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Testing entries with random exits?
Paul King, March 27th 2007
There has been some recent discussion on the trading forums I frequently
read about random entries and exits. Here is my opinion on this subject.
I believe that an entry's predominant characteristic is setting trade
frequency and entering trades at times where there is the least chance of stagnation of price movement and most
chance of continuing high volume. This helps to minimize slippage and also reduces the chances of a "flat line" trade that
uses up capital, takes risk, and achieves no return.
If there is any predictive nature to entries in any market, one
has to think about the likely time period over which the entry pattern is predictive of future prices. If this time period
is shorter than the average duration of trades, it is practically insignificant to your overall trading results.
would/could consider trading a random entry assuming it was chosen from a liquid universe of instruments and I had the choice
whether to take the trade or not. I would never consider trading a random exit under any circumstances. This to me indicates
my beliefs about the relative importance of entries and exits. Other traders may have a different opinion.
to test an entry by using some kind of random, fixed-bar exit is not really representative of real-life trading. Further,
a fixed bar random exit basically takes unlimited risk between entry and exit - price could go anywhere and you would not
exit. This overestimates the returns of any trading method compared to "real" trading where one normally limits risk during
the trade in some way (unless you want to blow up your account at some point).
Broker selection, liquid instrument
selection, setup, entry, exits, and position-sizing all combine to create a particular instance of a trading system. In my
opinion setup/entry influence your trading results the least out of all components, but that doesn't mean they have zero effect.
Trade frequency is much more important in my opinion than some short-term predictive anomaly associated with an entry.
know this goes against the grain with most traders, but isn't that what the fabled "search for the holy grail" of trading
is about - finding so-called "accurate" entry signals? Since I believe that winning percentage is determined by exits not
entries, "accurate entry signal" is an oxymoron to me.
Testing trading methods as a consistent "whole" that most closely matches the way you are going to trade
for real is an effective approach that does not put too much or too little emphasis on any one trading component. My
trading system component model is a useful model, but it's not the only way to think about how trading methods fit together.
Examining the effects of changing individual components of a trading method often yields useful (and counter-intuitive) results.
Try reversing the side (long or short) of an entry signal for a compete trading system leaving everything
else in place, and see what effect that has on the overall expectancy of the system. The results may surprise you.
Not much time left over for blogging
Paul King, March 23rd 2007
As you may have noticed I haven't written a blog entry in a couple of weeks. I'd take it as a good
sign that I've been pretty busy recently. A few of the things keeping me occupied:
- Having surgery on my shoulder and recovering with physical therapy.
- Taking a trip to Boston.
- Having 2 articles published in Futures magazine.
- The release of my first book.
- Helping my financial advice clients.
- Working with a UK firm to develop a US equity trading long/short incubator hedge fund trading program.
- Starting a new trading discussion forum on this site
If things quieten down a little I'll be able to get back to the at-least weekly blog, but for now I'm just
happy to be busy on other things.
Keep checking back, you never know when I'll be able to start blogging again.
"Long Option" or "Short Option" trading program profile?
Paul King, March 6th 2007
It's been estimated that 80% of option contract expire worthless. Some people use this as evidence
that this kind of trading is a loser's game. But what if the other 20% of the option contracts expire so far in the
money that it more than makes up for the 80% losers?
This "long option" profile of many small well-defined losers, and a few outsized winners, is typical for
a trend-following trading program. Discipline to stick to initial stops keeps losers small. Trailing stops that
protect profits, but also let them grow big creates outsized winners when markets are trending.
A typical winning percentage is between 20% and 40% which means you have to endure the long slow torture
of "bleeding to death" when you go through a prolonged losing steak - even though each loser is relatively small. On
the flip side, you are not taking a significant risk of "blowing up" by having a losing trade that represents multiple year's
worth of winning ones.
The opposite side to a tend-following trading profile would be a "short options" profile to your trading.
This is characterized by a high winning percent due to lots and lots of small winners, but with a (perceived) small
probability of a catastrophic loss every time you trade.
Personally I believe that a well-defined profile of "bleeding to death" is far more psychologically manageable
than having to deal every single day with the possibility of giving up your last 5 years of profit (and maybe your initial
capital, and more besides).
The only difficult thing about trading with a "long option" profile is that the consistent, positive returns
with lots of winners of a "short option" strategy looks superficially way better than the "long option" strategy - but only
until you hit the inevitable "blow up" point.
Do you want the huge future price swings to be with you or against you?
Do you want to make money or feel good about your trading because you win a lot of the time?
Choose the trading profile you are designing into your trading program carefully.
Equity markets are not a "zero-sum" game
Paul King, February 26th 2007
Commodity futures are a zero-sum game. Each contract outstanding is between 2 counterparties, one
long and one short. Every dollar one makes is a dollar taken from the counterparty on the other side of the contract.
The transfers won or lost are applied daily in "real cash" rather than some intangible notion of value. When you
run out of cash and can't cover margin, your position is closed. Wealth is neither created nor destroyed in the environment,
simply transferred. When trading costs are included it becomes a negative-sum game overall.
Equities, on the other hand are not a zero-sum game. If there is no short interest in an equity, and
it makes a new all-time high, every single holder has a profitable position. This is "equity" that did not exist before,
and has not been taken out of someone else's trading profits. It has simply been "created" by the price going up due
Because there is no physical constraint on how much prices can move up or down (for individual equities
anyway) this leads to an environment where trends can, and do, build up significant "momentum" that is far removed from any
"real" concept of value. We call this a mania and it's what profitable trend-following is all about capturing.
The reverse is true in a panic which is simply a mania in reverse.
What practical applications does this have? Consider these:
- Trends can and will travel farther, and persist longer, than any financial model anticipates.
- Always position-size so that when prices go into a mania or panic you don't blow up your account.
- Always assume current volatility is low compared to what it could be tomorrow.
- Never believe a price has "gone too far" and will "revert" to some kind of "mean".
Where is it specified that equity markets have to be "mean reverting" anyway?
The PMKing Trading Forum is launched
Paul King, February 21st 2007
Due to the release of my first book, The Complete Guide to Building a Successful Trading Business, I've been getting more questions and comments from people than usual (all positive so far I'm pleased to report :-).
I anticipate that many of your questions are going to be repeated, have lots in common, and be interesting to all my customers,
clients, and trading friends.
Therefore, I have decided to launch a trading forum where everyone can ask any questions they like about me, PMKing Trading,
The Complete Guide, our other publications and services, or anything else about trading you think I may be able to help
Obviously I have limited time and resources like everyone else, so I can't promise any kind of "turnaround time" or "service
level agreement" for responses, but I will try my best to answer any questions people have that I feel will be of benefit
to everybody. The needs of my paying clients will always come first, but I am hoping to be able to respond on the
forum in a timely manner (I can type pretty fast :-).
Happy trading and I hope to see you online soon.
Book Review: The (Mis)behavior of Markets, by Benoit Mandelbrot
Paul King, February 12th 2007
Occasionally I come across a book, article, or other publication that makes me think "I wish I'd read this
when I first started trading". The (Mis)behavior of Markets is a good example of this kind of book, although I suspect
that if it did exist when I started trading I would not have properly understood the implications of what Mandelbrot was saying.
Now I do understand, and it was a confirmation of some of the conclusions I had already come to by trial,
error, losing money, and a lot of research and deep thinking. Reading this book has helped me formulate my own "Stochastic
Price Change Model" which will be the subject of a future eBook or article and has helped me reach a different perspective
on how to more effectively test the robustness of trading methods.
You may have heard of Mandelbrot from his work on fractals, and in this book he applies that mathematical
model to explain exactly why all the existing financial models (the Black Scholes Option Pricing and the Capital Asset Pricing
Model to name but two) are not as useful as they are touted to be, or just plain dangerous.
"Prices are normally distributed", "fat tails are simply anomalies", "prices are independent of
each other". These are all fundamental assumptions of the mainstream models of the market and of risk taking.
Mandelbrot challenges all these assumptions and presents a more useful (or at least accurate) fractal view of markets which
may change your perception on how much risk you are really taking and how likely "unprecedented" events may actually be.
I immediately put this book on my trading "must read" list. The implications of what it discusses
will continue to be influential in my own trading and my trading beliefs in the future. Read it with an open mind and
see what happens.
A simple percent-based stop is not adaptable enough
Paul King, February 9th 2007
Having an exit point before you enter a position is a very important aspect of trading but simply
using a certain percentage loss to determine where to get out is not the best method.
Consider the situation where you use a, say, 20% change in price as an exit point. For a position
that moves about by 1% per day, a 20% stop loss represents about 20 days "worth" of movement. If you have another
position that moves by 0.5% per day then a 20% stop loss represents 40 days "worth" of movement. You are actually taking
different amounts of risk in both positions because they have different daily average daily movement, or volatility.
Maintaining constant risk across all positions helps to minimize the variability of your results, so having
a volatility-based exit point rather than a fixed percent is more effective.
A reasonable way to estimate volatility is to use the average true range (ATR) over a recent period as a
proxy for current volatility. You could simply use the high minus the low as a guide, but True Range takes into account
gap openings too. You can then use a fixed multiple of the ATR to use as your exit point.
In the example above it would mean that the stop for the position that moved 1% per day, would be twice
as far away as the stop for the position that moved 0.5% per day. This would mean that you should have a position half
the size in the higher volatility instrument. In this way each position in your portfolio would be taking the same amount
of risk, with the same probability of being stopped out. This helps makes your results more consistent and less volatile
than a fixed percent stop would.
The Complete Guide is now available
Paul King, February 6th 2007
The first edition of my book, The Complete Guide to Building a Successful Trading Business, is
now available from my print-on-demand publisher Lulu.com. For less than twenty dollars you can get a detailed outline
of mostly everything I've learned building PMKing Trading over the last 5 years. Not a bad deal really!
I have articles in the February and March issues of Futures magazine that are adapted from the book just
in case you want to check out my writing style before buying.
The book should be appearing on major online booksellers over the next few weeks, but right now, Lulu is
the only place you can get it. Thier innovative and creative publishing model minimizes time-to-market and maximizes
the author's revenue, so that's why I'm able to sell it for less than twenty bucks, and also publish in paperback immediately.
Buy and hold is an optimal strategy, but not for you
Paul King, February 2nd 2007
Most of the mainstream financial advisers tell people 2 main things about investments:
- Market timing is impossible
- Buy and hold is the only sensible investment strategy
These two beliefs basically get people to be 100% invested at all times and hold on for dear life whatever
happens while their "investments" go down the toilet. The interesting thing is that this is an optimal strategy
for investments; not for the clients, but for the businesses that manage your money.
If you are making money by charging, say, a 1% per year asset management fee, then the best way to make
the maximum fee is to have all your clients (as a group) take the maximum possible risk with their cash. The way to
take maximum risk with your cash is to be fully invested and have no "uncle point" when you will take your losses.
This means that some clients may make huge returns, some may lose all their investment, and some may make
or lose a little. Overall you will maximize the asset management fee and have to find new clients to replace the ones
who do lose all entire investment. This is a very similar model to the life insurance industry that can set premiums
to make sure they collect in more than they have to pay out based on an actuarial analysis. They don't care or know
when each client is going to die, but they do know how many are likely to die over any given period of time.
The same goes for a large collection of clients with an asset management fee model. The company has
no idea which clients will lose it all, just that for the lost asset management fees on the ones that "blow up" should
be compensated for by the ones that have lucky high returns. Overall they are simply maximizing their fee by maximizing
the total risk taken across all clients collectively.
So, if you have "investments" with a compmay that uses a simple asset management fee compensation model,
you'll now know exactly why they are telling you to be fully invested and hold on for the long term rather than actually helping
you limit your risk (by having an exit strategy); it's in their best interests.
If you want a model that aligns the company with the investor then you need some kind of shared profit model
which is not allowed by SEC regulations unless you are an accredited investor with a high net worth investing in a hedge fund.
My advice: make sure you have an exit strategy that limits your risk for all your investments so you
don't become part of the collective herd maximizing the asset management fee for your financial company.
Trading in the now
Paul King, January 25th 2007
easy to get sidetracked with trading and go down the “prediction path”.
Nothing in good trading has to depend on predicting the future. Everything
can be about using the past as a reasonable indicator of what to do in the present and letting the future take care of itself.
you consider a good trade right now could be based on an analysis of past data on the assumption that the present will
be similar to the past; at least for the duration of your trade.
to determine that now is a good time to enter a trade to maximize the chances of a position moving (but not necessarily in
your favor) could be based on recent volatility and what is happening right now.
when to enter the trade is also about what is happening right now.
position size to enter should be based on your tolerance for risk (right now) and your current account size.
you would exit your trade (winning or losing) should be based on what price is right now relative to your entry point.
all cases your decision are made based on historical data as an indication or proxy of what “normal” looks like,
and what is going on right now. Nothing is about what will, might, could, or
should happen in the future.
advice: Forget about the future, minimize your reliance on data from the past, and start trading in the present. A lot
of the problems associated with your trading overall may start to diminish if you attempt to identify and remove "prediction-based
beliefs" from your trading methods.
Procrastination can be very destructive
Paul King, January 17th 2007
Procrastination; just not getting things done, finding an excuse to do something
else, never reaching an answer, simple laziness. There are many types of it and all of them can lead to the same result:
You don't meet your objectives. This is, assuming that procrastination hasn't prevented you from even thinking about
and writing down your objectives. If you don't have any objectives you don't need to worry about not meeting them do
Procrastination takes many forms, some more subtle than others, and the key thing is to find out the reason
behind the procrastination. If you haven't written down objectives for your trading why not? What's stopping
you? If something else is always more important then maybe you're not that committed to trading.
If you seem to be in an endless loop of learning and "evolving" your trading towards that "perfect" system
(that doesn't exist by the way), then what's holding you back? Are you afraid of failing if you actually do some trading
and it turns out to be bad? Are you comfortable risking the cash in your trading account?
If you've found time to research, develop, and test a suitable trading method that fits your personality and
meets your objectives, what's stopping you implementing it? Are you trading with money you can't afford to lose?
Do you fear failure? Do you fear success? Do you prefer to stay in your comfort zone where you have a beautiful
tested trading system that you don't want to subject to the stress of trading real money in case you find out the system (or
worse still, the trader) is a total loser?
The objective of trading is to make money within your tolerances for risk. The only way to achieve
your objectives is to actually trade and take risk. If procrastination is stopping you from doing any of these things
then it's time to sit back and think about why you are really sabotaging your trading by failing to make decisions that get
you closer to your goals. Only you can stop you from procrastinating but that also means that you are the only thing
between no trading method and a successful one.
Stop reading this blog and nodding now and go do something that's useful
to meeting your trading objectives.
Brief update and other excuses
Paul King, January 14th 2007
It's been a couple of weeks since I posted to my blog and I thought it was
time to give a brief update about what's been going on and also my various excuses for not posting sooner.
As well as the normal Christmas and New Year stuff, I've had a Birthday that's rapidly approaching 40, and
also had surgery on my right shoulder to stabilize it due to a recurring disclocation problem that started with a nasty fall
ice skating in Central Park a few years ago. Life with a sling on your right arm is interesting - who knew putting one
your own socks was such a tricky maneuver?
As well as all that, I had a total computer meltdown of the hard drive (and backup drive) of my primary
trading computer. That can be a good stress test of your contingency plan. All is back to normal now but not without
a stress test of my patience too. I hope you all have a good contingency plan in place for your trading for that kind
of problem that absolutely can't happen.
Business related items are listed below:
- PMKing Trading has moved office (I know, when did I find time to do that too?) Our new address is 5
Park Street, Suite #2, Middlebury, Vermont.
- I recently signed a contract with a UK firm to start and manage a US-based incubator fund. The "place
holder" web site is at http://www.emblumoven.com. More details to come when I have them.
- I have finished my first book "The Complete Guide to Building a Successful Trading Business". If you
can't wait until global distribution is approved and want a pre-release copy right now please contact me.
- I have another article in the February 2006 issue of Futures Magazine and this one is about exits which are
the most important aspect of trading (after position-sizing) so try and check it out.
Normal blog entries should resume as soon as things are back to normal round here (whatever that means).
I hope you are all having a successful and prosperous start to 2007.
Product Review: Why Traditional Technical Analysis Doesn't Work from InvestorFLIX
Paul King, November 15th 2006
In this 1 hour DVD by
Grant Noble, there are some useful ideas about why traditional technical analysis doesn't work. The presentation is
10 years old, and the main body of what is presented isn't that useful, but there are two main ideas that are definitely worth
thinking about. These are:
- All charts should be adjusted for inflation and base-currency rates
- Technical analysis applied to fundamental data can be effective
whole presentation lasts for about an hour and doesn’t once mention position sizing or exits in much detail although
he does say that knowing when to take profits is a key part of trading, but doesn’t go on to say how you should do it.
beliefs that are prevalent through the whole talk are that a) off-floor traders have huge trading implementation expenses
to contend with and so must trade longer-term than floor traders and b) successful trading is all about making accurate predictions and having effective entry signals.
quirky idea is that it’s OK to have 12 or so indicators in your trading so you aren’t dependant on any one indicator
being right. Which 12 to use is not covered and nothing is stated about what
to do when they all contradict each other.
discussion of historical cycles in the S&P 500 makes the normal mistake of “spotting” a pattern that has only
occurred 3 times over the last 150 years and extrapolating from that what will happen in the future.
haven’t read the book that Grant touts in the presentation (saying that this presentation is not a commercial)
and I don’t feel inclined to after watching this talk.
advice is to think about adjusting your charts for inflation, and possibly using some technical analysis techniques on non-price
data. These may both be areas for useful research, but you don’t necessarily need to watch this presentation to find
Read our other InvestorFLIX reviews here
Paul King, November 9th 2006
It's not very often nowadays that I get to add a book to my Trader Recommended Reading
List (details here) but John Carter's Mastering the Trade is one of the best trading books I've read in a long while. John is
obviously an experienced trader who "walks the walk" and doesn't just "talk the talk".
The sections of the book on trader psychology, markets, hardware and software and
business planning are well-written, informative, humorous and easy to read. If I had a criticism it would be that a
large portion of the book is dedicated to intra-day and short-term specific setups for trades and I suspect these were included
because the publisher said "that's what traders want to see" rather than dealing with complete trading system concepts including
position sizing and exit strategies.
If you are looking for some ideas for useful intra-day setups, then this section
will be ideal. As with most trading books this one skirts round position-sizing and exit strategies when it is talking
about specific trading "systems".
Overall a worthwhile read, although I would recommend waiting for the paperback
version (assuming one is released eventually) since the $55 retail price is too expensive. Even the discounted Amazon
price is still too high for the casual reader in my opinion.
Q4 2006 Blog
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