If you Buy at 750 and you are prepared to lose up to 5 points on the trade, you can enter a Sell Stop order at 745. If the market price moves down to 745 (or lower), the Sell Stop order is converted into a Market Sell order and you exit your trade for a loss.

Conversely, if you open a short trade at 750 with a Sell order, you could enter a Stop Buy order at 755. If price rises to 755, the stop order is converted to a Market Buy order and you exit the short trade for a loss.

That is the theory, but it is not perfect! The problem is that there is no guarantee where a Market order will be executed, and there is no guarantee that price will move gradually in one direction or another…

For example, your Sell Stop order at 745 might get executed (filled) at 744.5.   That makes your loss half a point (10%) bigger than expected.

Even worse, bad news could hit the market! Suddenly, price drops to 740! Your stop is triggered, and you are filled at that level. That is a 10 point loss, double what you anticipated! Things like this can and do happen more often then you would think, but the risk is greatest if you have a position open overnight or through weekends. (Click here for a dramatic real life example.)

The day trader is much less likely to experience a catastrophic loss due to a big “gap” in the market, and that is one reason why I consider day trading to be one of the safer forms of trading activity.  The day trader will certainly experience slippage losses, but they can be anticipated and accounted for.

I never enter a day trade without a stop loss order in place. Some people disagree, but with me it is an article of faith.

Even though a stop loss order is not a perfect tool, it is still a very good form of insurance. The day trader, often undercapitalised, MUST acquire protection against being wiped out by one bad trade.

People who dislike the stop loss order point out that sometimes markets seem to reverse and take out your stop, before accelerating away in the direction of your original trade. You end up with a loser instead of a spectacular winner…

True! That does indeed happen all too often. However, all insurance costs money, and it is best to write these instances off as your insurance “premium” against a disaster. Experienced traders do not even consider the “what might have been” scenario, they just accept that they  had a losing trade.

So, given that we must have a stop loss order, where should we put it?

There are many approaches. One of the simplest is the money stop. With this approach, the trader decides what percentage of capital can be risked and puts the stop at a distance from the entry which would equate to the risk percentage (or a little less).

For example, if you are prepared to risk 3% of a $10,000 account, that is $300 in one trade. With the S&P 500 E mini contract each point is worth $50. If you are trading one contract, your stop could be six points away from the entry. If you are trading two contracts, the stop could only be three points away from the entry.

That is okay, but I prefer to make use of the information on the chart. By the time we enter a trade, we have significant information, and it seems a pity not to make use of it. Since the breakout trade is entered  during a pullback after a trend is detected, we know some of the short-term support and resistance levels in the market.

The depth of the pullback is a very significant measure. In an up trend, the session high point is clearly the resistance level, and the low point of the pullback is the short term support level. (I usually refer to this distance – between short term support and resistance – as R.)

Putting a stop one point below the support level is a (fairly obvious) valid position for a stop loss order.  The logic is that if support is penetrated, our long trade is no longer valid.

Some people use various multiples of R as their stop. Especially if they subscribe to Fibonacci theories. They may take a view that, once resistance has been penetrated, any subsequent pullback should not exceed (for example) 68% of the most recent move upwards – so they put their stop at 0.7R below the entry.

More conservative traders might place a much wider stop, say 2R below the entry point.

Obviously, the wider the stop, the less likely it is to be taken out by random fluctuations. In other words, with wider stops you get more winners.

On the other hand, with a wide stop you stand to lose more if it is taken out. So you can not afford to trade as many contracts and your wins will be smaller…

That is the dilemma of the trading system designer. It is up to you, the day trader, to decide where the sweet point lies in this delicate compromise.

TradeOnAuto defines R a little differently, depending on the type of entry being considered. See the User Manual, Page 19. (It is the distance between the planned entry and the “natural” stop one pip beyond recent support/resistance.)

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We know how to spot a rising (or falling) trend on our charts. If we see a series of candles with “higher highs and higher lows”, we have a rising trend. If we see a series of candles with “lower lows and lower highs” we have a downtrend.

I will look at a rising trend, but keep in mind that the exact opposite applies in down trends (which can, of course, be traded just as easily using futures contracts).

In a rising trend we know that we want to buy on a dip, or “pullback”. In my last article, we spent some time defining exactly what constitutes a “pullback”, but for the sake of argument we will assume that we have just had two candles with lower highs  than the preceding candle (which made a session high).

This puts us on alert for an entry. Our logic is that the market is trending up and that this pullback is just a price consolidation which will be followed by a new push to the upside.

But where shall we pull the trigger?

As with all trading decisions, there is no absolute “right” answer.The entry that will work brilliantly in one example will turn out to be a loser in another situation, and vice versa. Still, we don’t require to be right 100% of the time, we just need to be right often enough to make a good profit over time.

Probably the easiest entry point to understand is the “defensive” entry. The entry point is one pip above the session high. In other words, we wait for the pullback to finish and for price to move through the previous high. The logic of entering here is that price making a new high “confirms” the trend, so now is the time to enter.

Closely related to the defensive entry is the “normal” entry. Here, you don’t wait for the previous session high to be penetrated before buying; instead, you buy as soon as the pullback recovers and the previous session high is touched. You may not think there is much difference between the normal and defensive entries.

For example, if the market moves up in price to, say, 728.00 before pulling back, then our defensive entry is at 728.25 and the normal entry is that 728.00 (assuming a pip value of 0.25 such as is found in the S&P 500 E mini contract, or any of the grain contracts). Basically, one pip difference in the entry points.

However, the entries can work out very different in practice. You have to remember that not everybody is on the same strategy. In fact a good number of players in your market will be looking for different patterns, for example a “double top”. They will see the session high as a logical time to sell!

What this means to you as a breakout trader using the normal entry is that there are likely to be a lot of traders coming in with sell orders just as you place your buy order. Consequently, your order is quite likely to be “filled” without slippage. If you are lucky, you may even get positive slippage by having your order executed one or two pips below your target price.

The defensive trade entry point, however, is often different. Not only do a large number of fellow breakout traders place orders at this point, but it is also a natural stop loss point for short traders. By this I mean that there will be traders who went short as they saw price rising towards the previous session high point (anticipating a double top formation) and placed a stop loss order just above the previous session high.

These stops are buy orders which, combined with genuine new buy orders placed by breakout trend traders, can cause a significant price spike at the breakout point. Consequently, it is not uncommon to experience significant slippage at the defensive entry point. Your order might be filled several pips above your target price.

Why then, you might ask, would you use a defensive entry instead of a normal entry?

The answer is that, every now and again, price will touch the previous session high just before the trend peters out and price starts dropping. If you had a normal entry, you would have gone long at the high point for the day, whereas the defensive entry would not have been triggered.

It is for the trader to decide whether it is better to use normal entries, which occasionally pick up a losing trade, but almost inevitably suffer less from slippage, as opposed to defensive entries. The decision will be based on the characteristics of the particular market being traded as well as other aspects of the strategy. For example, if the trader is targeting a relatively small movement, slippage might represent a very significant percentage of the profits. Whereas, a trader looking for big moves is going to be less concerned about a bit of slippage on the entry.

Because successful traders often do the same type of trades day after day, these sort of decisions can be vital in determining their long-term success or failure.

The final entry point to be considered is the “aggressive” entry. In this case, the trader enters as soon as the pullback turns back upwards in the direction of the trend. For example, if the market has risen in an uptrend to a new session high point and there have now been 2 pullback candles, each with lower lows and lower highs than the previous candle, the aggressive entry is one pip above the high point of the second pullback candle. If the next candle is lower again, the aggressive entry moves down to a pip above the high. In this way, the aggressive entry can keep moving down as the pullback gets deeper…

Clearly, this is going to get us into the trend at a much more advantageous level than the normal or defensive entries. Equally clearly, it is a more risky strategy, because it runs a greater risk of us getting into losing trades which would be avoided if we were waiting for the more cautious entry points to be hit.

However, sometimes the aggressive entry can end up being the only one which wins, particularly if there has been a deep pullback. That is because the aggressive entry can get you in early enough to reach a profit target on occasions when a normal or defensive entry gets you in too late to reach your target point.

Again, there is no “right” answer, only choices which you, the futures day trader, make after reviewing the market you will be trading. Of course, it is possible to select different entry options at different times based on your “feel” for the current market position. If you can do this, I congratulate you!

Personally, I find it difficult. So my approach is to be consistent with the rules I use for entry. I know that if I do the same thing day after day, sometimes my entry rules will be outstandingly good, and sometimes I will curse them! However, most sets of rules based on sound trading principles should yield a sufficient number of winners to compensate for the inevitable losing trades.

Obviously these entry points are well known to all experienced traders. Because of this, they inevitably become battlegrounds in the market. Sometimes they represent major battles, sometimes just minor skirmishes, but they always attract attention. Therefore, some traders apply various tactics. For example, instead of buying or selling at the specific entry point, they may look for an entry at some “offset” from the standard entry point.

Consider a defensive entry one pip above the previous session high. If a trader anticipates a strong fight at that level, he or she may look for an entry using a limit order a few pips lower. That is, after the defensive entry is touched, a Buy-Limit order is placed a few pips lower. This obviously has the benefit of gaining a few pips in every successful trade, and it eliminates slippage on the entry (since you don’t get slippage on a limit order). On the other hand, you may miss out on some particularly good long trades where the market takes off quickly after the breakout and never retraces to your entry point. You will, however, never miss out on losing trades!

You can also offset your entry order further above the standard entry point. In other words, instead of entering one pip above the session high, you may wait until the market moves up 4 or 5 pips. You do this to avoid being caught by a “false breakout” where the market just goes one or two pips above the previous session high before reversing…

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In Part I & Part II we saw that trends often move in a series of waves, pushing to new highs (up trend) or new lows (down trend) before pulling back to consolidate and building strength for another push in the trend direction.

Our plan with the breakout trade was to wait for a “pullback” and then Buy or Sell in the direction of the original trend. Before we look at the timing of the Buy or Sell transaction, we need to think about what exactly constitutes a pullback.

As in much of trading practice, there is no hard and fast rule for this. Some people are happy to trade the merest stutter in a trend as a pullback, while others require a more substantial retracement.

Let’s look at a down trend. If we have seen a succession of candles with lower lows and lower highs, this tells us the market is trending down, so if now we get a candle which does not make a new low, this is the beginning of a possible pullback. (There was a time when I did not start the pullback unless the low was actually higher than the low of the previous candle, but these days I include candles with an equal low.)

The next question is how many candles like this do you want to see before you declare a valid pullback and go on alert for a trade? At least one, but there are those who might insist on two.  I have no hard and fast rules, because it often depends on the other elements of your strategy and the market you are in.

There may be other requirements too. For instance, if we call the candle that established the latest new low the “penetrating candle”, we might insist that the pullback goes at least as far as the length of the penetrating candle (ii), or maybe exceeds it (iii).

So far we have taken into consideration the minimum number of candles we expect to find in a pullback and the depth of pullback we require to confirm its validity. One final point you may like to consider is the maximum period of a pullback. For example, you may decide that if a pullback goes on for longer than 12 candles, you won’t regard it as a pullback any more – you may think that the pattern is now more likely to indicate a change in the market trend. If this happens when I am trading, I generally go back to a “neutral” bias and wait to see if the market initiates a new trend move by making a new session high or low.

There is one other type of pullback which I find useful, especially using shorter term candles at the open in volatile markets.  (I should explain that, when price is rising on my charts, candles are blue. When price is falling, the candles are red.)

If the first candle is blue, or there is a sequence of up to 3 initial blue candles each with higher high and higher lows (lower lows and lower highs in a downtrend), and the next candle also has a higher high and higher low, but is coloured red, I regard it as a pullback. If the high point of that candle is subsequently broken, that is a signal for the breakout trade. I call this a quick reverse trade, and I find it very useful in the first few minutes of a trading session.

These, then, are the things I look for when defining a pullback in any particular strategy. What is the minimum number of candles in the pullback? Do I need to see a particular depth of pullback? Is there a limit to the amount of time allowed for a pullback? Is there a quick reverse situation at a volatile open which I can count as a pullback?

You are not constrained to always using the same definitions of your pullback. It can be varied from strategy to strategy. For example, the quick reverse pull back can be very useful in fast timeframes (1 or 2 min candles), but may be inappropriate for longer timeframes (15 min candles, etc). In some markets, it may be wise to insist that the pullback be at least as deep as the penetrating candle; in others, it may not be so important.

One final decision you have to make is what to do if your pullback is so deep that it effectively changes the trend. To illustrate this point, consider a session which starts with three rising blue candles – clearly indicating an up trend. The fourth candle does not make as high a high as the third candle, so you classify it as the beginning of a pullback. However, subsequent candles continue to fall until eventually price falls through the low of the first candle (i.e. Below the session low point).

You have a choice of actions now. You can either switch your trend assessment from up to down, or you can stick with the initial uptrend assessment. If you switch to the downtrend, you are now waiting for a candle which makes a higher low to indicate a beginning of a pullback in the downward trend. (TradeOnAUTO lets you “lock” the initial bias, or allow the bias to follow the market automatically.)

There are no “right” answers in any of these situations. Sometimes one choice will work best, sometimes the other. Back testing may indicate to you the best decisions applicable in particular markets using particular strategies.

Here are some practical examples:

The third candle here is an example of a quick reverse candle, so if you use this criterion for a pullback, (i) is a breakout.

Even if you don’t use the quick reverse candle rule, the fourth candle is a pullback, so (i) is a breakout UNLESS you have specified that there must be more than one pullback candle.

The candle preceding (ii) is a short inside candle, so there is a breakout at (ii) UNLESS you have specified more than one breakout candle, OR you have specified that the pullback must be equal to or greater than the length of the penetrating candle (pointed to by (i) here).

In all situations, unless you have limited the length of a valid pullback to less than 3 candles, (iii) is a breakout point. (Note that in this case the candle pointed to by (ii) has become the penetrating bar.)

In all cases, unless pullback length has been limited, (iv) is a breakout point.

(v) may be regarded as a breakout point – because the preceding candle has an equal low to the candle before it and therefore initiates a pullback. However, this point would be screened if more than one pullback candle is required, or you have specified a depth restriction on the pullback (since this pullback is shorter than the penetrating candle).

In all cases, unless pullback length has been limited, (vi) is a breakout point.

(vii) looks like an obvious breakout point, but it might be filtered by a limit on the length of a valid pullback, or by a depth restriction. Note that the penetrating candle is the one pointed to by (vi) and is very long. Despite the lengthy pullback period, the pullback is never equal to (or greater than) the length of this candle.

about this blog...

In Part I we saw that the breakout trader seeks to Buy when price makes new highs and to Sell when price is making new lows. But the day trader is faced with some unique problems.

At the start of trading session, the day trader sees a blank chart!

Most traders review strategies by looking at complete session charts. This may fool them into thinking that entry points are obvious, because subconsciously they are imposing their knowledge of the future on to their hypothetical decision. In reality, the trader can never see past the right edge of the chart! He or she has to make decisions based on imperfect, limited knowledge. That is a great deal more difficult than saying “Of Course! I would have entered there!” afterwards, when you can see the entire chart.

So where are those key points – the highs which will trigger a breakout long trade and the lows which would trigger a breakout short trade?

Some traders answer this question by looking back over previous sessions, probably using a greater timeframe than the one they intend to trade in. For example, a trader using 2 min charts might look back through the last couple of weeks using hourly charts to pick out significant highs and lows.

In doing so, of course, the trader is simply identifying market “resistance” and “support” levels. The plan is to Buy when resistance is broken and Sell when support breaks.

I by no means denigrate this approach, which can be very successful. However, I have never found that it increased my success percentage, so I prefer to work entirely with the information provided to me within the session I am trading.

The traditional way of identifying an upward trend is when successive bars on the price chart have higher highs and higher lows than previous bars. Similarly, a downward trend can be detected when successive bars have lower lows and lower highs than preceding bars. So, as a day trader, you can watch the market unfolding using, say, 1 or 2 min bars, and use this method to identify which way the market is trending.

Consider a rising market. If you see a series of four or five bars, each with higher highs and higher lows, shortly after the market opens, that is indicative of an upward trend. You know that no market goes straight upwards; you expect a trending market to go up in a series of waves. So when eventually you see a bar with an equal or lower high than the preceding bar, it is taken as a sign that a period of consolidation is beginning at this higher level. I usually refer to this as a “pullback”.

For a breakout trader, the pullback is the signal to go on alert. If the trend is to continue, the pullback will end when price has consolidated at this level, and price will then break out to a new high. The job of the breakout trader is to make the best use of this knowledge, and enter a long trade at an appropriate point.

One problem with waiting for a series of bars with higher highs and higher lows (or vice versa for down trends) is that the trader may well miss an early opportunity to enter the market. The reason for this is that markets will often be very volatile when they open. This applies particularly to markets like many of the traditional commodities, because they are actually closed prior to the open. Therefore, a lot of orders build up as people take positions based on the latest news and analysis, and all these orders hit the market in the first few minutes of trading.

Even the more sophisticated electronic markets which have 24-hour trading can be very volatile at the traditional opening time. After all, it is when many professionals in finance companies and banks have arrived at work, got their morning coffee and switch on their screens to start their trading day. There is an inevitable spike in volume.

But how can a day trader, faced with a blank chart, take advantage of this early volatility when there are insufficient bars on the chart to indicate a rising or falling price trend?

One way would be to focus down to even finer time periods. For example, although you intend to trade with one-minute bars during the main session, you look at 15 second bars during the open.

Other traders use tick bars. In this approach, bars on the chart appear when a certain number of transactions take place. For example, every 1000 trades. In the opening minutes, several bars might appear on the chart because volumes are high. Later in the session, as volumes ebb, it may take several minutes for a single bar to form.

Both of these approaches are valid, but being a simple soul, I prefer a simpler solution. I just take the direction of the first bar in my chosen timeframe as my initial estimate of the trend. So if I am trading 2 minute bars, and the first bar closes higher than it opens, I am biased towards an upward trend. If the second bar does not make as high a high as the first bar, but its low is still higher than the low of the first bar, it is an “inside bar”. I usually treat this as if it were the beginning of a pullback after the move upwards in the first bar. That way, I latch onto a lot more of the early market moves.

Some people consider it naive to take the direction of the first bar as an indication of the session trend, but that is not the point. For a start, we are not interested in the entire session, only the trend for the next several minutes, since our trades are usually quite brief. Also, there is NO guaranteed way of determining the future trend, because the future can never be known. The important point is to form a view based on the best information you have, and to do this consistently in trade after trade. Sometimes you will be right and sometimes you will be wrong, but at least you have a framework upon which to make your trading decision.

If your percentage of successes is reasonably high AND you manage your trades well, then overall you will be successful and your account will grow.

As an example of this discussion, look at this chart showing the first 2 minute candles in a recent soybeans session (blue candle is rising price, red candle is falling price):

Is that a set up for a Buy?

Not if we are waiting for a series of higher high / higher low candles before we determine there is a trend. But it is if we take the first bar as indicating the trend direction and the second bar as a pullback.  A little while later we had this:

So you might have got an excellent entry during the 3rd candle as price broke out from the pullback rerpresented by the 2nd candle. What if you were more conservative and wanted to see a series of rising bars before you accepted there was a trend?

Candles 1, 3 and 4 all have higher highs and higher lows, so the standard test for a rising market is met. In that case, candle 5 is the start of a pullback…

A little while later we have this:

You can see that, after a brief pullback in candles 5 & 6, there was a breakout in candle 7. If a trade were taken there, without too tight a stop, it would have gone on to being a good trade (but not as good as the more aggressive entry in candle 3).

Sometimes the earlier entry gets you in to a bad trade because the trend never develops. Sometimes the cautious entry gets you into a bad trade because the trend is spent by the time you get into it. In this case, the trend continued for the whole session and both entries gave good results.

Note that you can configure TradeOnAUTO software to trigger on either approach.

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Take a look at this chart.

We are a little way into a S&P 500 Emini trading session, and the cloudy future is lurking beyond the mysterious right edge of the chart…

What to do? What’s the plan?

The breakout trade is one of the most important techniques for the new day trader to master. In many ways it is a counter-intuitive trade, because it requires a trader to BUY at the top of the market, or SELL at the bottom of the market.

People new to trading can be confused by this. They feel that when the market reaches the highest level it has ever been at, then that must be the time to sell. When it is at its lowest point for a long time, surely it will not go lower? Surely it is time to buy!

However, a little clear thinking helps to understand the situation better. For simplicity, I will only discuss a long trade (when the market is rising), but all my comments apply equally in the opposite situation for short trades (when the market is falling).

When the market is trending up, we typically see it moving up in a series of waves. What tends to happen is that price moves to a new high and then pulls back a bit while some consolidation takes place. After a while, there is another break through the previous high point and the market sets a new high. It then consolidates again before repeating the process. In a strong trend, this will happen time and time again.

This explains why, in a market which is trending up, it is a good time to buy when price breaks through the previous high point. The logic is that the breakout confirms the continuation of the trend, that the market will now move to a new high, consolidate for a while, and then continue to move up – hopefully for a whole series of subsequent waves.

By taking this trade, the trader is following the old precept of “the trend is my friend” which has been a trading mantra for us long as I can remember (too long!).

Of course, no matter how strong the trend, a time will come when it will break down. At this time, the breakout trader will be on the wrong side of the market and the trade will lose. (That is why a stop loss order must always be in place!) However, in a strong trend, the breakout trade may succeed several times before the trend peters out.

Markets are not always trending. Sometimes they move sideways, forming a price band where price varies between some upper and lower levels. You see various statistics bandied around, but the most common one is that the market trends for about 30% of the time and is moving sideways 70% of the time.

Timeframe considerations can enter into this. A market may look as though it is moving sideways when viewed on a daily price chart. However, the daily chart may mask strong trends in finer timeframes. For example, somebody looking at the same market using a two-minute price chart might detect strong trends as price moves towards the upper and lower levels of the horizontal price band observed in the daily charts.

A breakout trade is unlikely to be successful if the market is moving sideways in the timeframe being traded.

When you see a chart showing a rising trend, it seems obvious that you should buy an early breakout, but when you are in the midst of the action, it is not so obvious.  Here’s how the day panned out beyond the right edge for the chart at the top of this article.

Did you pick it as a possible setup for a Buy trade?

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No trade.

I spent some time speaking with a novice trader today. He was interested in finding new markets to trade while wheat is "quiet". I asked him how he knew wheat was quiet, and he replied it was because he had not had many trades "lately" (i.e. in the last few weeks). That brought us to the greatest mistakes made by new traders – overtrading and jumping from strategy to strategy (or market to market).

The decision not to trade is just as important an entry decision as entering a trade. It is simply a day you have decided to stand aside because your entry criteria are not met, it does not necessarily mean the market is quiet. Over time you get runs of trades and runs of "no trades". (Using this particular strategy we can expect to trade well over 50% of sessions in the long run.) It is important to resist the temptation to overtrade because of impatience with normal statistical variations…

Switching strategies/markets is also a recipe for disaster. Invariably traders who do this switch into markets which have been doing well and, as often as not, get there just as that market begins to pull back and the market they left starts to recover. Murphy’s Law is alive and well in the trading world. Particularly when winning trades can be 10% or more, it is essential that you are there when the market moves. Once again, patience and the ability to appreciate the longer term picture, are the keys to success.

What overtrading and market-hopping indicate are an addiction to "action". The trader feels that s/he is going nowhere by staying out of the market, and craves some excitement. They want to "press the button" – even if they lose!  It is a very, very common trait with new traders. Often they mean to be disciplined, but every now and then succumb to the addiction and sit through a session entering trade after trade…

If you recognise this in yourself, learn to appreciate that the market is always there. If you don’t trade for the next 50 days, nothing changes, the markets are still there after that! Patience is your most valuable asset. Learn to love "no trade" days – you have made a smart decision, you are still in the game. Trading is about controlling losses – concentrate on that and let winnings take care of themselves.

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    (Click on table/chart to expand)

about this blog...

Last week, we reviewed the blog strategy and compared it to an alternative S&P 500 E-mini strategy. This week we will look at a strategy in the soybeans market which has got very attractive statistics, particularly with current margin levels being lower for beans than wheat.

The average win is 1.64 times the average loss over the period tested and we win half the time. The equity curve rises steadily over time, unlike the equity curve for the blog which had a saucer shaped recession during the 1st half of the curve.

As with the equity curves we looked at last week, the fact that the curve rises more steeply towards the right-hand side does not mean that the markets have suddenly become more favourable. What it illustrates is the beneficial effect of reinvesting your winnings with a sound money management strategy. As your winnings compound, your capital increases more rapidly.

Two further points worthy of note with this strategy are that (a) the strategy trades relatively infrequently—just a little more than half the trades taken by the blog strategy—so there are a lot of “no trade" days, and (b) the maximum drawdown over the period tested was 22% as opposed to 32% for the blog strategy.

Details of this attractive strategy have been e-mailed to current TradeOnAuto Pro clients.

(The results posted are simulated in back-testing and do not necessarily represent real world trading outcomes. Nor do they take into account differing margin levels during the test period which would have a material effect on profits –  current margin levels were used in the test.)

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I mentioned last week I would feature some of the strategies which my son Simon has been working on, and this weekend we’ll start with a S&P 500 strategy.

                

             

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An Example of Overnight Risk

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From 18 Oct to 23 Nov we experimented with new settings in the blog account. The account opened at $8,031 and closed at $8,938 for a return of 11.3% over this period.

When trading options, it is possible to use a “straddle”, buying a call and a put option in the hope that you will get a big winner in one direction or the other. The strategy wins when the win is big enough to cover the premium paid to buy the options. You use a straddle when you think the market is likely to break out sharply in one direction or the other, but you are not sure which way it will go.

You can’t employ a straddle with a direct instrument like futures. However, we wondered if we could use ToA to give us a position in both directions, and it turns out to be easy…

We put in two trades with the following settings:

By fixing the bias to long in one trade, and short in the other, we achieve the desired result. Here is a typical positive result obtained on Oct 20.

The technique is by no means restricted to soybeans 1 minute charts.  Consider this wheat trade  on August 1st using 2 minute charts.

As you can see, the optimum result occurs when both trades win (long and short) – something that can’t happen with a conventional option straddle.

If you can win both ways, you can lose both ways. Here is an example of a losing trade.

Like the options straddle, this technique requires volatile price movement. A stagnant sideways market spells disaster. Success depends on being able to pick times when market movement is most likely to occur. Contracts with well defined openings – like the grains – can usually be relied upon to show good volatility in the first few minutes of the session. Similarly, most contracts exhibit volatility in the last few minutes before a close. Apart from that, specific movement times are hard to pick, although major economic announcements are a good bet, especially if they surprise the market.

So, there we have it.  This certainly isn’t a straddle, but it is a useful technique when the conditions that favour a straddle exist. That is, you expect a sudden explosive movement in one direction or the other, but you don’t have a clear view on the direction of the move.

Notice that only 50% of our capital is assigned to each trade. This is a bit of a restriction for small accounts. If your account balance is $8K, then you are only assigning $4K to the trade. If the margin is greater than $4K, you will not be able to take a trade. (That is what happened to us with soybeans when the margin was raised from $3,375 to $4,388 locking us out of a trade.)

You might think that you could assign 100% of your capital to each trade, as they do not run in parallel. However, the reality is that the margin from the first trade is not released in time, so the attempted entry to the second trade is rejected. (This fact can be used deliberately if your strategy is simply to take the FIRST signal that presents itself!)

The strategy we used relied on a close trail on the 1 minute bars to exit each trade, but any exit strategy is valid. For example, you could set the trades using a target with risk reward ratio of 1:3. This would have the benefit of hanging in when an errant bar could stop out the trade on a tight trail, but on other occasions could miss profits locked in by the trail. As always, there is no “right” answer in trading!

On one occasion, I deliberately traded the strategy manually to see what it felt like. It was difficult to monitor the charts, enter orders, set up and adjust stops, and calculate position sizes in the very limited time available. With one minute bars, the process would be error prone. Faster time frames would be virtually impossible.  And, of course, you had to be there! (As opposed to setting it up hours in advance using TradeOnAUTO, and getting on with other things while the trading took place…)

One issue with this strategy is slippage. We were taking market entry orders at the most volatile time of day and often experienced a quarter or half point slippage per trade. The worst instance was a full point of slippage on one entry. (Slippage occurs when, for example, we submit a buy at 550 but get filled at, say, 550.5. The half point of slippage costs $25 per contract in the grains markets and is a major trading cost.)

The following video clip shows this strategy in a relatively quiet opening of the soybeans market. In this instance the market opened around 5 points down from the previous day’s close, and in the early action we see a typical move back towards yesterday’s close, as the market tries to “fill the gap”.

TradeOnAUTO enters a short trade first, followed by a long trade as the market turns back up.  You can see at the top of the chart that overall profit for the day is $152. Trading is complete after 15 minutes! The trades ran automatically with no input required from the trader during the session.

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Soybeans  -  No Trade

Wheat  -  No Trade

This was one of those exciting days in the grain markets where a surprise US agency forecast, dramatically reducing the forecast for the corn harvest, caused corn, wheat and soybeans to open limit up (30 cents for corn, 60 cents for wheat and 70 cents for soybeans).  As you can see, there was no price movement at all in soybeans for the entire session.  Wheat did trade for a while after opening limit up, but then moved back up and ended the day at the limit.

This is one reason why I prefer day trading. Yesterday would have been a wonderful surprise for anybody who had a long position in soybeans at the close on Thursday, but do spare a thought for those people who held short positions. When the market opened this morning, their positions had gapped 70 points ($3,500 per contract) against them. What’s more, they couldn’t buy back their positions today, so they face the prospect of a very worrying weekend and the possibility that the market could open limit up again on Tuesday!  On occasion, markets remain locked limit up (or down) for days on end, trapping traders in an agonising position. Their only alternative is to try and cover themselves in the option market, but this can be very expensive. As day traders, we avoid this problem.

When the markets reopen, it is likely that the limits will be expanded for the next trading session.  I’ll post here before the market open if that is the case, because it is a good idea to enter expanded limits on the ToA control form.

Correction:  I originally stated the markets would be closed on Monday for Columbus day.  That was incorrect.

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