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Hi,
This is a long email. For those who like to 'read'
pictures I suggest the delete key.
As a trader are you trying to be a master of the difficult or are your
hoping to become a student of the easy?
As your still with me, this email gives:
- a
possible explanation of why most (it is said 95%) traders lose
money,
- a
practical example of one of three trading styles that seem to account for
the
majority of the successful traders.
The approach taken is to suggest it is perhaps easier to make money as a
not too effective trader, trading an inherently highly profitable
approach, than to try to learn to be a highly tuned money-making-machine
using a hard to win at style of trading.
I repeat, as a trader are you trying to be a master of the difficult or
are your hoping to become a student of the easy?
Traders who regularly make money trading with the trend are rightly
applauded.
For it is a difficult task to master, and that is why such traders are so
are few in number and rarely make more than 50% per annum every
year.
Even a consistent 20% plus a year is impressive for such trading, and an
investment manager that can make a regular 20% plus a year with limited
draw-downs and is willing and able (psychologically) to manage other
peoples money will have many ready takers.
And deservedly so, for such managers are masters of the difficult and
deserve every penny they make.
Some manage a trend following trading style without much stress and good
luck to them. There are techniques that can catapult them to
lower stress, more regular and higher profits - for example risk of ruin
considerations and position sizing and service concepts.
The fact that most trading material that is written assumes that trading
with the trend is the only way to trade is to be expected as:
- it
is simple,
- it
meets instant gratification needs,
- it
is what the majority of new traders want to hear,
- it
is assumed to be the only way to go,
- many
of 'fundamental' based players are natural trend followers,
- a
majority of 'technical' based techniques are trend followers tools,
- most
like to be a member of the crowd,
- most
spend their lives seeking rather than offering service.
So most new traders try to trade this way, hoping to emulate the masters
of the difficult, but then most traders lose and drop
out. But still the 'penny does not drop' - and for
some, because of human nature, perhaps never will, at least in this
life.
Most successful traders, and certainly an overwhelming majority of those
that regularly make 50% or more per annum seem to mostly use one of three
trading techniques or variants or combinations of :
- spread
trading strategies,
- volatility
breakout techniques,
- market
making techniques.
This is because these trading styles/techniques tend to have lower stress
and are inherently more profitable - so a mere student of the easy can
often exceed the success of the masters of the difficult.
We will look at the spread trading concept - as it is simple to describe
and to give some examples.
Some of the biggest traders by capital employed are
spreaders. Arbitrage of index futures against the underlying
cash instruments is a example of spreading. Let us look first
at these traders.
Let us assume the fair premium of the S & P 500 future (based on
interest rates, margin requirements, dividend distributions, time to
expiry) is 4 points for 2 months to go to expiry.
Imagine that the index future stands at 6 points above the cash
stocks. An index arbitrageur will buy the cash stock
(probably via an ongoing arrangement with a pension fund) and sell the
futures to an equivalent value.
He/she will then pick up the two points discrepancy to fair value by
holding the cash and futures to expiry of the futures and sell the cash
stock back to the original owner at the going rate.
He/she will pick up a net, near risk-less, 2 points in 2 months less
annual fees to the stock lender for his trouble.
Only 2 points you say, in 2 months - not a good return.
But often the profit is on money borrowed for the purpose, and that 2
points in say 1,000 is worth having - on say, $500,000,000 of stock, as
it amounts to a million bucks.
Yes, this is not an untypical trade size for arbitrageur of this
kind.
Also, in practice the premium often varies from 2 points above fair value
to 2 points below fair value and back again many times in two
months. Often the swings available are much higher than those
in the example.
So our hero/heroine takes his/her four points (or more) often many times
in the 2 month period.
So now you know why the big guys get bigger - they take nearly risk-less
profits over and over again on their own and/or other peoples
money.
They get paid well because they provide a range of services:
- they
are low risk borrowers for the banks and pay interest on big
chunks
of money to the lenders,
- they
help keep the futures premium within reasonable bounds so more
near
a fair premium is paid by future traders,
- they
provide a large supply of future contracts when everyone is bidding
up
the price of the future compared to the cash index - that is when the
premium
is high,
- they
provide a large demand for future contracts when everyone is
selling
the future compared to the cash index - that is when the
premium
is low,
- they
help keep the market makers books more balanced and requiring
less
cash for their activities,
- they
permit big buy and hold institutions such as insurance companies
and
pension funds to earn extra stock lending fees to add to dividends,
- ...
But let us look at a more practical spread available to those only with
pennies a point (not $50,000 a point) to risk and available more than
once most weeks.
Imagine you have an account with an internet trader that allows you to
trade in 1 cent units on the S & P 500 and the DOW. Real
time prices, updated every 20 seconds or better is provided free - so
your costs are limited to your internet charges. This is all a
reality now.
You have analysed the relationship between the movements on the DOW and
the movements on the S & P 500. You believe they move in
a ratio of 7 to 1, 8 to 1 ... 12 to 1 - each traders perception is
different. Whatever works for you.
This morning they move out of line (according to your ratio) by 25 (or 50
or 100 or other parameter) DOW points. You buy the cheap one,
you sell the expensive one.
Your studies tell you that such a discrepancy unwinds within the
hour/day/week/month 30%, 40%, ... 90% of the time - every traders
time horizon and perception is different.
When it unwinds or reverses (another alternative view) you take your
profit. If the divergence gets bigger you take your
loss or increase your position - another alternative.
You find perhaps you can take the equivalent of 2 full S & P 500
points every day out of the market net of losses.
An example based, for simplicity on 25 points discrepancy and assuming a
10 to 1 ratio will perhaps help.
I am sure your research will verify that 10 to 1 is not appropriate, but
it makes the arithmetic easier.
The S & P 500 today is say at 1000.0 at open and the DOW is at 10,000
at open.
By 10:03 a.m. the DOW has risen to 10050 and the S & P 500 has risen
to 1001.5.
They have not moved in line and you feel the discrepancy is sufficient,
based on your research, to try and exploit.
You buy 10 cents a point of the S & P 500 at 1002.0 (including all
dealing costs), and you sell 1 cent a point of the DOW at 10046
(including all dealing costs).
Your spread is much lower risk than just buying 10 cents a point on the S
& P 500 or just selling 1 cent a point of the DOW as you have a
spread and they tend to move together.
The margin for this trade will be less than $10 (that is right ten
dollars).
Your margin is higher - you pay margin on both sides - helping to stop
you overtrading.
Your research is good and most of the time (your percentage from your
research) the two markets come back in line by the end of the hour/day
... and you unwind at
1019.5 and 10198 including all costs with the results:
profit
$0.10 x (1019.5 -1002.0) = $1.75
loss
$0.01 x (10198 - 10046) = $1.52
Net profit $0.23. Not bad on a low risk trade in a hour or so
and on a standard margin of say $10 excluding running profits or
losses.
Assume you have an account of $1,000 and so you are only trading (in
terms of the $10 margin) about 1% of your account size.
Sometimes, based on your research - you take a loss.
Let us assume that $0.03 average allowance for losses must be made for
each profitable event.
You have made $0.20 profit, (net of allowance for losses) on
$1,000.
Assume this is available just once each and every day and you trade 200
days a year.
Your yearly net profit is $40 or 4% per annum.
Let us assume that you can continue this profit profile over several
months, building confidence slowly to be able to trade 20 cents against 2
cents (assuming the mythical 10 to 1 ratio).
You are now making 8% per annum. You take the time to
back-test by hand (by hand for optimum confidence) using the free data
supplied by your internet dealer over 30 years of data to include a very
big up day and a very big down day.
Your confidence grows. You go, small step by small step to
trading $1 on the S & P against 10 cents on the DOW (assuming you
still feel 10 to 1 is the appropriate ratio) - 10 times your original
risk level - your daily standard margin (excluding running losses or
profits) is now about $100 - well within the original $1,000 account -
leaving lots of room for any sudden dramatic doubling or trebling or even
quadrupling of margin. You are not going to be in the class
of losers that get closed at a loss out because you run out of
margin.
You are now making a net $2 a day - $400 a year and 40% per annum profit
ignoring compounding. And low risk and stress-free
too. You are a student of the easy, not a master of the
difficult.
As often as your research tells you, you count your profit and assess
against five criteria:
- profit
percentage per unit time after allowing for occasional losses,
- net
reward per unit risk,
- net
reward per unit margin,
- the
stress level,
- actual
market behaviour against theoretical behaviour.
You find the first is good, the second outstanding, the third poor, the
fourth lower than you have ever known, the fifth to build your
confidence, give you early warning of changes in spread relationships,
and data to refine your risk of ruin calculations.
Why predict and invoke your ego?
Why emote away and suffer for it?
Why not provide service in this case:
- by
buying that index most oversold,
- by
selling that index most overbought,
so you do not self-sabotage as you know you have provided service and
profit is your due reward. You get to keep your
profit.
Good thinking leads to stress-free enjoyable and profitable
trading.
And a life outside of trading - and the money and stress-free existence
to enjoy it to the full.
Effortless and simple. Much better to be a student of
the easy than to try to be a master of the difficult.
Unconditional regards, Ric.
www.traderscalm.com
P.S.
There are many pairs of markets to spread, each with their own opportunities and risk profiles.
Sometimes you can spread the same pair of markets for a profit several times in the same day.
The possibilities are as large as your imagination.
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