, you win the brass ring.If you are wrong, you pay the piper.
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C H A P T E R
8
Developing Your OwnTrading System
Key Concepts◆ Developing a Trading System Discipline◆ Maintaining a Money Management Discipline◆ Monitoring Personal Discipline◆ Managing Information◆ Staying Abreast of New Technology◆ Looking Ahead for Future Trading
Perhaps the biggest single mistake investors make when they begin to analyze the market is that they fail to put together a tradingsystem. An analysis procedure is not a trading system. Most tradersare attracted to technical analysis because they use or are exposedto a technique, such as moving averages or chart formation analysis, that works. They then want to apply this specific technique toevery situation.
DEVELOPING YOUR OWN TRADING SYSTEM
All technical tools described have been used to successfully tradethe futures markets at one time or another, but there are many, manytechnical approaches. A partial list might include astrological, complementary angles, Harahus pentagon, Japanese candlesticks, par-
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abolic, point and figure, price bar congestion, speed resistance lines,stochastics, and swing charts.However, neither a single technical analysis tool nor a combination of analysis tools makes up a trading system. Analysis is onlya part of a trading system—often a small part! True trading systemsare composed of three major components. The first and most important is a money management technique. The second is the analysis of the market, and the third is a market input-output mechanism.Consider the following guidelines for selecting an analysissystem.1. Choose an analysis procedure, or better yet, a series ofanalysis procedures, in which you have a high level ofconfidence.2. Pick a system that is qualifiable and quantifiable. It mustbe specific and tell you to go long or short and at whatprice.3. Be sure your procedures are able to withstand serious, historical testing. You must be able to use historical marketdata and to run simulations that can be done quite easilyon today’s personal computer systems.4. Choose optimizable analysis procedures. This will helpavoid using yesterday’s factors for tomorrow’s markets.Optimizing is a fine-tuning procedure. It does not meanabandonment of analysis principles. Optimizing adjustsyour analysis procedures based on a change in marketconditions, such as a major change in market volatility, notjust a change in your opinion.5. Make sure the analysis procedure tells you when to getinto a trade and when to get out.Computer-based systems work better than systems that aredifficult to computerize. Computers take much of the opinion outof decision making and allow more accuracy in determining historical track records and hypothetical performance.DANGERS OF LIQUIDITY
As you test trading systems, the accuracy of your hypothetical results will depend a great deal on how closely your projected entry
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and exit prices resemble reality. When testing futures market trading systems, it is common to add an extra cost factor of $100 pertrade to cover slippage and brokerage commissions. The degree ofslippage depends on liquidity and the spread difference betweenbid and ask prices.For grains such as soybeans, where high liquidity typically exists, slippage for an individual trade may only be a quarter of a centper bushel or $12.50 per 5,000-bushel contract. But in less activelytraded markets, such as orange juice, slippage may be as much as$200.MATCHING MONEY MANAGEMENT WITH ANALYSIS
Money management is a primary concern. You can’t trade successfully if your system constantly drains your trading account of equity. Successful traders talk about the necessity of surviving the rough,choppy markets so that they are in a position to profit when the market smoothly trends up or down. To succeed, you must first survive.Surviving simply means preservation of risk capital. You mustbe able both financially and psychologically to withstand some losing trades. You should cut your losses quickly and let your winnersrun. The trading system you select or develop should have a definite procedure for protecting positions with stops or “bailout”points.Money management may well be more critical than the analysis facet of the trading system. Even the best analysis procedure isseldom more than 50 percent right. Good money management preserves your chips when the analysis is wrong. It should providereadouts of risk-to-reward ratios.Know your trading limits. If you can select the correct amountof money to trade that suits your emotional makeup, you can reducethe negative influence of greed. At the same time, you need to invest enough to make the risk taking involved in the futures marketsworth your while.It’s common for beginning traders to overtrade. They often select markets that are cosmetically exciting and require large margins. Gold and silver are popular choices. Equally common are thenervous Nellies who invest too little. They have not fully acceptedthe concept of futures trading. If traders only stick one toe in the wa-
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ter, investing 1 or 2 percent of their risk capital, a doubling of theirmoney makes little impact.There are a number of formulas for selecting the proper riskcapital that should be devoted to high-risk investment opportunities. The following formula has proved to be effective.First, determine your net liquid assets (NLA). NLA include assets that are cash or can be converted to cash within 24 hours. Theseare savings accounts, CDs, common stocks, etc. They would not include real estate, life insurance policies, IRAs, etc.Once the NLA have been determined, no more than 10 percentof this capital should be earmarked for high-risk situations. Forexample, if an individual has net liquid assets of $50,000, the amountof investment capital will be 10 percent, or $5,000. This is the smallestinvestment recommended to a beginning commodity trader.Some informal studies have indicated that the larger theamount of investment capital placed in commodity trading, thegreater the chance for success. The rough percentages are as follows:With $5,000 in a commodity trading account, the probabilityfor success after 1 year is approximately 1 out of 10. With $10,000, itis 2 out of 10. With $20,000, it is 3 out of 10. With $50,000, it is 50 – 50.With $100,000, it is 6 of 10. Notice that the odds are stacked againstthe trader with less than $50,000 in an individual commodity trading account. This certainly heightens the importance of good money management techniques.The success ratio improves for two reasons as the investmentcapital available increases. The first is diversification. The moremoney in an account, the more markets you can test. The more markets you are in, the more likely you’ll be in a market that makes thebig moves.The second reason is staying power. If you have a very smallamount to invest, you may only have enough equity for one or twotrades. The odds get better of hitting a winner when you haveenough money to make 15, 25, or 60 trades.W. D. GANN MONEY MANAGEMENT ADVICE
W. D. Gann is one of history’s most noted Wall Street successes. During his commodity and stock trading years in the early part of thiscentury, he supposedly amassed tens of millions of dollars while
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documenting his trading techniques in a market newsletter and numerous books.He summarized his money management techniques for stocktrading into 24 rules. In the following pages, these 24 rules havebeen revised to apply to commodity trading.1. Determine the proper amount of capital to use. Divide theamount of risk capital that you are devoting to the commodities markets into 10 equal parts and never risk morethan one-tenth of this risk capital on any one trade.2. Use stop-loss orders. Always protect a trade with a protective stop.3. Never overtrade. One often makes this mistake after reaping a considerable profit from a recent trade. Overtradingalso occurs when a trader tries to recoup losses.4. Never let profit run into a loss. Once you have a profit, raiseyour stop-loss order so that you will not lose capital onthe trade.5. Never buck the trend. It is particularly important to knowthe trend of the market before you buy or sell.6. If you don’t know why you are in a trade or are not confident ofthe market’s direction, it is best to abandon your position. Never enter a trade when you are in doubt.7. Trade only liquid markets. Those are the active commoditiestraded. There are plenty of good, viable commodity markets you can trade that offer profit without your havingto go into left field and trying to trade the markets thatare thinly traded and dominated by commercial or localinterests.8. Diversify your risk. Trade commodities from variousgroupings (grains, meats, metals, financials, food andfiber) to balance your account. Try to avoid tying up allyour trading capital in one commodity or commoditygrouping.9. Trade only with market orders. Fixing a buying or sellingprice can be dangerous and should only be used whenyou have a specific purpose in entering a limited price onyour order.
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10. Don’t close out your trades unless you have good reason. Following the trade with a stop-loss order will protect yourprofits but will not allow you to exit the market on awhim. Let the market tell you what should be done. Ifyou are wrong, let the market kick you out by hittingyour stop.11. As you produce profits, place these profits into a surplus account to be used only in an emergency. This will help you toavoid becoming egotistical about your commodity trading and will discipline you to stay on the original trackthat you have set out for yourself.12. Never enter commodity trading for tax purposes alone.13. Never average a loss. If you have a loss in the market, donot increase the size of your position to lower your average loss. This is one of the worst mistakes a trader canmake.14. Do not lose patience in your positions. Don’t exit the marketsimply because you have lost patience or because you areanxious from waiting. (This is particularly true for options traders.)15. Avoid taking small profits and large losses.16. Never cancel a stop-loss order after you have placed it.17. Avoid churning your account. Avoid getting in and out ofthe market too often. Position your trades and stick withthem.18. Don’t be a one-way trader. Be willing to sell short just as often as you are willing to buy. Let your object be to keepwith the trend and make a profit.19. Don’t buy because you think the commodity is oversold or toolow, and don’t sell just because the price seems too high.20. It is dangerous to pyramid at the wrong time. The best timeto pyramid is when the commodity has broken resistancelevels and has become active. Treat a pyramided positionas a totally new position. If you would not buy if youdidn’t already have a position, then you should not bepyramiding the position. Remember that at the bottom ofall the great pyramids, there’s a dead pharaoh.
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21. It is best to pyramid on the buy side if the open interest hasdipped, and it is best to pyramid on the sell side after the openinterest has risen.22. Never spread off a loss. If you are in a loss position, get out.Do not spread the position and compound your error.23. Never change your position in the market without good reason.24. Avoid increasing your trading after a long period of success ora period of profitable trades.Besides money, another type of asset is just as vital. Only youcan manage “yourself” and function as a disciplined investor. To review, follow all the money management rules. Money at risk is, ofcourse, a very serious source of stress. If those rules are violated, following the other ones described below will not do you much good.Experiencing losses in the futures market is not failure. It’s the normal course of business. Don’t run your mind through the wringeron every trade. Once you make up your mind on a position, staywith it unless you uncover some overwhelming reasons to abort thetrade. Closely related is the ability to live with your trading decisions. You must accept full responsibility for them. At the same timeyou’re accepting responsibility for your actions, you cannot marrypositions. Stay impersonal. Be prepared to cut losing positions early through the use of stops. When you feel the market is draggingyou down, walk away for a while. Take a trading vacation.Take pride in yourself and your trading skills, but control yourreaction to success and stay humble. Pride often induces over, trading, which can result in serious financial damage. Maintain themaximum amount of self-discipline. Set concrete rules for yourselfand stick to them. Master yourself. Start a trade journal and includeremarks about your behavior. Then work at correcting any flaws.You must work against natural instincts to be stubborn, emotional,and inflexible. Find your character flaws and overcome them. Always be open and responsive to changes in the marketplace, particularly changes in the basic facts on which your decisions havebeen made. When necessary, change your mind and reverse yourposition. Eliminate all distractions. Never trade when you are physically or mentally not up to it or under stress from non-trade-related pressures.In summary, there are three areas of discipline every success-
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ful trader must master: (1) trading system discipline, (2) moneymanagement discipline, and (3) personal discipline.Discipline is training intended to produce a specific characteror pattern of behavior, or, more simply, controlled behavior. To besuccessful, it is important to train to do something as nearly perfectly as possible.Most traders lose what they gain through lack of commitment.Written goals, written plans, follow-up procedures—all are fine, butwithout wholehearted commitment they mean little.Studies seem to indicate there are a wide variety of systemsthat can make money in the markets. All trading systems have a fewfunctions in common. They give specific trade entry and exit signals, along with some type of a timing mechanism. Your function isto take the appropriate action. Discipline keeps you focused. Discipline also makes sure you do your homework updating the systemregularly, reviewing it, and following the signals.Money management is covered in W. D. Gann’s 24 moneymanagement rules. However, you need to be sure that you adoptrules applicable to your trading style. You need to put them in writing and keep them in front of you.The last area refers to personal performance. You must discipline your emotions—particularly your pride, greed, hope, andfear. These are the emotions that lead you back to your old losingways.HOW DO YOU STAY ON TRACK?
From here, you must develop specific strategies to accomplish yourmission. For example, following rules can be made easier if you seta firm schedule. Update and review charts daily by 7:00 p.m. everytrading day. Discuss markets with broker at 8:00 p.m. each night.Think about possible trading opportunities overnight and call broker in the morning to place orders. Update data and journal beforeleaving for work. Check the market at noon.You must back up your schedule with checklists, so nothinggets overlooked. It helps to match your homework with your personality. If you are not the type to do a lot of detailed numbercrunching each night, you need a simple system that doesn’t requireit. If you just don’t have any time, you shouldn’t be trading. Suc-
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cessful futures trading requires a lot of work. If you aren’t up to it,consider an alternative approach to the markets, like a discretionary,guided, or managed account.Homework includes the recognition of change and adaptationto it. Social and economic scholars have often observed that changeis drawn toward improvement, and the stronger the potential improvement, the more rapid the change. This Darwinism applied toeconomic considerations is usually played out in the marketplace.Over the last couple of decades of the twentieth century, therapid development of electronic trading has provided greater efficiency, market transparency, and speed to a wide variety of investors. The “vacuum” of demand has drawn financial firms to createInternet and other direct electronic methods of trading to many different types of markets.Rapidly expanding applications of the Internet are attractinginnovation and inspiring new ways of doing old processes. Certainly, if one defines an efficient market to be one in which the greatest diversity of participation in the creation of a price and this participation is inspired by a greater transparency of information, thenthe Internet and other electronic means of trading are revolutionizing the way investors trade markets.Until the past decade, futures trading was limited to the openoutcry system practiced in the trading pits of the futures exchangesaround the world. Traders stood in the pits on the exchange floorsin Chicago, New York, London, and other cities, frantically wavingtheir arms and shouting out their bids and offers. When the tradinghours ended, the action was over until the next day. However, thecreation of Globex, an electronic trading system, by the ChicagoMercantile Exchange in partnership with Reuters, the British newsagency and vendor, changed the complexion of the futures industry.Globex spawned other electronic trading systems at other exchanges, arousing the fears of exchange members who felt theirseats would be cheapened and their advantage in the trading pitswould be weakened. Partially because of those fears, electronictrading on the futures markets still hasn’t reached the point it has inthe equity markets, where individual traders can deal directlythrough their online broker. Nonetheless, electronic trading haschanged dynamically the way the futures markets are traded, andthe change will be even greater during the next few years.
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Despite the opposition, many futures market participants thinkthe days of the open outcry are numbered, mainly because the economics of electronic trading will prevail eventually. Created in 1971,Nasdaq was the first electronic equity exchange. Since then, otherstock exchanges around the world have either switched to electronic trading or set up electronic systems when they were formed.So far in the United States, electronic trading has been relegated to after-hours operations. In Europe it’s a different story. Futurescontracts on such exchanges as the LIFFE in London and MATIF inParis have switched to electronic trading, wiping out some openoutcry floor pits.Yes, Globex was the catalyst for electronic trading, shaking upthe traditional trading community and providing a glimpse of whatwas to come, but it was launched in the late 1980s, pre-Internet, pretechnological revolution. It was only an April shower before the deluge. The Internet was coming. The Internet and other online systems that have been spawned by the technological revolution of thepast two decades have turned the investing world upside down. Although the bids and offers are still sung out loud and clear in thepits of the futures exchanges, the wolf lurks nearby—computers inthe trading firms’ offices.The real impact has come in the amount of information nowavailable to a futures trader. Unlike the stock market where a tradercan register with an online broker and execute his or her trades directly online, futures trading online is still restricted to order entry.MANAGING INFORMATION
Futures traders, you may recall, can be defined as hedgers, speculators, and professional traders. Hedgers are mostly farmers, grainelevators operators, processors, packing plants—those who eithergrow or use the product. They use the futures markets for price protection, selling contracts to offset the material they are holding.Speculators are the traders who take up that hedge, buying or selling in the hope of making a profit. Professional traders may tradefor others, or be employed by a large brokerage firm, bank, or other institution.Traditionally, hedgers and professional traders have been seenas having an advantage over the speculator, because they have access to more resources and information. The Internet has leveled the
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playing field between professional traders and hedgers and thetypical speculator. Information is available via the Internet at littleor no cost that was once available only to the broker or professional trader at a high cost. Delayed price quotes and real-time newsare now offered free on many websites. Such websites as www.vtuniversity.com, www.smotass.com, and http://apollo.netservers.com/waldemar/f – main.html can provide a wealth of other sitesoffering futures materials.Your trading plan, which includes your objectives and tradingsystem, is your road map. All trading systems demand information.You must feed them their daily ration of prices, open interest, volume, or whatever they utilize. It is critical that this information beaccurate, timely, readily available, and reasonably priced. If not,your system cannot function over the long term.The computer axiom “garbage in, garbage out” applies to trading systems as well. If you don’t input clean, accurate data, you can’texpect reliable output.ONLINE CLASSES OF DATA
Futures (or stocks for that matter) price information is usually separated into three classes based on how and when you receive it. Youcan be online and receive “real-time” prices. These are prices thatare transmitted directly from the exchanges. They are sometimescalled tick-by-tick prices.To receive the online pricing, you have to pay a fee to the exchanges, as well as the monthly charge to your vendor. This service,depending on the bells and whistles included in the system, can runseveral hundred dollars per month. This price doesn’t always include the equipment, usually a personal computer.Additionally, you’ll need a communications link. This could bea satellite dish, dedicated telephone line, FM radio antenna, cableTV, or similar arrangement. Keep in mind that as long as the markets you are following are trading, your equipment is tied up.A less expensive variation of online services can be found inthe form of the 15-minute delayed price quotation services. Thesecost less because you no longer have to pay the exchange fees, whichcan run from under $10 to over $100 per month per exchange. If yousupply your own equipment, usually a TV set, these types of servicecan run less than $50 per month for individual investors.
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With online services, you also need to consider if and for howlong you are going to capture the data coming across the screen. Retaining the prices requires computer memory. Some systems are setup to capture and store data for the life of 30, 50, or 100 contracts.They send the price to memory every 5 minutes or every 15 minutes. Often you have a choice. Naturally, the more frequently yousave data, the faster the computer’s memory is filled up.The data saved can then be used to perform technical analysis.Most current price quotation systems include very sophisticatedstudies as part of their packages. When shopping for a system, findone that includes software with the appropriate analytic tools needed for the type of trading system you plan on trading. Several trading systems are available that might fit your needs.CALL-UP INFORMATION
Let’s say you can’t plant yourself in front of a monitor during trading hours, but your system requires you to review each day’s trading, tick by tick. You could utilize a call-up or dial-up service. Theseare computer service bureaus that sell you access to their databaseto retrieve whatever pricing data you want. Some will allow you toselect market by market, while others offer packages of 10, 20, 35, or50 markets.All you do, usually after 5:00 p.m. EST, is connect your computer through a modem and telephone line to their computer. Youpunch in your identification code and download the informationyou’ve agreed to purchase. You’re then billed on a monthly basis.The Internet also makes it easy to call up databases and retrieve suchinformation.Once you have the day’s data, you can study the informationat your leisure. You can combine the data with previously collecteddata to get the longer-term view or run your favorite technicalanalysis studies.HISTORICAL DATA
The least expensive pricing information is historical data. You canacquire these data on diskettes, or you can download them to yoursystem. With historical data, you can go back to when a contract or
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a market first began trading. System developers use this type of datafor evaluation purposes. They can use the data to hypothesize howwell a trading program performs over a wide variety of market conditions.
WHERE ARE THE DATA AVAILABLE?
Keep in mind that not all the services are reliable. Further, thechances for errors, human and mechanical, are compounded whenthe data are input from the pit to a computer, are repeatedly uplinked and downlinked via satellites, are uploaded and downloaded to computers, and finally are delivered to the users in a variety of formats.You have two basic sources: the full-service vendor and thespecialists. Your choice probably evolves around your use of data.If you’re just interested in keeping track of what’s going on,you might select a very general service. Yahoo, for example, provides some free financial information, as does AOL and other portals. Some of the vendors and wire services such as BridgeNews,Dow Jones, Reuters, and Bloomberg provide some free informationon their websites, but again, you have to pay for the more valuablematerial. Both prices and news may be limited and delayed unlessyou subscribe. In addition to futures prices, these services providestock quotes, news, weather, and even entertainment. There are specialized websites such as Pro Farmer and DTN/AgDayta, althoughtheir free information is limited.As mentioned previously, there has been a proliferation of Internet websites with futures information, much of it free, althoughthe more valuable sites usually require a subscription. The futuresand stock exchanges have a wealth of free information on their websites, including delayed quotes. Some exchanges are even offeringfree real-time quotes in select markets. Check your exchange website to see what is available.You can locate vendors and other information purveyorsthrough magazines such as Futures, which has an annual referencevolume, or on an Internet web directory. A search using the keywords futures or futures news information will turn up valuable information.
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KEEPING ABREAST OF TECHNOLOGY
It is not enough that you develop the disciplines for trading futuresand managing information from the investor perspective. You mustalso know what is taking place internally in the industry itself. Thatmeans you must watch what the exchanges themselves are doing toplay catch-up and what other pieces of the puzzle will be impactedfrom the massive changes now taking place. Be prepared to stopthinking national markets and start thinking global markets.
EXCHANGES
More and more firms are now offering two levels of order routing.One will go directly to the the floor and the other through the trading desk. Some brokerage firms won’t let customers enter morecomplicated orders such as options or spreads online because of thechance of confusion.Firms use the Internet to transmit orders in a variety of ways.They may link into the Trade Order Processing System (TOPS).This is a joint order-management system operated by the ChicagoBoard of Trade and the Chicago Mercantile Exchange. TOPS takesorders directly to the floors of the major exchanges and sends orderconfirmation and fill information back to the trader.The CME also has Universal Broker Stations (CUBSII) in thepits. They not only receive orders on a screen, but organize the order deck for the floor broker. Other brokers link directly into theGlobex system for immediate electronic order matching without using a floor broker in designated markets.Other brokerage firms want to keep control over their orders,so they don’t use TOPS or one of the other exchange systems. Instead, they have developed their own electronic systems to send orders straight to their floor staff.One sign that electronic trading is here to stay is the emphasisthe major exchanges have placed on after-hours trading. The benchmark after-hours trading medium is Globex (a division of the Chicago Mercantile Exchange). The first “after-hours” futures trading onGlobex occurred in June 1992. Via Globex, the online trader cantrade such futures and options markets as the S&P 500, Eurodollars,Japanese yen, Canadian dollar, Swiss franc, and many other cur-
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rencies, as well as the French CAC 40 stock index on the MATIF Exchange in Paris.The Chicago Board of Trade’s Project A allows the online trader to day-trade corn, soybeans, and wheat, as well as trade U.S. Treasury bonds, one of the most popular futures contracts in the world.Other U.S. futures exchanges, for example, NYMEX (the ACCESS system), also provide after-hours trading in futures marketssuch as crude oil, heating oil, unleaded gasoline, and natural gas.To obtain contract specifications on after-hours futures markets,as well as the times those markets trade, consult the exchanges’websites: www.cbot.com, www.cme.com, www.nymex.com, www.liffe.com, and www.matif.comIf you do trade after hours, you have to be aware of the liquidity in a market. Make sure it is adequate enough to ensure a goodfill. You also can trade markets that are not open after hours, but youwon’t get a fill until the open-outcry session starts the next tradingday. Volatility is typically less during after-hours trading, but not always. Try some basic trades when beginning. Save the more complicated trades for later, or go the route of the conventional broker.BROKERS
There is certainly no shortage of brokerages offering online futurestrading opportunities. As with all e-trading, you will have to determine which firms are reputable and responsive to consumer needs.To find an electronic trading broker via the web, simply useyour favorite Internet search engine and type in the words electronic futures trading or some