The Holy Grail of Trading

This article originally appeared in FutureSource FastBreak October 20, 2006

You may view it here.

Many traders spend a great deal of time trying to find trading’s “Holy Grail.” In this search, they move from one system to another, trying to find that one magic formula. Does the Holy Grail exist? There are a lot of frustrated traders that would tell you no. I, on the other hand, believe that it does exist. But I also believe that most traders seeking it are searching for it in the wrong place.

Too many traders, especially those lacking experience, focus on finding that one magic formula that will give them precise entry signals. What they fail to understand is that the trade entry is not as important as the exit. Here is an example that I have used in various seminars. We have two traders, one is short the market, and the other is long. They both offset the same day, same time, and same fill price. They both recorded a profit on their trade.

This example is often met with quite a few blank stares. How can this be? The answer is the trader who offset his short position was short from a higher price, while the long trader was long from lower prices. The time frame in the example does not matter, it could be one day trader and one position trader, or both could be day trading or position trading. The traders could have gotten in on different days or the same day. The point shown in this example is the importance of the exit.

Here is a visual example of what I am talking about. The chart below is a daily chart of Dec 2006 Coffee. Let us assume we have two traders trading this market. On 7/27, Trader #1 buys on the close at 100.90. Trader #2 gets an entry signal and sells the open on 8/28 and is short from 109.30. Both traders offset on the close of 9/11 at 103.75.

Chart copyright 2006 FutureSource

Now let’s take a look at what happened. Trader #1 bought at 100.90 and sold at 103.75. This would be a profit of $1068.75. Trader #2 sold at 109.30 and 103.75 for a profit of $2081.25. Which is more important, the entry or the exit?

Let’s expand on this by examining the importance of discipline. I touched on this in my articles last month on money management, but we need to look at this in concert with the importance of the exit over the entry.

Trader #1 is using a method that provides him profitable trades 80% of the time, but all trades are only long. His average winning trade is $750 while his average losing trade is $1000. After 10 trades, he is net positive $4000. Trader #2 has a method that is only short the market. It provides profitable trades only 20% of the time. But his average winning trade is $4000 and his average losing trade is $500. At the end of ten trades he is net positive $4000.

Table 1

Trader #2 has a method that only wins two trades out of ten, yet he has a profitability that is the same as Trader #1, who is right more often that wrong. Let us assume that Trader #1 is trading with a counter-trend method and Trader #2 is using a trend following method. Which is better?

In the example provided, the answer is neither. They are the same. Both are the proverbial “Holy Grail” as they provided the traders the same profitability. The importance was the trader’s discipline to execute the method over time. They understood what the method was, what the probabilities were for the method, and they each believed they had a net winning method. With this in mind, they each put their plan into action. They never deviated from the method one iota. In the end, they both ended up winners.

Here is a take home quiz. Rank the following in order of importance:

a. The trading method

b. Discipline to stick to the method

c. Timing of trade entry

d. Exit signal (or stop)

Here are my answers, in order of most important to least important: A, B, D, C.

OK, I have to admit, I threw a curve ball into it. A was number one because for any of this to matter, the method has to be solid. If we were to make the assumption that the trading method was, in fact, a net winning method, then B would have been the most important. But no matter what, entry goes at the bottom of the list. It is not that it is not important, because it is important in broader scope. But when compared to the other items on the list, it comes in dead last. I hope you are beginning to see why.

Now it is time to tie this all together. The primary keys, or “big four,” we discussed last time were:

1. Appropriate Capital

2. Knowledge of the market

3. Money Management

4. Discipline

(Note: These “Big Four” were discussed in my previous article on money management.)

It takes intricate knowledge of the market to construct a method that will succeed over time. In order to do this, you of course must have appropriate capital and sound money management. Once all of that is in place, you must have the discipline to execute without variance.

How does the exit factor into all of this? It is the stop loss that is probably the most misused and misunderstood concept in all of trading. This is primarily due to the fact that, as I mentioned earlier, most traders focus on timing of trade entry but leave the exit to work itself out. Most people use an arbitrary number as a stop – $500 or 5% of the account are common, as are other figures.

To be effective, the stop must factor in the market swings relative to the trades time frame. A $750 or $1000 swing in the market that doesn’t change the outlook on the market is a recipe for disaster using an arbitrary $500 stop. Likewise, if the swing points are $250, why would you leave a stop at $500? The market picture would have changed drastically by then.

It is perfectly acceptable to have levels of comfort, such as a maximum dollar risk or a percentage of the account. In fact, it is necessary. This type of money management is actually critical to success, especially the percentage risk. It is designed to keep the trader from going bust. But these concepts must be used within the scope of the current market conditions and price levels. If the market swings are outside the maximum comfort level, then you need to move to another market or pass on the trade altogether. If the swings are inside the maximum risk, you should adjust accordingly from the arbitrary to the precise. In other words, make sure your stop makes sense within the scope of the market conditions.

Not to be overlooked within all of this is the profit target. And possibly more important than that, what do you do if the market gets there? Take profits? Trail the stop? There is no single correct answer. But there is an absolute to consider. What you do if the market gets to the target must fit in with all of the other concepts we have discussed.

The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.

The content of this article is Copyright © 2007 by Chad Butler. No part of this article may be reproduced in whole or in part without express written permission of the author.