Chasing The Tiger Trade, Part 1: Setting Objectives

• December 31, 2002
• Selwyn Gishen

First things first:

Does my butt fit the saddle and my feet reach the pedals?

Have you got your unicycle?

Are you ready for the jungle?

Click here for my

Introduction.

Setting objectives, for me, means
figuring out what I want
and can reasonably expect from a well-executed trading
plan given my equity,
my style and my time frame
reference. Remember my style is my unique combination of method, selection and
risk management. Before you try to set your objectives, please take time out to
determine where you fit in relation to trading in general. I used the following
matrix to focus my ideas about trading.

Depending on your “fit,” you will have
different objectives, a different set of attitudes and will need to apply your
methodology differently. If you’re an A1 fit, with a small account
trying for some extra cash, you will play smaller trades with less of a stress
factor than if you are a B1 fit, relying on trading for a living to pay the
mortgage and the kid’s college. Your risk profile is different. If you have a retirement plan, you are
managing and are looking at fewer trades and longer positions, your
selection would be totally different than a daytrader’s. And if you are a
pro, trading
other people’s money for a fee, then risk of capital and
drawdown will
take on a new meaning. You can multitask too if you have the ability. No reason
not to, but I don’t recommend it if you are just starting out. First learn to
balance your unicycle before you embark on a long journey.

Let’s say my fit is B2 which is “to trade
for a living.” Then, my first job is to figure out how much I need to earn to
cover my monthly “lifestyle.” If I need $120,000 per annum to live on (after
tax) and I only have $100,000 capital available for trading, I will have to
generate a return on my capital of approximately 120%. How likely does that
sound? If this is the case, then I will have to
have a trading system or trading style that can produce such a 120% return over
a one-year period. This is approximately $10,000 per month. If there are 20
trading days in the month, that would be $500 per day. Now if this is what I
have to do every day to achieve my goal of $120,000 per year, I need to check if
my trading methodology is compatible with producing such a goal. So, if I am a daytrader, I need to net $500 each day. If I am a swing trader with trades
maybe only once or twice a week, I need to achieve about $2,500 per week with
just one or two trades.

Don’t forget that if I carry positions
overnight, I can operate a margin account and benefit with a 2:1 leverage.
Therefore my effective trading capital is $200,000. If I am daytrading only, my leverage is
4:1 or an effective $400,000. Now $120,000 on $400,000 is 30% but on $200,000, it
would be 60%. What percentage can my trading system return on average?

So far so good. Now since I won’t be
right on every trade I will need to understand my trading style very well and
know what its expectancy is. I assume you have a style or methodology
that you keep repeating over and over again. If you don’t, and you chop and
change between different systems and in different time frames, it’s time to stop
trading and take inventory. Close the doors and go back to the drawing board.
Otherwise your account WILL churn at best and you
WILL lose money at worst.

I am guilty of starting in a daytrade
and then switching to a swing, etc. Do not count the lucky trades that work out
well when you know darn well that LADY LUCK was on your side. Like when you
should have been stopped out according to your rules which you didn’t follow and
then witnessed a larger-than-comfortable drawdown, making you a little
religious. Then when things were looking terrible, the amazing happened. Just as
you knew it would, the market turned and you found yourself in a home run trade,
after which you gave yourself the high-five for being a true trading genius. If
you have a trade like this in your list, — EXCLUDE it when calculating your
expectancy.

Back to expectancy. Let’s go through my
last 50 trades. Add up all the winners and then add up all the losers. What
percentage were the winners? Let’s say 28 out of 50 were winners. My winning
percentage would be 56%. Then add up the dollar amount of my winners and the
dollar amount of my losers. Find the average of each. Say my winners came to
$53,000 and total losers came to $38,000. So my average win was $53,000/28 or
$1892 and my average loss was $38,000/22 or $1720, (1.08:1), which is a poor
ratio.

I will need to improve that ratio. My net
gain was $15,000 or $300 per trade.

Since I am daytrading and averaging one to
two trades per day with the above outcome, how can I possibly expect to earn
$120,000 by year end? My objectives are wrong for my trading system
or I am not
being disciplined enough when trading my system or I am not trading enough
or I
am not betting big enough. Possibly a combination of the above?

Here is a formula for expectancy;
{1+(W/L)} x P-1

W = Avg Winning Trade; L = Avg Losing Trade
and P=Percentage Win Ratio.

Applying it to the above results; =
{1+(1890/1720)} x .56-1 =
.1753

Therefore over the long term I can only
expect 17c per dollar of trading profit, using the above trading system.

Back to the drawing board. I have to find
a system that can produce enough dollars, $500 per day as determined above if I
am to meet my objectives. I know many of you probably know all this but I bet many of you won’t be surprised to know how many people trade without setting any goals. Since I figured my fit was to “Daytrade,” I decided to
study
Kevin Haggerty’s work, and so I attended one of his seminars.

Those of you
who are daytraders will know that Kevin has many different strategies, one such
being a “Slim Jim,” a narrow-range consolidation before a breakout. To test for
expectancy it is important to go back over your intraday charts bar by bar, as
if you had traded each time such a “Slim Jim” appeared. What was the result of
entering on the breakout? What was the potential gain? What was the risk? Did
you get a 3:1 ratio? A 2:1? Maybe, you only got a 1:1 ratio. Not letting profits
run or maybe poor execution?

Do this 50 times for different stocks on different
time frames. This is not exact science but one soon gets a feel for trading Slim
Jims. I try to understand the dynamics of the market that causes these patterns.
Kevin always says that “it is the dynamics of the market that make the pattern
and not the other way round. If you can grasp the concept you can trade the
pattern”. Otherwise, find a concept you do understand, like “fading a gap”
because the specialist has marked the price up or down too far. Or try
calculating the expectancy of a pullback trade into a confirmed trend. Build a
toolbox of strategies that will expand your opportunities. But only trade them
after you have calculated their expectancies. If you decide to do this important
step and you can show us the results, please share them with us and other
interested members.

By the way you can only really measure
the expectancy of your methodology IF you are using the same method over and
over again. If you are running around all over the place like a chicken with its
head chopped off, be careful of the expectancy number you derive from your
calculation. I believe it is better to calculate “expectancy per strategy.” This
will tell you how good the edge is for a particular strategy. If you have
several strategies, then you can calculate each one and add them together
afterwards to determine a total trading expectancy.

One last thing, if I am
happy with the .17 expectancy of my above system, I will need to dramatically
increase the number of trades I make if I want to achieve $120,000 profit by
year end. In fact I will need $12000/$500 or 240 positive trades. With the above
expectancy of .17 it means that the total number of trades will have to be 428
trades (240/.56), which amounts to at least two trades per day, especially if I
don’t trade every day. A good system should produce winners that are larger than
losers by at least 2X or better yet 3X. In 5% of cases you can get a 10X (the
tiger trade) or better, and that trade if properly sized can make your whole
month. I’ll cover my problem with that issue later. I bet you I am not the only
one who struggles to bag the “tiger.”

By the way I figure, $500 per trading day
should not be a big deal if I get all the parts together. So the next step I
will discuss is Time Frame. Without making this choice I will not be able to
setup a trading methodology and I won’t know which stocks to trade. How then can
I know how to size my trade?

Before I leave this section, I want to
mention that I often need to introspect about my personality profile. If I
discover more than one personality, then I need to do the exercise for each
personality. Just kidding. By the way, I do think the markets display multiple
personalities at different times and that is why there is a constant need to
synchronize one’s own personality with that of the prevailing market
personality. Again, you will be surprised to know how many people jump from one
concept to another, especially when the one strategy they selected is not
working and something else is. I find it is critical to stay the course with my
chosen strategy, providing it has a positive expectancy. I am trying to learn how
to ride a unicycle in a jungle while looking to bag a tiger? I must reconcile my
natural tendencies with my methodologies and objectives.

Since I hate the suspense of being in a
“big” position overnight and I constantly need to look at Bloomberg at 2:00 a.m. (old habits die hard) to see what is happening in Europe, I have
resolved to stay with daytrading. This way, I will close out each night and I
will sleep better. But I can’t expect the daytrades to produce the same huge
gains that I can get from longer-term trading. On the other hand, the instant
gratification that comes with daytrading allows me to feel more in control over
my trading destiny. Am I a control freak? I hate to watch drawdowns. I would
rather go in and out of a position several times than sit through a drawdown.

Of course, as I get more confident at
finding the tigers and develop more courage and the appropriate discipline, I
can learn to scale into swing trades from daytrades and adjust my attitude to
staying with the trade for longer periods. There is a strategy adjustment when
doing this. But I think one has to master one style of trading at a time. Before
we go Tiger (big bet) hunting on our unicycles, we should definitely be skilled
at keeping our balance on the cycle.

See you next week and keep pedaling.

Next Week: Choosing a methodology to
match my beliefs, personality and my objectives.

In our unicycle analogy; assembling the
wheel. This means assembling the hub (trading concept) to the three spokes
(selection, method, risk), to the time frame (wheel).

Part
1 — Setting Objectives
(If I don’t know where I’m going, any road will take me there. — Apologies
to Alice in Wonderland.)

Part
2 – Choosing Your Time Frame

Part
3 – Why Time Frame Controls Everything.

Selwyn Gishen is a
private trader who has been a member of TradingMarkets since its inception. Before switching to equities in 1996, he traded foreign currencies and
South African bonds. He lives in Boca Raton, Fla.