For Trading Success Be Open to Every Possibility

Most of us are discretionary traders. That goes for you system's guys too. After all, do you take every signal in every market? Probably not. Instead you impose discretion upon what products or time frames you're most comfortable trading. To use discretion means to filter. This filtering out process-regardless if enforced by mathematical rules or discovered through empirical observations-involves the favoring-even subconsciously -- of one set of circumstances over another. If I'm positioned long, then either my system or my beliefs encouraged me to outweigh contrary, bearish information.

In futures and options for every long there's a short. So if my trend following system issues a buy your trend fading system may say overbought. If I'm thinking inflation, you might be considering deflation. If I'm speculating prices will improve because of a shortage, simultaneously a commercial or institutional hedger could be selling off excess inventory. Computer or person -- each enters the market with an ax to grind.

Proper discretion is the off shoot of correct decision making. Still, calling the highest percentage play can't hardly predict if our normally accurate quarterback will throw a drive killing interception. Good traders, like coaches, reduce signal calling to a series of probabilities. Yet, we all know that any individual trade, no matter how high percentage it tests, can still have a horrible outcome.

For many traders and systems, making the mean reversion bet is playing the percentages. Even traders who are constructing positions with favorable risk to reward targets, i.e. risk $1 to make $3, are not immune from uncommonly deep draw downs after multi-consecutive losses from trying to pick s and bottoms. Too often we fail to account for the asymmetrical distribution of prices in runaway trending markets.

We've seen a litany of "blow out" moves in the past year. The break in S&P's from 1580 to 666, Crude Oil from 140 to the low 30's, not to mention a few noted financial stocks disappearing from our quote screen altogether. An undisciplined leveraged long in any of those aforementioned markets lost much, if not all of their trading capital. Persistently fading an outsized move can turn into a major disaster unless you're prudently risking small amounts of capital per trade. The speculator's handbook states a major component in your trading plan should be a contingency to not lose everything in a single market move. Not always easy. Lets discuss.

It's not just your risk "per trade" but you're risk per campaign.

Primarily, discretionary traders enter the market with a directional mindset based on a technical or fundamental view. It goes without saying that some opinions are better validated than others. When oil was at $140 you'd rather have shorted thinking "bubble" than bought thinking "next stop $200." So for starters, it's of paramount importance to identify what price action invalidates your predicted scenario.

Lets briefly examined the mindset of traders on the oil reversal. At $140, retail gasoline prices averaged north of $4 per gallon. Most traders-even many bulls-were not shocked that the oil rally could have a brief respite on the highs and sag back to the 115-120 area. Eventually, even the strongest of markets will print a "tradable" high and fill in some of the prior spike. The rotation lower is considered neutral activity. It could either be an opportunity to get long on a pullback or it could be the first warning of a trend change.

What was your thinking when the price you paid for gas quickly went from $4.10 a gallon to $3.45? Some of us thought, "one last tease before it's $5" others thought "it's still too high, gas should be in the high 2's." Very, very few of us considered at that time the possibility that we'd ever again, let alone just months later, be buying gasoline for well under $2 a gallon. The notion seemed far-fetched, eh?

Among many discretionary oil speculators, including Boone Pickens -- the prevailing viewpoint was that huge dips can be bought because it's virtually impossible for oil to negate the entire length of its 4 year rally. Wasn't there a great deal of fundamental information supporting that opinion? New all time lows in the dollar, new all time highs in grains and gold, an environmental lobby intent on banning both Alaskan and off shore exploration and continued political uncertainly with several nations in OPEC. I heard one oil trader say last year, "oil will trade under $60 again when there's peace in the Middle East which means never." For practical purposes we can assume that most retail oil traders, even if they'd been bearish at 140, 120 and 100 were now bullish at 80 thinking the break was overdone.

Unfortunately if you were stuck in the mindset that gasoline couldn't swiftly trade below $2 or if your trading system relies on buying "over sold" markets, there was little you could do other than lose money as an oil long. While most traders with a hypothetical $20,000 account wouldn't dream of risking 50-100% of their balance on single trade, many did in fact blow out trying to pick a bottom in oil because they lost 20% or more on several consecutive trades.

A friend of mine likens the oft revisited price action of a choppy market to that of a soap opera. No matter how many days of missed viewing, the plot/prices repeat themselves over and over. How can a degree of recency bias persist? Or harder yet, how does someone segue from trading an oil rally that squeezed shorts into oblivion straight into an oil implosion that sent a few billionaire longs into bankruptcy? Yes we already know we must be open to every possibility, but are there not scenarios impossibly difficult to imagine?

The phrase, "there's nothing new under the sun." doesn't ignore that specific new things are happening all the time. Instead it's the emotions and chart patterns produced by organically derived price that repeat with stunning frequency. Suffice to say if your excuse for losing big money is because you were wrapped in a trade situation that "never happened before" you better think again. Dramatic boom-bust scenarios have occurred for centuries. The problem isn't the market but rather our lack of recognizing/accepting new information and in turn lacking an exit strategy.

The next time you or me get stuck in a dogmatic mindset that says gasoline can't go to $1.70 or interest rates can't go to zero, we'll try to enforce some dreaded rules to avoid a blow out. We'll pick at least one of these.

Three strikes and you're out: Unless you're only risking minimal amounts of capital per trade, you simply can't allow yourself 8 straight losses from picking the same tired direction in one market or group of correlated markets. Tell yourself you're only going to accept premium entry levels and give it your best three shots.

Consider Spreading: A spread between two option months in the same commodity, or an intra-market spread between correlated classes is an excellent way to play direction and lower your exposure from a naked long or short.

Cut back your size: I'm the type who imprudently says if you like them at 8 you should love 'em at 4. Think about this though. Not only does common sense say bet smaller when you're cold and out of sync but the market will reward you when the elusive turn finally comes. In a run away bull or bear the ultimate reaction off a high or low is usually going to offer a volatile enough retrace that even on smaller size you'll have a home run opportunity.

Don't just pay lip service and nod your head to the reality of anything happening but actually developing an iron clad will help to deal with the unexpected. Your trading survival depends upon it.

While on the sports analogy: In the early 1980's at the height of Hagler, Hearns, Leonard and Holmes -- if someone told you that a decade later boxing would be virtually irrelevant with the sporting public or that stock car racing would be bigger than the Indy 500 - you'd have thought the prediction was crazy. Just think how safe selling that far out of the money put on boxing popularity would have seemed. The point I'm trying to make is that we don't set out to make wrong decisions and we're not necessarily biased toward an outcome because of personal likes or dislikes but instead we most often fall into bias for seemingly strong deductive reasons. Think of it this way: We're fooled into complacency and narrowness.

Kurt J. Eckhardt began his trading career in 1982 as an active floor trader in the Treasury Bond pit at the Chicago Board of Trade. Today Kurt is president of Eckhardt Research and Trading which offers the first ever futures pool to trade live on line while educating clients. Please go to Ecktrade.com for details and contact information.

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