We choose not to update the website on a weekly basis.

For example, over the past 8+ months – I have chosen to only provide regular updates via the newsletter. And from the feedback I have received – that format seems to be preferred.

Posts are delivered straight to readers inbox the moment I hit publish. They don’t need to visit the website. What’s more, they have each and every post on file for quick (permanent) reference (and the check any forecasts I may have made)

From my side, it’s also a lot less work!

I don’t mind spending 1-2 hours every night putting together a missive. But the additional time associated with updating a website can be painful (graphics etc)!

It’s enough volunteering an hour or two after the end of every work day.

Okay…

Below are the posts we issued to subscribers from mid-December and January 

December 2017

January 2018

For the purpose of this post – I am going to share (what I think) is the most valuable post of the past two months.

7 Principles to Start Your Trading Year in 2018

  • Use these 7 Principles as a Framework
  • Process – the key to Profitable Trading
  • A Good Plan is always Simple 

As opposed to making foolish forecasts for the year ahead (there’s already enough out there) — I wanted to offer readers a summary of seven key principles that I apply to my own trading.

My view is a trading plan should be simple.

It should be easy to apply, achieve, follow and explain.

But more than this, your plan should provide a strong foundation for you to approach every trade (systematically) and evaluate how things are working (or not working as the case may be).

When reading these principles – treat them as a framework or a guide. In other words, what follows is not designed to be a “trading bible”.

It’s a set of guidelines that you can choose to accept, reject, modify or edit to suit your own style, risk tolerance and timeframes.

These guiding principles are simply what works best for me.

As regular readers will know, I have been sharing these principles for ~6 years consistently.

Week in week out the same approach and evaluation model applies. And most of the time – things have worked out pretty well.

Let’s get into it – and I hope what I share helps you to become a more profitable, consistent trader in 2018.

7 Key Trading Principles

I have structured this post in three parts:

(i) how to choose a trade;
(ii) managing an open trade; and
(iii) capital management.

Each part is designed to (i) improve your probabilities of success; and (ii) optimise every trade’s profitability whilst not risking your capital.
Part I: Setting up a Trade

  1. Trade in the Direction of the Weekly Trend
  2. Choosing Optimal Entry Points
  3. Setting Your Initial Stop Loss
  4. Setting Your Initial Profit Target

Part II: Managing a Trade

  1. Using Trailing Stops to Protect Profits
  2. When to Exit a (Winning) Trade

Part III: Capital Allocation

  1. Capital Management – the “2&20” Rule

Regular readers will be very familiar with these principles. We have been sharing examples over the past 6 years. For those who are new (or in the first few years of their trading) – I hope this will be useful.

Part I: Setting up a Trade

(i) Trade in the Direction of the Weekly Trend

As regular readers know, I choose to only trade in the direction of the weekly trend. 

In short, probabilities tell me that your chances of success are significant higher if choosing to trade with a trend – and not against it.

However, the question I most often get is why weekly?

Why not daily? Or hourly? Or some other timeframe?

This is a case of choosing what works best for you and your own trading style / plan / risk appetite.

I choose not to look at a chart every day of the week. I could not think of anything worse. I also find the daily chart too “noisy” – providing far too many “whippy” (false) signals.

Now your broker will love you if you choose to trade a daily (or a more frequent) timeframe. I say that because most will charge you at least $10 per trade (to buy and sell) . As such, more frequent traders should factor this into their overall profitability.

But more than this, to be truly profitable with this game — we need to catch big sweeping moves. And to do this – you need to give trades time.

The next question is how to identify a weekly trend?

Again, this is something you can tweak to suit your own style. For me, I choose to identify a weekly trend using two moving averages in relation to each other. They are:

  1. the 10-week exponential moving average (EMA); and
  2. the 35-week EMA

For example, if you go to www.finance.yahoo.com – you can generate this for any stock, index, ETF, bond, commodity or currency:


Yahoo!Finance applying a 10-week and 35-week EMAs

In this case, we have generated the weekly chart for FedEx (FDX).

Two things to explain:

  1. On the top left – I have highlighted Yahoo’s indicators tool. This allows you to add both the 10-period and 35-period exponential moving averages (nb: you can nominate (i) chosen period (ii) simple or exponential; (iii) colours; and (iv) add as many averages as you wish; and
  2. I’ve also highlighted the timeframe in the centre of the screen; ie “2Y 5Y”. Choosing either of these timeframes will set the chart window to a weekly timeframe. For example, if you scroll your mouse slowly over each individual data point – it will advance by a one week period. If you chose the “1Y” timeframe, the increments will be daily.

I have generated two moving average lines:

  1. the 10-week EMA (red); and
  2. the 35-week EMA (green).

As it happens, for FedEx we find the 10-week above the 35-week EMA — which tells us the trend is bullish.  That is, prices are more likely (not certain) to move higher.

Now if the 10-week EMA was below the 35-week EMA (eg, as we see at the very beginning of the chart) — this tells us the trend is bearish and prices are more likely (not certain) to move lower.

(ii) Choosing Optimal Entry Point(s)

Once we have ascertained the direction of the trend — the next decision point to help improve your probability of success is when to enter a trade.

This will help answer the question “do you think xyz is a good buy at the moment? Or do you like “abc” and “yyy” stocks” (which I get regularly).

From mine, there are generally two opportunities in every trend:

  1. when we first see the 10-week / 35-week EMA’s cross; and
  2. when the price tests the 35-week exponential moving average

With respect to (2) – if the trend is bullish (ie 10-week EMA is above the 35-week EMA) – then we are looking for the price to move down to the 35-week before buying.

On the other hand – if the trend is bearish (ie 10-week EMA is below the 35-week EMA) – then we are looking for the price to move up to the 35-week before selling.

Let me illustrate the alternate entry points using the same chart:


Ideal Entry Points in a Bullish Weekly Trend

The first point identified (blue arrow) is where we see the initial bullish trend shift for FedEx (Mar 2016).

Here the price was just below $175. Since then, our weekly trend has not deviated (ie the 10-week EMA has remained above the 35-week EMA).

However, over the past two years, traders have been given four (good) opportunities to join the trend (ie pink arrows).

This is where the price was (a) at (or near) the 35-week EMA; and (b) whilst the trend remained bullish. 

  • Note: the price doesn’t have to “touch” the 35-week EMA to trigger a new buy signal. However, the closer to the 35-week EMA – the better the entry signal (ie it represents less downside risk). 

Let me also stress that often entry points require patience. 

For example, with FedEx in 2017, traders were only given two strong opportunities to enter the bullish trend (not unlike the S&P 500).

There should be no such thing as “fear of missing out” with trading. There are literally ‘thousands’ of trades will present themselves every day.

Let’s move forward to arguably one of the most important principles in trading – where to set your stop-loss after your initial entry. 

In other words, how do we know if the trade is not working out?

(iii) Setting Your Initial Stop Loss

Once you have pulled the trigger on a trade – it’s crucial to set a stop loss to protect your capital.

I cannot emphasize or stress enough how important this basic step is. Before we place any trade – we always know at what point it has failed.

Why do we do this? 

The first reason is we know that not all trades work out.

By way of example, when it comes to my own trading, I automatically assume that half of my trades will fail (ie where a stop loss has been triggered).

My method (this will not suit everyone) involves setting the initial stop-loss at the last major low using the weekly timeframe. 

And that level might be “5%, 10% or even 25% lower” than the current price.

What matters most is how much capital I allocate to the trade (which I will get to shortly).

Again, let’s take our weekly chart for FedEx:

Setting the Initial Stop (and Raised Stops)

Our initial entry point is where our two moving averages crossed.

At this point, we look back to see the last major low. In this case, that is ~23% lower (ie ~$125) than our entry of ~$163.

If the price closes below $125 – we move on to the next trade.

Again, we will talk to capital allocation and how we address a “23% fall” shortly.

Now, let’s say you missed out on the initial crossover (not uncommon). And let’s also assume we decided to enter FedEx at “Point 3” (ie in April 2017 at ~$183)

In this case, I would set my initial stop at the last major low of $159 – ie Point 2 on the chart (ie ~13% lower).

Whatever your chosen method – what’s important is your identify a predefined stopbefore you enter any new trade.

Don’t turn small losing trades into large losing trades. 

As we will explain shortly, if that stop is triggered, it only represents a small fraction of your total equity.

Remember: I often like to remind readers we are playing this game for the next “thousand trades… not just the next ten”.

(iv) Setting Your Initial Profit Target

Let’s recap where we are in the (setup) process:

  1. we have confirmed the trend (ie 10-week EMA above the 35-week EMA);
  2. we have bought the stock at the ideal entry point (on the basis there is a greater probability the stock will rise); and
  3. set our initial stop loss (telling us if the trade has failed to work out).

Next question:

How do we know when to take some (or all) of our chips off the table?

For example, what if the stock rallies 15% – do we sell?

What if it rallies 25%? Or 100%?

This is another question I often receive. And everyone will have a different approach.

I say that because I don’t believe there is a “fixed” method which works for all. However, I am happy to share what works for me.

When it comes to an initial profit target – I apply Fibonacci Ratios opposite what’s called a ‘retrace’. The challenge is identifying the ‘retrace’ or ‘structure’ from where to calculate our initial profit target.

Let’s use the same weekly chart and I’ll try to explain:

How to Calculate the 61.8% Initial Profit Zone

Labelled are two points: A and B

Prior to Point B – the stock continued to fall before it finally found support. From there, it retraced to $163.88 (highlighted with the yellow arrow and labelled Point A).

Retracements will occur from either (i) a support level after a move lower; or (ii) a correction lower from a high.

This is what I use to calculate initial profit targets. From here, I make two (basic) calculations:

  1. the size of the retrace (“A” minus “B” –  shown by the yellow arrow); and
  2. a move of 61.8% beyond the retracement (ie the green arrow)

Why do I do this? 

I’ve often found that prices will extend to a level of between 61.8% and 76.4% outside a retrace (both higher and lower) before finding a new area of consolidation (eg resistance or support).

Let’s work the Fibonacci numbers using the above example:

  • The high point of our retrace is (“A”) – with a value of $163.88
  • The low point of our retrace is (“B“) – with a value of $122.78
  • The difference between A and B is $41.10 (ie our retrace)
  • $41.10 x 61.8% = $25.40 (ie expected move higher)
  • $163.88 + $25.40 = $189.28 (ie setting our initial profit target)

As we can see, FedEx rallied to around this level before it found resistance (ie consolidated) from November 2016 through to June 2017. At this point, I would do two things:

  1. either sell one-third or one-half of the original capital outlay (de-risking our trade); and
  2. raising the stop loss to the last major low (highlighted in red)

This puts us in a very strong position – making it unlikely to lose money on the overall trade. For example, if the stock falls back to our (new) raised stop – we will still be profitable.

Which leads us to our next principle and Part II — managing the trade whilst we are in it.

Part II: Managing a Trade

(v) Trailing Stops to Protect Profits

There is no better feeling than taking your initial profit on a trade (whether it be one-third or one-half of your original capital outlay).

The reason is it puts us in a very strong position (what I call “risk free trading”)

The next part of the equation is ensuring we capitalize on the full extent of the trend. I say that because we don’t pretend to know (or guess) how far a trend can go.

Remember: we never try and pick the high of a market or the low. 

Trends will often go far higher (and far lower) than anyone can imagine or forecast (eg Bitcoin, the S&P500 in 2017, Lithium and many others).

For me, the best way to catch the “meaty” part of a trend is continue to use a trailing stop level.

Again, there is no set way to do this. This is a matter of personal preference and something you can tweak to suit your own style. The common goal however is two-fold:

  1. ensure you stay in the trend whilst it continues to rally (assuming you are long); and
  2. protecting against giving back all your (hard earned) profits.

For example, your trailing stop might be a moving average (eg the 10-week EMA or the 35-week EMA); or some other indicator / key technical level.

My personal preference is to raise the trailing stop (on the basis we are bullish) with each major new low until it is broken (more on this shortly with an example).

Repeating the chart from earlier:

Here we see the 5 “major lows” after entering the trade.

Our initial stop loss on entry was never threatened.

FedEx has continued to reach new highs – suggesting we would still be in the trade. However, our exposure would either be half or two-thirds of our original position.

Let’s now look at when to call the trade a winner and move on.

(vi) When to Exit a (Winning) Trade 

On old trading adage is “the trend is your friend until the (inevitable) nasty bend at the end”

Very true…

So how do we identify the “nasty bend at the end?”

Put another way – what tells us it’s time to step aside and take our remaining profits (given we don’t know how far a trend can go)?

For me, it’s simply the break of the last major low.  Again, I will use an illustration:

Exiting a Trade on the Break of a Trailing Stop

Here we see two (ideal) trade entries for FedEx – both when the 10-week EMA crossed back above the 35-week EMA (ie the red and green lines).

With respect to Trade Entry #1 — I have penciled in 3 trailing stops at each at major new low whilst trending higher.

Take a look at the third occasion. This was where our trailing stop was finally broken – signaling the end of the trade (highlighted in red).

As an aside, this also happened to correlate when our trend turned bearish (ie 10-week EMA below the 35-week EMA) – suggesting lower prices were likely to follow. Almost one year later– the bullish trend resumed and we re-entered the trade long. 

Again, how you choose to apply a “protective stop mechanism” for your trades is up to you.

For example, you might choose the break of a moving average. Or you might choose the break of previous major level of support. It’s entirely up to you. However, this is what I have found works for me.

What’s most important is your method allows you to protect the bulk of your profits made from the trend whilst staying with the trend should it move higher.

Again, we will never look to try and sell at the peak. And on the other side, we will never look to try and buy a trend at its bottom. We aim for the meaty part of a (long) trend.

Let’s now move to Part III of my guiding principles… capital management.

Part III: Capital Management

(vii) The “2&20″ Rule”

All of the aforementioned principles – what I like to call my “2&20 Rule” — will have the most impact on your profitability.

As a preface, I strongly recommending reading this post. It will help enormously (more so for those who are new).

For example, let’s say you have a trading capital of $100,000 and you did everything correctly in a trade. We might have taken solid partial profit at “25%” and then closed the position for a 100% winner.

But what if you only placed $1,000 on the trade? 

Unless it rallied several hundred percent – it’s unlikely to have a meaningful impact on your $100K portfolio.

Or let’s say the trade didn’t work out (which we should expect half of the time) and you placed “80% of your entire stake” on the trade? What then?

The “2 & 20 principle” helps address these (common) trader errors.

Let’s first start with the 2% component.

In short, my personal risk preference to never risk more than 2% of your total equity on any one trade. Your’s might be 3% or 5%. That’s up to you. For me it’s 2%.

For example, let’s assume our total portfolio is $100,000. 

Let’s also assume we were going to buy FedEx at $163 and our predefined stop loss was$125.

How does the 2% rule apply in this case? 

First up, we are looking at a 23% potential fall in FedEx if adopting those two parameters.

That’s not small.

Therefore, what amount of capital should we put to work to ensure we didn’t lose more than $2,000 (ie 2% of $100K) on the trade and FedEx fell below $125?

The answer is $2,000 / 0.23 = $8,695

And in terms of how many shares – that is simple $8,695 / $163 = 53 shares.

Therefore, if FedEx was to fall over and trade back below $125 we would only lose 2% of our total portfolio.

To backward check our calculation: $8,695 x 23% = $1,999.85

By applying this risk management principle – you would need to lose 50 consecutive tradesto lose all of your capital. That’s unlikely.

As an aside, many years ago I had 17 losing trades in a row. That obviously hurt. But it didn’t break me.

So here’s a question:

Would your current risk management plan (or system) withstand taking “17 losing trades” in a row? 

The second part of our “2&20” rule is the “20” component.

This is just as straight forward.

In this case, we limit our maximum position size against any one single trade at no more than 20% of our total portfolio.

For example, let’s assume our $100,000 total portfolio size. Using this principle — our maximum trade size would be $20,000. 

Again, why do we do this? 

We never want to put ourselves in the position of destroying most (or all) of our capital on any one trade.

Remember: 

Assume at least half of all your trades will fail. The thing you cannot possibly know is the sequence of those 50%. Eg: you might lose your next “17 trades” in a row.

Sometimes it might be tempting to “hit a trade hard” because you have a feeling or it’s a “tip” on good authority. But most of the time – these trades will not work out.

Every trade is a unique and random event. For example, if you flip an evenly weighted coin, the odds of a head or tail are 50%. But what’s to say you can’t flip 5 heads in a row. It happens.

Your standard disposition before every trade should be what could go wrong? 

What happens if I wake up tomorrow and this trade is “50% lower” on open due to some unforeseen event. It happens.

And whilst it’s unlikely your trade will go to zero (they can) — if you apply this rule — you can only lose 20% of your total portfolio. 

Further to this, traders should always look to ensure that both the 2 and 20 rules are in place for any one trade.

In other words, there will be many times when the stop loss percentage is very small (eg 5%) and the “2% rule” suggests you could (in theory) apply more than 20% of your capital.

Don’t do it.

20% is the most you can apply to any one single trade.

Putting it All Together… 

I hope you had a terrific year in 2017.

We are currently enjoying the second largest bull market in history.

2018 may see this trend continue… and it may not.

However, applying these 7 principles will set you up for more consistent, profitable results whatever the market presents.

Again, these are simply principles… not a trading bible.

This is what works for me. It may not work for you.

But feel free to take some (or all) of these principles and modify them to suit your own style, timeframes and/or risk profile.

Before I sign off, let’s me close with these 10 trading gems:

  1. The stop-loss rule is the most important rule in trading;
  2. The market is never wrong but opinions mostly are;
  3. Profits will always come – but losing (all) your capital is devastating;
  4. Expect half of all your trades to lose; 
  5. Trading profitability is more about the allocation of capital than it is reading a chart;
  6. Trading in the direction of the weekly trend increases your probability of success;
  7. We can never pick the very top (or bottom) of any chart (don’t try);
  8. We profit by riding the “meaty part” of a trend (ie, don’t leave too early nor stay too late); and
  9. Remain disciplined and patient. Sometimes the best trade is no trade at all; and finally 
  10. There is only one side of the market and it is not the bull side or the bear side, but the right side Jesse Livermore.
Regards
Adrian Tout

One thought on “Looking Back at Posts Over Dec & Jan”

  1. Thanks Adrian.

    Really enjoy the regular emails and you’re right, having them in the inbox for future reference.

    Have been using your insights and technical tools in the last couple of months and have been quite successful with my trading/investing. Even saved me from major pain with crypto.

    I know you mention it alot but just wondering if you could do a post regarding bond yields, interest rates and TIPS etc and how they relate to each other or if you could point me to a previous. After an in-depth explanation
    Still trying to understand wider macro tools.
    I take note of your blurbs re how 2yr and 10yr treasury rates can predict a recession but just don’t understand why etc.

    Hope all is well in SF.

    Cheers

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