Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading_3 pptx

The point is that my unit ofcapitalization is based on risk parameters, not on factorsoften used by novice traders in making decisions abouttheir trading operations.. Overall Risk Manage

periods of capital drawdown.

Historically, my average annual rate of return has been amultiple of two to three times my worst annual drawdown.There are several acceptable methods to express therelationship between return and risk (including the Sterlingratio, the Calmar ratio, the Sortino ratio, and the MARratio) For any given year, my modified Calmar ratio (theannual return divided by worst month ending drawdown)has been all over the map, ranging from a negative number

to as high as 30 to 1

The $100,000 asset increment is based on my desire tolimit my expected worst-case drawdown each year to 10percent of trading capital This does not mean that mydrawdowns will never exceed 10 percent—or that I will even

be profitable, for that matter The point is that my unit ofcapitalization is based on risk parameters, not on factorsoften used by novice traders in making decisions abouttheir trading operations I have actually heard novicetraders say something like the following: “I have a $25,000account and the margin for a soybean contract is $2,500;therefore I can afford to buy or sell 10 contracts.” As ageneral rule, I will trade no more than a single contract ofsoybeans per $100,000 of capital

My guess—and it is only a guess—is that many otherprofessional traders consider a capital unit to be at least

$100,000 Some of the better-known commodity tradingadvisors accept accounts capitalized by no less than

$500,000 or even $1 million These amounts obviouslyrepresent their standard trading unit

Overall Risk Management

Successful trading operations are dictated primarily by howrisk is managed Many novice commodity traders assumeeach trade will be a winner Professional traders managetheir trading to assume that each trade may be a loser.Obviously, there is a major difference between the twoperspectives

The Factor Trading Plan operates with several global

I have no idea where any given market isheaded I may think I know, but in reality I do notknow History has shown that my degree ofcertainty about a given market’s direction isinversely correlated with what actually happens.

In fact, I think a trader with excellent moneymanagement practices could take the other side

of trades in which I have a strong belief andmake money consistently

About 30 to 35 percent of my trades over anextended period of time will be profitable The probability of my very next trade beingprofitable is less than 30 percent

As many as 80 percent of my trades over shorterperiods of time will be unprofitable

There is a high probability each year that I willincur eight or more losing trades in a row There will be losing weeks, losing months, andeven losing years in my trading operations

Important risk management guidelines have beenincorporated into the Factor Trading Plan to address theseglobal assumptions The primary guideline is that the risk

on any given trade is limited to 1 percent of trading assets,and preferably closer to half of 1 percent of assets Because I think in incremental units of $100,000, thismeans that my risk per trade per unit of $100,000 is amaximum of $1,000 My trading assets committed tomargin requirements rarely exceed 15 percent I don’t recallever receiving a margin call for the account used to trade

my full program

If I risk 1 percent of assets per trade and am wrong eightstraight trades at least once each year, it means that I willexperience a drawdown of at least 8 percent with certainty,

at least on a closed trade basis

A 15 percent drawdown is about as much as I canemotionally handle I have encountered a drawdown of at

I find myself more risk intolerant as I grow older At thepresent time, my risk management protocol attempts tolimit the maximum annual drawdown to 10 percent(measured from week-ending peak to week-ending valley).

I attempt to ignore intraday equity spikes because I have nodesire to catch the bottom of each day’s high or low, and I

do not want to waste energy in even thinking about it Infact, as I will discuss in this book, I think it is unwise to payattention to account equity levels on a day-to-day basis

I consider correlation between markets whendetermining risk For example, a bearish trend by the U.S.dollar against the euro is also likely to be accompanied byU.S dollar losses against the Swiss franc and Britishpound A bull market in soybeans is likely to beaccompanied by advances in soybean oil or soybean meal

In composite positions of highly correlated markets (grains,interest rates, stock indexes, currencies, precious metals,industrial commodities), I attempt to limit my risk to 2percent of assets All successful trading operations must

be built on a foundation of overall risk management

to be profitable, someone else must lose money

Do you have adequate capital to tradecommodities, and can you afford to lose it? Can you understand and manage the emotionalswings of market speculation?

Do you have the emotional or psychologicalneed to be right on your trades? Can you accept

an approach to trading that is wrong on themajority of trading decisions?

Would your primary focus in trading be to find

management must be given priority over tradeidentification to achieve consistently successfulperformance.

What markets should I trade?

Should I be long or short?

Should I get in now or wait—and if I wait, whatexactly should I wait for?

These practical and tactical questions, and more, areanswered by the components within the trade identificationpillar of the Factor Trading Plan, as shown in Figure 3.1

FIGURE 3.1 The Trade Identification Pillar.

This is an appropriate point to reemphasize that I have

no pretention that my approach to trading is the best foreverybody or that my trading operations cannot beimproved In fact, as you read through this book you will nodoubt see many warts on my trading plan

The primary point I want to make by describing in detailthe Factor Trading Plan is not that my trading is particularlyclever, but that a comprehensive plan covering all of theimportant aspects is necessary for consistently successfultrading operations The process of trading is an importantpart of consistent success A trader needs to anticipate asmany contingencies as possible in his speculativemaneuvers

The Factor Trading Plan is based upon the following set

of assumptions:

The likely direction of any given market cannot

be determined by studying charts

Charts are a trading tool, not a predictive tool.Charts can provide traders with a slight edge,but should not be used to make price forecasts Charts should not be used to maintain a constantopinion or position in any given market

Do not assume that the next trade will beprofitable

More often than not a market will defy what itschart structure implies

Markets make enormous moves that can’t beexplained by classical charting principles

With these assumptions in mind, Chapters 3 through 5cover how the Factor Trading Plan works, focusing on thetrading components This chapter lays down the generalconcept used to identify trades and defines the terminology

or “shop talk” used by the trading plan Chapter 4 showsexamples of the ideal types of trades sought by the plan.Chapter 5 details the types and frequency of tradesengaged by the trading plan, discusses how trades areentered and exited, and explains the logistics of how theentire plan is managed

Trade Identification

There are numerous methods used by traders to define atrade The important point is that a trader must be able toknow what is or is not a trading signal, event, or moment.This is true whether a trader uses a mechanical ordiscretionary technical approach, a supply-and-demandfundamental approach, or an economic model Lack ofcertainty if a market is or is not setting up a trade is acardinal sin This is why I recommend that novice traderspaper-trade or trade a small trial account for a year or twoprior to placing real skin in the game

The Factor Trading Plan is based on a technical

study price behavior itself to identify candidate trades andgenerate trading signals In contrast, fundamental tradingapproaches are based on the supply-and-demand factors

of a market and general overall economic conditions It isnot within the scope of this book to delve any deeper intodifferent approaches to market analysis or trading The technical approach used by the Factor Trading Planfalls into a category known as discretionary (as opposed to

the mechanical approach used by many technical traders).

A discretionary trading plan requires that the trader makescertain subjective judgment calls from one trade to the next,whereas a mechanical (some market operators use the

t e r m black box) system is programmed to generate

precise entry and exit instructions in order to eliminate to-day human decision making

Using a discretionary approach is a personal preference,not in any way an indictment against mechanical systems

In fact, some of the more frustrating aspects of my owntrading could possibly be resolved if I used a mechanicalsystem But, in general, I believe that a discretionaryapproach better fits my personality and understanding ofprice behavior and dynamics

More specifically, the Factor Trading Plan uses classicalchart patterns as the basis for all trading decisions Adiscussion of classical charting principles can be found inChapter 1

Vocabulary of the Factor Trading Plan

All industries and companies have their own shop talk todescribe concepts and practices inherent in their businessoperations While definitions of terms often appear in theappendix of a book, I believe it is very important to lay outthe operating and tactical terms of the Factor Trading Plan

at this point of the book Understanding certain terms willenable you to follow my discussion of charts and tradesduring the remainder of this manuscript

The terms and definitions are not listed alphabetically but

in the order I think through things during actual tradingoperations

Trading Unit

As a trader, I think in units of $100,000 When I calculaterisk and leverage, it is always in relationship to $100,000blocks of capital Thus, if I am trading a $500,000 block ofmoney, I think about it as five trading units

Position Unit

A position unit is the number of contracts or size of aposition taken per $100,000 and determines the riskassumed on a trade The risk is normally about six-tenths toeight-tenths of 1 percent I refer to a position with less risk

as an underleveraged position and positions with more risk

as extended-leverage positions

Position Layering

Often, I attempt to build a position by entering into a trade

on multiple dates and at different prices For example, if Iestablish a position in anticipation of a future breakout, Iconsider myself to have established the first layer If Iestablish another position at the breakout of a majorpattern, I become two layers deep Perhaps a near-zero-risk opportunity to extend leverage develops at a retest;then I could become three layers deep Now if I can find apyramid opportunity, I will end up with a four-layer position I

do not add to a losing position, but put on layers only asearlier layers are profitable Even in a multiple-layerposition, my combined risk in a market rarely exceeds 1percent

Multiple-layer trades are not the norm

Breakouts

I am a breakout trader But I define a breakout in two ways.First, all patterns have boundary lines that define the exact

pen I draw boundary lines roughly, often cutting throughsome highs and lows in order to provide the best fit of anarea of price activity to a geometric pattern I also use thicklines, not a fine-point pen, to establish the boundary Ofcourse, there are instances when I call a breakout tooclosely—and I often pay the price for doing this.

Robert Edwards and John Magee considered abreakout to be a price penetration equal to or greater than

3 percent of the value of a stock This is far too generouswhen trading commodities For example, a 3 percentbreakout in $1,000 gold would be $30 per ounce

A breakout is more complicated than simply penetrating

a pattern boundary All patterns are comprised of minor orintermediate high and low points These high and lowpoints define the parameters of the boundary lines To be avalid breakout, I also want to see a market penetrate themost recent high or low price that defined the boundary.And to be most comfortable with a trade, I want to see amarket penetrate the highest or lowest price within thecompleted boundary Figure 3.2 show these chart points on

a weekly graph of the British pound/U.S dollar (GBP/USD)

FIGURE 3.2 Pattern Breakout in the British Pound.

Ice Line

I use the terms ice line and boundary line interchangeably.

should separate all the price action that preceded thebreakout from the price behavior following the breakout.The ice line is analogous to a sheet of ice on a lake in thewinter The ice supports a person or vehicle from droppinginto the water But once the person breaks through the ice,the ice sheet then becomes a barrier to survival Figure 3.3shows the ice line in GBP/USD Figure 3.4 displays thesame concept in platinum.

FIGURE 3.3 Ice Line in the British Pound.

FIGURE 3.4 Ice Line in Platinum.

Out-of-Line Movement

Drawing boundary lines on chart patterns is not an exact

draw a boundary line There is nothing magic aboutgeometric boundaries It is great when the minor orintermediate lows or highs of a market provide a perfectdemarcation for boundary lines, but this is the exceptionand not the norm A boundary line should be drawn to bestfit to an area of price congestion even if it means that theboundary line is drawn through some of the price bars There are occasions when a daily price bar significantlypenetrates a boundary line on an intraday basis, but thenalmost immediately returns back into the geometric pattern.Such price action was defined by Edwards and Magee as

an out-of-line movement While out-of-line movements cancreate some tactical challenges to trading, history willusually show the out-of-line price activity as just a one- ortwo-day freak incident Boundary lines do not need to beredrawn to accommodate out-of-line movement Figures3.5 and 3.6 exhibit out-of-line movements in London sugarand New York sugar, respectively

Premature Breakout

A premature breakout is different from an out-of-linemovement in the sense that a premature breakout canclose outside of a predrawn boundary line and even spendseveral days in breakout mode Prices then return back tothe geometric pattern However, the initial breakout wasonly a harbinger of things to come, and within a few weeks

a genuine breakout occurs I call these subsequentbreakouts secondary breakouts or pattern recompletions.

Figure 3.7 shows this concept in cocoa

FIGURE 3.5 Out-of-Line Movement in London Sugar.