In most pursuits, be it education, business or sports, we are taught that hard work is the key to success. This is not always so in trading, at least not at first. Most — this author included — experience this firsthand when they launch a trading career. Trading is different. Effort often seems inversely correlated with results if that effort is not spent on preparation.
Indeed, trading success often appears to exist independently of life experience outside the markets. Despite graduating from West Point, excelling in flight school, surviving combat, starting a successful company, raising $50 million in venture capital and taking it public as CEO, this beginner had his butt kicked by his first efforts in trading.
Ultimately, it became obvious that the problem was not the swing trading methodology, per se, but that the initial approach to market analysis was an unworkable fit for the trader. Finding this fit is perhaps the most fundamental ingredient to long-term success. The strategy you adopt cannot run counter to your temperament, goals, experience and risk-tolerance. In the sense that coming to this realization paved the way for a better understanding of what would work, the first year’s $20,000 "tuition" was well spent.
The lessons learned include the following:
- Trading became a job: It was tedious reading charts for pristine setups, monitoring open positions and continuously tweaking exit strategies – reacting to the latest twists and turns of the markets. While some thrive in this environment and relish the constant analysis, to others it is exhausting.
- Under-trading: With only two to four trades per month, results were highly dependent on single trades and, therefore, highly variable month to month. This created fear and defensive habits, such as taking profits too soon. With few opportunities to learn from actual trades, learning also was impacted.
- Overnight risk is stressful: While the investor in you may be able to sleep easy holding long-term positions, the trader side can be rocked by the stress of holding short-term positions overnight. The unknown can be crippling.
- Trading forward is not as easy as looking backward: We can learn from the past, but we also can’t confuse learning a technique with successfully trading with it. With some approaches, you must predict the direction of the markets twice: at entry and at exit. Some can do this. Some can’t. It’s an art that simply escapes those lacking a certain eye for discretionary chart analysis.
Approximately 15 months of intense effort were invested in a historically viable swing trading strategy, but it never worked. The techniques were valid, but with limited trading skills and a technique that didn’t fit with the trader’s profile, success would have to be found elsewhere. This was a battle for livelihood, happiness and financial security, so starting from scratch, the ancient classic "The Art of War" by Sun Tzu was dusted off. One of the first lines encountered was:
"So it is said that if you know your enemies and know yourself,
you can win a hundred battles without a single loss."
Most struggling traders don’t understand their "enemy" — the markets in this case — but they likely know themselves. Indeed, following a failed attempt, a trader likely has a keen understanding of his trading strengths (say, discipline and math) and limitations (say, impatience, limited experience and an inability to grasp the art of chart reading).
Another key for some new traders is a strategy that trades frequently enough to offer constant input to accelerate the learning curve. Other criteria may be not wanting to trade all day or to hold positions overnight.
This brings us to another line from Sun Tzu:
"Victorious warriors win first and then go to war, while defeated warriors
go to war first and then seek to win."
This single statement has the power to properly focus many trading careers. While many traders conduct extensive analysis to select trades, they are not prepared to win the battle after identifying trade prospects. The mistake is "seeking to win" by counting on chart analysis to determine when to enter and exit each trade. Instead, traders should "go to war" (trade) only when they know exactly how much they can expect to win, how much they must risk and the odds of success. With these three factors, it is possible to calculate profit expectancy and then trade only when this number is in your favor.
More experienced traders may feel this is too simplistic an approach — that more time should be spent reading trading books than war books, perfecting technical analysis techniques.
For some, though, the more direct approach is the better approach — identifying a setup that requires no (or minimal) discretion for entering and exiting the trade. Then, they analyze the historical win rate and profitability of that setup using a wide range of position sizes and stop placements and other variables to zero in on those that had produced strong historical results and avoid those that had not.
The setup finally accepted, after several months of analysis, was fading (trading in the opposite direction) the opening gap in the equity indexes. Gaps occur daily and historically more than 70% fill, or retrace to the prior day’s closing price, by the end of the day. The entry and exits are easily predefined: simply enter at the opening bell and exit at the prior day’s closing price once the gap is filled. If the gap doesn’t fill by end of the day, close the trade and sleep well without the fear of overnight surprises.
But there is a critical step: estimating profit expectancy. The formula is:
[(Probability of Winning)* (Expected Profit)] – [(Probability of Losing)*(Expected Loss)]
Traditional discretionary technical analysis suggests that stops should vary for trades based on the differing levels of support and resistance suggested by current market conditions. However, you cannot use the above formula to estimate your odds of a winning trade, nor how much you expect to lose, if you don’t know exactly how wide or narrow a stop you use. Without the ability to backtest variable, chart-based stop placements, it was decided to backtest the past 10 years of gaps in the Dow Jones Industrial Average and use whatever had worked best. The key number was about one-half of 1% of the value of the index.
This stop width permitted the fading of the opening gap, and accommodated the normal post-open volatility. It captured the majority (about 85%) of all gaps that filled, without first being stopped. It also limited losses on those days that the gap did not fill but instead continued in the direction of the opening.
Most important, a fixed and known stop size allowed the calculation of profit expectancy. That was the good news. The bad news was that it only generated a modest profit historically after commissions and slippage.
Improving the technique
Sun Tzu delivered another gem with this quote:
"He who knows when he can fight and when he cannot will be victorious."
To make money trading a fixed stop and pre-defined target (gap fill), you must know when to fade the gap and when not to fade the gap. In other words, our gap system needs to be optimized to select only the best risk/reward opportunities. Specifically, it’s necessary to calculate when conditions favor a gap fill with low opening volatility, and when they do not.
A simple, but effective technique for analyzing and selecting the best gap fade opportunities is using the opening location or "zone." By using the open, high, low and closing price of the prior day and the direction of the prior day’s open-to-close price action (up or down), all historical opening gaps could be segmented into one of 10 zones — each with significantly different gap fill win rates (see "Gap zone map," below).
While additional filters, such as market conditions, candlestick patterns and seasonality (day of week and part of month), can eke out more gains or better risk control, the core of the strategy is robust. It performs in all types of markets.
A challenge with discretionary strategies is producing a reliable back test. However, this mechanical gap trading technique back-tests well and performs profitably with real trading too. The actual equity curve for 2008-2009, trading 10 lots in the e-mini S&P 500, is shown (see "Equity curve" on below).
Depending on your temperament and risk tolerance, focusing on the opening gap can allow you to avoid many of the issues some traders struggle with while swing trading. Second, while many strategies will work in the markets, the key to success is finding what works for you — in this case, planning to win the fight before pulling the trigger and making sure the gun is aimed in the right direction.
"The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand."
Scott Andrews is a private trader and founder of MasterTheGap.com. You can reach him at firstname.lastname@example.org.