Thursday, May 24, 2007

Part 3. Defining My Objectives

This post will conclude my work in the “Setting Your Objectives” chapter from Tharp’s Trade Your Way to Financial Freedom.

You can read my previous two posts, parts 2 and 1, here and here.

Part 3. Trading Ideas

What kind of markets do you want to trade? Is it appropriate to specialize? Do you want to trade only liquid markets, or are there some illiquid markets you’d like to trade?

I want to focus on trading stocks and ETFs. I am also interested in trading stocks listed on foreign exchanges. While I am interested in learning more about commodities and futures, I am definitely not ready to begin trading them. As for liquidity, I will likely test my systems on stocks trading at least 100K shares as a daily average.

Do you want any conditions to set up before you enter the market? If so, what are those conditions?

This is a hard question to answer as the type of system I’m trading may determine whether market conditions allow for entry. Because I do not yet have a system, I will simply say that if I were to test and subsequently trade a long-term trend following system, I would think that market conditions would not matter greatly. This seems intuitive, but may be incorrect. A long-only or short-only system may benefit from the market being in an up or downtrend. I am also considering testing several different systems so that if one performs better under certain market conditions, I might overweight that system if the market conditions become optimal.

What beliefs do you have about entering markets? How important do you believe entry to be?

I am learning that the entry is not nearly important as it intuitively seems to be. One could randomly enter any strongly trending market and probably become profitable. One could also enter any market at anytime and have news, world events, a fund selling out, etc. cause the entry strategy to fail. However, I do intend to manage risk by testing entry strategies that allow tighter stops with reduced probability of getting stopped-out before the big move. These strategies may involve using the average true range and other measures of volatility.

Lately I have been trading counter-trend moves. Trading counter-trend used to be impossible for me as I was initially indoctrinated with the “buy high, sell higher” philosophy. While I do not want to attempt to catch falling knives, I do think there are fairly robust entry strategies that will find moves off of a bottom.

Given your goals in terms of returns and drawdowns, what kind of initial risk stop do you want? If it’s close, will you be able to get right back into the market so that you will not miss a move? [In other words, discuss what kind of stop loss you plan to have.]

This is another difficult question as I think the system-testing will identify the appropriate stop-loss. Without over-optimizing the system, I think that a short-term swing trading strategy may employ a stop which would trigger if the stock trades below (or above) previous n day’s low. I would want to use this type of stop for counter-trend trades and breakout strategies.

However, if I were to test long-term trend following strategies where I’m attempting to catch just a few HUGE moves over a year’s time, I would expect to set a looser stop to ensure I would not get stopped out before the large move developed.

It is important to consider these issues when deciding initial risk. When trading a system that is often wrong, but wins big when it is right, one doesn’t want to risk too much, as the system will often get stopped out. Similarly, one doesn’t want to risk too little, and get stopped out before the big move. I want to test these stop strategies.

All that being said, my initial risk will likely be no less than .3% of capital and no more than .75% on any position.

How do you plan to take profits? Reversal stops? Trailing stops? Technical stops? Price objectives? Contrary to popular opinion, much of your emphasis should be in the area of stops and exits.

Again, this depends on the system. For short term systems, I will explore technical and time stops. For longer term systems I want to test reversal stops. I think that for my personal psychology, reversal exits will be hard to honor, as I will have to watch profits erode a bit before the system exits. This may be hard for me.

I guess I really need to decide what type of system (long-term or swing) will be the best for me, my family, and my work responsibilities. I’m hoping that the statistics generated from rigorous testing of both will help me decide.

What do you do in terms of position sizing?

I typically start small positions, usually ~5% of account value, risking between .5% and .75% on each trade. I add shares if the trade is a winner. I also want to test the effect of position sizing on each strategy.

In conclusion, If you have been following along, I think it is becoming clear why I will need robust software to run the tests and generate the statistics required to meet my goals.

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