I came across the website www.tradingfutures.biz recently. It debunks the trading philosophy I advocate, so naturally I was fascinated! It is clearly written by a real trader, and it is well reasoned and witty. I particularly enjoyed the author’s section on trading jargon in Appendix 4.
As it was written in 2004 some of it is a little dated now, but I find myself in agreement with much of the content, even though I don’t agree with all the conclusions drawn. It’s good reading for anybody contemplating a futures trading career.
The “perfect system”
The author begins by describing his perfect system. The perfect system is very simple. He advocates buying and holding futures contracts in equity indices. His rationale for this is that there is an inherent bias for the indices to rise because of inflation. He says that this increasing trend has been apparent for the last 400 years, during which time there have been “hardly any” ten-year periods where the index value has not risen. He points out that the system involves very little actual trading, making it unprofitable for brokers.
He then goes on to give the lie to many of the common trading techniques advocated by brokers to encourage churning of your trading account, enriching them and impoverishing the trader! He dismisses wave theory, Fibonacci retracement, oscillator indices like stochastics, “filling the gap” strategies, “going with the flow” (i.e. trend following) strategies, day trading and system trading as techniques advocated by greedy brokers with the sole objective of churning your account. Even stop loss orders get a lashing!
My trading approach
I should come clean now and state that I am a system trader and a day trader – two of the approaches canned in the article. So the author and I have followed similar paths and reached very different destinations. On the other hand, I do share the author’s contempt for financial “indicators” which I have never found to be of much use. And I certainly wouldn’t take trading advice from a broker.
My technique is to use simulation to analyse market activity around intraday support and resistance levels over a long period, based on my understanding of the way traders react when those key levels are approached. If I can find a set of tactics which have been successful – by which I mean they have made a good return AND they have a low drawdown – I consider incorporating them into my trading strategy.
Critiques of day trading
The author criticises day trading on the basis that “most day traders lose while most long-term traders win.” I am not sure where he gets this information from, although there are anecdotal stories from brokers which certainly imply that most of their day trading clients go broke or at least drop out of the market. So I suppose the statement is probably true for the majority of amateur traders.
However, most trading is not done by amateurs. The vast majority of trading transactions are carried out by financial institutions, and I believe that the majority of those transactions are short-term by nature. In other words, substantial institutions with large trading rooms seem to prefer short-term trading. My view is that while amateur short-term traders may not do well competing with these professionals, the institutional traders (the majority) must find it profitable.
The other criticism the author makes of day trading is that because the markets are so chaotic and volatile, it is impossible to know what will happen in the next 60 seconds. However, he says, it is much easier to determine what will happen over the next 60 years. In response to that, I believe that if you take the trouble to study the way the majority of traders operate, there are certain points during the market day when you can make a good statistical guess at what the market will do in the short term. (In contrast, I am not so certain of what will happen 60 years from now. For instance, I am concerned that sometime during that period the giant Ponzi scheme that most Western economies have become will collapse, with unpredictable results.)
What long-term traders often tend to miss when they criticise day trading is that a day trader is focused on the reaction of other traders in the market, not on the fundamentals of the underlying commodity. For example, one might consider Elliott waves and Fibonacci retracement’s to be complete bunkum – I do – but if, in a particular market, the majority of institutional traders are trained to measure the size of waves during an uptrend and buy if there is a 68% retracement, then this is important information for the short-term trader. In terms of making a trade which may last for just a matter of minutes, knowledge of these indicators and how people react to them is considerably more valuable than knowing that the weather is a bit iffy in South American coffee growing regions. (Of course, if you have inside information that no one else knows, that’s different, but if you do this is also usually illegal.)
A critique of system trading
The author criticises system trading on the basis that, if such a system existed, those with knowledge of it would become fabulously rich (and certainly never sell it), and it would eventually lead to the breakdown of the market. In response to that, I would argue that system trading doesn’t mean that you always do exactly the same thing at the same time forever. All markets change and no single strategy is successful all the time.
However, I see system trading as being synonymous with planned trading, whereby anybody entering the market has a precise plan covering all aspects of a proposed trade, taking into consideration all possible market contingencies. Such a plan is fully specified and can be traded automatically, eliminating execution errors and expensive impulsive trading decisions made in the heat of the moment without proper analysis.
When, and if, markets are perceived to be changing, the daily trading plan can be changed to adapt to new conditions, but it must still be properly thought out and fully specified, so that it can be system traded.
Analysing historic results
The author and I seem to agree on the importance of analysing historic results. He makes the not unreasonable assumption that because equity indices have risen steadily for 400 years (in ten-year chunks), they will continue to do so. That assumption may or may not prove to be correct, because, as our brokers always assure us in the small print, “past performance is no guarantee of future performance”, but it does at least seem to be a reasonable projection, based on his understanding of the way markets work.
Of course, I could then ask why he would not incorporate improvements to the system. For example, returns might be vastly improved if he went to a cash position every time the 50 day moving average dropped below the 200 day moving average!
I basically do the same thing, analysing historical data for profitable patterns. Only I focus my analysis on short-term intraday movements. I make the same leap of faith that he does, trusting that what has worked in the past is a good indication of what will be successful in the future. It doesn’t always work, but it is one way of making the best use of the limited information we have in an extremely complex situation.