I doubt many traders would disagree with me when I say “This is tough!” In fact this is about as bad as I have ever seen it for short term trading and understandably many traders are feeling disillusioned. There is every reason to feel disillusioned, it is our job to trade but the markets are not conducive to providing payment for our efforts.

But there are two reasons to keep our spirits up as much as possible:
There is a simple formula for working through such times, and
Better times are on the way

Simon’s survival formula

Those who trade with me in my Trading Den each week already know this formula for surviving times as rough as this. This is why we have been able to hold onto our equity highs throughout this taxing last few weeks.

But for those that don’t know my survival formula, here it is. The plan has three elements to it:

Trade much less frequently
Risk far less on each trade
Be patient and have faith

Trade frequency

Lets say you are typically used to finding 3 to 5 trade opportunities per day, which is about what our short term trading provides us with. In this random noise environment there are actually far fewer real opportunities than normal. Maybe just 1 or 2 per day – if that even.

However noise has this wonderful way of tricking you into thinking you can see opportunities that in reality are totally fictitious. If you are not careful you will get lured into making MORE trades than normal rather then LESS. This is why such environments are so very dangerous and the long term fate of many traders is determined by these very periods.

So my simple logic says that if the number or real opportunities are fewer per day then our number of trades per day must be scaled back. So the solution is to go into the day knowing IN ADVANCE that your number of trades will me a maximum of 50% of the number you would usually expect. Instead of 3 to 5 plan on taking 1 or 2 only and certainly not the 5 to 10 or more that the noise will try to fool you into thinking exist!

When you think you see an opportunity, here’s what you do. Get up off your chair, walk to the back of the room and look at your chart from there. If you still see a nice clear trade set up, take it. If all you see from the back of the room is noise then that is exactly what it is! Sit back down and do nothing except watch the market quickly move to the place you would have put your stop! Trust me on this after years of gathering scars to prove how misleading noise can be, I have taught this crazy little technique to many people who all swear by using this “filter” to keep themselves out of trouble.

Trade risk

Over the years I have heard many people talk about the secret to trading noisy markets is to use wider stops – to keep the stops outside of the bandwidth of the noise. Sounds logical right?

Wrong! Absolutely dead flat out wrong! Try it if you like, but in practice you will find that for the very occasional trade that you might get away with without getting stopped out there will be ten that still stop you out just for larger amounts than usual!

The big mistake in the wider stop approach is that it assumes a degree of predictability to the noise and hence the argument that you can keep stops out of reach by assessing the bandwidth of the noise. But by definition noise is UNPREDICTABLE that is why it is just random motion.

So my solution, contrary to popular opinion, is to do quite the opposite. I use stops that are much tighter than normal. I give the market about half as much room to perform as I normally would.

You might be thinking “Simon that’s crazy, you are putting you stop right in the thick of the noise so it is certain to get hit!” Yes you are right, but only if your premise is based upon the need to stay outside the bandwidth of the noise. But that is where you and I would have to disagree. My premise has nothing to do with the bandwidth of the noise, I think that is a classic red herring.

My premise is quite different – If the trade is going to work it needs to work immediately. It isn’t going to hang around. Either it does what I expect and just goes, or else I don’t want it! So in a noise environment I give any trade far less room and far less time to prove itself. Because if it hangs around – then isn’t it true that we are still just in noise and the opportunity is in fact bogus?

If it is bogus why do I want to risk a full unit to find that out, let alone a larger unit than normal? Sorry but for me if it doesn’t do what I expect immediately I just want to get out for a tiny cost and be able to say I tried but it didn’t work.

Patience

The hardest part of my formula and the hardest part of all trading is having the patience to wait until a worthwhile opportunity materialises. Gaining the skill of patience is hard work, no question about it. But let me give you a couple of little incentives to think about when you are feeling the urge to click that mouse.

If you follow the guidelines above, i.e. cutting by at least half (if not more) the number of trades per day and the risk per trade, you reduce your daily risk by at least 75%, probably a lot more. Realistically your worst case risk per week in this dangerous environment is now no more than you would be risking per day in a decent environment.

This buys you time to ride out the rough patch without doing much too damage to your capital and this is before we even talk about the option of cutting back trade size (a topic maybe for another time).

Buying time and keeping losses under control is critical for the following reason, aside from keeping your sanity…

When it all changes and comes good again, would you prefer to spend most of the good time making up some dirty great drawdown which was largely avoidable, or would you prefer those new profits to be propelling your equity curve to new highs almost from the start?

I have done both, many times, in my career and I know which one I prefer. So when I look at my short term trading results over the last few weeks and say to myself “damn it we haven’t made any progress recently” I quickly remind myself “yes but we are only a couple of decent trades off of equity highs and THAT matters!”

These are the factors I think about more and more and as you engrain such principles deeper into your mind, the easier it becomes to summon up the patience that every single trader on the planet struggles to have.

Better times are coming

As I mentioned at the beginning we will see better times again soon. Quite when is anyone’s guess.

Every time we hit these patches it feels like “this time is different it will never improve”. Yet over history it always has. Every time we see these nasty markets there is a reason why it may never recover. Every time it does.

There is no getting away from the fact that we live in uncharted times in very many different respects and there is every reason to argue that “it will never be the same again”.

Personally I believe that it will be the same again at some time, but that even if it wasn’t I would still find a way to align myself to the markets to make steps forward once again. Half that battle is avoiding taking too many steps backwards during the tough times.

I suspect the timing of the pick up will be a lot to do with the turn down in equity markets. Historically that is when volume and volatility come flooding back into not just index futures but so many other markets too.

Of course when that will be I also have no idea. It will be when it will be and when it does ranges should expand again, volume should return again and those who have followed the guidelines above will be pushing new equity highs within the first few trades.

For what its worth our longer term model is now short the S&P from the 1350 area, which may offer a glimmer of hope but there is no knowing in advance if the trade will work out or not and if it does there is no saying that this will be any sort of turning point. But it just might be the first sign that the tide is turning as we haven’t had a short signal for a very long time now.

My great friend George Kleinman taught his “secret indicator” at our seminar last summer. If you were there you might like to take a look at the daily Nasdaq chart, which is rather tantalisingly also showing a short signal there.

Will either trade turn into anything more than a scalp? Who knows, certainly not me. It’s just my job to take the trades and the market gives us what it gives us. But one day the trend will change and my guess is that will be the time that the short term trading game will come back to life once again.

Take care of your capital, try not to be too frustrated and have faith that things will get better. We’ll all ride out this storm together.

Copyright 2012 by Simon Townshend Ltd., all rights reserved

Derivative transactions, including futures, are complex and carry a high degree of risk. They are intended for sophisticated investors and are not suitable for everyone. Simon Townshend Ltd is educational in nature and does not provide brokerage services or make investment recommendations.

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