Principles of Profitable Trading
You’ve put our Portfolio Strategy to work. Your retirement and investment accounts are secured and on track. What’s next? Want to try your hand at trading for fun and profit with some mad money?
Relative Momentum: DRYS vs. S&P 500 Index, Daily Chart
The Six Elements of Profitable Trading
In The New Market Wizards: Conversations with America’s Top Traders, legendary trader William Eckhardt told author Jack Schwager that, “Anyone with average intelligence can learn to trade. This is not rocket science. However, it’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies.”
Eckhardt was right on. Good trading practices are frequently counterintuitive. Situations that look good from far are often far from good.
If you make a bad trade and you have money management you are really not in much trouble. However, if you miss a good trade there is nowhere to turn. If you miss good trades with any regularity you’re finished. — William Eckhardt
Success is the result of using common sense, understanding the madness of crowds, and applying a handful of robust analytical tools. Yet for most, success is elusive because one or more of the critical elements is missing:
- Identify appropriate trading candidates;
- Trade a basket of diversified securities;
- Use relative momentum analysis;
- Implement a position sizing strategy;
- Follow the buy and sell signals; and most of all,
- USE LOW LEVERAGE.
If you like financial entertainment, I won’t stop you. If you are trading Forex at 1:100 or can barely make intraday margin for e-mini futures, pray for a miracle that you will succeed where hedge funds failed.
If you have some mad money and want objective analytics that actually work as part of a well-balanced trading program, show your hard-earned money that you mean business by starting with good software and dependable data. It’s more economical than you think.
Why TradeStation or eSignal?
Our proprietary analytics FOR DAILY CHARTS are available for two leading software platforms that we personally use. InVivo.Analytics are available ONLY for TradeStation 8.x and eSignal OnDemand/Premier. We will not make them available for any other platform in the foreseeable future.
Premium members are welcome to add InVivo.Analytics for $149 per year. If you have never used eSignal, you might consider eSignal OnDemand. It’s only $24.95 per month and provides access to global market coverage. TradeStation 8.x is now practically free. Accounts can be opened with a minimum $5,000 deposit.
Key Principle: Relative Momentum
Relative momentum is the measurement of the price movement of A against B. For example, we can measure GOOG against a benchmark index such as the NASDAQ 100 Index. We can also measure a sector against an index. This type of analysis is often called “relative strength” (NOT Wilder’s RSI or the IBD ranking) or “ratio charts”, and since there is so much confusion, we call it relative momentum.
Having a tool that objectively measures relative momentum is very important because knowing where we stand in a speculative cycle is often the only way to protect yourself because investors tend to be extremely bullish at the top and very bearish at the bottom. Relative momentum tools can help traders avoid performance chasing (buying after a long uptrend) and countertrend trading (buying all the way down).
We offer two studies: InVivo.RMI PaintBar and InVivo.RMI Histogram. RMI stands for relative momentum indicator. These two studies are applied to DAILY CHARTS ONLY.
The RMI Histogram compares price action of a stock (or sector) against an appropriate benchmark index while the RMI PaintBar colors price bars according to the status of the histogram values. This provides us with (i) a detailed, bar-by-bar account of a stock’s performance against the benchmark and (ii) helps identify potential change of trends in the big picture when price bars are painted yellow.
Relative Momentum: USO vs. S&P 500 Index, Daily Chart
The position of the green and red histogram bars relative to the grey threshold line is very important. A number of combinations and permutations can occur. Price bars are colored based on information contained in the histogram according to these rules:
- Green = RELATIVE OUTPERFORMANCE = Histogram > 0 AND Histogram > Threshold Line
- Red = RELATIVE UNDERPERFORMANCE = Histogram < 0 AND Histogram < Threshold Line
- Yellow = POTENTIAL CHANGE OF TREND = all other combinations
Key Principle: Use a Stop Loss
Stops cannot be eyeballed. A trader that places stops arbitrarily or uses stops calculated incorrectly is destined to always exit too early and miss the home run, or exit too late after a change of trend.
I have been a fan and an admirer of your work for many years and, in fact our SmartStops exit logic contains an idea or two I learned from you. . . . I do not view us as competitors but rather think of us as allies in a battle against ignorance and the unacceptable risks of buy and hold. I find your Invivo Stops to be both effective and intelligently designed.
Chuck LeBeau
December 11, 2008
InVivo.Stops are engineered to reflect actual volatility and range, providing users with a real edge over other so-called volatility-based indicators or bands. Stops can be used in two ways:
1. They establish the appropriate price to exit a trade.
2. They can also establish the appropriate price to enter a trade.
Stops must be placed strategically, yet nearly all commercially available stops have serious flaws. In Engineering Better Bollinger Bands and Thoughts on the Kase Dev-Stop, I demonstrated why stops must accurately reflect volatility and range. That is why we never, ever place stops based on what we can afford to lose. Stops must be placed where they ought to be, and we reduce our trading size as required to manage risk to capital. This is our definitive edge.
Many systematic traders spend the majority of their time searching for good places to initiate. It just seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprisingly well with a good liquidation criterion. — William Eckhardt
There may be many moving parts, but make no mistake, a strategic exit is the backbone of any trading system or method because it helps you manage risk.
Using InVivo.Stops
Trading with the trend — also known as “directional” trading — is basically a game of musical chairs. The key to playing the game profitably is to know when the music stops, but if the end comes abruptly, the dots show us a timely exit.
InVivo.Stops Applied to Intel, Daily Chart
Our stops are smarter stops and we’ve made using it easy to apply them to your charts.
The Buy and Sell Rule
Use InVivo.Stops according to the following two rules:
- BUY RULE: A *close* above a blue dot is buy signal.
- SELL RULE: A *close* below a pink dot is a sell signal.
While the math behind InVivo.Stops is complex, using this indicator is easy as 1-2-3. It shows you the exactly where your stop should be at all times.
A Word About The StopFactor
The “tightness” of the stops is based on the StopFactor setting. The default is set to UniversalStop = True. The indicator dynamically selects an appropriate StopFactor setting between 1.0 and 1.5. You can also manually select a StopFactor.
If you wish to set the StopFactor yourself to accommodate your style of trading, enter UniversalStop = false along with the desired setting for the StopFactor. Investigate a range of settings between 1 and 1.5 at 0.1 increments. StopFactor settings under 1 are insufficient while settings larger than 1.5 are unnecessary.
In trend (directional) trading, it is perhaps not possible to tighten the initial stop or trailing stop beyond what volatility dictates. Time and again, we have seen that a wide range of trading “problems” tend to be resolved by trading in a larger time frame while simultaneously reducing trade size and leverage with the use of appropriate stops.
Key Principle: Know Thy Swings
InVivo.SwingLines was the first tool we ever released. This indicator connects upswings and downswings to help us identify chart patterns and HIT AND RUN trade setups documented in the glossary of trade setups (for Premium Members).
InVivo.SwingLines Applied to TLT
The highlighted area shows the hallmark of a steep uptrend: higher swing lows and higher swing highs with very small bull flags.
InVivo.SwingLines Applied to TLT
The highlighted area shows an “M” shaped test of top with a lower high made on the test. The present swing is down. Premium members should listen to the Trade Like a Commando podcast to learn how we identify trade setups by process of elimination. In this case, the smallest buy setups have been eliminated, but larger ones have not.
Key Principle: Implement a Strategy
In practice, traders must pull it all together to make a trading strategy. They must have a method to pick stocks. Each trade must be pre-qualified by imposing additional conditions such as relative momentum, trend, etc. Last, and most importantly, the amount of leverage used must be carefully calibrated in order to calculate position size that helps limit exposure and risk.
InVivo.RMI Strategy Applied to USO, Daily Chart [LARGER CHART]
You already have enough on your hands with stock selection. We can’t pick them for you, but we can definitely help you manage risk with InVivo.RMI Strategy, a TREND TRADING SYSTEM that incorporates relative momentum, a trend filter, leverage and position sizing. Use it as a learning tool, to test ideas or grow your mad money.
