Description: Playing the game

Speculative strategy

     Learn the discipline to be able to be many times, and right once, yet be profitable.

     On beginning a new trade, a risk/time metric exists. A good trade almost immediately shows a profit, and then it continues that way. That is an ideal, but on ever starting any trade a participant is exposed to the fact that the market is entirely unpredictable. Price action can move against even the most excellent reasoning for an unknown period of time, which eventually forces the trade to close once the trading budget is exhausted, the only exception being when a defensive hedge (stop) is triggered. The risk/time metric is always there, and to prevent small losses turning into overwhelming losses, any trade must be insured.

     So beginning a new trade risks a specific amount of capital at the market, the limits determined by risk tolerance for trading budgets, until insurance kicks in by means of an option, a hedge or stop. With protection in place, usually only measured losses are likely, so when excellent reasoning is proved wrong by the market only the insurance premium is lost. Indeed the only measurable certainty is how much money you can lose, and you could lose all the money in the world to insurance premiums by continually risky trades beginning wrongly. Well, this essay is not just to investigate how to lose money in small amounts, but how to take profit when you get it right.

     Experimenting with properly beginning a trade is a combination of your choice of security, timing, volatilities and insurance. Initially there are two main outcomes: your trade is either proved right by the market, or proved wrong by the market. We can see that the speed at which the market shows its proof (I am told a wise economist always predicts tomorrow will be the same as today) depends on the volatility of underlying market action. A highly volatile market is quicker to show its hand than a less volatile market, but I suspect both are just as unpredictable.

     Then on beginning a trade, if you are proved wrong, you only lose your insurance premium because the market hits your stops, or you can exercise your options or some other hedging instrument. But if proved right, you can 'cover your costs' by moving your stop near to, or to the opening level... If the market later turns against you, you then lose nothing, but only confirm the lesson that the market is unpredictable.

     Well fantastic, but there's far more trouble ahead. With the crucial first discipline of risk management applied you can trade without losing all of the money in the world all of the time, but like a growing business other problems start happening. It makes it alot easier to begin right, but even if you get in a position supported by the market: How can you stay right? As the market gyrates, how do you protect against losses but also ensure some kind of profit on a trade? Essentially, how do you win? It follows that any trade is not only protected but there is also some "take profit" signal in mind. The target performance signal will perhaps become clearer as market action develops, but there is always risk that if you do not get a signal, then a high volatility market a little time later or a low volatility market a long time later simply reverses and removes you from the picture. Even though a "good decision" was made to begin with, you are only ever marginally profitable. You don't lose, but you don't win.

     Let's say your trading book shows a profit on a trade. With hedges ready you're unlikely to lose your trading budget. A relief indeed, but for how long can you stay with the market, undeterred by reactions and resistance, trying to outreason the unreasonable, until your trade achieves some target signal? A trend started in a day may end in a day. Reactions derived from only one event, like say one particular month's employment report, only last as long as that one event affects the market conditions. Some volatility comes through having in the past discounted the future (as it was then forseen in the past) until the actual conditions are confirmed or denied in the present. Then there may - or may not - be a correction of the past model, depending on risks with other random future conditions. The numberless forces behind volatility build or destroy random performance trends. Longer underlying trends are built up by event after event, each profile interpreted in some unpredictable way. So what I suppose is that finding profit targets has something to do with measuring volatility.

     It is interesting that it makes little difference whether you risk 100 or many mio when you begin a trade because every position suffers the risk/time metric: depending on your trading budget then risking more money of course means you lose more if you are wrong to begin with, but win more if you were right.

      So what is the way to win? At some point the volatile nature of the trade changes from protectionist to offensive. It does not do to risk a trade, protect yourself and then follow some random trend for a while, let alone a long while, only to find that the market reverses and reduces your many points profit all the way back to the few points you needed to use to protect yourself at the start of the trade. What would be the point of bearing the risk of trading if this happens? If you just defend then you won't grow your portfolio. It follows that like music or literature consider that a trade has a beginning, a middle, and an end.

      To win, the trade must be managed so defense becomes offense. Sounds a bit like American football, a good knowledge of the US national sport may be useful. We know one approach to offense is a performance signal, but an offensive is usually against the opposing team. So what about the guy on the other side of our trade? Well he has covered his risk almost immediately, or he has collected the spread between an opposite party (bringing together buyers and sellers). So either your trade is cancelled out, or hedged. If it's hedged then the hedgee is going to re-hedge with someone else as soon as it gets anywhere near uncomfortable. And that someone else is just as ready to move it on to another, and another and another, and so on, and just look which way the market's now going... and who knew? I think it follows that if you ever win big on a trade then the winning performance is actually going to be made up of lots of small losses from many others hedging the opposite side.

      So that's how opposing teams work, which I suppose has little impact on the approaches available for offense. Some of these are:

     1. Take many small profits yourself, hoping profitable trades outweigh losing trades.
     2. Add risk to those trades on random winning trends, imagining trends could continue.
     3. Roll stops, letting trends run until the hedge gets hit.
     4. Measure volatility, and when it rises or falls then if your trade shows a profit it's a take profit signal.

      It appears that the higher the quantity of positions you can begin and be sure to defend, the more chance you have of picking a winner. In a random portfolio some trades will turn out to be good. Conversely the higher the quantity of positions you begin, the more chance you have of losing, the many small losses turn into one large loss, destroying your trading budget. For any take many small profits strategy to work, you must have take profit signals further away from the initial market level than where you set your stops. Then in order to win at all, you have to hit as many profit targets as stops, which probably won't happen consistently in the long run.

      Tighter stops means less insurance bills, so more budget to get onto a winning trade, but things are still very tricky: let's say you open - beginning properly - a portfolio of 50 positions and you manage to get 20 positions defended. So on 30 you have to pay the insurance premiums, but on 20 you can cover your costs. The latter 20 now (probably) cannot lose. However, if you do not soon get offensive, there is every risk that at some point (perhaps even in a very long while), the market moves against your portfolio castle and kicks down the portcullis. Along with the insurance premiums you paid, each protected trade eventually makes no profit, for all your risk and hard work. Very amusing!

      So losing trades always expire in the moat of your well protected, but so far unproductive, financial fortress. How could you be less arbitrary and extend your offensive?

      With winning trades you carefully extend your protective stop orders, as if you were a Baron expanding his borders. But besides meaning a nobleman, the word Baron is latin for 'fool'... is just extending defensive positions really a successful offensive strategy? It is conservative, and attractive because you are beyond defeat. Growing hedges acts like defensive profit targets, and one does not exit from the market during any prolonged trend (and also cannot lose any money). Yet difficult problems remain, like just how much space do you allow for market reactions, and just when do you roll your stops? What if there is never any trend? It's disappointing to see a once good paper profit actually realised at a defensive level because the market chaotically reversed, and you never took a profit. Moving hedges is such a random strategy, and given the costs of all the sure loser trades taken to get things going, then by itself it will all probably amount to nothing. See On setting stops for some view on the experience of stops.

     So not setting stops is a losing strategy, as is never taking a profit. There is then a dynamic between the situations of defense and offense. With a profit signal you have taken the offensive, and potentially maximised the risk/return ratio of a trade. With rolling stops, you remain in the market until you are forced out by chance, but you have defended any small profit. The trick is how to play these two parameters, this might be the middle of the trade.

      A further offensive strategy is to pyramid trades in winning trends, if there are any. Every additional trade exposes your capital to the risk/time metric and the chance of a loss, requiring insurance, but then also the chance to profit on a trend that apparently exists. If you start using a small fraction of your trading budget you can watch the market prove you right or wrong with a small amount before you commit more capital to any trend. This is an offensive strategy with one great advantage: the market has already proved you right in the trade, at least - randomly - for a certain amount of time.

      With some trades sitting tight is easy. The market indicates you are right, and reactions are inconclusive. But markets are too volatile for these lucky trends.

      Finally, we have setting a take profit signal according to volatility rather than price. By knowing the general condition of the market when the trade was placed may help signal when to take profit, when the general condition changes. Then again, a change in conditions may go even further in your favour.

      Reviewing offensive strategies: We know we need offense because just leaving defences as they are will not make the distance in the long run. Extended winning trades are rare because reactions are often aggressive, so you have to attack in small steps to win. What we need is a mixture of defence and offence. Begin rightly, with small "indicative" trades. If any are successful, both roll the stops, add some risk, and set a volatility based profit taking signal, getting out when conditions change rather than at some random price level.

      In conclusion, the end to any DEFENSIVE trade is being wrong to begin with, or the market turning around and forcing closure. There could be one of three situations:

     1. an opening defensive play is breached, costing the insurance premium (trade loses).
     2. a protective defensive play is compromised at around breakeven (trade covers costs).
     3. an offensive defensive play is thwarted (trade makes small profit after rolling stops are randomly hit).

      The end to any OFFENSIVE trade is a market signalling a profit target, and this is in other situations:

     1. The market storms through a random profit target on some bizarre trend far higher or lower (big lucky profit).
     2. The market randomly hits a profit target before a reaction (profitable trade).
     3. The market just catches a profit target before reversing within some trading range (profitable trade).

      A trick of successful trading, then, is to separate defence from offense, and be ready to renegotiate new campaigns. It is like playing tennis or squash, where you ought never to play to 'no mans land' in the centre of the court. Defensive positions have to be defensive, until you can aggressively take the opportunity to make an attacking move. This means setting loose rolling stops that give the market the right amount of room for movement according to local volatility, before you decisively take some profit. But I cannot tell you what's a winning shot! A winning strategy is to serve well in the first place, meaning to begin rightly. Then play safe, waiting until your opponent makes a mistake you can take advantage of, meaning to pay the insurance premiums, but then watch for a change in volatility. Raising your stops to cover premiums or to take an experimentally offensive position too impatiently is like playing a dolly shot to the middle of the court. However not taking targeted profits is failing to take the advantage when you find yourself in a position to hit a winner. Finally, after one point is played the next point then begins. How do you master this? By playing the game...

     Lastly, like a sportsperson, consider the reasons which stop people from doing it "right" on the markets. Here's a brainstorm of quite a few contradictory problems. Enjoy!

     But also consider the reasons which allow the chance of doing the right thing. For me, things like:

     If you have enjoyed reading this, and have any comments, please get in touch!