Developing a discretionary day trading method with Joe Ross.

Many aspiring day traders lack the key element — a clear-cut plan — for developing a method by which they can trade successfully. Yet there are specific steps one can follow that lead to the development of a reliable trading method. The steps are:

1. Selection of a market and a time period
2. Definition of entry rules
3. Definition of exit rules
4. Evaluation of the method
5. Improvement of the method.

Let’s examine each of these steps.

1: Selection of a market and a time period

It is possible to trade most markets and most intraday time spans successfully with a day trading method. However, if you attempt to look at all the different futures markets and six major periods of time (one minute, five minutes, 10 minutes, 15 minutes, 30 minutes, and 60 minutes), you will need to evaluate hundreds of possible options. How can you limit your choices?

Although you could attempt to trade every futures market, these days it is a lot better to stick with the electronic markets (e.g. e-mini S&P and other indices, Treasury bonds and notes, currencies). These markets are usually very liquid, and you won’t have a problem entering and exiting a trade. Another advantage of electronic markets is lower commissions—expect at the most to pay an amount no more than half the commission you pay on non-electronic markets. Sometimes the difference can be as high as 75 per cent.

When you select a shorter time (less than 60 minutes), your average profit per trade is usually comparatively low. On the other hand you get more trading opportunities. When trading in a longer time span your profits per trade will be larger, but you will have fewer trading opportunities. It’s up to you to decide which suits you best. There is a trade-off, and it’s up to you as the trader to make that decision.

Shorter times mean not only smaller profits, but also, usually, smaller risk. If you are starting with a small trading account, you might want to select a shorter time to make sure you are not overtrading your account. However, keep in mind that because the shorter time offers more opportunities, you could very well end up overtrading your account by taking too many trades.

This reminds me of a trader I know who discovered a method for the 60-minute chart, which he could prove statistically gave him an edge. So this trader attempted to exploit his method by trading the e-mini S&P on a 1-minute chart. He ended up churning his own account, and losing $45,000. Why? It was because on a 1-minute chart the moves were not sufficiently large to allow him to make enough profit to cover the losses and overhead.

We have found that our most profitable day trading methods use longer times, like 30 or 60 minutes. These methods work without the need to sit in front of a screen intently watching every single tick. You get to trade less, which is desirable and more fitting to the lifestyle most traders tell us they would like to have.

2: Definition of entry rules

Entry rules need not be complicated. Basically there are three different kinds of entry setups. The first is entries triggered by statistical probability. You notice that when certain patterns occur, prices move a certain way most of the time. Examples are pattern trading and setup trading. The second is entries triggered by trend following. When prices are moving up, you buy, and when prices are moving down, you sell. Examples are Elliott Wave trading, moving average containment, volatility containment and channel trading. The third kind of entry setup is entries triggered by trendfading.

Examples are found where trading bounces from support or resistance: Fibonacci, Daniel code trading and channel trading. Channels lend themselves to both trend-following and trendfading entry rules. Most indicators in your charting software belong to one of these two categories: you have indicators for identifying trends (e.g. moving averages) or indicators that define overbought or oversold situations and therefore offer you a trade setup for a short-term swing trade.

Don’t become confused by all the possibilities for entering a trade. If you use an indicator, be sure you understand why you are using it and what the indicator is measuring.

3: Definition of exit rules

There are three different exit rules you should consider applying:

• stop loss rules to protect your capital
• profit taking exits to realise your profits
• time stops.

The first two exit rules can be expressed in four ways: a fixed dollar amount (e.g. $500); a fixed percentage of your account; a percentage of the current price (e.g. one per cent of the entry price); or a percentage of the volatility (e.g. 50 per cent of the average daily movement).

Using a fixed dollar amount seems to make little sense because markets vary considerably. For example, natural gas changes an average of a few thousand dollars per day per contract. However, Eurodollars change an average of a few hundred dollars a day per contract. You need to balance and normalise this difference when developing a day trading method and testing it in different markets. That’s why you should consider using percentages for stops and profit targets (e.g. one per cent stop) or a volatility stop instead of a fixed dollar amount.

A time stop limits the amount of time you will be in the trade (e.g. exit after 30 minutes). A time stop gets you out of a trade if it is not moving in your chosen direction, thereby freeing your capital for other trades. There are two ways you can be wrong about a trade: you are wrong about the direction, or you are wrong about the timing.

4: Evaluation of the method

The first figure to look for is the net profit. Obviously you want your method to generate profits. But don’t be frustrated when, during the development stage, your day trading method shows a loss. If it does, try reversing your entry signals. If you are going long at a certain price level, and you lose, then try going short instead. Often this is the easiest way to turn a losing method into a winning one.

An important figure to look at is the average profit per trade. Make sure this number is greater than slippage and commissions, and that it makes your day trading worthwhile. Day trading is all about risk and reward, and you want to make sure you get a decent reward for the risk you take.

Take a look at the profit factor (gross profit/gross loss). This will tell you how many dollars you are likely to win for every dollar you lose. The higher the profit factor is, the better the day trading method is. A method should have a profit factor of 1.5 or more, but be careful when you see profit factors above 3.0 because it might be that you have over-optimised the method. There are some additional characteristics you might want to consider besides the net profit of a method.

i) Winning percentage

Many profitable day trading methods achieve a nice net profit with a rather small winning percentage, sometimes even below 30 per cent. These methods follow the principle: “Cut your losses short and let your profits run”. However, you need to decide whether you can stand seven losers and only three winners in 10 trades. If you want to be ‘right’ most of the time, then you should pick a method with a high winning percentage, realising that there is a trade-off; the higher the winning percentage, the less you can expect to make per winning trade.

ii) Number of trades per month

Do you need excessive intraday action? If you want to see something happening every day, then you should pick a day trading method with a high number of trades per month. Many profitable day trading methods generate only two to three trades per month. If you are not patient enough to wait, then you should select a day trading method with a higher trading frequency.

iii) Average time in trade

Some traders become very nervous when they are in a trade. Some traders can’t sleep at night when they have an open position. If that’s you, then you should make sure that the average time in a trade is as short as possible. You might want to choose a method that does not hold any positions over night.

iv) Maximum drawdown

A famous trader once said, “If you want your system to double or triple your account, you should expect a drawdown of up to 30 per cent on your way to trading riches.” Not every trader can stand a 30 per cent drawdown. Look at the maximum drawdown the method produced so far, and double it. If you can stand this drawdown, then you may have found the right day trading method. Why double it? Remember—your worst drawdown is always ahead of you.

v) Most consecutive losses

The number of most consecutive losses has a huge impact on your trading, especially when you are using certain money management techniques. Five or six consecutive losses can cause you a lot of trouble when using aggressive money management. In addition, this number will help you to determine whether you have enough discipline to trade the method. Will you still trade the method after you have experienced 10 losses in a row? It’s not usual for a profitable trading method to have 10 to 12 losses in a row, but it can happen.

5: Improvement of the method

There is a difference between ‘improving’ and ‘curve-fitting’ (overoptimising) a method. You can improve your day trading method by testing different exit methods: if you are using a fixed stop, try a trailing stop instead. Add a time stop and evaluate the results again. Don’t look only at the net profit, look also at the profit factor, average profit per trade, and maximum drawdown. Many times you will see that the net profit slightly decreases when you add different stops, but other figures might improve dramatically.

Don’t fall into the trap of over-optimising; you can eliminate almost all losers by adding enough rules. Simple example: if you see that on Tuesdays you had more losers than on the other weekdays, you might be tempted to add a ‘filter’ that prevents your method from entering trades on Tuesdays. Next you find that in January you had much worse results than in other months, so you add a filter that enters trades only from February to December. You add more and more filters to avoid losses, and eventually you end up with a pile of trading rules that render the method worthless over long periods of time. Though you may have eliminated all possibilities of losing (in the past) and the method is now producing fantastic profits, it’s very unlikely that it will continue to do so when it hits reality.

When you are developing a method, there is a very important concept to keep in mind. Picture it this way: the market is presenting you with its face as it is right now—squarely in front of you. The method works while looking at its face head-on.

But what happens when the face of the market changes? Does the method still work if its face changes by 45 degrees? If so, the method is a good one. What if the face of the market turns further, to 90 degrees? If the method still works, you have an excellent method. What if the face of the market turns by 135 degrees? If the method still works, you have a most astounding method. Finally, what if the face of the market changes 180 degrees, and you are now looking at the back of its head? If your method still works then, you will have discovered the holy grail of trading.

The point is that every method stops working at some time because the market will be showing you a different face. This is where a discretionary method differs from a mechanical trading system. When a method stops working, you stop trading it. You wait patiently for it to come around to where the market’s face enables the method to begin working once again.

Joe Ross is a trader, author and trading educator. He day trades stock indices, currencies, and forex. Joe trades futures spreads and options on futures, and has written 12 books about it all. Joe is the discoverer of The Law of Charts™, and is famous for the Ross Hook™ and the Trader’s Trick Entry™. His websites are www.tradingeducators.com and www.spread-trading.com.

This article was originally published in the Mar/Apr 2008 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd. To subscribe click here, or to purchase this issue as a single back issue, click here.