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How to trade. Part 3  A complete beginners guide to the concepts of trading  

 

The method of instrument selection for trend following ( How to choose what to trade and what to avoid )

 

If you grasp the concepts in this section it will make a huge difference to your performance in the long run.

 

Unfortunately this is the hardest point to convey to others. As most comment that I have a gift that they do not have. This is of course complete rubbish, it is more likely that they are too lazy to seek the best instruments.  We all have eyes and those eyes see exactly the same things. So the first thing to explain to you is to see what you see, not to see what you want to see. Listen to your subconscious mind when it tells you that something is wrong. If I had not grasped this important factor which came to me by self education and relentless system testing, then I would never have achieved the huge returns I made.

 

Learn to read the charts and understand good and bad price action

 

 

Lesson 1. The trend is your friend and randomness - unpredictability - noise are your enemies.

 

Below there are two charts shown over the exact same time period.  Please take a long hard look at each one.

 

 

 

Please consider which example appears to be more suitable for trend following?

 

You can decide this by looking at some obvious factors. 

 

1. The range of the highest and lowest prices in the two charts

2. The ferocity of the movements that go in the OPPOSITE direction to the main trends.

3. The perceived predictability of the movements

 

 Question 1  

      

Which instrument is more suitable for trend following trading? Assume bid - offer spread is equal for both

 

                                        1. Example 1                            2. Example 2

 

If you noticed that one of the examples is many times more suitable than the other you can be pleased with your visual cortex for helping you see it.

 

 

Factor 1

One chart has a high to low range of approximately 200 to 800  which gives us a simple ratio of volatility. 800 / 200 = 4. Compared to the other example which has a high low range of 160 to 360 . Which gives a volatility ratio of 360 / 160 = 2.25.  So for factor 1 we can see there is more movement in chart 1 than in chart 2  ( 4 / 2.25 ) = 1.7 times more to be exact.

 

Factor 2

One chart has many many swings which are contrary to the direction of the trend and all these moves will cause you to lose money. The other example has smaller swings against the major trends and there are less of them. This means less chance of your stop loss getting hit and more chance of riding a big trend and making a big profit.

 

Factor 3

One chart is clearly more predictable than the other. If you cannot see which one it is then you will never be a good trader so for this there will be another question. Considering that many people find sticking to a trend somewhat difficult it pays to notice that if you are riding a rising trend which increases each week, your are much more likely to able to stay with it ( correct procedure ) right up to the end of it. But if you get on board a horrible chopping volatile trend then it is psychologically much harder to ride through it and the stress levels felt will be much greater as your money is gaining and losing with more ferocity.

 

 Question 2

      

Which instrument in the chart ABOVE is more predictable?

 

            1. Example 1                            2. Example 2

 

 

 

 

Lesson 2. Predictability is your friend and unpredictability is your enemy.

 

 

Two more chart examples to examine below. 

 

If your eyes are effective you will see a very big difference in the clarity and predictability of these examples.

 

 

 

 

 

 

 

 

 

One chart is clearly more predictable than the other. Tell me which one?

 

 Question 3

      

Which instrument is more predictable?

 

            1. Example 1                            2. Example 2

 

Think about the benefits of selecting more predictable instruments to trade.

  1. You will be right more often therefore make more profits.

  2. You can use tighter stops and achieve better risk reward ratios

  3. Your account will be less volatile and suffer smaller draw downs

  4. You will be less stressed and more relaxed.

Example 1 has a huge amount of "noise" compared to example 2. Higher noise means you get a lower signal to noise ratio. High signal to noise ratios are exactly what trend following systems need to perform well. See below.

 

Noise is dangerous to you when trading as noise means a wider stop has to be used therefore your trade size will need to be reduced to keep risk levels to a sensible level. Low noise means tighter stops can be used which means a bigger trade can be placed without increasing risk. 

 

What is noise?

 

 

 

 

 

Noise is the fluctuation within the major trend. The major trend is the signal. 

Here is a simple formula which will stand you in good stead for assisting you in instrument selection for the rest of your trading days.

 

Signal divided by Noise = Signal to Noise raito ( SN ratio)

 

In the above stylised example the red line representing the signal or major trend is going up from 115 to 142 giving us a signal of 142-115 = 27 and the noise at the maximum point of deflection is ranging from 119 to 132 which gives us noise of 13.

 

Signal 27 / Noise 13 = SNr of 2.07

 

In trend following it is wise to seek instruments which have a high historical average signal to noise ratio.

 

For a more detailed explanation of the benefits of understanding signal to noise see the information here

 

 

Lesson 3. The spread is wide? Don't dismiss the market  for this reason.

 

Please pay full attention to this section as understanding it is vital to understand it.

 

Think it through carefully as you read. I have explained above that "noise" is the enemy of the trend following trader.

So let us consider the conditions that lead to high or low noise market behaviour.

 

Noise is caused by day traders - scalpers ( people who try to steal a few points in a few seconds or minutes)

 

The people are not trend following traders and are looking for an adrenaline rush experiences as a primary objective and 95% of them will be regularly losing money from their foolish activities and they are creating NOISE.

 

Think about this, which of the example bid ask prices below are more likely to attract the people mentioned above?

 

 

Question 3

      

Which market instrument is most likely to have a high noise and low signal due to attracting day traders and scalpers? Remember these people want to be in and out of the trade with a fast profit.

 

  1.   66.75 -  67.25                  2.   109.90 - 109.95             3.   102-104

 

 

Think now about the opposite situation. Remember you are looking for a market which is going to be trending and not suffering from high noise output. You will pay a little more initially for the wider spread but will have more chance of getting a relaxing ride on a long trend.

 

 

 

Question 4

      

Which market instrument is most likely to have institutional clients and long term investors buying it for a long term trade?

Remember these people want to be in for a long period of time and might hold their position for several years or more.

They do not care about paying a bit more in costs as they believe the instrument will make a big prolonged movement.

 

  1.   66.25 -  67.26                  2.   105 - 110             3.   102-102.5

 

 

Basically the point I am trying to get over to you here is that the moves in wider spread instruments are typically much more reliable and real.

 

In contrast to this the noise levels in tight spread instruments cause a huge amount of "false moves". I have added a pair of charts to make this point crystal clear. 

 

Chart 1 below has a spread which is 189-189.5  ( in a percentage this is around a quarter of a percent )

 

 

 

 

Chart 2 below has a spread which is wider at 108-109  ( in a percentage this is just under 1 percent )

 

 

 

 

Question 4

      

Which market of the two above is more favourable to trend following?

 

     1. Example 1                       2. Example 2

 

Just  to make sure you have got this point embedded into your mind...

 

Question 5

      

Which market of the two above is more favourable to scalping and day trading?

 

     1. Example 1                    2. Example 2

 

From my perspective I am always shocked that most people ( even highly intelligent ones ) never seem to get this point, they just cannot see past the first deception of paying a higher deal cost as being a barrier to profits. True it is a barrier to profit, but once you balance it up with the amount of money you will lose on all the false moves generated by high noise and tight spread instruments you just have to get it. Don't you?

 

Well saying it as it really is, if you don't get it now you might as well resign yourself to being a losing trader for most of your trading life. 

I have enjoyed 13 straight years of positive returns from 25% per anum to 16,000% per anum because I understand this point.

 

Lesson 4. The spread is tight? Think it is good to trade? Think again!

 

There are many many markets in the stock market.  The tightest spread can be found in Forex ( foreign exchange ) otherwise known as FX.

 

For this reason forex is full of noise. In percentage terms the movements in forex compared to stocks and futures are usually very low. Whilst the low cost to entry is appealing to most in the same way that a cheap holiday appeals more than an expensive holiday, the same points above apply to these FX markets.

 

PENNYWISE IS OFTEN POUND FOOLISH

 

Of course there are times when these markets will go into a smooth and long lasting trend, just as the Swiss franc did before pegging to the euro. Indeed I actually jumped on that nice trend in the franc and did very well from it. But most of the time these choppy markets will not be worth a second glance as there is often more noise than there is signal.

 

This means lots of whipsaw losing trades and not many trends. If you don't believe me then do your research on spread versus range.

 

Look at the highest high over 1 year and deduct the lowest low for 1 year. This gives the range.  Then compute the size of the largest contra trend noise movements. Divide range by noise and compare different types of markets.

 

 

 

For a more detailed explanation of the benefits of understanding signal to noise see the information here

 

 

If you  have  a questions then please send me an email

 

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