THE POWER OF RESEARCH
Rob Hanna is a trader and the writer of the Quantifiable Edges blog, a unique site that tracks historical patterns in the stock market. His electronic newsletter goes out daily, detailing the trades he places from his research. For traders, the blog and newsletter are unique tools that can extend their market edge. I particularly find historical patterns relevant to discretionary trading, as well see in Chapter 10. With a sound understanding of historical performance, we are in a great position to identify markets that are following their usual patterns and those that are not. Both scenarios can generate excellent trade ideas.
Jeff Miller is a money manager in Naperville, Illinois, who also shares his ideas about markets and trading through his blog, A Dash of Insight (http://oldprof.typepad.com). He frequently challenges accepted trading wisdom and offers perspectives on markets that reflect his disciplined analysis and understanding of economics. He has researched trading systems and uses those systems in his portfolio management. Like Rob, Jeffs edge is that he tests ideas before he trades them, giving him confidence in risking his capital.
Robs answer to my question of what hes found most helpful to his self-mentoring as a trader was quite simple: Research, research, and research. He explains, I know that sounds like one answer repeated three times, but its not. Its the top three answers . . . Ive been through several stages in my career and traded using different methodologies. The one constant Ive found with any method of trading Ive employed is that it takes a substantial amount of research outside of market hours to successfully implement them.
Rob Hanna started his career day trading, focusing on short-term setups, such as those described in Jeff Coopers Hit and Run books. What Rob found most useful was not the setup patterns, but the screening for volatile, trending stocks to implement the strategies. He began creating his own scans based on trading patterns, focusing on trades with the best risk/reward. I wrote down each potential trade in a notebook along with the trigger price for the next trading day, Rob described. When the trade was done, I would log the results in my accounting software. I kept a field in the accounting database called reason. It was there I entered the name of the setup I used to initiate the trade. This is a theme we see time and again with successful traders: they track their results meticulously to aid their learning curves.
Keeping records of trades that work cements success patterns in your mind.
Rob Hanna points out that keeping his trades in a database accomplished two goals: it forced him to have a reason for every trade, and it enabled him to track his results as a function of the trade setups employed. It made it extremely easy for me to determine which setups worked best and which ones struggled, he explains. By doing this, I knew which setups I should continue to focus on and which ones I should scrap altogether. When Rob didnt have a solid reason for a trade, he simply entered the word Hunch as the reason for the trade. It didnt take long for me to figure out how much the Hunch trades were costing, he recounts. He quickly scrapped trading from hunch alone.
The second phase of Robs research occurred when he switched to longer-term trading that utilized patterns inspired by William ONeils CANSLIM approach. Rob began to utilize technical screens with the TC2000 software from Worden Bros., with his final lists filtered through fundamental criteria. With TC2000, he describes, I am able to easily place notes on the chart. This is incredibly useful. If a stock pops up with an interesting pattern, I may have already researched that stock in recent weeks. With the note feature, I can see if I already checked the fundamentals and rejected it for some reason. No need to waste time looking up the same symbol over and over. As with the day-trading patterns, the setups were less important than the work that went into implementing them. Once again, he notes, I found it was the research and not the trading that made me the money.
In Robs third phase of research, he has formally back-tested his trading ideas, using Excel and TradeStation as primary tools. This back-testing has enabled him to generate actionable trade ideas. As he puts it, I love taking these trades because I have a good idea of my success rate and profitability expectation going in. Reviewing a variety of price, breadth, volume, sentiment, and other indicator data helps him develop a view on markets, but it also helps me to unveil what is truth and what is lore with regards to conventional market wisdom. There is so much information out there. Its difficult to know whats valuable and what information is simply hype . . . There is great value in being able to test ideas and understand what indicators and setups actually provide a quantifiable edge, and what ones dont.
Much conventional trading wisdom does not stand the scrutiny of objective analysis.
For Rob, research has been his source of edge. Whether my focus has been day trading, intermediate-term momentum trading, or quantitative swing trading, he explains, I have consistently found that its been the nightly research that has facilitated my growth as a trader more than anything . . . The ideas are all constructed at night. Market hours are simply used for executing those ideas. Research (stock screening and charting), research (quantitative analysis), and research (results analysis) are the three things Ive found most helpful in coaching myself as a trader.
What I most like about Robs perspective is that it highlights the relevance of research for every kind of trader, not just those that trade mechanical systems. Rob has tested and traded setups, but he also has treated himselfand his tradingas a subject for study. When Rob identified the ideas that work best for him, he has been able to maximize opportunity and eliminate the hunches and market lore that cost him money.
Jeff Miller approaches markets differently from Rob, but his perspectives on self-mentoring are surprisingly similar. The most important thingby farin my trading is having a system and/or method, he stresses. Without a system in which you have confidence, you are adrift. You second-guess yourself on every occasion. This leads to selling winners too soon, holding on to losers too long, and many other errors. You need to know that your basic method works. If you really understand and believe this, you can focus on making the correct decisions, which may not always be the winning decisions.
The key word Jeff uses is know. Many traders dont know their edge; they dont know how well their methods work in different market conditions. They have beliefs, but not deeply held convictions about the ways in which they make decisions. As a result, traders lose discipline. This loss is not because they cannot follow rules. Its because they dont deeply believe in the rules to begin with.
Many times, poor discipline is the result of shallow conviction. If we dont truly know our edge, how can we believe in it?
A second important element for Jeff Millers self-coaching is analysis and review. Having a system means testing it properly, he explains. This is not back-fitting for a short time period. It is developing the method in one era and testing over out-of-sample data covering different markets. Only then can you be confident. Even with this method, you must do regular performance reviews to make sure that something in the world has not changed. There may be a tough decision about whether you are in a predictable slack period or circumstances that are really different. In other words, trading is fraught with uncertainty; even the best ideas have a limited shelf life. The purpose of analysis and review is to generate an edge, but also to monitor changes in that edge over time. Its not as simple as finding systems that make money for all time and all markets.
Jeffs third area of self-coaching is learning to recognize exceptions. Understanding your method means knowing when something truly exceptional is happening, he points out. We all know the danger in saying that, This time is different. Keeping this in mind, there are exceptional trading opportunities lasting a day or a week, even for those of us with longer time horizons. This thought gets us back to the excellent point raised by Henry Carstens: knowing when to turn your trading off. When markets are behaving in historically abnormal ways, the usual methods may not produce their usual results. Exceptional markets yield exceptional risks as well as rewards.
The takeaway from Rob and Jeff is the value of self-knowledge. The more you know about your trading methods, the more you can play to their strengths and avoid their weaknesses. Note that for both Rob and Jeff, this has meant considerable time and effort outside of trading hours to hone their edges and stay on top of how they change. I consistently find that a major predictor of trading success is the amount of time devoted to markets outside of trading hours proper. The time spent in defining and refining trading methods is a major part of this commitment. When you are your own trading coach, you are no different from a basketball or football coach: much of your success will come from the hours you put into recruiting new talent, practicing, and planning.
Your assignment for this lesson is to treat yourself as a trading system, so that you can research, research, research your performance over various markets and market conditions. For this assignment, pay particular attention to the kinds of trades that make you most of your money. Do they occur at particular times of day, or in particular market conditions? Do they occur primarily in a few markets or stock names? Are they primarily short-term trades or longer-term ones? Are they mostly reversal trade, or are they trend following? Your goal is to clearly identify your bread and butter as a trader, so that you can allocate most of your risk to what you do best and reduce the risk associated with trades that are outside your wheelhouse. Understand what you doespecially what you do bestas it is the most effective means for developing and sustaining confidence in your work. Weekly and monthly reviews of each of your trades by categories are a great start in this direction.
Track the number of trades you place that break even or that make or lose only a small amount of money. Many times, this is a sign of good discipline in cutting losers (although it can also reveal problems with exiting winning trades far too early). Recognize quickly when a trade is wrong to help keep the average size of losing trades below that of winners, an essential ingredient of trading success.
