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13. Make certain that you keep track of open orders.
14. If you are trading several systems or methods, then I strongly recom-mend keeping a separate sheet for each as well as a separate account. Itwill make your recordkeeping easier and you will always know how thesystem is doing. If you mingle trades from different systems it will bedifﬁcult for you to parse out the performance of the different methodsand you may have opposite trades in the same market which wouldcancel each other out.
Figure 19.2 gives an example of a completed trade log.
DIVERSIFICATION
If there is any one thing I can tell you that makes all the difference in theworld it is this:
Diversiﬁcation is one of the major keys to success in all trading and
investing.
The fact of the matter is that unless you diversify your trades you will bevery limited in the success you can achieve. What exactly is diversiﬁcation?The “old school” thinking on diversiﬁcation meant simply that you need tobe in a variety of unrelated markets as opposed to “putting all of your eggsin one basket.”
As an example, consider the following equity curve of a nondiversiﬁedtrading method in Figure 19.3. Note the lack of stability in performance aswell as the sometimes lengthy periods of decreasing net proﬁts.
EQUITY CURVE WITHOUT DIVERSIFICATION
Figure 19.4 shows an equity curve of my Grand Super System (GSS), whichis diversiﬁed on three levels (as discussed below). Note the signiﬁcant dif-ference between this curve and the undiversiﬁed approach shown above.
In reality things are not as simple as just one level of diversiﬁcation. The“Jake school” of thinking on this subject is that there are at least three levelsof diversiﬁcation. These levels are described in the following sections.
Diversiﬁcation across Markets
This level is the basic one and the application is simple:
Do not accumulate too heavy of a position in one market or in related
markets.
If you want to diversify the seasonal method, for example, trade one ofthe meats, one of the grains, two unrelated currencies, one of the interest
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FIGURE 19.3 Equity curve.
FIGURE 19.4 Equity curve without diversiﬁcation.
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Structure Your Trading Portfolio for Maximum and Consistent Gains
165
rate futures markets, one of the precious metals, one of the energies, oneof the interest rate futures, and the like. This approach will not weight youtoo heavily to closely correlated markets. In short, you will have balance,which will minimize losing streaks and sleepless nights.
Diversiﬁcation across Time Frames
This is a level that very few traders talk about. The fact is that some marketsare better for short-term trading while others are better for long-term orintermediate-term trading. Use the best market for the best time frame.
Diversiﬁcation across Trading Methodologies
Some markets are more suitable for trading gaps, while other markets arebetter performers with momentum divergence. Wheat, for example, is pri-marily a seasonal market. It should therefore be traded primarily with sea-sonals. Wheat is also a good long-term market that works well with theCOT approach discussed in previous lessons. Thus, you want to trade eachmarket based on its best methodology.
I believe that diversiﬁcation on all three levels will serve you best. Youdo not need a huge amount of money to do this. You can trade as few asthree markets using this approach. The next lesson will give you consid-erably more details about diversiﬁcation across time frames, markets, andmethods.
REVIEW
This lesson taught you the importance of organization and recordkeeping.While these are not nearly as exciting as trading is, the lack of an effectiveand organized recordkeeping system can cost you dearly both in errors aswell as in kissed opportunities.
Please take some time to answer this lesson’s quiz questions.
LESSON 19 QUIZ
Choose the correct answer.
1. Proper organization of your trades is:
A. A prerequisite to success.B. Necessary in order to avoid missing trades.
C. Helpful in keeping track of your performance.D. All of the above.
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2. Diversiﬁcation is:
A. A trading system that uses diverse indicators.
B. Necessary if you want to spread risk and smooth out performance.
C. Only used by hedgers.
D. Automatically accomplished by using gap trades.
3. When using your Daily Trade log keep a record of:
A. Only trades that get ﬁlled.
B. Market on close orders.
C. Stop-losses and trailing stop-losses.
D. All trades and all orders.
4. The three levels of diversiﬁcation are:
A. Setup, trigger, and follow-through.
B. Short-term trading, intermediate-term trading, and seasonals.C. Diversiﬁcation across markets, time frames, and trading methods.
D. MIT order, stop losses, and MOC orders.
5. It is best to segregate trades from different methods and systems into
separate accounts because:
A. It will help you keep organized.
B. It will help you keep track of individual system performance.
C. It will avoid accidental liquidation of positions based on other meth-
ods.
D. All of the above.
6. Which of the following trading portfolios are diversiﬁed?
A. Cattle, gold, and T-notes.B. Cattle, hogs, and feeder cattle.
C. S&P, soybeans, and cocoa.
D. Swiss franc, eurocurrency and U.S. dollar index.
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L E S S O N 20, D A Y S 25–27
Diversiﬁcation
I f there is anything in these lessons that I consider to be of the greatest
importance, it is diversiﬁcation. As I stated in the last lesson, your effortswill not be handsomely rewarded unless you are able to diversify yourtrading across time frames, across systems, and across markets. Whetheryou like it or not, this is a fact of market life. You may have been led tobelieve that if you become a specialist in one market, or in one system, thatyou will be successful. This is partially true. However, if the characteristicsof that market change or if the market loses its popularity for t technicalor fundamental reasons, then you are “up the creek without a paddle.”In the medical profession, a specialist can do very well without the fear ofbeing replaced. In trading, however, things are radically different. Naturally,opinions vary, but I have seen enough and done enough over my 35 yearsto know whereof I speak.
In the last lesson, I referred to the three levels of diversiﬁcation: di-versiﬁcation across markets, diversiﬁcation across time frames, and diver-siﬁcation across trading methods. I believe my approach to be very valid;however, the average trader has neither the experience nor the time to de-termine how to implement such a process. This lesson gives you some verypragmatic solutions to this issue.
THE BEST MARKETS FORTHE BEST TIME FRAMES
Some aspects of diversiﬁcation are obvious while others are not so simple.For example, it is very clear that the most volatile markets are also the best
167
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markets for day trading and short-term trading. Volatility creates frequentchanges and large price swings. Short-term traders and day traders thrive onsuch opportunities. Currently, the S&P, petroleum complex markets, somecurrencies and various U.S. and European interest rate futures offer thebest prospects in these time frames.
On the other hand, determining which markets are best for intermediateand long-term moves is not as simple a proposition. You need to take intoconsideration the so-called “trendiness” of a market as well as the stability ofthe market within its trend. You could conduct lengthy and time-consumingresearch, or you can take advantage of my research, which is provided inthis lesson. Some of the results may surprise you. For example, it turns outthat Standard & Poor’s is an excellent market for short-term trading as wellas an excellent market for long-term trading. However, it is not as good assome markets for intermediate-term trading.
In addition, the lean hog market emerges as a very good candidate forshort-term trading, contrary to what one might expect intuitively. The fullresults are contained in the synopsis of markets, systems, methods, andindicators discussed and summarized in the next section.
TYPES OF TRADING SYSTEMS
Figure 20.1 is a summary spreadsheet of markets, systems, methods, andindicators (which will be referenced again in this lesson’s quiz). It offers asummary of my views on which markets work best in which time framesand with which methods. In order to understand it, though, a few deﬁnitionsare in order.
The truth about trading is that the markets are not linear in terms of sys-tems and methods. That is, some markets are best suited for certain sys-tems while others are not. Wheat, for example, is a terrible market for anyshort- or intermediate-term trading system unless it is based on seasonals.The T-bond and T-note markets are excellent systems for volatility break-out methods. The energies are fabulous markets for seasonals as well astrend-following systems, breakout systems, momentum divergence, andseveral others. You would not know any of this unless you had consider-able experience or unless you have done considerable research.
Trend-Following Systems
Trend-following systems are essentially moving average–based systems thatattempt to enter markets after a new trend has started. Because these
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systems tend to enter after the start of a trend, they are generally low inaccuracy and all too often have numerous consecutive losing trades.
They are not the best systems you can use, but they do make money if
you can cope with low accuracy and large drawdowns.
Volatility Breakout Systems
Volatility breakout systems are based on the idea that markets tend to movein sideways patterns that, from time to time, break out in one direction oranother. These are generally good systems with higher accuracy.
Breakout Systems
Breakout systems are systems that tend to buy when prices have penetratedgiven resistance levels and sell when prices have penetrated given supportlevels. Depending on how they determine support and resistance levels,they can be very accurate systems.
Seasonal Systems
Seasonal systems use seasonality and timing. These are among the mostaccurate systems if used correctly.
Swing Trading Systems
Swing trading systems are generally short-term systems that attempt tobuy at support in uptrends and sell at resistance in downtrends. These areusually very good systems if they are based on valid and reliable trendindicators.
Divergence Systems
Divergence systems are based on divergence between prices and indica-tors. These are excellent systems for most markets if they are based onappropriate divergence indicators that combine effective follow-throughmethods.
Price Pattern Systems
Price patterns such as gaps, 30-minute breakout, the 8OC, reversals, andthe like are often excellent short-term methods if their logic is solid. Unfor-tunately there are many traditional price patterns for which validity has notbeen veriﬁed and which should not be used.
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Diversiﬁcation
171
Market Geometry Systems, Astrology-basedSystems, and Market Structure Theories
Market geometry systems such as Gann, Elliott, Fibonacci, and the like arenot reliable because they are often subject to numerous different interpre-tations. My advice is to steer clear.
Astrology-based systems should be avoided entirely. I see absolutely no
validity on these methods.
Market structure theories such as the Market ProﬁleTM or Liquidity BataBankTM have great potential, but they require serious study and analysisbefore they can be turned into objective trading systems. They are highlycomplex and beyond the scope of this book. There are other systems aswell. These, however, are among the most popular.
REVIEW
This lesson discussed diversiﬁcation and its implementation on three differ-ent levels. Now that you have been exposed to my views on diversiﬁcation,I advise you to review the methods and systems taught in the precedinglessons and to construct your own diversiﬁed portfolio. Remember thatyou can do this with as little as three markets and limited capital.
The lesson quiz that follows tests you on using the Market Systems,Methods and Indicators Spreadsheet in Figure 20.1 in at least eight marketsthat are good for seasonal trading while timing your ability to create adiversiﬁed portfolio. Let us see how you do!
LESSON 20 QUIZ
Instructions: Circle the correct answers.
1. Which of the following are correct?
A. Some markets work better in certain timeframes than in others.
B. S&P is a good market for day trading and for COT.C. Currencies are not good markets for short-term trading.
D. Wheat is a primarily seasonal market.
2. Astrology-based systems:
A. Are highly effective.B. Are not reliable based on my experience.
C. Only used by hedgers.D. Are best used with COT.
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3. Volatile markets:
A. Are good for seasonal trading.B. Are good for the Market ProﬁleTM method.C. Are good for day trading and short-term trading.
D. Are best for new traders.
4. Using the Market Systems, Methods, and Indicators Spreadsheet in Fig-ure 20.1, construct a diversiﬁed portfolio of four markets and list thembelow:————————————————————————————————————————————————————
5. Using the Market Systems, Methods, and Indicators Spreadsheet in Fig-ure 20.1, list at least eight markets that are good for seasonal trading withtiming:————————————————————————————————————————————————————————————————————————————————————————————————————————
6. Why is the oats market not suitable for day trading?
A. It is a new market and does not have enough historical data.B. It is primarily used by cattle producers to hedge positions.
C. It is not sufﬁciently volatile.
D. It only moves with the currency markets.
7. Using the Market Systems, Methods, and Indicators Spreadsheet in Fig-
ure 20.1, list a diversiﬁed portfolio using at eight markets:————————————————————————————————————————————————————————————————————————————————————————————————————————
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L E S S O N 21, D A Y 28
Putting It AllTogether
I f you have survived the last 20 lessons and learned from them, then I truly
believe that you have in your possession some of the most powerful toolsthat a trader can possess. These tools, combined with the discipline andconsistency that the setup, trigger, and follow-through structure provideshould bring you excellent results. I have spent very little time teaching andpreaching to you about the psychological and behavioral pitfalls that canlimit your proﬁts or, at worst, cause you to take losses no matter how goodyour systems, methods, or indicators may be.
This next-to-last lesson—which is not be followed by a quiz—will putthings together for you by giving you a list of dos and don’ts, not necessarilyin order of importance. If you adhere to the methods that I taught you inthese lessons, follow the STF structure, and observe and implement therules and procedures in this lesson, you will increase your odds of successdramatically.
WHY TRADERS LOSE
In my over 35 years of trading, teaching, and analyzing markets, I have hadliterally hundreds of opportunities to observe my mistakes and the mistakesof other traders. Human nature is a curious thing. It is at one and the sametime wonderful and sad. It is wonderful because we can do so much withour minds. It is sad because all too often our minds keep us from beingsuccessful. Here are some of the reasons that traders lose money in spiteof their otherwise good trading systems:
173
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Insufﬁcient starting capital. Too many traders begin with a very smallamount of capital and attempt to trade too many markets. Beginningwith a small amount of money and attempting to trade too many marketsis an invitation to failure.Lack of a system or method. This has been discussed extensively inpreceding lessons.Lack of organization, which causes traders to make impulsive decisions.Trading on the advice of a broker.Spreading a position to avoid taking a loss.Buying out-of-the-money options.Trading too often.Taking quick proﬁts and riding losses.Failure to maximize proﬁts on each trade.Using too many indicators.Getting trading suggestions in Internet chat rooms.Getting too many recommendations from too many newsletters.Adding to losing positions to average your cost.Pyramiding positions by adding larger numbers of contracts as pricesmove in your favor.Failure to know what kinds of orders to use and when to use them.Using stop-losses that are too small for the volatility in the market youare trading.Day trading for small proﬁts.Lack of a trading plan.Failure to follow the STF model.Impatience.Inability to follow a trading method when it suffers a few consecutivelosses.The mistaken belief that all trading indicators are worthwhile.Overoptimizing trading systems.Attempting to trade in too many time frames and in too many marketsat once.Playing with “scared money” (money you cannot afford to lose).Watching every price tick all day long.
There are probably even more losing behaviors those traders can engage
in, but I think I have covered the vast majority of them.
WINNING BEHAVIORS
As you can see from the partial list above, there are many things traders cando that will virtually guarantee them losses. The list of positive or winningbehaviors is a very short one. It is, nevertheless, a very important one.
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Putting It All Together
175
Here are the behaviors and procedures you will want to incorporateand internalize in your trading. They will not guarantee success but theywill facilitate it!
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Use the STF structure for all trades you make . . . orUse a totally mechanical trading system that uses solid rules not opento interpretation.Be totally organized, by which I mean know all your trades, all yourpositions, all your orders at all times.Learn what different order types mean and how they are used.Avoid broker opinions and Internet chat rooms.Play your own game unless you have a trading partner or partners.Avoid reading more than one or two newsletters or hotlines.Avoid day trading unless you can do it full time.Diversify your trades across time frames, systems, and markets.Plan your trades and trade your plans.Begin with sufﬁcient capital.Don’t overextend your margin.Be willing to accept as many as seven consecutive losing trades.Don’t trade more—trade less.Segregate your trades from different methods into