Planning Your Trading: Part 2
In the first post in this series, we took a look at the importance of planning one’s trading and the kind of information that goes into a trader’s business plan. Specifically, we compared a trading business to a manufacturing plant, where trade ideas are the product. A variety of raw materials and processes go into generating that product and making it profitable. Your plan for your trading business is a road map that captures your “edge”—your unique advantage in markets—and how you will turn that edge into a profitable business.
No business can be successful if it does not possess a competitive advantage in the marketplace. Anyone can generate ideas to trade; the challenging part is manufacturing ideas that have a superior promise of profitability. For example, let’s say you notice stocks or commodities that tend to trend in price for long periods of time. If you could identify such trends early in their life, you could ride them for consistent profits.
When you start to develop trend-following as your potential source of edge, you quickly learn that you’re hardly the first to think of this idea. Many market participants are looking at price-based oscillators, moving averages, and chart patterns as a way of catching directional movement. If you’re hoping to build a business by following trends, you have to recognize that this is like wanting to start a restaurant in a neighborhood jam packed with eateries. With so many others competing in that space, what will make you stand out?
Clearly you have to do something unique, something different. If you were starting a new restaurant in a crowded entertainment district, you might begin by surveying people visiting the district and learning about their wants and needs. Perhaps they are looking for more than a dining venue: somewhere where they can also enjoy great music and drinks. That could lead you to open a very different kind of entertainment/dining destination.
Similarly, when establishing your edge in markets, you typically have to conduct market research: what patterns do you perceive that others might be missing? Where do you see unique market opportunity?
Let’s take a hypothetical example: suppose you examine trends in U.S. stocks and you notice that low-volume shares (those trading with recent volumes below their longer-term average) tend to have more durable trends than high-volume shares (those trading with volumes above their longer-term average). Indeed, after looking at chart after chart, you begin to detect a pattern to bull market moves: unloved stocks start to rise and gradually gain interest from investors, moving from lower volume to higher volume. Eventually they become very popular and trade with high volume, only to reverse when there are no more buyers left and early participants take their profits.
So now your job is to create a filtering system. You need to identify rising stocks that, during their rise, have shifted from low volume to higher, but still moderate volume. Perhaps there will be other elements in your filter as well, such as a strong fundamental story (rising earnings) or strong relative strength (outperforming an overall market or sector index). As you examine case after case, the winning and losing trade ideas begin to jump out at you. Now you’re not just trading a price trend: you’re using price, volume, and fundamental data to gain a sense for the supply/demand equation for each stock. Seeing more and more of those patterns makes you sensitive to new occurrences: gradually you become expert at identifying stocks that are gaining popularity, much as a fashion retailer becomes expert in identifying hot trends.
There are unlimited potential sources of edge in financial markets. In broad terms, traders refer to two types of competitive advantage:
- Fundamental: Gaining a superior understanding of macroeconomic data, central bank policies, geopolitics, commodity supply/demand, and/or company operations to assist in buying/selling decisions;
- Technical: Gaining a superior understanding of the supply and demand for a particular stock or trading instrument based upon how they have been trading (price movement, volume, volatility).
As a very broad rule, fundamental factors tend to be relevant and important to longer-term traders and investors; technical factors become more central for shorter-term and day-traders. If one’s average holding period is six months to a year, economic developments over that span become quite meaningful. If the holding period is six minutes to an hour, far less will have changed in the world’s fundamentals during that time to impact the trade.
We can also categorize sources of trading edge as:
- Directional: Based on whether we expect an asset to rise or fall in value over time;
- Relative: Based on whether we expect one asset to move a particular way relative to some other asset.
If we are trend-trading by buying the S&P 500 Index, that is directional trading. If we are buying the S&P 500 Index and simultaneously selling the Eurostoxx Index, that is a relative trade. In the first case, we make money if the S&P rises. In the latter case, we profit if the S&P is stronger than the Eurostoxx—even if both decline.
The key to success in any of these approaches is pattern recognition: Finding fundamental or technical patterns, directional or relative patterns, that have a positive expected return. Identifying patterns—and learning to recognize them in real time—requires a significant amount of time observing markets. Often, it also involves a degree of research, to test out one’s ideas and make sure they promise a genuine, valid edge. It is not enough to take someone’s word that a particular data release or chart pattern are bullish or bearish. Only first-hand observation and research can validate your ideas and provide a sound basis for your trading business!
In the next post in this series, we will take a look at how developing traders can turn a potential market edge into a viable plan for trading.