Professional traders approach trading in a different manner compared to the average person.   Professional traders approach trading in a similar manner to how a martial artist develops their skills as a fighter.  They first determine their trading doctrine, which is their overall approach to trading in the markets.  They then develop strategies in accordance to this doctrine in order to achieve long term success.  Finally, the professional trader develops tactics as a means of executing this strategy.

Most new traders simply learn a strategy or tactic without fully understanding the doctrine behind its development.  Without this knowledge, they will lose confidence in the strategy as soon as a losing streak occurs.  Professionals understand that losses are simply the cost of doing business as a trader.

DOCTRINE

Doctrine is simply a set of broad and general beliefs.  Different types of trading doctrines include trend following, arbitrage, fundamental valuation, etc.  The first step toward becoming a successful trader is to determine what trading doctrine is most suited to the individual.

An example of doctrine in the martial arts is the art of Taekwondo.  This discipline focuses on using the  feet as primary weapons, rather than the hand.  As a result, fighting strategies and tactics are developed to employ the feet.  This type of martial artist will try to keep the opponent at a distance where the feet can do the most damage with a variety of kicks.  On the other hand, a martial artist specializing in Wing Chun focuses more on use of the hands, and prefers to fight in close.

In trading, the individual must determine what type of doctrine is most suitable to their personality.  Are they able to withstand long losing streaks and trade as a trend follower?  Or, do they prefer analyzing supply and demand issues in an effort to determine the underlying value of a commodity or market?  For the purposes of this article, we’ll focus on the trend following doctrine.

Systematic trend following is the doctrine most commonly applied by the longest running commodity trading advisors (CTAs).  One of the most famous of these traders is John W. Henry, owner of the Boston Red Sox.   Henry managed client funds from 1982, until closing his shop at the end of 2012.  One of the largest CTAs in the business, Campbell & Company based in Towson, Maryland, currently manages assets in excess of $3 billion.  Campbell & Company has managed client assets since the early 1970s, and primarily employs trend following strategies to trade in the futures and currency markets.  Other notable trend followers include Richard Dennis and William Eckhardt, noted for their training a group of traders known as the Turtles, William Dunn, Ed Seykota, and Salem Abraham, to name a few.

Trend following when it comes to trading is simply buying high and selling higher, or selling low and buying back lower.   The idea is to exploit the few large trends in the markets that occur from time to time within the larger context of generating long term, positive absolute returns.   When the markets are not trending, these strategies tend to experience losses.  In an effort to generate more consistent returns then, CTAs will employ trend following strategies of varying length to capture long, medium and short term trends.

Trend following generates excellent returns over the long run, but it is a difficult strategy to employ for a number of reasons.  First of all, the majority of the trades end up as losses.    The typical trend following strategy will have only 30% to 40% winning trades.   This makes it psychologically difficult for most people to employ a trend following strategy.  Secondly, while most trend following strategies lose when there are no trends, they also lose when major trends reverse, since these strategies never exit positions at the absolute high or low of a long term move.  Finally, trend following strategies generally require a sizable amount of capital to trade using appropriate risk limits.  Trading this type of strategy with too little money increases the risk of ruin substantially.

STRATEGY

To gain an understanding of how trend following works in the futures markets, it is necessary to understand some of the concepts behind the doctrine.   These include some gaming concepts such as risk of ruin, probabilities and trading with an edge.

Risk of Ruin

In gambling, risk of ruin refers to the possibility that you will lose all of your money due to a string of losses.  For example, consider a dice game where every time we roll a 1,2 or 3, we win $2 for every $1 we bet, and every time we roll a 4, 5 or 6, we lose $1.  The odds are that after four rolls, we should be up $2, because we should have two winning rolls and two losing rolls.  Therefore, how much should we bet on each roll if we have $20 in our pocket?

While the odds of the game are in our favor, we can still lose all of our money.   For instance, if you had $20 and bet $10 each time, you only need to lose on your first two rolls and you are out of money.  The probability of this happening is actually 25%!

The larger the bet size, the greater the risk of ruin.  Risk of ruin will actually increase almost geometrically as the size of the bet is increased. This is why many gambling addicts lose.  They don’t understand this concept of risk of ruin.

Risk Management

Risk management simply refers to managing the size of market risk in order to continue trading through losing streaks.   In the futures markets, the markets usually move within choppy trading ranges.  These periods result in many losing trades for trend followers, no matter what method they use for entering positions.  Therefore, it is necessary to develop a risk management strategy that anticipates these losing periods in an effort to preserve enough capital to exploit a larger trend when it comes along.

Traders typically employ risk management strategies that are based upon portfolio size and the volatility within the markets they are trading.

Trading With An Edge

Trading strategies that work in the long run have what is known in gambling as an edge.  An edge refers to having a systematic advantage over an opponent.  Most games offered in a casino provide the casino with long term edge over its clientele.

In trading, an edge is an exploitable statistical advantage based upon market behavior that is likely to occur again in the future.  An edge is identified by locating entry points where there is a greater than normal probability that the market will move in a particular direction within the desired time frame.   These entry points are then paired with exit points that are designed to profit from the move in which the entry point is designed.

Trading system edges come from three components….Portfolio selection, entry signals and exit signals.  An example of a strategy that combines these three components would be a system that only trades an opening range breakout strategy in the S&P 500 if it is trading above its 20 day moving average.  It may enter the position if price breaks out above the high of the first 30 minutes of trading, and exit the position at the close of trading if the position is profitable.

Trend following strategies will come in different forms, such as the moving average crossovers, channel breakouts and pattern recognition.  In all cases, the idea is to exploit a trend of some duration.  Some strategies seek to exploit trends that may last a year, while others seek to exploit trends of much shorter duration, such as just a few days.  The strategies employed will generally be suited to the personality of the trader employing them.

TACTICS

Once the trader has developed his overall trading strategy, he needs to develop appropriate tactics for executing the strategy.  Tactics generally involve the execution of the trades themselves.  For traders who are managing many millions, it is necessary to execute the orders with extreme care in order to decrease the cost of slippage.  Smaller traders can often get away with simply using market orders when employing trading strategies.  However, large traders will often employ multiple order types, such as market and limit orders, and may often use several different brokers.

One tactic employed by the famous Turtle traders was the whipsaw technique.  The basic Turtle strategy was to trade breakouts.  These traders knew that a number of their trades would be false breakouts.  In other words, the market might breakout to a new high, but then quickly reverse.  So, in an effort to cut down on the amount of the loss, the Turtles would employ a technique where they would exit the position if the trade only moved a little bit against them.  For instance, if their normal stop loss was $2 below the breakout price, they would exit at 50 cents below the exit price, and continue to employ this tactic until the market finally continued in the direction of the breakout, or failed completely.

Another tactic employed by the Turtles was to enter positions in piecemeal fashion.  They might enter part of the position just below the breakout price, right at the price, and then a little bit above the price.  This would help them reduce their overall slippage, and would also help them anticipate breakouts ahead of other similar traders.

CONCLUSIONS

The professional trader approaches the markets with broad set of beliefs known as a doctrine.  Trend following is one such doctrine.  Within that doctrine is a trading strategy that provides the trader with a long term edge that allows them to profitable in the long run.  The trader will then employ a variety of trading tactics in order to execute that strategy.

The Turtles mentioned throughout this article were a group of traders trained in the mid-1980’s by Richard Dennis and William Eckhardt.  At the time, Dennis was worth well over $200 million.  Dennis and Eckhardt indoctrinated the Turtles with the belief that trend following can produce substantial profits in the futures markets.  They then provided the Turtles with strategies to exploit these trends, and taught then tactics to execute these trading strategies.

This is the basic process that every trader must undertake in order to experience long term success in the markets.  It may take years to go through the process, but it is absolutely critical to the potential success of the individual.