Congestion Levels

A congestion level is an area on a chart where the market trades a substantial amount of volume within a compressed area. While not a defined pattern with implicit predictive implications, congestion levels are interesting for technical traders as they represent the creation of vested interest at or around a price level. Any rapid move away from that level will create winning and losing positions, which the winners will want to keep and the losers will be desperate to unwind. Congestion levels are particularly interesting in markets with low intraday liquidity, where a temporary surge of participant enthusiasm can create a volume of new positions that cannot easily be unwound without moving prices sharply higher or lower. 

Consider the following tick chart, which depicts 500 individual trades:

Figure 4.19       Congestion levels in tick data.

The first 234 trades on the chart are clustered between $99.30 and $102.15. As soon as the market breaks below $99.30 there are 234 winning short trades and 234 losing long positions. While not all losing traders will immediately seek to exit their position, many certainly will. If the market makes a low volume move away from the congestion level it may be difficult for the losing traders to exit, which will continue to drive the market lower. This type of self-perpetuating market move is sometimes called a “rolling stop-loss,” where the actions of traders closing out positions push other traders past their point of comfort, motivating additional buying or selling. It can be very beneficial for traders to monitor the volume accumulated during a congestion formation, as even a rough estimate can provide a sense of the losing positions that will need to be unwound and give some perspective on the potential magnitude and duration of any buying/selling motivation. 

From Chapter 4 - Technical Analysis, Pages 138-139.

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Prevailing Volatility Will Impact or Restrict Usable Strategies

What the market is doing is important, but how it is doing it also greatly impacts the trader’s choice of strategy. The prevailing market conditions will, to a great extent, act to determine the types of trading strategies that can be productively employed at any particular point in time. Consider a graph of two price trajectories, one with high and one with low volatility, centered around the same sinusoidal trend:

Figure 8.1     High and low volatility price paths around the same central trend.

In the low volatility case it is possible to establish a long position early and hold it with minimal suffering. The move from $101.00 to $108.00 is relatively linear, with no material pullbacks to cause doubt or inflict mark-to-market pain. When the market plateaus between $108.00-109.00 there is a prolonged period of time to evaluate the position and exit the exposure. 

In the high volatility case the trader is faced with daily fluctuations ranging between $2.00-$4.00 that severely distort the appearance of the in-progress trend. With perfect execution, it is possible that a skilled trader who recognizes the choppy conditions and is proficient at operating in dangerous markets could buy at $100.00 and, after riding out a material amount of volatility, sell at $110.00. A less-skilled (or less lucky) trader could easily buy early in the trend at $104.00 and sell late in the move at $106.00, making a paltry $2.00 (or about half a typical day’s trading range) for enduring a significant amount of suffering. 

In a non-volatile market with tight bid-offer spreads there is often little difference between executing at the market bid or offer and exercising good tradecraft and negotiating a better price or providing liquidity by posting a two-way. The slight difference in price will not materially impact the profitability of the overall trade. In a volatile or panic-driven market the bid-offer spread can widen appreciably, forcing the trader to execute efficiently at both entry and exit or risk significantly eroding the potential inherent in the trade. 

The prevailing volatility should be factored into the pre-trade risk-reward assessment, as seen in Chapter 7. The more volatile the market, the greater the skill necessary to execute and establish a position at levels that will allow it to be survivable. At extreme levels of volatility survivability becomes a key consideration, and the ratio between the amplitude of the daily and intraday fluctuations and the pain the trader can afford to endure before being stopped out of the position must be carefully considered. A market exhibiting daily swings that are wider than a trader’s stop means that even with optimal execution there is a high probability that the trader could be forced out of her position within the next 24 hours. There is no magic formula to determine how much volatility is too much. Assessing the relative operability of the prevailing conditions comes down to the trader’s skill, experience, and not infrequently, self-confidence. 

From Chapter 8 - Directional Trading Strategies, Pages 287-288.

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The Entry of New Participants With Fresh Money

Elite poker players hate to play at a table full of other professionals, understanding that with their evenly matched skills no player has an advantage and the money will end up eddying aimlessly around the table. Eventually everyone will go home bored and with more or less the amount that they started with. The same can be said of a very homogenized, static market with similar, familiar entities circulating in well-established behavioral ruts. The entrance or departure of new classes of players, particularly if they are well funded, can have paradigm-shifting effects on a market. 

On a macro level, the slow rotation of global money flows from asset class to asset class and country to country have huge impacts on both the absolute level of prices and the relative number of people paid to trade and analyze them. Any hot or up-and-coming market will see massive inflows of capital to the detriment of established mid- and late-stage products. From bonds (1970s-80s) to equities (1980s) to derivatives (1990s) to technology stocks (1990s-00s) to commodities (2000s) to cash (2008-2009) and riskless assets (2009-10) back to equities (2010 to present), one market will capture the collective imagination of institutional investors. Firms with an established presence in the hot market will assume a leadership position and see an influx of customer business, which will lead to investor interest, which will inevitably lead to growth and expansion. Those not participating will feel left out of the market, the profits, and all of the cool cocktail party conversation. They will panic, and try to buy their way in at any cost, raising the price of talent and, usually, the product itself. The inflationary effects of new capital are particularly intense for any ownership-based product, like equities or real estate. Contractually backed markets like derivatives can expand much more easily, which is one of the reasons why jumbo-sized institutions prefer financial products. It is significantly easier to buy a billion dollars worth of mortgage bonds than a billion dollars worth of houses. 

From Chapter 2 - Know the Enemy, Page 55.

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Mastering the Minimum

In contemplating strategic alternatives to implement his view, a trader will, for the first time, begin to examine something other than historical data and future projections. The bridge between the known facts of the past and the presumed trajectory of the future is a never-ending series of small events occurring in the present. All forms of trading are immersive, but directional trading demands the most intense focus on the current operational environment. The trader must observe and interpret the day-to-day, hour-to-hour, and minute-by-minute fluctuations of the market in response to each incremental piece of information that will, in aggregate, influence the perceptions of the participants and motivate them to action. 

The relative simplicity of directional trading reduces the number of moving parts while dramatically increasing the relative importance of each remaining variable. By definition, every position is a trader-constructed subset of the total market risk-reward space. A directional position is unique in that it creates an unmitigated exposure to the totality of the market’s price movement, unlike the inherent exposure limitations of an option or the self-hedging characteristics of a spread. Directional trading is about control and execution, and requires a degree of engagement and commitment not necessary with other, more limited forms of exposure. 

Good directional traders are extremely skilled at the basic, unglamorous blocking and tackling that, while not flashy, is often the determining factor between winning and losing. For this reason, many of the basic topics covered in this chapter will be assumed as prerequisites for the sections on spreads, options, and quantitative trading that follow. The more complex strategies allow the trader to express subtler, more nuanced views of the market, but all either retain a directional component to their performance, or can also be used to express directional views. 

From Chapter 8 - Directional Trading Strategies, Page 284.

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Evolution of the Risk-Reward Calculus

As with market characteristics, risk-reward ratios change as a trade evolves. What the ratio was when the trade was put on may bear no resemblance to what it is in the current moment. The risk/reward ratio can be impacted by positive or negative changes to the fundamental facts, the technical analysis, or shifts in the probabilities of favorable/unfavorable outcomes.

The risk-reward can also shift with the movement of price over time. Consider a position entered into at $100.00 with an initial $5.00 of downside and $35.00 of upside for a very favorable 7:1 risk-reward ratio. The market moves in the trader’s favor and earns $10.00 from the entry point. The trader is now risking $15.00 ($5.00 initial possible loss + $10.00 unbooked profits) to hopefully make another $25.00, if everything goes as planned. The downside is that the risk-reward ratio has eroded significantly, from 7:1 to 5:3. As a position nears the profit target, the ratio can become skewed toward risking (much) more than could possibly be incrementally gained. In this case, when the price reaches $130.00 the trader is risking a total of $35.00 ($5.00 initial possible loss + $30.00 unbooked profits) for only an additional $5.00 gain, for a thoroughly terrible 1:7 risk-reward ratio. Paradoxically, great trades with favorable risk-reward characteristics that perform perfectly will have, at the end of their life, evolved into bad trades that should be taken off immediately. [60]

Figure 14.1    The risk-reward ratio of a trade will evolve during the holding period.

[60] The trader can (and should) use a rolling stop-loss to control degradation of the risk-reward ratio and protect profits. 

From Chapter 14 - Managing Positions & Portfolios, Pages 535-536.

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Factoring In Real Costs

The trader must also take into consideration the costs of executing and maintaining the position. Some will be fixed, known fees and others will depend on the market conditions and the time horizon over which the trader intends to hold the position. The principal costs are the bid-offer spread, slippage, brokerage and exchange fees, and the holding cost of credit or collateral. 

The bid-offer spread acts as a transaction tax; the amount paid is a function of the market conditions and the trader’s skill. In general, traders assume that under normal conditions they will have to pay one full bid-offer spread, half when entering the position and half on exit. It may be possible to pay less in a negotiation-friendly market, or if a sudden uptick in interest acts to temporarily narrow the spread. In contrast, market-making traders attempt to earn the bid-offer spread by posting numbers that they hope other market participants will hit or lift, allowing them to get paid for putting on positions. 

Slippage is the amount of value wasted between the time a trader starts executing and the time he amasses or distributes the desired exposure. A certain amount of slippage is unavoidable, unless the trader somehow manages to do 100% of the volume transacted in the market during the execution window and gets it all done at the same price. Slippage is almost impossible to quantify in advance, but the more deeply immersed in the market the trader is, the better he is able to gauge the potential impacts of transactional activity.

Most trades will involve paying a fee to the trading platform or brokerage for arranging the transaction. The trader may have to pay exchange fees for processing the transaction and clearing fees for routing it to the clearing broker. In most evolved markets the brokerage, exchange, and clearing fees will be a non-trivial but not onerous cost to the trader. 

Credit and/or collateral costs can vary significantly from strategy to strategy, and have a large impact on the relative attractiveness of an array of alternatives. Unlike transaction-based fees that are paid once, the cost of financing the trader’s position across the anticipated holding period will depend on a host of factors, including the volatility of the product (which will impact the base-level margin requirements set by the exchange), the firm’s credit rating (which will impact the extra or the multiplier the clearing broker applies to the basic exchange margin requirements), the directionality of the exposure relative to positions already held by the clearing broker, etc.

Consider a trade with a potential $3.00 of upside and $1.00 of downside and a two-month intended holding period. A 3:1 risk-reward ratio would generally be a proposition that any trader would immediately seek to execute. When evaluating the relative attractiveness of the exposure the trader must also take into consideration the $0.25 bid/offer spread that she will have to pay away to a market-maker, a $0.01 brokerage charge and $0.01 clearing fee on both the buy and sell transactions, and $0.13 per month of financing costs to maintain the position. The $0.55 (= $0.25 + ($0.02 × 2) + ($0.13 × 2)) total that the trader must pay away in fees and costs adds to the cost of a loser and subtracts from the profits of a winner. In reality, the trader is risking $1.55 ($1.00 projected loss + $0.55 costs) to make $2.45 ($3.00 possible gain - $0.55 costs) for a risk-reward ratio of 2.45-to-1.55, which most traders would typically not entertain. 

Traders have a tendency to underestimate the fees and costs inherent in their transactions for a variety of reasons. Some, like the bid-offer spread and the slippage, are difficult to fully assess without actually attempting to execute the transaction. Others, like the financing cost of holding the position, frequently end up being larger than expected as the trader clings to an exposure that with the hope that it will pay off someday.

From Chapter 12 - Evaluating Trades & Creating a Trading Plan, Pages 485-486.

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Dealing With Large Losing Positions

Sooner or later, even a highly disciplined trader with a fundamentally sound, well-constructed position will experience a large enough exogenous market shock to step-function prices through their stop-loss levels. Large losses can also occur as a result of a discipline breakdown, where a small- to medium-sized losing trade is neglected or mismanaged until it becomes a legitimate problem. Regardless of whether the damage is self-inflicted or the result of a low-probability event, the trader needs to deal with the problem as efficiently as possible and prepare for the inevitable consequences.

If there is time, the trader needs to immediately notify management and the risk group as to the position, the estimated P&L impact, and the mitigation plan. This demonstrates that the trader is aware, engaged, and to the extent possible, managing the position. Managers hate losses, but they will never forgive being blindsided by a trader. Just as a trader has to deal with the immediate market consequences, the manager has to deal with the subsequent organizational consequences, which may involve shifting exposures or requesting additional resources if the trader’s loss is impactful to the firm as a whole. 

With the immediate reporting taken care of, the trader needs to fix the problem. There is no point in hashing through the logic, re-examining the underlying rationale, or engaging in any other time-wasting activity. The exposure that is currently destroying the P&L is no longer a decision item; it is a problem that needs to be solved as quickly and efficiently as possible. In the aftermath of an unusual market event there is only a certain amount of liquidity to be had, typically significantly less than normal. The trader needs to capitalize on whatever narrow execution window exists to take off or neutralize the position before the market becomes untradeable. 

Once the exposure has been mitigated, the trader needs to start working on organizational and career damage control. There will be questions from management about the decision-making process, the size and composition of the exposure, and the overall handling of the risk. The trader should pre-empt these as much as possible by giving the rationale, the market events that unfolded to impact the trade, the P&L estimate, and the lessons learned going forward. By providing this information before it is asked for, the trader appears engaged and in control of the situation. This is critical, because senior management will certainly be reevaluating the trader’s future risk-taking activities in terms of both size and scope, and possibly his future on the desk. They may stop by to have a chat to see how the trader is doing. They do not care how the trader is doing, they are checking to see if the trader is broken, defective, or is worn out and needs to be replaced. It is permissible to be unhappy, it is never permissible to be out of control, throwing a tantrum, or acting like a child. Management will want to see that the trader has accepted responsibility, understands what happened and why the trade was not successful, and has a plan for incorporating this information into going-forward analysis and future risk taking.

Once the dust has cleared, some traders immediately want to jump into the market and try to earn it all back as quickly as possible. This is a temptation that most traders should probably resist, as their decision-making process is likely highly compromised and their market view cannot be robust. There will also be a temporarily skewed personal risk-reward relationship, where making back some small quantity of money is marginally useful, but losing incremental dollars while under heightened management scrutiny will look very, very bad. 

A trader’s first post-disaster trade should be a model of risk-reward assessment, clear analysis, and flawless communication about the rationale, goals, and execution strategy. It should be appropriately sized for the trader’s new economic reality and standing relative to allocated limits and goals. This can be frustrating, particularly if the trader had been running well and accustomed to larger bets with the house’s money. Starting from zero, which is in many ways what every trader is doing post-disaster, is all about rebuilding credibility and confidence along with P&L. Large losses are part of the game, and on a long enough timeframe they will eventually happen to everyone. Having a career as a professional trader is highly dependent on developing good crisis management skills to ensure that the first bad position isn’t the last. 

From Chapter 14 - Managing Positions & Portfolios, Pages 550-551.

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A Trader's View of the Market

This Is My View. There Are Many Like It, But This One Is Mine
It is important to be mindful that the trader’s view is entirely a product of his: 

•    Relative informational advantages and disadvantages.
•    Acquisition, manipulation, and processing skills.
•    Particular interpretation biases, strengths, and weaknesses.
•    Access to incremental, going-forward information and the ability to feed it back into the decision loop.

As explored in Chapter 3, every individual in the market is working with a subset of the total available information. It is possible for different traders to begin with the same starting information and, through differences in technique and interpretation, arrive at very different views of the market. This disparity is exacerbated when, in most markets, traders and trading companies will start with widely different sets of information and possess varying degrees of observational and interpretational acumen. Every trader must understand that, of the factors that combine to create their view, they will have above-average skill with some, be even with the market in others, and lag behind with the rest. The trader must take into consideration, for each of the primary variables and key drivers that makes up his view:

•    What he personally is good at or has a comparative advantage in?
•    What he personally is bad at or has a comparative disadvantage in?
•    What the firm is good at or has a comparative advantage in?
•    What the firm is bad at or has a comparative disadvantage in?

The trader must make a clear and intellectually honest assessment of his skill and that of the analysts at their firm, relative to the market, or he deceives himself into a proposition where he is operating from a perceived advantage but an actual disadvantage. It is difficult, but possible, to beat the market with average information. To do so, the trader will have to compensate by leveraging other strengths to make up for the lack of an informational edge. His analysis will have to be better than the rest of the market’s, his risk assessment superior, and his trade selection more creative. He will need superior position management skill and iron discipline. 

It is probably impossible to be long-run profitable with consistently worse-than-market information. No amount of skill on the trader’s part can be expected to overcome such a critical structural disadvantage. 

Articulating the Trader’s View
To remote observers a trader’s market view is like an iceberg. The jagged part that does all the P&L damage is easy to see from a great distance, but the preponderance of the underlying rationale will remain hidden deep beneath the surface, impossible to gauge. A trader’s view on the market, also like an iceberg, has a tendency to roll over and change direction with little to no warning.

An unarticulated view, regardless of how meticulously researched and reasoned, is invisible to management. Documenting a view and the underlying rationale pre-trade can be massively useful in the event that the position turns out poorly. For any unusually committing trade, either in terms of size, risk, or novelty, making management aware of the underlying reasons for the exposure in addition to the stop and profit targets should be considered mandatory. 

For any position that requires management or senior management approval, the ability to clearly articulate the view will frequently be the primary reason that the authorization for the exposure is approved or denied. A trader that cannot clearly explain and justify why she wants to create a position will not be given the latitude to do so. 

From Chapter 7 - Developing a Cohesive Market View, Pages 256-257.

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Trading Around a Trend

Trading around a trend is an extremely productive strategy that involves holding a core position aligned with the direction of the macro trend, then opportunistically adding incremental volume following intermediate retracements that is exited when the macro trend has re-asserted itself and is approaching resistance. Trading around a trend requires a well-formed technical channel and a productive, but not excessive, level of intermediate and micro-level fluctuation. Too much chop, and a trader could potentially be scared out of an incremental position that would otherwise be profitable. Consider the chart of a well-defined trend:

Figure 14.5     Trading around a trend.

A trader with a fundamentally bullish view of the market and core long position would observe a trend in motion in a well-defined channel, the width of which is defined by the alternating higher lows at (L1) and (L2) and higher highs at (H1) and (H2). When the market retraces to support, the trader would purchase an incremental volume (B1), which he would hold with a tight stop, re-selling once the market reached the top of the trend channel at (S1). This process would be repeated at (B2) and (S2), and continue for as long as the trend remained viable. When market reaches the profit target or the trend ultimately ends, the trader would exit both the core position and any incremental trades held at the time.

Trading around a trend has several advantages:

1.    The trader maintains a core positioned with the trend, and is incrementally adding in the direction of the trend and decreasing the position size prior to potential countertrend moves.
2.    The trader buys “cheap” and sells “expensive” within the context of the trend.
3.    There is a good balance between aggression and risk-reward.

The principal risk of trading around a trend is that, if the trend abruptly fails immediately after an incremental addition, the trader will be taking losses on a larger-than-core position. 

The relationship between the size of the core position and the magnitude of the incremental trades is also important. If the core position is not materially larger than the incremental buys and sells, the trader will effectively be attempting to derive the majority of the P&L by trading the swings in the market and not the more predictable central trend.

It is also common for a trader wanting a larger core exposure to use retracements to add permanent volume to the position, with the hope of carrying the additional weight for the full duration.

From Chapter 14 - Managing Positions & Portfolios, Pages 543-544.

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How The Market Gets From Point A to B Matters

How The Market Gets From Point A to B Matters
A trader must examine the texture of the chart, as a whole. If it is making lower highs and lower lows, the market is in a downtrend. But how is the market making the highs and lows? Is it grinding higher in small increments over many days, only to give it up in sudden, massive sell-offs? Does it drift lower only to be blown skyward by intermittent stimuli? Is the pattern regular and predictable, bouncing back and forth between channel lines, or does it surf the top then crash to the bottom before re-establishing somewhere in the middle? These are critical distinctions if the trader intends to utilize the intermediate trend to get positioned (generally a good idea) or to trade against the macro trend (possible, but risky). If the trader intends to ride the macro trend, understanding the “normal” intra-pattern characteristics is crucial for risk to reward assessment and execution strategy. A seemingly obvious trend may, on closer examination, not be tradable at all. Assessing the tradability of a market move will be covered in much more detail in Chapters 7 and 12.

From Chapter 4 - Technical Analysis, Page 143.

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Response to Stimulus

Response to Stimulus
The trader will need to monitor and evaluate the degree to which the position responds to the underlying fundamental and technical motivators. It is possible that the trade will outperform the trader’s expectation, perform as expected, underperform, or have a problematic negative outcome or puzzling non-response. 

Figure 14.6     Potential performance trajectories of trade performance. 

It’s Working Too Well – Radical Outperformance
If the trader is in the enviable position of holding a position that has radically exceeded the profit target in a step-function move or at an highly accelerated pace, the only real question is whether to immediately exit the position and book the profit, or take the time to determine if something has fundamentally or technically changed such that the market is now capable of moving further beyond the goal. The danger in taking time for analysis is that the market may just as quickly reverse direction, potentially costing the trader some or all of the recently acquired profits. If the trader does decide to maintain an exposure, it would be prudent to consider lightening up by closing a portion of the position, adding a protective option position, and/or setting a tight rolling stop to prevent giving away windfall profits.

It’s Working Like It Should – Productive Response
If the trader’s position has reached the profit target set in the trading plan due to the anticipated evolution of the fundamental or technical landscape, then he should exit the exposure in as efficient a manner as possible, book the P&L, and start looking for the next idea. 
 

It’s Not Working Like It Should – Underperforming
If the fundamental and technical landscape has developed as the trader anticipated and the market’s reaction was positive but decidedly uninspiring, the trader will face a challenging decision. It is possible that the market has yet to fully assimilate the new information and that additional gains may be forthcoming, but it is also possible that the incremental drivers were not nearly as impactful as the trader was anticipating. Unless the trader can make a compelling case that the new information is not priced into the market, it may be more productive to take the (small amount of) money and run while there are still profits to be had.  If not, the trader risks being forced to make a decision on a breakeven or negative transaction, which is an altogether worse state of affairs.

It’s Slightly Negative or Not Really Doing Anything – Problematic
Positions that underperform or hover around breakeven through a productive fundamental or technical development are a warning sign for experienced traders. If the market can barely rally in the face of bullish information, the most logical explanation is that the overall sentiment is significantly bearish. This is problematic for a trader with the underperforming position, because if the market barely budges higher with bullish development, how far is it going to fall if something materially bearish occurs? 

Slightly positive and break-even trades are psychologically easier to give up on, as the trader can exit with only the opportunity cost of utilized limits. Slightly negative positions are the bane of every trader’s existence. It is all too easy to hang on to a small loser in the hopes that some unspecified, to-be-determined event will push prices back in the trader’s favor, allowing an escape at breakeven. This is a trap. If a trader is unwilling to take a small loss on a position, the reward is usually a large loss realized at a later date.

Maintaining an unproductive position can be hazardous and expensive. The longer the trader sits on the position, waiting for something beneficial to happen, the greater the chance of an exogenous event impacting the market. Even if the market remains docile, there are nontrivial credit and collateral costs associated with holding a position. Paying rent on an unproductive exposure while waiting for a black swan to make things bad enough to exit is foolish.

From Chapter 14 - Managing Positions & Portfolios, Pages 544-546.

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Understand What The Chart Is Saying As a Whole

Understand What The Chart Is Saying As a Whole
Many traders cannot see the forest for the trees with technical patterns, obsessing over the smallest details and ignoring the totality of the chart and the picture it is painting. Others use the chart as a convenient rationalization for an action they had already planned to take.

Seeing What They Want to See
Any scientist worth her lab coat knows that constructing an experiment with a particular result in mind will, unsurprisingly, tend to produce that result. This is also true of technical analysis. Traders with a fundamental bias are particularly susceptible to this methodological flaw. They take a well-reasoned, sound fundamental view and attempt to use technical analysis to buttress the argument. “The market must be near a fundamental bottom, see if the chart says that.” Worse yet, others will develop some hunch, pet theory, or “feeling,” then pore over charts looking for some sort of significant squiggle or sketchy line they can draw to justify whatever they were planning on doing all along. 

Connecting The Dots In a Thin Market
In extremely thin or choppy markets it is particularly important to look at the whole picture, as a lack of trades⎯and therefore observations⎯can make spotting breakouts and measuring responses challenging. The overall picture will be less crisp, so the trader must forget about micrometer-level precision and instead focus on the major theme, if there is one to be found. 

From Chapter 4 - Technical Analysis, Pages 142-143.

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Vitruvian Trader

Everyone wants to know what it takes to be a trader, what intangible characteristics separate the winners from the losers. For the vast majority of successful traders, there is no single thing that steers them down the path toward either the penthouse or the outhouse. If there were a perfect trader, her approach might look like this:

Vitruvian Trader

•    The ideal trader has a clear sense of what she is trying to achieve at all times. 
•    The trader expects a particular market response when a base set of fundamental and technical conditions are disturbed by incremental change or the influence of external stimuli. This informed perspective on the future of price is called a view.
•    The trader considers a variety of strategies to implement her view, selecting the one with the closest response to the underlying driver with the best potential reward, the lowest probable risk, and the best performance characteristics.
•    The trader sets the position with a defined profit target and a stop-loss. 
•    The trader monitors the position for changes to the underlying thesis while maintaining an alert, intellectually engaged but emotionally detached state. 
•    If action is required, the trader executes with the maximum possible efficiency.
•    The trader evaluates the results and adjusts the operational parameters (trade selection criteria, stops, targets, etc.) of the methodology as necessary. 
•    Repeat. 

Being a professional trader is a two-part problem, how to evolve to be the best possible risk-taker and how to develop, refine, and deploy the most efficient process.

For most people, success as a trader is less a matter of deus ex machina brilliance and more a result of a steady progression, an ongoing evolutionary process wherein every student starts with innate skills and attempts to out-learn and out-develop peers. This chapter will explore the attributes common to successful traders and the common mistakes that keep neophytes from reaching their potential. Not all traders approach the job in the same way, and not all trading jobs are the same. Understanding the subtle distinctions will shed light on the development necessary, in terms of both the steepness and duration of the learning curve.

From Chapter 1 - Know Yourself, Pages 9-10.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Archimedean Trade Selection

Archimedean Trade Selection
Visualize the market risk-reward as a partially filled bucket, where some portion of the total volume is risk (water) and some is reward (air). Now imagine each possible strategic implementation of the trader’s view as an opaque balloon, varying in size relative to the total amount of exposure inherent in the trade. Each strategic balloon will be filled with some volume of risk (water) and some quantity of reward (air). If the trader were to place the balloons into the bucket, each would sink to the degree to which they were filled with water. The heavier, mostly-water balloons would sink low in the bucket and the mostly-air balloons would sit with most of their volume above the surface. The relative proportion of risk and reward inherent in each transaction would be easily observed and the best strategy would, literally, float to the top.

Figure 12.1     Archimedean trade selection.  

Unfortunately, assessing the relative merits of an array of strategic alternatives is not nearly as scientifically straightforward.

The evaluation process begins with the trader’s view of the market and a set of potential implementation strategies. From there, the trader must determine:

1.    What can be done, given available resources
2.    What could be done, given the current P&L relative to goals
3.    What should be done, by evaluating strategies
4.    What will be done, by selecting the best implementation
5.    How it will be done, by developing a trading plan.

From Chapter 12 - Evaluating Trades & Creating a Trading Plan, Pages 477-478.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

The Fractal Nature of Technical Analysis

The Fractal Nature of Technical Analysis
A fractal is a geometric pattern whose general form is constructed out of smaller iterations of itself that repeat under increased magnification with infinite complexity. [18]  Financial markets have a fractal element to their price fluctuations, as the same types of patterns form on monthly charts, daily charts, and 1-minute and tick charts, and the larger patterns and trends are built out of the aggregation of compounded smaller patterns and trends. The micro scale influences the intermediate scale, which impacts the macro scale. If a trader can figure out what a market is doing right now, it may inform what happens for the rest of the day. If a trader understands today, that will give greater clarity to their view of next month.

Most technicians will ultimately spend the majority of their time on a chart resolution and study timeframe that works well in their market and for their methodology. It is important to look at the same product through a different lens from time to time, dropping down to a faster chart for intraday patterns or zooming out to a multi-year perspective to look for long-term trends. 

Tipping Points
The tendency of technical patterns to appear at all resolution levels of the data can lead to a circumstance where a small intraday pattern can have an outsized influence on the longer-term trend. Imagine a long-term downtrend experiencing a normal countertrend retracement to near the top of the downtrend channel, where on an intraday chart the market forms a bull flag. If the bull flag breaks out to the upside it may provide enough impetus to extend the countertrend and push the market outside of the downtrend channel, a neutral signal if not outright bullish. Conversely, if the bull flag fails then the countertrend movement is likely at an end and the long-term downtrend is intact.

Figure 4.13       Micro-level patterns that impact intermediate patterns that impact macro patterns. 

[18] The best-known example is the Mandelbrot Set, named after renowned mathematician (and sometime financial theorist) Benoit Mandelbrot.

From Chapter 4 - Technical Analysis, Pages 131-132.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Poker as a Whetstone

Poker As a Whetstone
Good poker players are extremely analytical, as success depends both on an advanced understanding of the underlying probabilities of the game and a feeling for the nuances of human nature. Professionals spend a great deal of time studying their opponents, and characterizing their playing style based on two attributes: the degree to which they are conservative or adventurous with their money, called being “tight” or “loose,” and their general inclination toward passivity or aggression. Mapped on intersecting axes, they yield the quadrants Loose/Passive, Loose/Aggressive, Tight/Passive, and Tight/Aggressive: [3]  

A Loose/Aggressive player, sometimes called a maniac, gambles wildly and without control. This player is a thrill-seeker, who plays to feel the rush and takes huge swings up and down, rarely having enough money to withstand the self-induced volatility and usually going broke as a result. 

A Loose/Passive player gets involved indiscriminately but gives up easily, squandering small amounts of money over and over as the game goes on. This person, derisively labeled a calling station, wants to be involved but lacks commitment, making him an easy mark for aggressive players.

A Tight/Passive player will sit at the table forever waiting for the perfect situation that never, ever materializes. She is frequently referred to as a rock, is not inclined to get involved, and doesn’t like to take any risk when she does. 

A Tight/Aggressive player will wait patiently until the odds are decisively in his favor, then act with maximum aggression to extract as much money as possible from opponents at the table.

Tight/Aggressive For The Win!
Most top poker professionals believe that Tight/Aggressive is the only winning behavior over the long run. More interestingly, elite players feel that a Tight/Aggressive approach to the game is not a naturally occurring set of traits. Very few people are intuitively disciplined enough to limit their participation to situations when they have a real statistical advantage and also willing to exert maximum pressure on their opponents. It is a learned behavior. A winning poker player has consciously, intentionally modified her decision making and approach to the game to be both more calculating and more aggressive in order to maximize the chances of success. This is exactly the right mindset for a professional trader, and the behavioral model maps perfectly.

A Loose/Aggressive trader is a thrill-seeking adrenaline junkie, swinging around in the market to satisfy a need for action, consequences be damned. 

A Loose/Passive trader will always have some sort of a position, but never anything significant, and will tend to give up at the first sign of a loss. 

A Tight/Passive trader is waiting, always waiting, for the perfect opportunity that just never quite seems to appear. 

The Tight/Aggressive trader waits for the conditions to be favorable, and then commits to a strategy with a meaningful position managed in a tactical, controlled fashion.

The first thing strong poker players do when sitting down at a table full of opponents is, surprisingly, nothing at all. They will sit and watch the ebb and flow of the game for a half hour, an hour, or as long as it takes to preliminarily classify their opponents and to see how the game is playing at the moment. They will study the betting, the aggression level of the participants, and the quality of cards being played. They will listen to the players talk about how they played previous hands to gain insight into their thought processes, style, and skill level. They will see how much money is in play, and by whom, as an indicator of how much profit there is to be made. Finally, they will make a candid assessment of themselves relative to what they have learned about the game, its participants, requirements, and profit potentials relative to the risks involved. As the saying goes, “if you can’t spot a sucker at the poker table, then you are the sucker.” Smart players know when to stand up and walk away from a game that is too tough or that does not suit their style, even without playing a single hand. They also know when to settle in for the long haul if they find a situation that seems profitable.

Here is the previous paragraph again, with replacements in italics.

The first thing strong traders do when entering a market full of counterparties is, surprisingly, nothing at all. They sit and watch the ebb and flow of the market for a half hour, an hour, or as long as it takes to preliminarily classify their counterparties and to see how the market is trading at the moment. They will study the prices, the aggression level of the traders, and the fundamental information. They will listen to the traders talk about how they put on previous positions to gain insight into their thought processes, style, and skill level. They will see how much money is in play, and by whom, as an indicator of how much profit there is to be made. Finally, they will make a candid assessment of themselves relative to what they have learned about the market, its participants, requirements, and profit potential relative to the risks involved. As the saying goes, if you can’t spot the sucker in the market, then you are the sucker. Smart traders know when to stand up and walk away from a market that is too tough or that does not suit their style, even without doing a single trade. They also know when to settle in for the long haul if they find a situation that seems profitable.

[3] This common model for categorizing player behavior may have originated from Alan N. Schoonmaker’s grid-based system seen in The Psychology of Poker (Henderson: Two Plus Two Publishing LLC, 2000), 71-79.

From Chapter 1 - Know Yourself, Pages 11-13.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Traits of Bad Traders

Traits of Bad Traders

1.    Not admitting that they are wrong.
2.    Not taking responsibility for poor decisions.
3.    Making the same mistakes again and again.
4.    Trading too much.
5.    Engaging in thrill-seeking behavior.
6.    Making simple things complicated.
7.    Ignoring their limitations.

Bad Traders Do Not Admit They Are Wrong
A trader holding a losing position faces a painful decision: suffer the losses in the short term in the hopes that things get better and not worse, or exit the position and move on to other opportunities. Some traders allow their ego to become part of the decision making process, refusing to remove negative positions because they cannot accept booking a loss. In other cases, particularly with an inexperienced trader, they may fear that the losing position will be a referendum on their capabilities as a risk taker. Regardless of the underlying reason, if the trader is unable to admit that a position is not working and proactively rectify the situation, then he has stopped managing risk and has become a passive spectator, riding the exposure wherever it may go. 

Bad Traders Do Not Take Responsibility for Poor Decisions
This is a classic symptom of a weak, undisciplined trader. Every good trade is a product of her unique and singular genius, planned with the calculating tactical brilliance of Sun Tzu and executed with the effortless virtuosity of Paganini. Any losing trades are obviously the fault of the stupid analyst, the stupider weatherman, the insipidly stupid salesman, the buffoonishly stupid quant group, or the toxically stupid management, all of whom are conspiring to bring down the One True Hero of the markets. This distancing from any sort of negative outcome prevents productive self-critique and impedes refinement of a trader’s technique and methodology. 

Bad Traders Make the Same Mistakes Over And Over Again
Poker players refer to any persistent problem in their life or their game that causes them to lose money as a leak. Visualize water leaking out of a hole in a bucket. Whenever a trader says “I always lose money when I do this or that trade,” the obvious question is, “Why do you keep doing it?” There are allowances for suboptimal performance when learning a new market, instrument, affecting a stylistic change or implementing a new methodology. Beyond some point, however, consistently unprofitable behavior cannot be tolerated and the trader will have to revise his approach or cease activity. This can be tremendously difficult, particularly for historically high achievers unaccustomed to failure. 

Bad Traders Trade Too Much
It can be very frustrating for a trader to not be able to find any positions that seem worth taking, particularly early in the year when all of her colleagues are off and running or late in the year when they are desperately trying to meet a goal. If a trader cannot find anything that meets the normally exacting criteria, the easiest remedy is to simply lower the standards a bit and start re-considering previously discarded ideas. Eventually, with a low enough hurdle to clear, something has to seem worth doing, even if it is a 50/50 coin flip or worse. “At least I’ve got a position! I’m in the game!”

Having tasted the sweet nectar of bad decision making, professional over-traders rarely stop there. With newly lenient standards they become transactional dervishes, executing every trade not patently awful, buying and selling and buying again with reckless abandon.

Bad Traders Engage in Thrill-Seeking Trading
Overtrading is a good impulse warped by desperation and desire. Thrill-seeking trading is a manifestation of boredom and an unhealthy, destructive attitude toward risk taking. Thrill seekers trade to feel the rush, to be in the action, and are generally poor stewards of the firm’s capital as a result.

Bad Traders Make Simple Things Complicated
A close cousin to both the desire to overtrade and a desire to not take responsibility for losing positions is the tendency to take a bad position and, instead of cleanly exiting and taking the pain, attempting to fix things by putting on some sort of semi-equivalent off-setting trade to hedge the exposure. When the new trade inevitably exhibits some unwelcome performance characteristics, the trader tacks on a third deal to correct that, and a fourth to compensate for flaws in the third. The end result is a giant knot of positions that wobbles inexplicably back and forth with every tremor in the market, but that allows the trader to brag on any particular day that he has something that is working. 

Bad Traders Ignore Their Limitations
There is a saying: “a good trader can trade anything.” Given time to learn the structure of a market, assimilate the applicable fundamentals, and discover the unique nuances, any trader with a disciplined, rigorous methodology should have a better-than-even chance of finding a way to be profitable. Many traders take the success they have worked so hard to achieve in one market and simply assume that the underlying methodology is universally applicable, without bothering to understand how the unique characteristics of a different market will influence their approach. This is particularly common in young traders who, caught up in the excitement of mastering a market assume that they have mastered all markets. This can be a particularly expensive delusion.

From Chapter 1 - Know Yourself, Pages 18-19.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Traits of Successful Traders

Traits of Successful Traders:

1.    Disciplined.
2.    Self-analytical.
3.    Intellectually honest.
4.    Rationally accepting of failure.
5.    Have an ability to suffer.
6.    Learn from their mistakes.
7.    Hyper-competitive, driven.
8.    Have a strong work ethic.
9.    Positive.
10.    Prepared.
11.    Ethical.

Good Traders are Disciplined
It is easy to wonder what is right, somewhat more challenging to figure out what is right, more difficult still to understand why something is right, but very hard indeed to do what is right, particularly when the course of action may be unpopular, unpleasant, and involve personal or professional costs. It is very easy for anyone to say what she is going to do; it is much more rare to find someone who consistently does what she says. The other ten traits are important; discipline is mandatory. Discipline enables all of the other traits to be expressed, and allows a strong analytical process to be translated into thorough trade selection, rock-solid execution, and effective position management. This is one major reason why former athletes and ex-military are so highly prized by trading firms, often above more highly intellectually pedigreed individuals. If an ex-Marine or Navy SEAL says they’re buying here and selling there, you had better believe things are getting bought here and sold there. 

Good Traders are Self-Analytical
All machines break down from time to time, and every motor needs the occasional tune up. Flaws can creep into any (or all) aspects of a trader’s methodology, and if left undiscovered or unchecked will destroy even the most robust process. While honest, objective feedback should always be welcomed, a trader cannot rely on others to diagnose the flaws in his technique. A trader’s peers may be unwilling or unable to offer productive critique, and even if they are, the trader may not be able to process and use the information. A professional trader must be both willing and able to forensically examine the decision-making process and all aspects of the methodology to determine if there are flaws that need to be addressed. Debugging a trader’s methodology will be discussed in greater detail in Chapter 16 – Navigating the Corporate Culture.

Good Traders are Intellectually Honest
Most people find it extremely easy to lie to themselves about the underlying motivation for their actions. This prevents personal growth by denying them opportunity to learn from their mistakes. 

Taking a significant amount of risk is a very committing exercise, requiring a great deal of forethought and no small amount of emotional stress. Once invested (in both senses of the word), it can be difficult to hear counter-arguments or process incremental new information, regardless of how critical, timely, or obvious. In extreme cases, traders will go to elaborate lengths to convince themselves the market is acting “irrationally” or “stupidly,” that the shift in fundamentals was “bad data,” and that devastating information is “just noise.” It is difficult to believe how fully intelligent, perceptive individuals can deceive themselves under stress.

Intellectual honesty allows traders to self-police their actions. Traders must be able to step back and ask themselves “why am I doing this?” If they don’t have an answer, (or it isn’t a good one) they need to check themselves before they wreck themselves. 

Good Traders are Rationally Accepting of Failure
Poker players sometimes say, “A real gambler doesn’t need anything.” It does not take any self-actualizing philosophy to imagine that desires can, and do, influence the decision-making process. Wanting to win too badly can muddy up what needs to be a clinical assessment of the risks and rewards inherent in any proposition. Needing a particular result makes it paradoxically more difficult to achieve. 

This behavior is on display every weekend on television as highly compensated professional athletes miss short putts, drop easy catches, and brick free-throws that they could make with their eyes closed at practice or with nothing at stake. The sudden pressure of having to do something completely ordinary (and the associated consequences of failure) can transform any task from routine to impossible. Losing traders who approach their maximum allowable loss for the year almost inevitably explode violently shortly thereafter. The combined pressure of wanting desperately to succeed but being unable to fail is too much, leading to poor decisions and, ultimately, the exact circumstances the trader was seeking to avoid. 

A trader must put himself in a space where, given what is at risk and what he hopes to gain, he is completely comfortable with either outcome, that is, the potential profit is worth the probable risks involved. A trader needs to learn to think that a particular trade could work, given the probabilities, not that it should work or that it will work. It must never need to work. Trading ideas that don’t work are an unpleasant yet inevitable byproduct of the process. A trader must accept that losing is part of the game and move on with the minimum of psychological damage, because there will be a lot of losing over a career. Traders are not in the perfection business. The name of the game is batting for average and controlling the risk, so that the trader can afford to play again tomorrow. Traders need to learn to trust in themselves and trust in their process. Poker, with its reduced probability set and defined outcomes, is a perfect laboratory for developing this kind of self-confidence. 

Poker also teaches the difficult-to-grasp concept of divorcing the short-run outcomes from the quality of the decision-making process that created them. This may seem counterintuitive, particularly when applied to a results-centric endeavor. “Isn’t the point to win, to make money? Isn’t it a good decision if it makes money, and a bad decision if it does not?” Sometimes good decisions lose, and poor decisions win. If offered a chance to bet $1.00 to win $1.00 on the flip a coin that comes up heads 99% of the time and tails 1% of the time, any trader would be insane not to bet on heads. If, when flipped one time, the coin comes up tails, it was not a bad bet, just a bad probabilistic outcome. There will always be exogenous events and instances of random chance. Bad luck happens.

For many high achievers, not succeeding immediately as a trader may be the first significant failure in life. Athletes with experience losing have more likely developed productive coping/compensation behaviors. When I studied karate as a boy the first thing I was taught was how to fall so that I did not injure myself. Every trader must learn how to fail so that he does not hurt himself.

Good Traders Have an Ability to Suffer, or to Displace Suffering
One key survival mechanism involves having or developing a larger than normal ability to tolerate suffering or the intellectual capability to compartmentalize it. The trader must find ways of dealing with the pressure and discomfort such that it does not degrade the decision-making process. If the trader has structured and sized trades correctly and adopted a good gambler’s mindset, it is possible to not care too much about any one particular outcome, trusting that in the long run there will be more gains than losses. Sooner or later, however, every trader will misjudge the market and find out what he is made of under the worst possible circumstances. 

Good Traders Learn From Their Mistakes
In any given day, month, or year, a trader’s approach to the market will be a success or a failure. It is easier to learn from failure where it is possible to start from the logical premise that the method may be flawed and forensically examine it for defects. Adapting to a changing environment while still generating productive results is vastly more difficult, and will require a visionary sense that the underlying conditions are either eroding or are vulnerable to a seismic shift. Observant traders will look for clues like a decreasing winning percentage, greater difficulty finding good trades, greater execution slippage, and thinner margins. Profitable traders are like snakes, shedding their methodologies like so much dead skin when they are no longer productive. 

Making mistakes is part of the evolution of a trader, but there is no excuse for making the same mistake twice (let alone multiple times). Whenever possible, it is far better to learn from other people’s mistakes by studying other markets and trading styles and observing what does (and more importantly) does not work.

Good Traders are Hypercompetitive, Driven
Traders must first be profitable (or they will not be traders for long), and then distinguish themselves relative to their peers. Traders will be compared to their desks, to traders in other products at the firm, and to standardized industry benchmarks. They will be graded on total dollars earned relative to the cost of the resources utilized, and on the amount of risk taken. At most firms, management will start to look askance at the minimally productive trader, and will usually manufacture some reason to shuffle an underperformer into a different role (or out the door) to make room for a shiny new up-and-comer with potential.

Good Traders Work Very Hard
Good traders work much harder than average traders, and do so throughout their careers. A strong work ethic helps a trainee outlearn peers and get a shot at the desk. Junior traders must claw their way up to competency as fast as possible to keep their seats. Traders must continually out-work their peers in the market to remain profitable and be compensated for their production. Senior traders must remain current while at the same time always pushing to find the next product, market, or strategy that will expand or extend their career. 

Good Traders Prepare
Good traders do vast amounts of research to minimize the chances of being surprised by a data item, research report, or economic indicator that they should have factored into their decisions. Traders are in the anticipation and reaction business. The more time spent pre-planning for contingencies, the faster and the more precise the reactions. Doing the homework allows the trader to spend the critical time period after any market event executing a plan, not pondering the possible ramifications as the market moves.

Good Traders are Positive
Good traders believe that they can accomplish what they set out to do, that through hard work and skill that they can find profitable opportunities, design and execute a trading plan, and make money for their firm and themselves over time. Part of this is having rational expectations, but most of it is fairly straightforward psychology. A baseball player who thinks he can’t hit the ball will never step up to the plate. There is no point adding artificial barriers, there will be plenty of real ones there already.

Good Traders are Ethical
Most traders are ethical because they acknowledge and accept the carrot and stick implicit in their job description. A good trader at an aggressive firm can make so much money that there is no justifiable, logical reason for them to break the law or do anything else that could jeopardize their extremely lucrative career. Being ethical is also is good for their business. Once established, a trader’s reputation becomes well known and difficult to shake. Behaving unethically eventually becomes extremely counterproductive, and failure to honor a transaction or live up to the terms of a deal will lead to an immediate cessation of business with the offending party. A trader cannot expect to get better treatment in the market than she is willing to give, and in a fast-paced environment the shoe will be on the other foot very quickly. Within the rules rough play is allowed, however, and should be expected.

For those that, for some unknown reason, do not value the tremendous privilege their position implies, there are substantial penalties for transgression, including severely punitive fines and the very real threat of significant jail time. 

From Chapter 1 - Know Yourself, Pages 13-17.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

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