EXERCISE: LEARNING TO TRADE AND EDGE LIKE A CASINO’ Flashcards
(117 cards)
1
Q
The object of this exercise is to convince yourself that trading is just a simple game of
A
probabilities
(numbers), not much different from pulling the handle of a slot machine.
2
Q
At the micro level, the
outcomes to individual edges are
A
independent occurrences and random in relationship to one another
3
Q
At the macro level, the outcomes over a series of trades will produce
A
consistent results
4
Q
From a
probabilities perspective, this means that instead of being the person playing the slot machine, as a
trader, you can be the casino, if:
A
- you have an edge that genuinely puts the odds of success in your favor;
- you can think about trading in the appropriate manner (the five fundamental truths); and
- you can do everything you need to do over a series of trades. Then, like the casinos, you will own the
game and be a consistent winner.
5
Q
SETTING UP THE EXERCISE
Pick a market.
A
options trading
6
Q
Choose a set of market variables that define an edge.
A
This can be any trading system you want. The
trading system or methodology you choose can be mathematical, mechanical, or visual (based on
patterns in price charts).
7
Q
It doesn’t matter whether you personally design the system or purchase it from
someone else, nor do you need to take a long time or be too picky trying to find or develop the best or
right system. This exercise is not about system development and it is not a test of your analytical
abilities.
A
In fact, the variables you choose can even be considered mediocre by most traders’ standards,
because what you are going to learn from doing this exercise is not dependent upon whether you
actually make money.
8
Q
If you consider this exercise an educational expense, it will
A
cut down on the amount of time and effort
you might otherwise expend trying to find the most profitable edges.
9
Q
Trade Entry
The variables you use to define your edge have to be
A
absolutely precise
10
Q
The system has
to be designed so that it does not require you to make any subjective decisions or judgments about
A
whether your edge is present.
11
Q
If the market is aligned in a way that conforms with the rigid variables of
your system, then you have a trade; if not,
A
then you don’t have a trade. Period! No other extraneous or
random factors can enter into the equation.
12
Q
Stop-Loss Exit.
The same conditions apply to getting out of a trade that’s not working. Your
methodology has to tell you exactly how much you need to
A
risk to find out if the trade is going to work.
13
Q
There is always an optimum point at which the possibility of a trade not working is so diminished,
especially in relationship to the profit potential, that you’re better off
A
taking your loss and getting your
mind clear to act on the next edge.
14
Q
Let the market structure determine where this optimum point is,
rather than
A
than using an arbitrary dollar amount that you are willing to risk on a trade.
15
Q
In any case,
whatever system you choose, it has to be absolutely exact, requiring no
A
subjective decision making, Again, no extraneous or random variables can enter into the equation.
16
Q
Time Frame. Your trading methodology can be in any time frame that suits you, but all your entry and
exit signals have to be done on
A
same time frame.
17
Q
For example, if you use variables that identify
a particular support and resistance pattern on a 30-minute bar chart, then your risk and profit objective
calculations also have to be determined in a
A
30-minute time frame
18
Q
However, trading in one time frame
does not preclude you from using other time frames as
A
filters.
19
Q
For example, you could have as a filter a
rule that states you’re only going to take trades that are in the direction of the
A
major trend.
20
Q
There’s an
old trading axiom that “The
A
trend is your friend.”
21
Q
“The trend is your friend.” It means that you have
A
a higher probability of success
when you trade in the direction of the major trend, if there is one
22
Q
“The trend is your friend.”
In fact, the lowest-risk trade, with the
highest probability of success, occurs when you are buying
A
dips (support) in an up-trending market or
selling rallies (resistance) in a down-trending market.
23
Q
To illustrate how this rule works, let’s say that
you’ve chosen a precise way of identifying support and resistance patterns in a 30- minute time frame
as your edge. The rule is that you are only going to
A
take trades in the direction of the major trend.
24
Q
A
trending market is defined as a series of
A
higher highs and higher lows for an up-trending market and a
series of lower highs and lower lows for a downtrending market.
25
The longer the time frame, the more
significant the trend, so a trending market on a daily bar chart is more significant than a trending
market on a 30-minute bar chart. Therefore
the trend on the daily bar chart would take precedence over
the trend on the, 30-minute bar chart and would be considered the major trend
26
To determine the direction of the major trend, look at what is happening on
daily bar chart.
27
To determine the direction of the major trend, look at what is happening on a daily bar chart. If the
trend is up on the daily, you are only going to
look for a sell-off or retracement down to what your edge
defines as support on the 30-minute chart. That's where you will become a buyer.
28
On the other hand, if
the trend is down on the daily, you are only going to look for a
rally up to what your edge defines as a
resistance level to be a seller on the 30-minute chart.
29
On the other hand, if
the trend is down on the daily, you are only going to look for a rally up to what your edge defines as a
resistance level to be a seller on the 30-minute chart. Your objective is to
determine, in a downtrending market, how far it can rally on an intraday basis and still not violate the symmetry of the
longer trend.
30
In an up-trending market, your objective is to determine
how far it can sell off on an
intraday basis without violating the symmetry of the longer trend.
31
. In an up-trending market, your objective is to determine how far it can sell off on an
intraday basis without violating the symmetry of the longer trend. There's usually
very little risk
associated with these intraday support and resistance points, because you don't have to let the market
go very far beyond them to tell you the trade isn't working.
32
Taking Profits. Believe it or not, of all the skills one needs to learn to be a consistently successful
trader, learning to take profits is probably the most difficult ____
to master.
33
A multitude of personal, often
very
complicated psychological factors, as well as the effectiveness of one's market analysis, enter into
the equation.
34
There is a way to set up a profit-taking regime that at least fulfills the
objective of the fifth principle of consistency ("I
pay myself as the market makes money available to me").
35
If you're going to establish a belief in yourself that you're a consistent winner, then you will have to
create experiences that correspond with that belief.
36
If you're going to establish a belief in yourself that you're a consistent winner, then you will have to
create experiences that correspond with that belief. Because the object of the belief is
winning
consistently, how you take profits in a winning trade is of paramount importance.
37
You would have to be an
extremely sophisticated and objective analyst to make the distinction between a
normal retracement,
when the market still has the potential to move in the original direction of your trade, and a retracement
that isn't normal, when the potential for any further movement in the original direction of your trade is
greatly diminished, if not nonexistent.
38
If you never know how far the market is going to go in your direction, then when and how do you take
profits? The question of when is a function of your ability to
to read the market and pick the most likely
spots for it to stop.
39
In the absence of an ability to read the market and pick the most likely
spots for it to stop to do this objectively, the best course of action from a
psychological perspective is to
divide your position into thirds (or quarters), and scale out the position
as the market moves in your favor.
40
If you are trading futures contracts, this means your minimum
position for a trade is at least
three (or four) contracts
41
For stocks, the minimum position is any number
of shares that is divisible by three (or four), so you don't end up
with an odd-lot order
42
. On average, only one out of every ten trades was an immediate
loser that never went in my direction. Out of the other 25 to 30 percent of the trades that were
ultimately losers, the market usually went in my direction by three or four tics before revising and
stopping me out. I calculated that if I got into the habit of taking at least a
third of my original position
off every time the market gave me those three or four tics, at the end of the year the accumulated
winnings would go a long way towards paying my expenses.
43
I was right. To this day, I always, without
reservation or hesitation, take off a portion of a winning position whenever the
market gives me a little
to take.
44
Using a three-contract trade as an
example, here's how it works:
If I get into a position and the market immediately goes against me
without giving me at least four tics first, I get stopped out of the trade for an 18-tic loss, but as I've
indicated, this doesn't happen often. More likely, the trade goes in my favor by some small amount
before becoming a loser. If it goes in my favor by at least four tics, I take those four tics on one
contract. What I have done is reduce my total risk on the other two contracts by 10 tics. If the market
then stops me out of the last two contracts, the net loss on the trade is only 8 tics. If I don't get stopped
out on the last two contracts and the market moves in my direction, I take the next third of the position
off at some predetermined profit objective.
45
If I get into a position and the market immediately goes against me
without giving me at least four tics first, I get stopped out of the trade for an 18-tic loss, but as I've
indicated, this doesn't
happen often. More likely, the trade goes in my favor by some small amount
before becoming a loser.
46
If it goes in my favor by at least four tics, I take those four tics on one
contract. What I have done is reduce my total risk on the other two contracts by 10 tics. If the market
then stops me out of the last two contracts, the net loss on the trade is only 8 tics. If I don't get stopped
out on the last two contracts and the market moves in my direction, I take the next third of the position
off at some
predetermined profit objective.
47
This is based on some longer time frame support or resistance, or on the test of a previous significant
high or low. When I take profits on the second third, I also move the stop-loss to my
original entry
point
48
Now I have a net profit on the trade regardless of what happens to the last third of the
position.
49
In other words, I now have a "risk-free opportunity." I can't emphasize enough nor can the publisher
make the words on this page big enough to stress how important it is for you to experience the state of
"risk-free opportunity."
50
When you set up a situation in which there is "risk-free opportunity," there's no
way to
lose unless something extremely unusual happens, like a limit up or limit down move through
your stop
51
If, under normal circumstances, there's no way to lose, you get to experience what it really
feels like to be in a trade with a
relaxed, carefree state of mind
52
you get to experience what it really
feels like to be in a trade with a relaxed, carefree state of mind. To illustrate this point, imagine that you
are in a winning trade; the market made a fairly significant move in your direction, but you didn't take
any profits because you thought it was going even further, however....
instead of going further, the market trades all the way back to or very close to your original
entry point. You panic and, as a result, liquidate the trade, because you don't want to let what was once
a winning trade turn into a loser. But as soon as you're out, the market bounces right back into what
would have been a winning trade
53
If you had locked in some profits by scaling out, putting yourself in a
riskfree opportunity situation, it s very unlikely that you would have
panicked or felt any stress or
anxiety for that matter. I still have a third of my position left. What now?
54
I still have a third of my position left. What now?
I look for the most likely
place for the market to stop. This is usually a significant high or low in a longer time frame.
55
I still have a third of my position left. What now? I look for the most likely
place for the market to stop. This is usually a significant high or low in a longer time frame. I place my
order to liquidate just below that spot in a
long position or just above that spot in a short position. I
place my orders just above or just below because I don't care about squeezing the last tic out of the
trade.
56
I have found over the years that trying to do that just isn't worth it. One other factor you need to
take into consideration is your
risk-to-reward ratio.
57
The risk-to-reward ratio is the dollar value of how
much risk you have to take relative to the
profit potential.
58
Ideally, your risk-to-reward ratio should be at
least
3:1
59
Ideally, your risk-to-reward ratio should be at
least 3:1,
which means you are only risking one dollar for every three dollars of profit potential.
60
If your
edge and the way you scale out of your trades give you a 3:1 risk-to-reward ratio, your winning trade
percentage can be less than 50 percent and you will still
make money consistently.
61
A 3:1 risk-to-reward
ratio is ideal. However, for the purposes of this exercise,
it doesn't matter what it is, nor does it matter
how effectively you scale out, as long as you do it.
62
Do the best you can to pay yourself at reasonable
profit levels when
when the market makes the money available
63
Every portion of a trade that you take off as a
winner will contribute to your belief that you are a
consistent winner,
All the numbers will eventually
come into better alignment as your belief in your ability to be consistent becomes stronger.
64
Trading in Sample Sizes.
The typical trader practically lives or dies (emotionally) on the results of
most recent trade
65
If it was a winner, he'll gladly go to the
next trade;
66
. If it was a winner, he'll gladly go to the next trade; if it wasn't, he'll start
questioning
the viability of his edge
67
he'll start questioning
the viability of his edge. To find out what
variables work, how well they work, and what doesn't work,
we need a systematic approach, one that doesn't take any random variables into consideration
68
he'll start questioning
the viability of his edge. To find out what variables work...this means
that we have to expand our definition of success or failure from the limited trade-by-trade
perspective of the typical trader to a sample size of 20 trades or more
69
Any edge you decide on will be
based on some limited number of market variables or relationships between those
variables that
measure the market's potential to move either up or down.
70
From the market's perspective, each trader
who has the potential to put on or take off a trade can act as a force
on price movement and is,
therefore, a market variable
71
No edge or technical system can take into consideration every trader and
his reasons for putting
on or taking off a trade.
72
No edge or technical system can take into consideration every trader and
his reasons for putting on or taking off a trade. As a result, any set of market variables that defines an
edge is like a snapshot of something
very fluid, capturing only a limited portion of all the possibilities.
When you apply any set of variables to the market, they may work very well over an extended period
of time, but after a while you may find that their effectiveness diminishes.
That's because the
underlying dynamics of the interaction between all the participants (the market) is changing.
73
New
traders come into the market with their own unique ideas of what is
high and what is low, and other
traders leave.
74
Little by little, these changes affect the underlying dynamics of how the market moves. No snapshot
(rigid set of variables) can take these subtle changes into consideration. You can compensate for these
subtle changes in the underlying dynamics of market movement and still maintain a consistent
approach by trading in
sample sizes.
75
Your sample size has to be large enough to give your variables a
fair and adequate test, but at the same time small enough so that if their effectiveness diminishes, you
can detect it
before you lose an inordinate amount of money
76
Testing.
Once you decide on a set of variables that conform to these specifications, you need to test
them to see how well they work.
In any case, keep in
mind that the object of the exercise is to use trading as a vehicle to learn how to think objectively (in
the market's perspective), as if you were a casino operator. Right now, the bottom-line performance of
your system isn't very important, but it is important that you have a good idea of what you can expect
in the way of a win-to-loss ratio, (the number of winning trades relative to the number of losing trades
for your sample size).
77
Accepting the Risk.
A requirement of this exercise is that you know in advance exactly what your risk
is on each trade in your 20- trade sample size.
78
. As you now know, knowing the risk and accepting the
risk are
two different things.
79
I want you to be as comfortable as possible with the dollar value of the
risk you are taking in this exercise. Becuse the exercise requires that you use a 20-trade sample size, the
potential risk is
is that you will lose on all 20 trades
80
It is as
likely an occurrence as that you willwin on all 20 trades, which means it isn't very likely. Nevertheless,
it is a possibility. Therefore, you should set up the exercise in such a way that you can
accept the risk
(in dollar value) of losing on all 20 trades.
81
For example, if you're trading S&P futures, your edge might require that you risk three full points per
contract to find out if the trade is going to work. Since the exercise requires that you trade a minimum
of three contracts per trade, the total dollar value of the risk per trade is $2,250, if you use big contracts.
The accumulated dollar value of risk if you lose on all 20 trades is $45,000, You may not be
comfortable risking $45,000 on this exercise.
82
If you're not comfortable, you can reduce the dollar value of the risk by trading S&P mini contracts (EMini). They are one-fifth the value of the big contracts, so the total dollar value of the risk per trade
goes down to $450 and the accumulated risk for all 20 trades is $9,000.
They are one-fifth the value of the big contracts, so the total dollar value of the risk per trade
goes down to $450 and the accumulated risk for all 20 trades is $9,000.
83
You can do the same thing if
you are trading stocks: Just keep on reducing the number of shares per trade until you get to a point
where you are comfortable with the total accumulated risk for all 20 trades. What I don't want you to
do is change your
established risk parameters to satisfy your comfort levels.
84
If, based on your research, you have determined that a three-point risk in the S&Ps is the optimum
distance you must let the market trade against your edge to tell you it isn't worth staying in the position,
then leave it at
three points
85
Doing the Exercise.
When you have a set of variables that conforms to the specifications described,
you know exactly what each trade is going to cost to find out if it's going to work, you have a plan for
taking profits, and you know what you can expect as a win-loss ratio for your sample size, then
you are
ready to begin the exercise
86
The rules are simple: Trade your system exactly
as you have designed it.
87
This means you have to commit yourself to trading at least
the next 20 occurrences of your edge
88
not
just the next trade or the next couple of trades, but all
20, no matter what.
89
You cannot deviate, use or be
influenced by any other extraneous factors, or change the variables that define your edge until you have
completed a
full sample size.
90
By setting up the exercise with rigid variables that define your edge,
relatively fixed odds, and a commitment to take every trade in your sample size, you have created a
trading regime that duplicates how
a casino operates.
91
Why do casinos make consistent money on an event that has a random outcome? Because they know
that over a series of events, the odds are in
their favor
92
They also know that to realize the benefits of the
favorable odds, they have to participate in every event. They can't engage in a process of picking and
choosing which hand of blackjack, spin of the roulette wheel, or roll of the dice they are going to
participate in, by trying to predict in advance the outcome of each of these
individual events.
93
. If you
believe in the five fundamental truths and you believe that trading is just a probability game, not much
different from pulling the handle of a slot machine, then you'll find that this exercise will be
effortless
94
effortless because your desire to follow through with your commitment to take every trade
in your sample size and your belief in the probabilistic nature of trading will be in
complete harmony.
95
effortless because your desire to follow through with your commitment to take every trade
in your sample size and your belief in the probabilistic nature of trading will be in complete harmony.
As a result, there will be no
fear, resistance, or distracting thoughts.
96
What could stop you from doing
exactly what you need to do, when you need to do it, without reservation or hesitation?
Nothing!
97
On the other hand, if it hasn't already occurred to you, this exercise is going to create a head-on
collision between your desire to think
objectively in probabilities and all the forces inside you that are
in conflict with this desire.
98
The amount of difficulty you have in doing this exercise will be in direct
proportion to the degree to which these
conflicts exist.
99
To one degree or another, you will experience
the exact
opposite of what I described in the previous paragraph. Don't be surprised if you find your
first couple of attempts at doing this exercise virtually impossible.
100
How should you handle these
conflicts? Monitor yourself and use the technique of
self-discipline to refocus on your objective
101
Write
down the five fundamental truths and the seven principles of consistency, and keep them in front of you
at all times when you are trading.
102
Write
down the five fundamental truths and the seven principles of consistency, and keep them in front of you
at all times when you are trading.
Repeat them to
yourself frequently, with conviction
103
Every time you notice that you are thinking,
saying, or doing something that is inconsistent with these truths or principles,
acknowledge the conflict.
104
Don't try to deny the existence of conflicting forces. They are simply parts of your
psyche that are
(understandably) arguing for their versions of the truth
105
Don't try to deny the existence of conflicting forces. They are simply parts of your psyche that are
(understandably) arguing for their versions of the truth. When this happens,
refocus on exactly what
you are trying to accomplish.
106
If your purpose is to think objectively, disrupt
the association process (so
you can stay in the "now moment opportunity flow"); step through your fears of being wrong, losing
money, missing out, and leaving money on the table (so you can stop making errors and start trusting
yourself), then you'll know exactly what you need to do
107
Follow the rules of your trading regime as best
you can. Doing exactly what your rules call for while focused on
the five fundamental truths will
eventually resolve all your conflicts about the true nature of trading.
108
Every time you actually do
something that confirms one of the five fundamental truths, you will be
drawing energy out of the
conflicting beliefs and adding energy to a belief in probabilities and in your ability to produce
consistent results.
109
Eventually, your new beliefs will become so powerful that it will take
no conscious
effort on your part to think and act in a way that is consistent with your objectives.
110
You will know for sure that thinking in probabilities is a functioning part of your identity when you
will be able to go through
one sample size of at least 20 or more trades without any difficulty,
resistance, or conflicting thoughts distracting you from doing exactly what your mechanical system
calls for. - Then, and only then, will you be ready to move into the more advanced subjective or intuitive
stages of trading.
111
A FINAL NOTE
-
Try not to prejudge how long it will take before you can get through at least one sample size of trades,
following your plan without deviation, distracting thoughts, or hesitation to act.
It will take as long as it
takes. If you wanted to be a professional golfer, it wouldn't be unusual to dedicate yourself to hitting
10,000 or more golf balls until the precise combination of movements in your swing were so ingrained
in your muscle memory that you no longer had to think about it consciously.
112
what are advanced subjective or intuitive
stages of trading.? (this is a self question of curiosity)
113
When you're out there
hitting those golf balls, you aren't playing an actual game against someone or winning the big
tournament. You do it because you
believe that skill acquisition and practice will help you win.
Learning to be a consistent winner as a trader isn't any different. I wish you great prosperity, and would
say "good luck," but you really won't need luck if you work at acquiring the appropriate skills.
114
The first stage is the mechanical stage. In this stage, you:
1. Build the self-trust necessary to operate in an unlimited environment.
2. Learn to flawlessly execute a trading system.
3. Train your mind to think in probabilities (the five fundamental truths).
4. Create a strong, unshakeable belief in your consistency as a trader.
115
The second stage is the subjective stage of trading.
In
this stage, you use anything you have ever learned about the nature of market movement to do
whatever it is you want to do. There's a lot of freedom in this stage, so you will have to learn how to
monitor your susceptibility to make the kind of trading errors that are the result of any unresolved selfvaluation issues I referred to in the last chapter
116
The third stage is the intuitive stage
Trading intuitively
is the most advanced stage of development. It is the trading equivalent of earning a black belt in the
martial arts.
The difference is that you can't try to be intuitive, because intuition is spontaneous. It doesn't come
from what we know at a rational level. The rational part of our mind seems to be inherently mistrustful
of information received from a source that it doesn't understand. Sensing that something is about to
happen is a form of knowing that is very different from anything we know rationally
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