high volatility is a bad time to trade. It simply means that you can't trade as much as you can during low volatility periods. Trading the same number of contracts or shares no matter the volatility simply decreases your odds of success. Who wants to do that?

A main reason for always measuring volatility is for the psychological benefit. If you have too much volatility (and your trade size is not correctly decided) in any one position it attracts your attention. Your focus shifts to one particular position and you can lose sight of the big picture. Measuring volatility and then adjusting your risk exposure for any given trade keeps you psychologically balanced. If one particular market has an explosion of volatility you can trust your rules to decrease your trading size to reflect the new level of uncertainty. Sounds simple enough? Perhaps it is, but most people ignore the wisdom.

Stock Tips & Volatility

Have you ever received a stock tip from a friend, CNBC, or your broker that also included a volatility measure? Have you ever heard a market commentator tell you how much of a stock to actually buy or sell within the context of what current volatility is? If you do not consider volatility daily are you not one step closer to the blowout of all blowouts?

More on Volatility.

Jim DiMaria learned an important trading principle in the less lucrative arena of baseball statistics: The players who score the most runs are home run hitters, not those with consistent batting records. It's the same with trading, DiMaria says. Consistency is something to strive for, but it's not always optimal. Trading is a waiting game. You sit and wait and make a lot of money all at once. The profits tend to come in bunches. The secret is to go sideways between the home runs, not lose too much between them.Jim DiMaria

Why is basing your time horizon on quarters such a big mistake? The preoccupation that so many people have with twelve month returns is not smart trading. Top traders could not care less about twelve month returns, so why must you? The prime objective of top traders worldwide is to make money.

Quarters do not predict: Top traders know that focusing on quarterly objectives has nothing to do with success since that would assume you can control how much you make. Does anyone believe they can control how much they make? Quarterly performance reporting is nothing more than another way to mislead yourself pretending you can predict the market or shoot for profit targets.

Quarters are not real: They are artificial start and stop points. You are bombarded by references to quarterly performance numbers from almost every media outlet right? Most people focus on their portfolios from a quarterly perspective only. Why? Because the perspective may not be real, but it is easy, and most people prefer to go through life mindlessly. However, to properly evaluate any trading style a rolling 36 month window must be employed at a minimum. For example, say your trading system had little performance gain for the last 3 months of the year, but since Trend Following is long term in nature, it explodes with profit in the first month of the new year. With quarterly reporting you would look at this system as having a bad fourth quarter and a good first quarter. How does this interpretation help you? It does not.

Ponder what Jim DiMaria said above. Home runs may not feel easy or safe, but what is your alternative? You can either trade aggressively putting yourself in position to get rich or you can give your money to a mutual fund and buy and hope. DiMaria is really talking about being trapped in the quarterly performance cycle spin. You can worry about meeting some artificial time objective or you can be a home run hitter and take what the market gives no matter when it arrives.