Learning From Our Best Trades
Please note: I will be discussing this topic in greater length during my Sunday evening podcast with Better System Trader live. You can use the link to sign up; the session will be held on Sunday, July 11th at 8 PM ET / 7 PM Central.
Since the writing of Trading Psychology 2.0, I have emphasized the importance of studying our best trades to identify "best practices" that are unique to our success. It is in combining these best practices that we become able to develop "best processes" that make us consistent in our performance. It's a great example of how our trading psychology follows from our development as traders: we become confident and consistent as we develop our talent the right ways.
Friday was one of my best days in the market in a while, so I thought I would share a few of the learning lessons reinforced by the day's profitability.
If you click on the chart above (screenshot from Sierra Chart), you can see how Friday morning's trade in the SPX (ES) futures evolved. We went into the day's session considerably oversold on short and medium time frames, but in an uptrend on longer time frames. For example, we closed on Thursday with fewer than 50% of SPX stocks closing above their 3, 5, 10, 20, and 50-day moving averages, but over 50% of stocks closing above their 200-day moving averages (data from IndexIndicators.com). Over the last two years, that has occurred 19 times, with 15 of those occasions closing higher five days later for an average gain of 1.74%. So we went into the session with possible upside edge. Interestingly, a pattern I had posted earlier in the week also suggested a multiday upside edge. So there's the first best practice:
Best Practice #1: Only go into a trade with a backtested edge and preferably more than one.
So, did I enter a long position at the close of trading on Thursday? Not at all. In the historical sample, there were a few instances of decent sized losing days. The backtest provides a worthwhile idea, but I want to see the idea playing out before committing my hard-earned capital! You can see from the above chart that we moved nicely higher in overnight trading, with transactions lifting offers (pink arrow). That means buyers are aggressive. With that price strength, we see the short-term moving average cross above the longer-term one on the Ehlers Adaptive Moving Average system (yellow arrow). This confirms we have moved to an uptrend. This leads us to a second best practice:
Best Practice #2: Wait for a good trading idea to turn into a good trade by getting confirmation from price action.
So, did I enter a long position on the moving average crossover? No, I didn't! Why not? It was between 2:00 AM and 2:30 AM in the morning and I was sleeping! Did I get frustrated that I had missed a signal, where the market continued rising afterward? Not at all. The backtested edge was over a multiday period, so my default entry mode was to buy the first short-term retracement in the market. That occurred a little before 6 AM ET (blue arrows). I entered a first clip of risk on the retracement and then added a second clip on the subsequent rise. The market was now going my way nicely and I set a stop where I had entered the first clip. That provided very good reward relative to risk, leading us to the third best practice:
Best Practice #3: Don't worry about catching highs or lows when you enter. Focus instead on inflection points that provide superior risk/reward.
As the stock market opened for the day on Friday, I noticed that advancing stocks were swamping losers by more than 5:1. The NYSE TICK was skewed toward upticks and, during the first hour of trading, we never saw significant levels of downticks. In short, buyers were solidly in control. I knew from my prior research that such strong openings out of oversold conditions often lead to upside trend days, as many short-sellers are stopped out and buyers jump back in. That gave me confidence to hold the position rather than take quick profits, setting up our fourth best practice.
Best Practice #4: Adjust your position sizing and holding period to evolving price action. A backtest and favorable price action will get you into a trade, but it's the subsequent price behavior that gets you to build your size and hold onto the trade.
Notice that I don't start the day looking for "setups". If there's no solid edge, there's no trading. And notice that I'm not concerned about "missing" or "chasing": I'm following the edge in the trade and the evolving market action. I don't get big in the trade until I see confirming evidence lining up. Finally, note that I'm not simply generating ideas from chart patterns or "macro" stories that link a limited number of data points. There's no guarantee that a pattern that has played out in the recent past will play out in the immediate future, but the alternative is to trade in ignorance of market history. That doesn't strike me as a rational and promising alternative.
Once you've identified your best practices, they can form the basis for a checklist that guides your trading going forward. Consistent profitability begins with a consistent process. Correcting mistakes can help us limit the downside, but it's by maximizing our strengths that we find meaningful upside.
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