Defining the Trader's Edge

Since I started teaching students of Online Trading Academy, I have obviously taken a great interest in the development of their careers and progress along the way. I have taught a variety of individuals, hailing from different backgrounds and each with their very own reasons for taking on the tough challenge of seeking a life as a professional Forex trader.

Some are just looking for a secondary or supplementary income, some are just looking for a new interest in life and others want to become completely self-sufficient from a consistent and profitable trading career.

No matter the needs or ambitions of the trader, one should fully understand the real requirements for successful trading of any kind and that is all about developing an "edge." I have read many articles and listened to a number of students and traders alike and time over, I hear people talk about their edge in the market; however, I sometimes wonder myself if people know exactly what this edge really is that they love to talk about.

Well, if you are confused about talk of the edge and would love to know more, then I guess today is your lucky day...welcome to the Sam Evans definition of the Trader's Edge.

In my opinion, the edge, as we like to call it, is made up of a number of key aspects which shape any trader or independent speculator's ability to profit from the movements of the financial markets. I would categorize these into the following areas:

1. Fundamental and Technical Analysis
2. A Plan for Trading
3. Risk Management

Market Mind Games: What is a Trading System?

Market Mind Games: What is a Trading System?: "A trading system is a collection of formulas and rules that generate buy and sell recommendations. Trading systems ..."

What is a Trading System?

A trading system is a collection of formulas and rules that generate buy and sell recommendations.

Trading systems have been developed for decades, but the recent advances in technology with the pc and internet have increased interest in them and broadened the number of people actively involved in their use.

Technical indicators such as oscillators, moving averages and band indicators are most frequently used to form the rules of trading systems. Combinations of technical indicators are also often used to create of a rule.

Trading systems are optimized in order to manage risk and increase profitablity, and this is done by modifying different parameters within each rule.

Trading systems remove emotion from trading. This has several obvious benefits – for example a trading system will not place an excessively high risk trade due to frustration from a prior losing trade.

Systems can now be fully automated, freeing up time for the trader, and in some cases can run completely ‘hands free’, where even the orders are entered automatically.

Probably the largest problem with trading systems is that it is very difficult to forecast future results in a live market environment- even though a system may have been thoroughly backtested.

Historical backtesting will help indicate the profit potential of a system – however testing should also take place in a live environment through a simulator.

Simulators, while they have the advantage of showing live market results will never be able to recreate exactly how a fill would have taken place and consequently the results in a live market will be subject to slippage.

Slippage reflects the extent to which an orders fill price differs negatively from the price level at which it was entered. For example if a sell stop loss order was placed at 1.2762 in the eur/usd and the order was filled at 1.2755, one would have experienced 7 pips of slippage on the order.

Trading Systems and Foreign Exchange Market

The forex market is the largest and most liquid financial market in the world. The daily dollar volume of currencies traded in the currency market exceeds $1.9 trillion, many times larger than the combined volume of all U.S. equities and futures markets.

Here are some things to bear in mind when considering trading systems and the fx market:

- The massive liquidity of the forex market is an attractive feature for systems developers.

- Normally in trading the spot forex market, there are no commissions, but bear in mind that you will normally be paying a spread of at least 3 pips to enter a trade.

- The most popular fx trading systems are trend following. The forex market generally trends more than the other markets, because it is influenced by macroeconomic trends that take long periods of time to be fully absorbed by the market.

- The 24 hour nature of the market during weekdays makes exiting positions easier, creating a better environment for systems that carry overnight positions.

Trend-Following Systems

Trend following systems, as the name suggests, aim to enter a trend and profit from continued price movement in the same direction.

Perhaps the most famous proponent of trend following systems is the famous commodities trader Richard Dennis.

In 1983 Richard Dennis was having an ongoing debate with his friend and business partner Bill Eckhardt about whether great traders are born or made – whether it is possible to teach the ability to trade successfully.

Dennis firmly believed that trading abilities could be broken down into a quantifiable system of rules that can be taught, while Eckhardt felt the ability was something innate.

Dennis suggested that they recruit and train some traders and give them actual accounts to trade to see who was right on this issue. Ten individuals were selected, invited to Chicago and trained for two weeks.

Dennis taught a trend following trading methodology to the group of inexperienced students, and nicknamed them ‘Turtles’ having recently visited turtle farms in Singapore.

They began trading live accounts shortly after completing their course. Dennis won the bet – over the next four years the Turtles earned an average annual compound rate of return of 80%. Jerry Parker of Chesapeake Capital Corp. was a turtle and now manages more than US $1 billion.

Richard Dennis was featured in the original Market Wizards book by Jack Schwager, a classic of trading literature.

Countertrend Systems.

This type of system aims to identify reversal points in price.

Breakout Systems

A volatility breakout system might entail entering a trade on a stop order above or below the range that has been previously trading – with the expectation that since a breakout has occured price will continue to move in that direction.

Volatility breakout systems are based on idea that if the market moves a certain percentage from a previous price level, the market is likely to see follow through in that direction. In this scenario you are looking for a continuation of the move based on momentum.

The idea is that when a new high or low is established after having been contained within a range of a certain time period, price will be carried by momentum in the direction of the breakout.

Reverse Breakout Systems

A reverse breakout system is designed to fade the move described above.

Another popular type of system are the group based on Moving Averages.

Developing a Trading System

What you will need:

In order to develop a system you will need a data feed in order to do backtesting. Esignal is a popular data provider.

Next, you will want to consider what software platform you want to use.

If you can program well in C++ or MS PowerBasic or .Net languages then you might consider designing your own custom analysis and trading program. For systems where there is not too much data, such as end of day systems, it is possible to build and test the systems in spreadsheet applications such as Excel.

Otherwise, here are several software platforms on the market that you can use to develop systems – the most famous is probably TradeStation. TickQuest’s NeoTicker is another less well known program. Some platforms allow for automatic execution of trades. Normally the platforms will have a proprietary language such as TradeStations EasyLanguage for programming the system.

EasyLanguage is similar in syntax to Delphi, and enables users to construct rules for buying and selling based on anything from a simple technical indicators such as moving averages to complicated algorithms.This languages are normally not very difficult to learn, so you need not be intimidated by this, even if you do not consider yourself a techie.

System development software normally allows you to backtest and generates reports outlining profit, number of successful trades etc.

Performance measures to use when evaluating a trading model include: total number of closed out trades, percentage of winning trades, percentage of long winning trades, percentage of short winning trades, gross cumulative profit or loss, net cumulative profit, maximum drawdown, ratio of net cumulative profit to drawdown, maximum winning trade, maximum losing trade, average winning trade, average losing trade, average profit or loss per trade, number of consecutive losing trades, unrealized profit or loss in open position and distribution of profits over time.

In evaluating your system you should look first at the net profit and also average profit per trade.

You will start out by selecting a market and timeframe and defining entry and exit rules.

For entry rules, you will be looking to parameters relating to the type of system you want, such as trend following, breakout etc. Exit rules can be expressed in a variety of ways, such as fixed dollar amount, a percentage of the current price, a percentage of the volatility, or a time stop.

Smaller timeframes mean smaller profits, but usually smaller risk, while longer term systems, operating on a daily and weekly timeframe offer higher profit potential and also higher risk.

Bear in mind also that in your backtesting you need to have an adequate number of trades to make a valid assumption, so you need to consider this in addition to the time period.

You should test the robustness of your system by applying it to multiple markets and time periods. It is also important to to factor in commissions and any other transaction costs.

If you over optimise a system by adding too many rules, it will be unlikely to do as well under live market conditions. This is what is known as ‘curve fitting’ a system. Generally speaking the fewer rules used the better in designing a trading system.

Market Mind Games: Trend Analysis using Open Interest and Volume

Market Mind Games: Trend Analysis using Open Interest and Volume: "Open Interest (also known as Open Contracts or Open Commitments) refers to the number of active or open contract..."

Trend Analysis using Open Interest and Volume

Open Interest (also known as Open Contracts or Open Commitments) refers to the number of active or open contracts for any given security. It applies to the futures and options markets but not to stocks.

In the futures market it refers to the total number of contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. Each open transaction has a buyer and a seller, but for calculation of open interest, only one side of the contract is counted.

The open-interest position that is reported each day for a given market shows the increase or decrease in the number of contracts for that day in the form of a positive or negative number.

It is one of the foremost tools for confirming trends and forecasting trend reversals in the futures market.

- Open interest rising along with prices is a bullish indicator that an uptrend is in progress and is likely to be sustained. It shows that new money is entering the market.

- Falling open interest and rising prices is a bearish indicator, suggesting that the rise is being caused by short sellers covering their positions. The upmove is unlikely to be sustained because new buyers are not entering the market.

- Open interest in a sideways market can suggest a breakout in either direction.

- A rise in open interest in a falling market suggests that a downtrend is in place. New money is entering the market through short sellers.

- When both open interest and prices are falling, this suggests that the longs are closing out their positions, indicating a trend reversal and an upward movement in price.

- Static open interest along with rising or falling prices suggests a possible market top or bottom and trend reversal.

Volume is often used along with open interest. Volume refers to the number of contracts that have to have been traded within a given session. Volume precedes price. 

The higher the volume traded, the more likely a trend will continue. Rising open interest confirms that new money is supporting the prevailing trend.

Market Mind Games: Five Tips for Trading ETFs

Market Mind Games: Five Tips for Trading ETFs: "Every week I tell you about exchange traded funds (ETFs) that you can use for various investment purposes. You could be wondering, though, ..."

Five Tips for Trading ETFs

Every week I tell you about exchange traded funds (ETFs) that you can use for various investment purposes. You could be wondering, though, what’s the best way to buy them. So in today’s column I’ll give you some practical information that will help you implement whatever ETF investment strategy you might want to pursue.

Professional investors make a distinction between portfolio management and trade execution. You might not be a professional, but you can still use the same thought process …

Portfolio management is when you make the decision to buy or sell a particular security. Normally there will be limits on the decision. For example, maybe you only want to buy the shares as long as the price is less than $50. Or perhaps you want to sell all of your shares and be completely out by the end of the month.

Trade execution comes after the portfolio decision. You’ve already decided what you’re going to do; now you want to do it as cost-effectively as possible. Maybe you’re willing to pay $50 a share, but you’d be even happier if you can get in at $49. Good execution helps make this happen.

The importance of execution is directly related to your time horizon. If you’re planning to hold an ETF position for years, a few pennies on the entry and exit may not seem so important. However, those same pennies can add up quickly if you’re moving in and out every week.

With that in mind, here are five suggestions to help improve your ETF trading results …

Trading Tip # 1:

Shop Around for Lower Commissions

Years ago, the only way to get into the stock market was through a broker, who charged dearly for his trouble. Now the story is different. You can bypass the smooth-talking salesman and buy stocks, mutual funds, and (best of all) ETFs online for a very small fee.

If you deal with a full-service broker, he’ll probably try to justify his exorbitant paycheck by telling you his firm really “works” your orders to get the best price. If you’re throwing around millions of dollars at a time, this may be true.

For the rest of us, you probably aren’t getting any better execution than you would at a discount broker. In fact, you may do better at a discount broker that doesn’t have a proprietary trading desk working against you.

These days it’s not hard to find reputable discount brokerage firms with rates of $8-12 for a typical small trade. And there’s really no reason to pay any more.

Trading Tip # 2:
 

Get Inside the Spread

If you look at an ETF quote during market hours, you’ll probably see some numbers called “bid” and “ask.” They may be quite different from the “last” trade price.

Bid and ask are the current market prices. The bid is the highest advertised price that you can get if you’re selling right now. The ask is the lowest advertised price you’ll pay if you’re buying right now. The “spread” between these numbers is how market makers earn a profit.

The key word here is “advertised.” Often you can buy for less than the ask, or sell for more than the bid. That’s why it is usually a good idea to try for a price somewhere between the bid and ask.

For instance, if you want to buy an ETF that has a bid/ask of $25.50/$25.80, try placing a limit order at $25.65. Wait a couple of minutes and see if anyone takes the bait. If they do, you just saved yourself fifteen cents a share.

Also keep in mind that the bid and ask aren’t unlimited. They apply only to a certain share quantity. A bid of $25, for instance, may be good only for 100 shares. Sell any more than that and you’ll get a lower price — and it could be a lot lower!

Trading Tip # 3:
 

Use Limit Orders

Notice that I said in the above example to enter a “limit” order. This is simply an instruction to your broker not to process the trade unless the price is at or better than the limit you define.

If you enter a “market” order, you might not get the best price. What you will get is the best available price at that moment. And it could be substantially higher or lower than you thought you’d get.

I’ve found that it’s almost always better to use a limit order when trading ETFs, even if it means your order isn’t filled right away. The odds are that you’ll get a better price by waiting.

The only exception is a handful of mega-ETFs like SPDR S&P 500 (SPY) and PowerShares QQQ (QQQQ). These big, actively-traded ETFs normally have very tight spreads and ample liquidity. Small orders are filled instantly at the quoted bid or ask price.

Trading Tip # 4:
 

Watch the Underlying Market

Several factors define an ETF’s liquidity. One of the most important is the depth of the underlying market. This is the basket of stocks that compose the ETF. Institutional trading desks often try to pick up some quick profits by moving back and forth between ETF shares and baskets of the corresponding index.

If the index is composed of large, actively-traded stocks, the ETF will probably have an efficient market as well. Likewise, when the index consists of low-volume stocks, any ETF designed to reflect it will also reflect the lack of liquidity.

It also helps for the underlying market to be open when you’re trying to trade an ETF. For instance, if you’re trading an international ETF composed of European stocks, you may do better in the morning. That’s because there’s a few hours in the morning when the European and the U.S. exchanges are open. This means more depth and, usually, better prices.

Trading Tip # 5:
 

Be Aware of the Crowd

On a normal day the stock market tends to have a lot of volume in the first half-hour or so, less action in mid-day, and furious trading just before the close. The same is true of ETFs.

This pattern can work either for you or against you. If you’re trying to move a big quantity of shares, you probably want to take advantage of the depth present in the last hour. If you want to trade against someone who may not have thought ahead, you might find some good prices at lunchtime.

The point is that you must be aware of your surroundings. Market conditions are constantly changing. Just as you don’t go out in the rain unless you want to get wet, you shouldn’t go into a thin market unless you’re ready to turn it in your favor.

Follow these five trading tips and you’ll be surprised how much your results can improve. Are they magic? No, not at all.

You’ll still have plenty of ups and downs. But good trade execution is still a very important step for more active investors.

Best wishes,