The Secret to Trading Success

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John Forman - The Essentials of Trading author

If you’re reading this blog post because you actually think there is some one thing that successful traders know that unsuccessful ones don’t, then let me first say:

There is no single secret to successful trading!

And by that I mean there is no secret wisdom passed down from master to pupil, or sacred texts sharing with readers the knowledge of the ancient masters. The idea that some traders are using secret techniques which ensure their trading success and that without those secrets one cannot possibly trade well is farcical. That simply isn’t the way of things. Sorry to disappoint you if that was your thinking.

Trading success comes from developing for yourself a good, well thought-out trading plan. That’s a plan which is based on your personal needs, strengths, interests, and all of that. This is something which takes time. It will not happen in one day. It takes exploring and learning.

You will often hear from successful traders that it took them a couple of years before they really found their feet trading. I know that was certainly my own case. You try things. Some work and some don’t, and you make adjustments.

Remember, though, that a trading system is not a trading plan. It’s only part of one. (see the series of articles I wrote about building a trading plan starting with Creating Your Own Trading Plan.)

Trading success also comes from being consistent. That means repetitively applying your trading plan over and over and over again. That probably sounds pretty boring, but the truth of the matter is that good trading quite often isn’t the most stimulating thing in the world - at least in terms of the execution.

Both elements of this are equally important. Not having a well developed plan will mean failure just as not sticking to that plan will. As Brett Steenbarger recently wrote in his blog:

“It’s a common observation that traders fail because they don’t stick to their plans. My experience is different. Traders develop plans and trade patterns that simply don’t work; they’re based on randomness. When the patterns don’t work, traders become frustrated and abandon their plans. So it looks like lack of discipline causes trading failure. But planning doesn’t create success; sound planning does. Sticking to plans based on randomness is no virtue.”

And it most definitely doesn’t stop there. Another secret to successful trading is that you must never stop learning. Steenbarger noted “The successful traders have a passion for markets, which is very different from a passion for trading.” and that ”The ratio of “practice” time (time spent on markets outside of trading) to trading time is a worthwhile indicator of a trader’s prospective success.” From a system trader’s perspective, Bill Rempel added “System development and testing never stops.”

Markets change and you must adapt to survive.

Actually, it all reminds of a movie that most likely you’ve never even heard of - A Circle of Iron. It’s based on a script written by Bruce Lee with David Carradine one of the lead actors. The hero goes on a quest to find the Book of All Knowledge. Of course he must overcome many challenges to find it. When he finally gets to read the book (spoiler coming!) he finds that it’s nothing but mirrors. It’s all very Zen, of course, but the lesson that the secret lies with you is very much the point I’m trying to make here.

So there you have the secret to winning in the markets.

The Trader’s Wish List

My Trader’s Wish List of good books, audio and video content, and other resources comprises a dozen posts. Here’s how they break down:

Entry #1: Books by Brett Steenbarger

Entry #2: The Market Wizards Collection of Books, Audio, and Video

Entry #3: Liar’s Poker - a view from the inside

Entry #4: Paul Erdman Books - great financial fiction

Entry #5: The Darker Side of the Markets - stories of the bad boys

Entry #6: Trading and Markets Movies - drama to comedy

Entry #7: Market Profile

Entry #8: Trading Fiction - great stories around trading

Entry #9: George Soros and Jim Rogers - two of trading’s biggest icons

Entry #10: Risk and Money Management

Entry #11: Metastock - fantastic charting and system development software

Entry #12: Everything Else!

By all means, feel free to add your comments, thoughts, suggestions, and whatnot. What do you like, don’t like, recommended, advise against, enjoy, hate?

Misunderstanding the Bid/Ask Spread in Stock Trading

This morning I came across a blog post talking about the bid/ask spread in the stock market. It talks about how the spread is a hidden cost in trading, which it is to be sure. A lot of folks don’t realize that to be the case in stocks since they primarily see just closing value. As with every market, though, there is a bid/ask spread.

The post’s author made some good points in general, but had a few things incorrect. I figure that if he is off in his thinking on the subject, then it’s likely other stock traders and investors are as well. Let me lay it out here.

The first error the post author made was to say that when you trade stocks your broker makes the spread because it is on the other side of the trade. That’s simply not true.

In an exchange driven market like stocks you are rarely trading against your broker - and pretty much never if you’re using a discount broker. Brokers are just pass-through agents. Your order goes into the market and is matched against what’s available there, meaning an opposing order put in by some other trader, probably through some other brokerage (or directly). That other trader could be a market maker, an institution of some sort, or even just some other individual trader like yourself.

The point is, your broker doesn’t keep that money as profit. The people who profit from the spread are the market makers who constantly seek to buy at the bid and sell at the offer. They are essentially being paid for providing liquidity. (Note: Price makers are always better off than price takers).

The author also used the term pay to describe the impact of the spread on your account and that essentially you pay half up front and half when you close out the trade. Again, that’s not quite right.

You never “pay” the spread. Yes, if you go in and buy using a market order your trade value will immediately be lower because you will have bought at the ask(offer) price and would have to sell at the lower bid price. It’s not as though that money actually comes out of your account, though, like a commission. It’s a paper loss.

And you only take the hit to your position value once, when you first put the trade on, not half when you open and half when you close. When you buy you immediately suffer a paper loss equal to the spread value. From that point on, however, your position value is based on the bid price. You don’t take another hit getting out of the trade like you do with your commissions.

Lastly, the blog author said that long-term investing was better than short-term trading because ”…it takes less gain to overcome the expenses”. That’s factually incorrect.

If the spread is $0.50 then it takes a $0.50 move in the market in your favor to overcome that cost. Your holding period doesn’t matter. If you’re trading frequently and going after smaller profits, though, the spread does represent a larger portion of your gains, as does the commission. I’m guessing that’s what he really meant.

Ways to approach news events in your trading

A question recently came up in regards to the impact of news on trading performance. The questioner was feeling a bit overwhelmed with the idea of trying to deal with all of the different sources of potentially impactful news and information that hits the markets. Let me share some thoughts on the subject.

Firstly, I can completely understand how mind-boggling it can be. There is seemingly a constant stream of data coming out. Forex traders in particular see loads of it each day as the various major industrialized countries put forth economic data and have prominent speakers on the schedule. Then too there are any number of things that can crop up anywhere in the world related to gold or oil, for example.

Here’s the first thing I would say in that regard.

It is possible to narrow significantly the list of scheduled items that are likely to have a significant impact on the market you trade. Clearly, a stock trader has to worry about earnings reports, but retail sales data may be completely meaningless. A forex trader has to worry about things like trade, but won’t concern themself much with corporate earnings. An interest rate trader will certainly keep an eye on employment figures, but won’t worry as much about the speach by the head of the European Central Bank.

The implication is that you can generally pick and choose the calendar events that you need to focus on for your trading. Of course there are always going to be surprise events that happen, but you can only deal with that though a generally solid risk management approach.

Now, once you have identified the data releases and other events that are meaningful to the market you trade there are three ways to trade in relation to them.

1) Take positions ahead of the releases, speach, or whatever.
This is basically gambling and not recommended.

2) Make sure that you are flat ahead of the aforementioned events.
For most short-term traders this is generally the best approach. It keeps one out of the wildness that can come with unexpected results. That volatility makes meaningful trading very challenging, and not very profitable for most people. The majority of folks are better off waiting to see how the market settles out afterwards.

3) Trade in a timeframe for which the kind of intraday swings created by news events are of no significant impact.
This generally means taking on positions with relatively wide stops that are expected to be held for at least several days, if not weeks or more. The approach here is to play the bigger price movements with the view that intraday swings are just blips.

You personal trading style will dictate the approach you take.

One other thing I would add in comes in the area of trading systems and their performance around news events. If a system has been tested over a sufficiently large data set relative to the timeframe it trades then that means it would include any number of data releases and other news items, and thus their impact on prices. As such, the user of such a system, if the performance is deemed solid, should not concern themself over much with releases. They are, essentially, factored in to the system’s performance.

Trading for a Living vs Trading for Wealth Building

Something recently came up on one of the discussion boards I visit. It’s hardly a new topic, but even still, I think it’s worth a few inches of screen space to discuss. It’s the difference between what it means to “trade for a living” as opposed to trading to grow your portfolio or account value, and by extension your general wealth.

My definition of trading for a living is pretty simple. I think of it as using trading to generate the earnings you need to pay for daily life - housing, utilities, food, etc. Think of it like a job with a salary or hourly wage. You put in your time and you take home your pay for doing so.

This contrasts with what most people think of when the having trading in mind. They see it as using the markets to create profits in order grow portfolio starting value $X to portfolio value $Y, with $Y being some higher value than $X. How much isn’t the real question for this discussion. It’s sufficient to say that most people think of trading as an asset building exercise.

The reason I differentiate things here is because trading for a living requires a different mindset and approach than does “normal” trading. Think about it. If you are trading to pay your living expenses, that means you need to make a certain amount of money each month, money which needs to be withdrawn from your account. That income needs to be fairly predictable in nature. Sure, you can have some higher months and some lower ones, but there cannot be too much variability or you risk not being able to pay the bills some months!

The regular trader, on the other hand, is more readily able to have ups and downs in their trading performance. They can wait out drawdowns because the money isn’t needed for life’s general expenses.

What does that mean in terms of approach?

It’s firstly a question of trade frequency.  Those who trade for a living are usually looking for small, consistent profits. That means trading on a regular basis. I don’t mean to say with high frequency, though. Sure, that can be the case, but what I mean to say is that generating consistent profits means having consistent opportunities to do so, which means trading regularly.

The second part of the equation is risk. Regular traders can ride out drawdowns knowing that future profits will more than make up for it. One trading for a living, though, cannot do that. A drawdown can mean withdrawls from the account that reduce the available trading funds, which could put pressure on future income potential. That’s not a risk that can be taken. Sure, there are bound to be small drawdowns along the way, but they cannot be big, the kind requiring significant time to be made back up. Normally, this equates to relatively smaller position sizes for those trading for a living.

I should note that I don’t necessarily consider “professional” traders the same as those who trade for a living. My reason for differentiation is that in most cases the pros are not dependent upon their week-to-week or month-to-month results to live on. They either have a salary of some kind, or if they are just trading their own money, they have a sufficiently large asset base as to be more than able to make withdrawls to meet their living needs should the trading suffer during a particular timeframe.

Also, trading for a living doesn’t necessarily mean trading eight hours or more each week. I wouldn’t automatically call trading for a living full-time trading, or vice versa. It is perfectly possible for one to only spend a couple of hours per day, or maybe even less, in the markets and earn enough to live on. Similarly, a regular trader can definitely put in loads of screen time hours. The time requirements are just a question of the required trade frequency one has and the strategy employed.

These are all things to keep in mind if you are giving any thought to giving up your regular job to try to make it trading. My personal advice on that would be to make sure you have a sufficiently large capital base as to make earning your required profits quite easy - meaning it wouldn’t require much risk.

How much leverage to use? Wrong question!

I’ve been involved in a discussion recently on the topic of leverage. The question that started it all basically was “What leverage ratio should I use?” This came from a forex trader, but could certainly just as easily have come from a futures trader as well (or even a stock trader in some cases).

If you’ve ever wondered that same thing, you are asking the wrong question. Any position you take in the markets should start first with the question of how much risk you are going to take on that trade. There are a variety of different approaches to that, and I won’t get that discussion going here. For the sake of things right now, let’s just assume you’ve decided it will be $500.

Now consider the trade you are thinking about making. You should have some idea of what the point/pip risk is going to be on the trade. Translate that in to a dollar value on a per trading unit basis (contract, lot, etc.). That leaves you with three basic scenarios:

More than your acceptable risk
In this situation you find that the reasonable risk on the trade is more than what you have defined as your cut-off ($500). If that is true, there is only one course of action. Walk away. Another trade will come along. Don’t take on a trade that is riskier than what you have defined in your trading plan.

At or close to your acceptable risk
If you find that the per unit risk is close to your $500 risk target figure, put on a one unit trade. Very simple.

Below your acceptable risk
Should you discover the per unit risk for the trade you are looking at is well below your $500 limit, you can take on a bigger trade. For example, if the risk is $125/unit, do a four unit trade.

The leverage part comes in to the equation at this stage. The question becomes how much leverage do you need to use to take on the position size you have determined going through the process above.

Let’s look at things in terms of a trading unit being $100,000 in value to keep the numbers round, and that you have a $10,000 account. Throwing out the situation above where the trade risk is higher than your $500 cut-off, we are left with two situations.

In the case where the per unit risk is at or near your allowable risk, you put on the one unit trade. That means taking a $100,000 position, so you would employ 10:1 leverage. If, however, you are in the third situation where the per unit risk is $125 you can put on a four unit trade. That means a $400,000 total value trade. This is 40:1 leverage. (Note: margin requirements for forex and futures trading is often 2% or less, meaning 50:1 leverage or higher.)

Do you see how this process reverses the way you think things through?

So the real answer to the question of how much leverage to use is “the amount that allows you to trade the position size that matches your allowable per trade risk.”

An Introduction to the Fixed Income Market

This article is a basic introduction to the fixed income market.  It covers the primary facets and features of fixed income as they relate to trading from the individual, as opposed to institutional, perspective.

The term “fixed income” is used to describe a collection of securities which have predefined pay-out terms.  An example would be a certificate of deposit (CD) in which one deposits a set amount of money and in return receives a given amount of money, which includes both the original deposit plus interest income, at some future date, known as the maturity.  Fixed income securities, unlike stocks, are based on loans.  While one might think of “buying” a CD, what he/she is in fact doing is loaning the bank money, for which they are paying interest.  That interest, which is pre-determined in some fashion at the outset, is the “fixed income”.

Money Markets

Fixed income securities come in a wide array of maturities.  Those with initial maturities of one year or less trade in what is often referred to as the money market.  This term comes from the fact that these short-term instruments tend to be very liquid and often traded between banks.  Money market instruments included such things as:

• Bankers’ Acceptance: A draft or bill of exchange accepted by a bank to guarantee payment of a bill.
• Certificate of Deposit: A time deposit with a specific maturity date shown on a certificate; large-denomination certificates of deposits can be sold before maturity.
• Commercial Paper: An unsecured promissory note with a fixed maturity of one to 270 days; usually it is sold at a discount from face value.
• Eurocurrency Deposit: Currency deposits in a domestic bank branch or a foreign bank located outside the country of the currency in question.  For example, Eurodollars are deposits of US Dollars outside the United States.
• Federal Agency Short-Term Securities (in the US): Short-term securities issued by federally sponsored agencies such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
• Federal Funds (in the US): Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve.  These are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal Notes: Short-term notes issued by municipalities (cities, towns, counties, etc.) in anticipation of tax receipts or other revenues.
• Repurchase Agreements: Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
• Treasury Bills: Short-term debt obligations of a national Treasury issued to mature in 3 to 12 months.

Most of the securities above are out of the realm of the individual trader, but a handful can be traded, generally via the futures markets.  Money market instruments normally trade at a discount which means the buyer (lender) pays some amount below the final pay-off value.  For example, if a Treasury Bill is going to pay 100 at maturity, the buyer might pay 95.  The difference would be the interest earned.

Notes and Bonds

The intermediate term fixed income market is made up of securities which are generally (but not exclusively) referred to as notes.  They are instruments which have initial maturities of two to ten years.  Bonds, on the other hand, are the longer-term instruments with initial maturities of more than ten years at the time of issuance.

The standard structure of notes and bonds are the same.  They each feature a par or principle value which is paid at maturity, as well as intermediate interest payments, referred to as coupon payments, which are paid out on a predefined periodic basis (monthly, semi-annually, etc.).  The coupons represent the nominal interest on the bond or note.  For example, if a bond has a 100 par value, and a coupon of 10 per year, that means a 10% interest rate.

Notes and bonds, however, will not always trade at par value.  Depending on the overall interest rate market, they can be priced at a discount (below par) or at a premium (above par).  The result is that the effective interest rate may not be the same as the nominal rate.  For example, if the bond  above were trading at 90, the effective interest rate would be 11.11%.  Note, though, that the bond price of 90 represents a 10 point discount off the 100 par value.  Those 10 points become extra profit to the bondholder when he/she is paid par at maturity.  That then becomes part of the yield to maturity equation.  If the bond in the example has a 20-year maturity, its yield to maturity is about 11.28%.  Were the bond trading at a premium (above 100), then the yield to maturity would be lower than both the effective and nominal interest rate.

Notes and bonds are both actively traded on a number of exchanges.  Individual traders can transact in them via either the cash or futures market.

Callable vs. Non-Callable

Some fixed income instruments are callable.  That means the issuer can essentially buy them back from the holders prior to maturity.  Normally there are specific terms related to this such as a date after which calling is allowed, or not allowed.  When an issue is called, the holder receives the par or principal value, and sometimes a premium as well, depending on the call conditions.

Issuers

Fixed income securities are issued by a wide array of organizations.  Probably the best known and most liquid of them all are the government instruments, which are often referred to as sovereign debt because they come from national governments.  They come in a wide array of varieties and maturities from country to country, though the most commonly traded securities tend to be the notes and bonds.  They have names like Gilts (UK), Bunds (Germany), and JGBs (Japan).  Individuals can trade in government debt via the cash market through direct purchase, or they can go through the futures market.

Corporate debt is also quite well common.  A great many companies issue debt as an alternative to issuing more stock.  Many of these issues, generally notes and bonds, are listed and traded on stock exchanges.  As such, they are readily tradable by anyone with a brokerage account.

States, counties, cities and towns also issue debt, which is commonly referred to as municipal or muni debt.  These issues are often less well known and actively traded than government or corporate securities.  Unlike the other two, however, they often come with incentives for the debt holder such as the interest being federally tax-deductible.  As such, they will generally trade at lower yields.

Government agencies and quasi-government agencies also issues fixed income instruments.  Among the best known in the U.S. are the Federal National Mortgage Association (FNMA - Fannie Mae) and the General National Mortgage Association (GNMA - Ginnie Mae).  Like government debt, these instruments are accessible to the individual through either the cash or futures market.

The last major group of issuers is the supra-national organizations such as the World Bank.  These issues are not commonly a part of the portfolio of the individual trader, but can be transacted in the cash market.

Credit Ratings

Fixed Income securities all have ratings assigned to them by one or more credit agencies.  These ratings are an indication of the creditworthiness of the issuer.  They are essentially an indication of how likely the instrument is to be paid off by the terms of its issuance.  The higher the rating the better.  For example, the sovereign debt of most major industrial countries is of the highest rating.  So too are those of many large corporations.  An issuer need not have a top level rating for it’s securities to be considered a good risk, though the yields will generally increase with lower debt ratings.

Non-investment grade debt, or junk as it is often called, is the collection of securities which carry low ratings.  Issuers with ratings in this category often have high amounts of debt outstanding, may possibly have defaulted, or otherwise are considered to be in financial stress, suggesting that the debt holder is at risk of not being paid off as per the terms.

Influences on Fixed Income Prices

Since the fixed income market is driven by interest rates (prices are inversely related to yields), those things which impact on rates directly influence prices.  The biggest driver of these rates, from a macro perspective, is monetary policy, the decisions central banks make in regards to the level of domestic interest rates.  Since the central banks directly control interest rates (at least short-term rates), they have a heavy influence over their level and direction.  Other, less direct, influencers include:

• Government fiscal policy
• General economic growth
• Employment
• Inflation
• Currency exchange rates and trade

Obviously, when considering the likes of corporate debt, considerations related to that particular issuer come in to play.  This includes things like earnings, total debt outstanding, interest cover ratios, and others.  All of this, though, is also account for in the credit rating.

Yield Curve

The yield curve is the graphic portrayal of yields over the array of maturities, from shortest to longest.  An example is shown on the following chart.

 

Notice that the plot above depicts two lines.  The blue line is the more standard, upwardly sloping yield curve in which the longer-maturities feature higher yields.  The spread between the long maturity issues over the short maturity ones is positive.  The pink line, shows an inverted, or negatively sloped curve.  A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment.

It should be noted that while it is most often the case that when one discusses yield curves that it is the government rate curve to which is being referred, it need not always be the case.  There are yield curves for corporate debt, for example.

Additional Topics

• Mortgage-Backed Security (MBS): Instruments which are based on commercial and residential property mortgage loans.  These loans are packaged together and securitized by the likes of Fannie Mae.  The primary consideration for an MBS is that since mortgages can be prepaid, the actual maturity of the security is unknown, though it can be estimated.
• Convertible: Some bonds and notes (mostly corporate) can be exchange for another security (generally stock).  For example, a company could issue a bond which allows the holder to convert the bond in to 10 shares of company stock.  The terms of these conversions are pre-set in terms of price of the security into which the issue can be converted, and oftentimes also the timeframe in which the conversion is allowed.  The price of convertible securities are heavily influenced by the price of the security they are convertible into.
• Inflation Protected Securities: This is a group of fixed income securities which are tied in to inflation, as measured by the Consumer Price Index (CPI) or some other similar measure.  The interest and/or principal payments of such instruments vary based on a formula.  The idea is the nullify the influence of inflation on the holder so that the real rate of return (nominal rate minus inflation) will remain fairly steady.

Further Study

This article is but a brief introduction to fixed income.  If you wish to go further, consider the following as worthy resources.

The Handbook of Fixed Income Securities By Frank Fabozzi This book is considered the bible among market participants and academics alike.  It is very comprehensive.

The Bond Market By Christina RayWhile not nearly as thorough as the Fabozzi book above, it is a very practical guide to the markets in application.