I stopped Trading the Trend

I am a trend trader. That is how I make the bulk of my profits. Other traders make money other ways, but I follow trends. The fact of the matter is that in the markets I trade, there were no good trends from April to July, with the exception of one currency pair – Kiwi Aussie.

What I should have done was – nothing! I should have sat on my hands and waited for a good trending trade. Instead I got chopped up trying to trade break-outs that turned out to be false break-outs and then I made the mistake of trading the range. I should have recognised earlier that we were in a range trading market. I should either have kept my trades very small or I should not have traded at all.

2. Overtrading

As you will see from the summary below I did 271 trades in just over six months. If I take out the holiday weeks where I was not trading, it means on average I did 11 trades per week, or over two per day! Note that I am NOT a day trader. In fact I am a medium term trader who takes a view over a number of weeks or months.

Profitable medium term trades DO NOT occur 11 times per week. In fact they generally occur only a few times per year.

Critical Principle Profitable medium term trending trades only occur a few times

per year. WAIT FOR THEM.

My overtrading mistake is a common one for professional traders. I sit in front of a computer screen all day looking at fifty different financial instrument. Although nothing jumps out at me as a good trade, I often see something that I think I can make money on, and so I take the trade. This is a mistake. There is always going to be something that looks okay if you look hard enough. But taking an “okay” or “quite good” trade is an avenue to the poor house! Funnily enough it was not until a week after I completely stopped trading that I recognised this. While I was in the midst of trading like this I literally could not see the wood for the trees. It didn’t occur to me that I was trying to chase a market that wasn’t there!

One of the reasons that the Turtle Traders described in Curtis Faith’s book (see below) traded so well is that they were literally not allowed to take a trade until a prescribed set of rules was met. They played a lot of ping-pong to help the hours go by when there were no trades allowed!

I need to do the same thing. I now have a strict set of rules that will only allow me to enter a trade under certain specific circumstances. I know I have a lot of things I can do with the extra time!

For illustration purposes here is a summary of my trades for the 2008 calendar year:

Total Number of Trades for the Year: 342

(NB This includes multiple entry points for staggered trades. Excluding the multiple entries, there were 153 trades).

Number of Profitable Trades: 155

Number of Losing Trades: 187

Total Equity at 1 January 2008: $150,000

Total Equity at 31 December 2008: $465,490

Total Net Profit for the year: $315,490

(net of brokerage and carry costs)

In cash terms, beat last year by: $144,213

Percentage gain for the year: 210.33%

Net Profits from Currency Trades: $180,959 Net Profits from Agricultural Commodities: $130,848

Net Profits from NZ Bank Bill Futures $ 7,715

Net Losses from Precious Metals: - $ 7,601

Net Losses from Equities: - $ 18,277

Net Losses from Crude Oil Futures: - $ 21,304

Total $315,490

Analysis

1. The first point is that I had 21% more losing trades than winning trades (in 2007 it was 39% more losers than winner!). Once again the reason I was nevertheless profitable for the year is that I cut my losing positions quickly and let my winning positions run.

In 2008 I had four significantly profitable trades. Two lasted a few weeks each and the other two were short trades. Essentially I made all of my profits from the year on these four trades:

One series of Agricultural Commodity Trades; One NZD AUD Currency Trade; and

One series of Bank Bill Trades; and One short USD trade.

2. What sticks out is that I made a huge profit in Agricultural Commodities which I have never really traded seriously before this year. I owe all of these profits to reading two books: “Hot Commodities” by Jim Rogers, and “Way of the Turtle” by Curtis Faith. It just shows me how important it is to read, read, read!

3. Once again I had a significant loss in equities. This is an area I really had to improve on because it had been a losing category for me for two years. 4. As I already said, I overtraded. 271 trades in six months is way too many. In

last year’s summary I said I overtraded but this year I traded 2.8 times as often!!! I will say it again – great trades do not come up every week or even every month – so what am I doing taking trades that do not look great? Answer: throwing money away.

My Four Most Profitable Trades

Total Profit: $135,872

This was the trade that took just five working days in December 2008. The best thing about this trade is that the TOTAL risk on the trade was $2,775. Yes just two thousand seven hundred and seventy five dollars. The reason the risk was so low is that I only started with one position long 100,000 Euro vs USD. I put my stop loss in so that my maximum loss was only $2,775. When that position was profitable I locked in the profit by raising my stop loss and then I took another position. I continued to do this until I had many hundreds of thousands of dollars worth of positions, all protected by trailing stop losses. NOTE CAREFULLY this was one of the best of all of the trades available in 2008. The USD dollar fell 17 big figures (that is 1700 points) in five trading days. That is almost unprecedented and falls of that magnitude only happen a few times in a decade, so do not think you are going to go out tomorrow and risk $2,775 to make $135,000.

2. Bought Agricultural Commodity Futures Total Profit: $122,921

I used a staggered approach so that I started small and increased my exposure as the price rose. I traded a number of these commodities

concurrently during February and March and did especially well with Cotton, Soybean Oil, Cocoa, and Soybeans (in that order).

3. Sold the New Zealand Dollar against the Australian Dollar Total Profit: $93,344

I started this trade with a physical (margin trade) position of $400,000. When it became strongly profitable I added a second $400,000 position. When that position it became strongly profitable I added a third $600,000 position. Then when that position was also profitable, I sold all three physical positions and put all of the profits into buying an option over $3m. That option cost me

NZ$25,170. Using the same strategy as 2007, once that option had doubled in value, I used the paper profits to buy another option, this time over $2m. I did this one more time and purchased a third option over $5m. At this stage I had options over NZ$10 million. I sold all of my options when it looked like the market had turned, and took my profits.

However, after this trade was completed I analysed what would have

happened if I had just kept my $1.2m in the physical (cash) position and not sold this to buy options. As it turned out I would have been better off if I had kept the physical positions. The reason for this is that this currency pair moved

slowly. Where currencies move slowly it is better to have a physical position because the time value of the option erodes faster than the currencies are moving. Also there is usually a big spread between the price of buying and selling the option and you need to make up that spread during the time of the trade.

As I said in the 2007 summary; currency options are best in fast moving markets but not so good in slow markets.

4. Bought New Zealand Bank Bill Futures Total Profit: $45,676

This is a good example of a profitable trade that was easy to see and was very likely to be profitable. Unfortunately it is not a trade that is likely to be

repeatable in the near future. Bank Bill Futures are primarily valued in relation to the expectation of the future Reserve Bank Official Cash Rate (OCR). At the time I traded these, the Bank Bills were priced such that a cut in interest rates was not expected until late 2008 or early 2009. It was my strong conviction that the Reserve Bank would have to cut interest rates earlier than that. Bank Bill Futures rise in price as expectations of an interest rate cut increase. It was relatively straight forward to hold these futures over market announcements (which were usually bad) and take profit after the announcement.

Unfortunately the opportunity has now gone, but there will be a time in the future when the market is mispricing interest rate policy, and I look forward to that!

My Two Biggest Losses

Similar to last year my two biggest losses occurred when I took large up-front positions rather than scaling in to positions. When am I going to learn? Answer: now! I have strict rules against this practice now.

1. Sold $1.5m NZ$ against Japanese Yen AND sold $1.5m US$ against the Japanese Yen.

Total Loss: $44,594

I started this trade with $500,000 positions in each currency pair and I quickly added two more $500,000 positions in each. This was way too much to have on this trade. Even though I scaled in only when the previous positions were in profit, and I used stop loss orders, when the trade turned around I went from a profit of $20,349 to a loss of $44,594 in one night! So in one night I lost

$64,943 which is a ridiculously high level of risk when my starting equity for the year was $150,000. Of course once again it occurred after I had made big gains elsewhere. However it is critical that I limit my potential losses to 4% of my equity on any one instrument. This is also now a rule!

2. Long Crude Oil. Total Loss: $26,488

I made this trade and took this loss in under six hours – ouch! My position size was too big and my stop loss was at a place where everyone else had their stop loss. Consequently I had a slippage loss of over US$10,000. I also

(knowingly) traded through the weekly crude oil inventory news release which caused the big sell off and therefore the slippage. Also I was “playing the range” rather than staying with the trend. In other words I got bored waiting for a good trending trade and decided to try to buy it at a low point in the trading range, hoping to sell it higher in the trading range. I am sure there are a lot of traders who are good at trading the range. However, I am not one of them! I should have been patient and traded what I am good at – trading the trend.

Trade I Missed

There is one glaring trade I should have taken that would have increased my profitability by at least $100,000.

I watch around 15 futures contracts and when I get a buy signal I must buy each time and every time. Unfortunately I was too busy in February trading my agricultural commodities to look at Heating Oil. The buy signal in Heating Oil Futures was given in early February and the contract climbed strongly until the end of May. Had I taken it, the trade would have been my second most profitable of the year. The lesson here is that I need to keep looking at all of the signals on all of the commodities I trade. I also need to look for a second entry point if I miss the first entry point. If I had entered in March I still would still have taken 75% of the profit from the trade.

Summary

210.33% is an excellent result. However with more discipline it would have been smoother and even more profitable.

Also, I had large equity swings from month to month:

January -17.63%

February 168.72%

March 31.29%

May -25.30%

June 20.91%

July -49.42%

August Did not trade

September Did not trade

October -1.15%

November 3.00%

December 93.53%

This doesn’t look good and it doesn’t feel good! I have instituted a new “Preserving Capital” rule as follows:

If in any one month my equity falls 9%, cut all existing trades (except strongly profitable trades) and enter no new trades until the beginning of the next month.

Having had the discipline in 2008 to stop completely for three months, I realise the huge benefit of stepping back from the markets to get some perspective.