The Entry of New Participants With Fresh Money

Elite poker players hate to play at a table full of other professionals, understanding that with their evenly matched skills no player has an advantage and the money will end up eddying aimlessly around the table. Eventually everyone will go home bored and with more or less the amount that they started with. The same can be said of a very homogenized, static market with similar, familiar entities circulating in well-established behavioral ruts. The entrance or departure of new classes of players, particularly if they are well funded, can have paradigm-shifting effects on a market. 

On a macro level, the slow rotation of global money flows from asset class to asset class and country to country have huge impacts on both the absolute level of prices and the relative number of people paid to trade and analyze them. Any hot or up-and-coming market will see massive inflows of capital to the detriment of established mid- and late-stage products. From bonds (1970s-80s) to equities (1980s) to derivatives (1990s) to technology stocks (1990s-00s) to commodities (2000s) to cash (2008-2009) and riskless assets (2009-10) back to equities (2010 to present), one market will capture the collective imagination of institutional investors. Firms with an established presence in the hot market will assume a leadership position and see an influx of customer business, which will lead to investor interest, which will inevitably lead to growth and expansion. Those not participating will feel left out of the market, the profits, and all of the cool cocktail party conversation. They will panic, and try to buy their way in at any cost, raising the price of talent and, usually, the product itself. The inflationary effects of new capital are particularly intense for any ownership-based product, like equities or real estate. Contractually backed markets like derivatives can expand much more easily, which is one of the reasons why jumbo-sized institutions prefer financial products. It is significantly easier to buy a billion dollars worth of mortgage bonds than a billion dollars worth of houses. 

 

From Chapter 2 - Know the Enemy, Page 55.

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Mastering the Minimum

In contemplating strategic alternatives to implement his view, a trader will, for the first time, begin to examine something other than historical data and future projections. The bridge between the known facts of the past and the presumed trajectory of the future is a never-ending series of small events occurring in the present. All forms of trading are immersive, but directional trading demands the most intense focus on the current operational environment. The trader must observe and interpret the day-to-day, hour-to-hour, and minute-by-minute fluctuations of the market in response to each incremental piece of information that will, in aggregate, influence the perceptions of the participants and motivate them to action. 

The relative simplicity of directional trading reduces the number of moving parts while dramatically increasing the relative importance of each remaining variable. By definition, every position is a trader-constructed subset of the total market risk-reward space. A directional position is unique in that it creates an unmitigated exposure to the totality of the market’s price movement, unlike the inherent exposure limitations of an option or the self-hedging characteristics of a spread. Directional trading is about control and execution, and requires a degree of engagement and commitment not necessary with other, more limited forms of exposure. 

Good directional traders are extremely skilled at the basic, unglamorous blocking and tackling that, while not flashy, is often the determining factor between winning and losing. For this reason, many of the basic topics covered in this chapter will be assumed as prerequisites for the sections on spreads, options, and quantitative trading that follow. The more complex strategies allow the trader to express subtler, more nuanced views of the market, but all either retain a directional component to their performance, or can also be used to express directional views. 

 

From Chapter 8 - Directional Trading Strategies, Page 284.

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Evolution of the Risk-Reward Calculus 

As with market characteristics, risk-reward ratios change as a trade evolves. What the ratio was when the trade was put on may bear no resemblance to what it is in the current moment. The risk/reward ratio can be impacted by positive or negative changes to the fundamental facts, the technical analysis, or shifts in the probabilities of favorable/unfavorable outcomes.

The risk-reward can also shift with the movement of price over time. Consider a position entered into at $100.00 with an initial $5.00 of downside and $35.00 of upside for a very favorable 7:1 risk-reward ratio. The market moves in the trader’s favor and earns $10.00 from the entry point. The trader is now risking $15.00 ($5.00 initial possible loss + $10.00 unbooked profits) to hopefully make another $25.00, if everything goes as planned. The downside is that the risk-reward ratio has eroded significantly, from 7:1 to 5:3. As a position nears the profit target, the ratio can become skewed toward risking (much) more than could possibly be incrementally gained. In this case, when the price reaches $130.00 the trader is risking a total of $35.00 ($5.00 initial possible loss + $30.00 unbooked profits) for only an additional $5.00 gain, for a thoroughly terrible 1:7 risk-reward ratio. Paradoxically, great trades with favorable risk-reward characteristics that perform perfectly will have, at the end of their life, evolved into bad trades that should be taken off immediately. [60]

JPEG Figure 14.1 Evolving Risk & Reward.jpg

Figure 14.1    The risk-reward ratio of a trade will evolve during the holding period.

[60] The trader can (and should) use a rolling stop-loss to control degradation of the risk-reward ratio and protect profits. 

 

From Chapter 14 - Managing Positions & Portfolios, Pages 535-536.

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Factoring In Real Costs 

The trader must also take into consideration the costs of executing and maintaining the position. Some will be fixed, known fees and others will depend on the market conditions and the time horizon over which the trader intends to hold the position. The principal costs are the bid-offer spread, slippage, brokerage and exchange fees, and the holding cost of credit or collateral. 

The bid-offer spread acts as a transaction tax; the amount paid is a function of the market conditions and the trader’s skill. In general, traders assume that under normal conditions they will have to pay one full bid-offer spread, half when entering the position and half on exit. It may be possible to pay less in a negotiation-friendly market, or if a sudden uptick in interest acts to temporarily narrow the spread. In contrast, market-making traders attempt to earn the bid-offer spread by posting numbers that they hope other market participants will hit or lift, allowing them to get paid for putting on positions. 

Slippage is the amount of value wasted between the time a trader starts executing and the time he amasses or distributes the desired exposure. A certain amount of slippage is unavoidable, unless the trader somehow manages to do 100% of the volume transacted in the market during the execution window and gets it all done at the same price. Slippage is almost impossible to quantify in advance, but the more deeply immersed in the market the trader is, the better he is able to gauge the potential impacts of transactional activity.

Most trades will involve paying a fee to the trading platform or brokerage for arranging the transaction. The trader may have to pay exchange fees for processing the transaction and clearing fees for routing it to the clearing broker. In most evolved markets the brokerage, exchange, and clearing fees will be a non-trivial but not onerous cost to the trader. 

Credit and/or collateral costs can vary significantly from strategy to strategy, and have a large impact on the relative attractiveness of an array of alternatives. Unlike transaction-based fees that are paid once, the cost of financing the trader’s position across the anticipated holding period will depend on a host of factors, including the volatility of the product (which will impact the base-level margin requirements set by the exchange), the firm’s credit rating (which will impact the extra or the multiplier the clearing broker applies to the basic exchange margin requirements), the directionality of the exposure relative to positions already held by the clearing broker, etc.

Consider a trade with a potential $3.00 of upside and $1.00 of downside and a two-month intended holding period. A 3:1 risk-reward ratio would generally be a proposition that any trader would immediately seek to execute. When evaluating the relative attractiveness of the exposure the trader must also take into consideration the $0.25 bid/offer spread that she will have to pay away to a market-maker, a $0.01 brokerage charge and $0.01 clearing fee on both the buy and sell transactions, and $0.13 per month of financing costs to maintain the position. The $0.55 (= $0.25 + ($0.02 × 2) + ($0.13 × 2)) total that the trader must pay away in fees and costs adds to the cost of a loser and subtracts from the profits of a winner. In reality, the trader is risking $1.55 ($1.00 projected loss + $0.55 costs) to make $2.45 ($3.00 possible gain - $0.55 costs) for a risk-reward ratio of 2.45-to-1.55, which most traders would typically not entertain. 

Traders have a tendency to underestimate the fees and costs inherent in their transactions for a variety of reasons. Some, like the bid-offer spread and the slippage, are difficult to fully assess without actually attempting to execute the transaction. Others, like the financing cost of holding the position, frequently end up being larger than expected as the trader clings to an exposure that with the hope that it will pay off someday.

 

From Chapter 12 - Evaluating Trades & Creating a Trading Plan, Pages 485-486.

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Dealing With Large Losing Positions

Sooner or later, even a highly disciplined trader with a fundamentally sound, well-constructed position will experience a large enough exogenous market shock to step-function prices through their stop-loss levels. Large losses can also occur as a result of a discipline breakdown, where a small- to medium-sized losing trade is neglected or mismanaged until it becomes a legitimate problem. Regardless of whether the damage is self-inflicted or the result of a low-probability event, the trader needs to deal with the problem as efficiently as possible and prepare for the inevitable consequences.

If there is time, the trader needs to immediately notify management and the risk group as to the position, the estimated P&L impact, and the mitigation plan. This demonstrates that the trader is aware, engaged, and to the extent possible, managing the position. Managers hate losses, but they will never forgive being blindsided by a trader. Just as a trader has to deal with the immediate market consequences, the manager has to deal with the subsequent organizational consequences, which may involve shifting exposures or requesting additional resources if the trader’s loss is impactful to the firm as a whole. 

With the immediate reporting taken care of, the trader needs to fix the problem. There is no point in hashing through the logic, re-examining the underlying rationale, or engaging in any other time-wasting activity. The exposure that is currently destroying the P&L is no longer a decision item; it is a problem that needs to be solved as quickly and efficiently as possible. In the aftermath of an unusual market event there is only a certain amount of liquidity to be had, typically significantly less than normal. The trader needs to capitalize on whatever narrow execution window exists to take off or neutralize the position before the market becomes untradeable. 

Once the exposure has been mitigated, the trader needs to start working on organizational and career damage control. There will be questions from management about the decision-making process, the size and composition of the exposure, and the overall handling of the risk. The trader should pre-empt these as much as possible by giving the rationale, the market events that unfolded to impact the trade, the P&L estimate, and the lessons learned going forward. By providing this information before it is asked for, the trader appears engaged and in control of the situation. This is critical, because senior management will certainly be reevaluating the trader’s future risk-taking activities in terms of both size and scope, and possibly his future on the desk. They may stop by to have a chat to see how the trader is doing. They do not care how the trader is doing, they are checking to see if the trader is broken, defective, or is worn out and needs to be replaced. It is permissible to be unhappy, it is never permissible to be out of control, throwing a tantrum, or acting like a child. Management will want to see that the trader has accepted responsibility, understands what happened and why the trade was not successful, and has a plan for incorporating this information into going-forward analysis and future risk taking.

Once the dust has cleared, some traders immediately want to jump into the market and try to earn it all back as quickly as possible. This is a temptation that most traders should probably resist, as their decision-making process is likely highly compromised and their market view cannot be robust. There will also be a temporarily skewed personal risk-reward relationship, where making back some small quantity of money is marginally useful, but losing incremental dollars while under heightened management scrutiny will look very, very bad. 

A trader’s first post-disaster trade should be a model of risk-reward assessment, clear analysis, and flawless communication about the rationale, goals, and execution strategy. It should be appropriately sized for the trader’s new economic reality and standing relative to allocated limits and goals. This can be frustrating, particularly if the trader had been running well and accustomed to larger bets with the house’s money. Starting from zero, which is in many ways what every trader is doing post-disaster, is all about rebuilding credibility and confidence along with P&L. Large losses are part of the game, and on a long enough timeframe they will eventually happen to everyone. Having a career as a professional trader is highly dependent on developing good crisis management skills to ensure that the first bad position isn’t the last. 

 

From Chapter 14 - Managing Positions & Portfolios, Pages 550-551.

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Liquidity Does Not Equal Depth

Liquidity Does Not Equal Depth
Traders and risk managers frequently use “liquidity” and “depth” as near synonyms referring to the capacity of the market to absorb transactions. They are similar, but not equivalent concepts. Liquidity is a measure of the total volume and frequency of transactions, and is a function of bid-offer spread and decision latency. The growth of high-frequency trading has produced a dramatic uptick in the number and speed of transactions, but has not produced a concomitant increase in the amount of positions that trading firms are willing to hold at a particular point in time. 

Depth is an attempt to quantify how much of a particular product the market can absorb in a relatively short period of time without significantly altering the prevailing price. Depth is a measure of how much of a position the aggregate market participants are willing to hold (or how much they are willing to modify their positions) at a particular time, and is a function of capital base, risk tolerance, and transactional interest. A trader intending to break a large transaction into many small pieces that will be executed over a span of time is more concerned with liquidity, a trader needing to move size in a short period of time will worry that there is enough depth to accommodate the transaction without moving the market.

It is important to distinguish the character of the volume transacting in the market. Who is out there doing business? What percent are day traders who churn like crazy but carry minimal positions, providing liquidity but no real depth? What percent are hedgers, who set a position and intend to keep it forever? How many positional traders are there who have significant interest that they will accumulate, hold, and eventually distribute?

 

From Chapter 13 - Trading Mechanics, Pages 514-515.

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A Trader's View of the Market

This Is My View. There Are Many Like It, But This One Is Mine
It is important to be mindful that the trader’s view is entirely a product of his: 

•    Relative informational advantages and disadvantages.
•    Acquisition, manipulation, and processing skills.
•    Particular interpretation biases, strengths, and weaknesses.
•    Access to incremental, going-forward information and the ability to feed it back into the decision loop.

As explored in Chapter 3, every individual in the market is working with a subset of the total available information. It is possible for different traders to begin with the same starting information and, through differences in technique and interpretation, arrive at very different views of the market. This disparity is exacerbated when, in most markets, traders and trading companies will start with widely different sets of information and possess varying degrees of observational and interpretational acumen. Every trader must understand that, of the factors that combine to create their view, they will have above-average skill with some, be even with the market in others, and lag behind with the rest. The trader must take into consideration, for each of the primary variables and key drivers that makes up his view:

•    What he personally is good at or has a comparative advantage in?
•    What he personally is bad at or has a comparative disadvantage in?
•    What the firm is good at or has a comparative advantage in?
•    What the firm is bad at or has a comparative disadvantage in?

The trader must make a clear and intellectually honest assessment of his skill and that of the analysts at their firm, relative to the market, or he deceives himself into a proposition where he is operating from a perceived advantage but an actual disadvantage. It is difficult, but possible, to beat the market with average information. To do so, the trader will have to compensate by leveraging other strengths to make up for the lack of an informational edge. His analysis will have to be better than the rest of the market’s, his risk assessment superior, and his trade selection more creative. He will need superior position management skill and iron discipline. 

It is probably impossible to be long-run profitable with consistently worse-than-market information. No amount of skill on the trader’s part can be expected to overcome such a critical structural disadvantage. 

Articulating the Trader’s View
To remote observers a trader’s market view is like an iceberg. The jagged part that does all the P&L damage is easy to see from a great distance, but the preponderance of the underlying rationale will remain hidden deep beneath the surface, impossible to gauge. A trader’s view on the market, also like an iceberg, has a tendency to roll over and change direction with little to no warning.

An unarticulated view, regardless of how meticulously researched and reasoned, is invisible to management. Documenting a view and the underlying rationale pre-trade can be massively useful in the event that the position turns out poorly. For any unusually committing trade, either in terms of size, risk, or novelty, making management aware of the underlying reasons for the exposure in addition to the stop and profit targets should be considered mandatory. 

For any position that requires management or senior management approval, the ability to clearly articulate the view will frequently be the primary reason that the authorization for the exposure is approved or denied. A trader that cannot clearly explain and justify why she wants to create a position will not be given the latitude to do so. 

 

From Chapter 7 - Developing a Cohesive Market View, Pages 256-257.

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Trading Around a Trend

Trading around a trend is an extremely productive strategy that involves holding a core position aligned with the direction of the macro trend, then opportunistically adding incremental volume following intermediate retracements that is exited when the macro trend has re-asserted itself and is approaching resistance. Trading around a trend requires a well-formed technical channel and a productive, but not excessive, level of intermediate and micro-level fluctuation. Too much chop, and a trader could potentially be scared out of an incremental position that would otherwise be profitable. Consider the chart of a well-defined trend:

JPEG Figure 14.5 Trading Around A Position.jpg

Figure 14.5     Trading around a trend.


A trader with a fundamentally bullish view of the market and core long position would observe a trend in motion in a well-defined channel, the width of which is defined by the alternating higher lows at (L1) and (L2) and higher highs at (H1) and (H2). When the market retraces to support, the trader would purchase an incremental volume (B1), which he would hold with a tight stop, re-selling once the market reached the top of the trend channel at (S1). This process would be repeated at (B2) and (S2), and continue for as long as the trend remained viable. When market reaches the profit target or the trend ultimately ends, the trader would exit both the core position and any incremental trades held at the time.

Trading around a trend has several advantages:

1.    The trader maintains a core positioned with the trend, and is incrementally adding in the direction of the trend and decreasing the position size prior to potential countertrend moves.
2.    The trader buys “cheap” and sells “expensive” within the context of the trend.
3.    There is a good balance between aggression and risk-reward.

The principal risk of trading around a trend is that, if the trend abruptly fails immediately after an incremental addition, the trader will be taking losses on a larger-than-core position. 

The relationship between the size of the core position and the magnitude of the incremental trades is also important. If the core position is not materially larger than the incremental buys and sells, the trader will effectively be attempting to derive the majority of the P&L by trading the swings in the market and not the more predictable central trend.

It is also common for a trader wanting a larger core exposure to use retracements to add permanent volume to the position, with the hope of carrying the additional weight for the full duration.

 

From Chapter 14 - Managing Positions & Portfolios, Pages 543-544.

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Common Execution Mistakes

There are a number of ways that a trader may self-sabotage execution:

1.    Not having a clear idea of what he is trying to accomplish. 
2.    Incorrectly identifying the current market conditions and/or selecting an inefficient execution strategy. 
3.    Lack of urgency when conditions are favorable.
4.    Indecision in a fast-moving market.
5.    Panicking, and either freezing or thrashing around in the market.
6.    Accidentally transacting at an unintended price or incorrect volume by fat-fingering, mis-clicking, or out-trading.
7.    Being a passive participant in the market.

Not Having A Clear Idea of What He is Trying to Accomplish
The trader must know the volume he intends to transact and the price that would trigger execution, both of which should have been predetermined in the trading plan. Attempting to sell 1,000 lots at the trader’s $100.00 price target if the market prints at that level is vastly different from wanting to “sell a little, if prices get a bit higher.” 

Incorrectly Identifying the Current Market Conditions
Traders who are not active, regular participants in the market are at increased risk of misreading the subtle cues that indicate participant interest, or lack thereof. How is the market trading? Is the intraday trend, if one exists, constructive for the trader’s position and execution plan? How much volume is going through at each price point, how wide are the bid/offer spreads, and how large are the trade-to-trade gaps? If the market is granular enough to observe individual transactions, are bids getting hit or offers getting lifted? How is the market re-framing after each transaction?

If the trader needs to be a buyer and the last 47 trades in the OTC market have been a seller hitting the bid and aggressively trying to get them to double the ticket, there is no need to wade in and start lifting offers like a madman. It would be more productive to sit on the bid and wait for the selling interest to work down to their level.

Conversely, if the trader needs to be a buyer and the last 47 trades in the OTC market have been offers getting lifted and the buyer aggressively asking to double the ticket, sitting on the bid will be unproductive. The trader will have to compete for offers with the aggressive buying interest, or wait on the sidelines until the sentiment changes and motivated sellers emerge. 

There is no substitute for market feel, and no shortcut to acquiring it, so in its absence a trader should not attempt to outsmart herself. She should find the best price and the best liquidity and execute as efficiently as possible. Traders that are immersed in the market and in tune with its rhythm will be better able to recognize favorable conditions, allowing them to utilize more of the intraday ebb and flow to wait for better prices and identify pockets of liquidity. 

Lack of Urgency When Conditions Are Favorable
Squandering favorable market conditions is the most perplexing, frustrating execution error. Assuming that the trader has a defined plan and is engaged and paying attention to the market, there is no excuse for failing to hit a bid or lift an offer at the desired price and volume. Most commonly, the trader is either assuming that the market will hang around at his preferred level until he deigns to transact, or he is hoping that the price will continue to improve. More often than not, the market will move away from the trader’s target level or another, more aggressive participant will deal on the price.

Indecision in an Unfavorable, Fast-Moving Market
Trying to efficiently execute a runaway market is one of the most frustrating things imaginable, particularly if the trader isn’t 100% clear on the objective. In any proper market explosion or meltdown there will be an inflection point where the price action goes from bad but still orderly to a disorderly melee, with any offer getting lifted or any bid getting hit, regardless of quality. A trader attempting to accumulate a position has the ability to sit on her hands and wait out the madness. A trader trapped in a bad position has no such option, and will have to shift from an idealized “buy/sell at X” to “buy/sell anything better than Y,” and if the market blows past Y, start considering Z, ZZ and ZZZ. 

Panicking
No trader is immune to panic, and sooner or later a combination of a bad position in bad market conditions will test the discipline of even the strongest, most iron-willed risk-taker. Most commonly a trader will either freeze up and become a passive participant in his own demise, or fall prey to the fight-or-flight instinct and hack and slash his way out of the position, irrespective of the P&L damage. 

Fat-Fingering, Mis-clicking, and Out-Trading
Things can get hectic on a trading desk, particularly when the market is moving rapidly and/or the trader has an unusually high level of stress. When a fast market meets a distracted trader, the result is often a fat-finger, mis-click, or an out-trade: 

•    Incorrectly entering a component of a trade when posting an order to an exchange is called fat-fingering, and commonly manifests itself in a misplaced decimal (buy 1,000 shares at $5,900), a trailing zero added or subtracted (buy 100 or 10,000 shares at $59.00), or the transposition of two numbers (buy 1,000 shares at $95.00). 
•    A mis-click occurs when a trader scrolling around on an exchange screen for some unknown reason randomly presses a mouse button and executes an unintended trade. Bonus points are awarded for mis-click trades caused by spilling a drink on the keyboard or having the mouse hit by a thrown object. A different, less clumsy variety of mis-click occurs in a fast-moving market, where it is possible for the best bid or offer to disappear in the time it takes a trader to physically depress the mouse button. Unless the trader is quick enough to notice that something is different and stop, she will transact on whatever price and volume is next in the stack, no matter how large or small, cheap or expensive. 
•    An out trade is the verbal over-the-counter equivalent of a mis-click, and occurs when the broker and trader have not communicated properly about the product and/or price under negotiation. There are endless varieties of the out-trade, but the most common are price discrepancies, trading the wrong instrument or maturity, or both parties thinking they are the buyer or seller in the transaction. 

Fat-fingers, mis-clicks, and out-trades are purely mechanical errors that can and should be preventable, if the trader has time to verify that what he is actually doing is what he thought he was doing.

Being a Passive Participant in the Market
If there is no bid-offer spread at all, the trader will have to decide if it is worth the risk to act as a market maker to add liquidity and provide some structure to the market. The trader who makes the market should get the first look at any countering bids and offers from interested participants, drawing transactional volume toward the market maker’s prices. 

The easiest path to good execution is having a sense of the plan of action and implementing it as efficiently as possible at the first opportunity. 

 

From Chapter 13 - Trading Mechanics, Pages 525-528.

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How The Market Gets From Point A to B Matters

How The Market Gets From Point A to B Matters
A trader must examine the texture of the chart, as a whole. If it is making lower highs and lower lows, the market is in a downtrend. But how is the market making the highs and lows? Is it grinding higher in small increments over many days, only to give it up in sudden, massive sell-offs? Does it drift lower only to be blown skyward by intermittent stimuli? Is the pattern regular and predictable, bouncing back and forth between channel lines, or does it surf the top then crash to the bottom before re-establishing somewhere in the middle? These are critical distinctions if the trader intends to utilize the intermediate trend to get positioned (generally a good idea) or to trade against the macro trend (possible, but risky). If the trader intends to ride the macro trend, understanding the “normal” intra-pattern characteristics is crucial for risk to reward assessment and execution strategy. A seemingly obvious trend may, on closer examination, not be tradable at all. Assessing the tradability of a market move will be covered in much more detail in Chapters 7 and 12.

 

 

From Chapter 4 - Technical Analysis, Page 143.

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Response to Stimulus

Response to Stimulus
The trader will need to monitor and evaluate the degree to which the position responds to the underlying fundamental and technical motivators. It is possible that the trade will outperform the trader’s expectation, perform as expected, underperform, or have a problematic negative outcome or puzzling non-response. 

JPEG Figure 14.6 Price Response To Stimulus.jpg

Figure 14.6     Potential performance trajectories of trade performance. 


It’s Working Too Well – Radical Outperformance
If the trader is in the enviable position of holding a position that has radically exceeded the profit target in a step-function move or at an highly accelerated pace, the only real question is whether to immediately exit the position and book the profit, or take the time to determine if something has fundamentally or technically changed such that the market is now capable of moving further beyond the goal. The danger in taking time for analysis is that the market may just as quickly reverse direction, potentially costing the trader some or all of the recently acquired profits. If the trader does decide to maintain an exposure, it would be prudent to consider lightening up by closing a portion of the position, adding a protective option position, and/or setting a tight rolling stop to prevent giving away windfall profits.

It’s Working Like It Should – Productive Response
If the trader’s position has reached the profit target set in the trading plan due to the anticipated evolution of the fundamental or technical landscape, then he should exit the exposure in as efficient a manner as possible, book the P&L, and start looking for the next idea. 
 

It’s Not Working Like It Should – Underperforming
If the fundamental and technical landscape has developed as the trader anticipated and the market’s reaction was positive but decidedly uninspiring, the trader will face a challenging decision. It is possible that the market has yet to fully assimilate the new information and that additional gains may be forthcoming, but it is also possible that the incremental drivers were not nearly as impactful as the trader was anticipating. Unless the trader can make a compelling case that the new information is not priced into the market, it may be more productive to take the (small amount of) money and run while there are still profits to be had.  If not, the trader risks being forced to make a decision on a breakeven or negative transaction, which is an altogether worse state of affairs.

It’s Slightly Negative or Not Really Doing Anything – Problematic
Positions that underperform or hover around breakeven through a productive fundamental or technical development are a warning sign for experienced traders. If the market can barely rally in the face of bullish information, the most logical explanation is that the overall sentiment is significantly bearish. This is problematic for a trader with the underperforming position, because if the market barely budges higher with bullish development, how far is it going to fall if something materially bearish occurs? 

Slightly positive and break-even trades are psychologically easier to give up on, as the trader can exit with only the opportunity cost of utilized limits. Slightly negative positions are the bane of every trader’s existence. It is all too easy to hang on to a small loser in the hopes that some unspecified, to-be-determined event will push prices back in the trader’s favor, allowing an escape at breakeven. This is a trap. If a trader is unwilling to take a small loss on a position, the reward is usually a large loss realized at a later date.

Maintaining an unproductive position can be hazardous and expensive. The longer the trader sits on the position, waiting for something beneficial to happen, the greater the chance of an exogenous event impacting the market. Even if the market remains docile, there are nontrivial credit and collateral costs associated with holding a position. Paying rent on an unproductive exposure while waiting for a black swan to make things bad enough to exit is foolish.

 

From Chapter 14 - Managing Positions & Portfolios, Pages 544-546.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Troubleshooting Trading Technique

Forensic Self-Diagnosis
It is surprising how little thought many traders put into diagnosing the potential causes of extended periods of sub-optimal performance. They will attempt to tough out a seemingly never-ending stretch of bad results, doing the same things that got them into trouble without entertaining the possibility that they may be the loss-making part of the equation. The very best traders have a keen sense of when they are out of synch with the market and have a process for forensically evaluating their performance and diagnostically examining their execution technique and view-derivation methodology. 

The obvious starting point for the trader’s analysis is the historical fluctuations in the daily P&L. The trader will want to be alert for any periods where their P&L flat-lines or turns south, exhibits larger than normal swings, or has sharp drawdowns relative to the year-to-date total. Once identified, the trader must then break down the problematic section of the performance history on a position-by-position, strategy-by-strategy basis. He should be principally concerned with:

•    The ratio of winning to losing trades. 
•    The size of the winning trades relative to the losing trades. 
•    The distribution of P&L across all trades. 

The trader should reconstruct the pre-trade rationale for each position, including the analysis that lead to the view, the key fundamental and/or technical drivers, and how the thesis played out in the market. There are a number of common problematic behavioral patterns that the trader must be alert for:

•    A large number of small winning trades eclipsed by a few large losing positions could indicate an over-eagerness to book profits that is sub-optimizing the good positions, a lack of discipline that is allowing small losing positions to balloon into large problems, or both. Is the trader exhibiting poor discipline with well-placed stops, or setting stop-losses too generously for the potential profit inherent in the trade? Is the trader sub-optimizing good trades that would have been more productive if allowed to more time and latitude to work?
•    An equal number of similarly-sized winning and losing positions that net to zero could speak to poor trade selection. The trader must tighten up criteria in an effort to tilt the balance to a net winning ratio.
•    An obvious connection between the winning or losing trades, either strategically, thematically, or in the tools and resources used to derive the view.

Forensic self-diagnosis is not intended to be an exercise in self-flagellation. The goal is to look for problems and behaviors that the trader was unable to diagnose in the moment, but which may be blatantly obvious after the fact. Traders fortunate enough to have a trustworthy colleague(s) with good technique may be able to avail themselves of an external critique, which may yield a fresh perspective or provide additional clarity.

 

From Chapter 16 - Navigating the Corporate Culture, Pages 592-593.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

The Event Path of Future Fundamental Drivers

The Event Path of Future Fundamental Drivers
During the course of any given day, month, or year there will typically be a number of key events or inflection points that have the ability to materially change the value perceptions of the market participants and alter the future trajectory of prices. The common denominator is that events on the path are high-visibility, industry-wide data points that force a re-evaluation of the factors underlying the current market price. 

For a trader holding a short-term natural gas position that is sensitive to every incremental piece of information, the event path for a typical day might look like:


5:00AM     Overnight weather models
6:00AM     Morning weather models
8:00AM     Production statistics
10:30AM     Prior week storage estimates
11:15AM     Intraday weather model #1
11:45AM    Intraday weather model #2
12:15PM     Intraday weather model #3
2:30PM     Futures market close
3:30PM     Intraday weather model #4

A trader with a longer-term, more investment-like natural gas position might need to take into consideration an event path that spans multiple weeks:

Monday     Forecast update for next month from weather vendor #1
Tuesday    No events.
Wednesday     Production update from 3rd party analyst A
Thursday      10:30AM Weekly natural gas storage report
Friday        No events.

Monday     2:00PM Seasonal forecast from weather vendor #2
Tuesday     Energy Conference Day 1
Wednesday     Energy Conference Day 2
Thursday    10:30AM Weekly natural gas storage report
Friday         Medium and long-term demand report from 3rd party analyst B

The longer-term trader is concerned chiefly with events that will impact the intermediate or macro trend, where the short-term trader is dealing with micro trend phenomena. Every trader, regardless of product or market, will closely monitor the news of the day for any regulatory actions, geopolitical events or other unexpected, unscheduled factors with the potential to move markets. 

Events come in all shapes and sizes. In the previous two-week example the trader must be on the alert for firm-reported statistics, model runs that will be compared to prior iterations of the same model and third-party pre-run forecasts, updates to analyst or vendor forecasts, and data items, news stories, and filtered and aggregated attendee chatter from an industry conference. The trader must be cognizant of and have a healthy respect for all of the data items, not just the ones that they have, in their judgment, predetermined to be significant. What may seem irrelevant to one trader can be interpreted as a critical, paradigm-shifting data point for another. 

 

From Chapter 3 - Fundamental Analysis, Pages 93-94.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Understand What The Chart Is Saying As a Whole

Understand What The Chart Is Saying As a Whole
Many traders cannot see the forest for the trees with technical patterns, obsessing over the smallest details and ignoring the totality of the chart and the picture it is painting. Others use the chart as a convenient rationalization for an action they had already planned to take.

Seeing What They Want to See
Any scientist worth her lab coat knows that constructing an experiment with a particular result in mind will, unsurprisingly, tend to produce that result. This is also true of technical analysis. Traders with a fundamental bias are particularly susceptible to this methodological flaw. They take a well-reasoned, sound fundamental view and attempt to use technical analysis to buttress the argument. “The market must be near a fundamental bottom, see if the chart says that.” Worse yet, others will develop some hunch, pet theory, or “feeling,” then pore over charts looking for some sort of significant squiggle or sketchy line they can draw to justify whatever they were planning on doing all along. 

Connecting The Dots In a Thin Market
In extremely thin or choppy markets it is particularly important to look at the whole picture, as a lack of trades⎯and therefore observations⎯can make spotting breakouts and measuring responses challenging. The overall picture will be less crisp, so the trader must forget about micrometer-level precision and instead focus on the major theme, if there is one to be found. 

 

From Chapter 4 - Technical Analysis, Pages 142-143.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Vitruvian Trader

Everyone wants to know what it takes to be a trader, what intangible characteristics separate the winners from the losers. For the vast majority of successful traders, there is no single thing that steers them down the path toward either the penthouse or the outhouse. If there were a perfect trader, her approach might look like this:

Vitruvian Trader

•    The ideal trader has a clear sense of what she is trying to achieve at all times. 
•    The trader expects a particular market response when a base set of fundamental and technical conditions are disturbed by incremental change or the influence of external stimuli. This informed perspective on the future of price is called a view.
•    The trader considers a variety of strategies to implement her view, selecting the one with the closest response to the underlying driver with the best potential reward, the lowest probable risk, and the best performance characteristics.
•    The trader sets the position with a defined profit target and a stop-loss. 
•    The trader monitors the position for changes to the underlying thesis while maintaining an alert, intellectually engaged but emotionally detached state. 
•    If action is required, the trader executes with the maximum possible efficiency.
•    The trader evaluates the results and adjusts the operational parameters (trade selection criteria, stops, targets, etc.) of the methodology as necessary. 
•    Repeat. 

Being a professional trader is a two-part problem, how to evolve to be the best possible risk-taker and how to develop, refine, and deploy the most efficient process.

For most people, success as a trader is less a matter of deus ex machina brilliance and more a result of a steady progression, an ongoing evolutionary process wherein every student starts with innate skills and attempts to out-learn and out-develop peers. This chapter will explore the attributes common to successful traders and the common mistakes that keep neophytes from reaching their potential. Not all traders approach the job in the same way, and not all trading jobs are the same. Understanding the subtle distinctions will shed light on the development necessary, in terms of both the steepness and duration of the learning curve.

 

From Chapter 1 - Know Yourself, Pages 9-10.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

How Markets React to Information

How Markets React to Information
Markets jump from states of equilibrium to states of disequilibrium and back again. The transitions between states, and the relative smoothness or violence thereof, are caused by the assimilation and interpretation of new information. The way a particular market reacts to new information will be highly contextual, depending on the players currently inhabiting the space and the fundamental factors that inform the balance of the market. Reactions will be dependent both on the quality and magnitude of the new information, but also the recent price action and fundamental history. A material piece of information may perturb a static market, cause a move to accelerate, or violently stop a trend and reverse it in its tracks. Or, perplexingly, it may have no impact at all. 

Markets are moved by traders who are wrong. There are many varieties of wrong. Wrong by misjudging the direction, magnitude, or speed of a market move. Wrong for thinking that they had appropriately sized their position, only to find that their losses were more than they can stand, (or worse than they had considered possible). Uninvolved firms that rush in once a trend is under way will add fuel to the fire, and winners may add to their positions and provide continued momentum, but the primary impetus of any move will always be the people suffering the most, the traders and firms that need to exit, regardless of price. 

No two markets are the same, and no two react in the same way to new information. The characteristics that will shape and influence the magnitude and ferocity of a market move are: 

•    Total volume or open interest of positions in the market. If there are no participants with a vested interest, there is no one to react violently to new information. 
•    The percentage of that volume that trades on a day-to-day basis.
•    The number of players present, and the presence of one or more extremely large positions relative to the market as a whole.
•    The mix of short-term speculators, hedgers, and long-term investors, and the disposition of the larger players on that spectrum. 
•    The extent to which the major players’ positions are currently deep in the money, at the money, or far out of the money. Are the large winning/losing positions in “strong hands,” or with easily rattled individuals?
•    The extent to which the information ecology is currently very evenly distributed, well understood, and subject to a uniform interpretation, or the existence of a variety of simultaneous fundamental interpretations. 

Traders spend a great deal of time pondering not just if, but how the market will go from A to B.

 

From Chapter 5 - Understanding Volatility, Pages 169-170.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Archimedean Trade Selection

Archimedean Trade Selection
Visualize the market risk-reward as a partially filled bucket, where some portion of the total volume is risk (water) and some is reward (air). Now imagine each possible strategic implementation of the trader’s view as an opaque balloon, varying in size relative to the total amount of exposure inherent in the trade. Each strategic balloon will be filled with some volume of risk (water) and some quantity of reward (air). If the trader were to place the balloons into the bucket, each would sink to the degree to which they were filled with water. The heavier, mostly-water balloons would sink low in the bucket and the mostly-air balloons would sit with most of their volume above the surface. The relative proportion of risk and reward inherent in each transaction would be easily observed and the best strategy would, literally, float to the top.

JPEG Figure 12.1 Archimedian Trade Selection.jpg

Figure 12.1     Archimedean trade selection.  


Unfortunately, assessing the relative merits of an array of strategic alternatives is not nearly as scientifically straightforward.

The evaluation process begins with the trader’s view of the market and a set of potential implementation strategies. From there, the trader must determine:

1.    What can be done, given available resources
2.    What could be done, given the current P&L relative to goals
3.    What should be done, by evaluating strategies
4.    What will be done, by selecting the best implementation
5.    How it will be done, by developing a trading plan.

 

From Chapter 12 - Evaluating Trades & Creating a Trading Plan, Pages 477-478.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Managing Shared Positions

Managing Shared Positions
Optimizing the trading plan and execution strategy for an exposure that has multiple owners can be extremely challenging. It is critical to predetermine the entry criteria, the underlying thesis, and the exit strategy, and get documented buy-in from all participants. There should be a documented statement of ownership and control of the risk that spells out the percentage of the risk allocated to each trader before the position is accumulated. A single trader should be nominated to monitor and execute on the strategy, acting in accordance with the agreed-to plan and providing reporting to the other interested parties. 

The degree of coordination required is proportional to the ease of execution and the divisible nature of desired exposure. Two people deciding to each buy 100 shares of an extremely liquid equity can easily go their own way if the partnership proves unwieldy. A consortium of eight firms with different resources and agendas that form a temporary alliance to buy a stake in the unproven mineral reserves of a developing nation face a significantly more committing proposition. In general, good, shared positions involve similarly aligned traders sharing a clearly defined strategy or a single dominant market expert and what amounts to a group of passive investors. 

Any shared exposure where the interests, market views, or pain thresholds of the participants are not aligned is a recipe for disaster. Having one or more members of the group prepared to risk significantly more or who can afford to lose significantly less than the others can alter the group dynamic, potentially allowing the outlier(s) to exert undue influence on the plan of action. The lack of a clearly defined plan and predetermined execution delegation can also prove deadly, as achieving consensus in the midst of a crisis will be all but impossible. 

 

From Chapter 14 - Managing Positions & Portfolios, Pages 547-548.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.

Evolving Risk

Evolving Risk
Assume that a company has a set of risks A, B, and C at time T and that it is able to place a perfect hedge against each at a fair cost in a manner acceptable to its corporate governance, auditors, and accountants. Now, start the clock. Production schedules change, forecasts are revised, the macroeconomic climate shifts and the situation evolves in a complex and unpredictable fashion. As the underlying conditions evolve, risk A diminishes, B remains constant, and C definitely grows much larger. The unchanged hedge positions are out of balance with the exposures, and are no longer mitigating the underlying risk in a one-for-one fashion. The manager in charge has two options, either true up the position to current projections⎯which may be expensive, politically untenable, or just impossible⎯or live with the exposure imbalance. 

Very few executives would identify this exact moment as the point that they launched an internal proprietary trading group. It happens every day, and to companies that would never be expected to be running material speculative financial exposures. More confounding for board members, regulators, and, ultimately, the shareholders and employees is that it is often impossible to distinguish between well-intentioned risk mitigation strategies that naturally drift and clearly out-of-bounds behavior designed to juice up profits (and bonus payouts) by building invisible casinos. 

If the firm decides to proactively manage risks and seeks to reconfigure the hedge position, it faces a host of operational issues:

•    The natural will have to incorporate forecast updates that impact the magnitude of the exposure to be hedged, and therefore the volume of hedges required. 
•    Assuming that the model is generating useful information, is it possible for the firm to make meaningful modifications to the hedge position given the available instruments and liquidity?
•    Can the firm afford all of the explicit and implicit costs of making changes to the hedge positions, including brokerage, slippage, credit/collateral, etc.?

 

From Chapter 6- Understanding Risk, Pages 230-231.

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Fundamental Analysis

No matter how narrowly defined an operational interest, it is unlikely that even the most talented trader or analyst can come remotely close to collecting, processing, and assimilating all of the data, news, statistics, figures, and other assorted miscellany that go into understanding price movements. 

Therefore, everyone in the market is operating from a subset of the total informational ecology at all times. The omnipresent factual deficit is meaningful for several reasons. First, and most obvious, traders must be aware that they are operating with less than perfect information, the degree being proportional to their resources and analytical capabilities. Second, they must be comfortable making decisions under uncertainty. Third, due to differences in access and differences in prioritization, processing, and interpretation, it is possible to arrive at any number of possible fundamental views starting from the same set of facts. A trader must be comfortable having a unique view, even to the extent that he may not agree with the people sitting around him. 

Though there are firm-to-firm and market-to-market differences in approach, the basic template for developing a fundamental view on a market involves:

1.    Assembling the available data about the demand for a particular product and the available supply, which can be examined on a short-, medium-, and long-term basis.
2.    Conducting a detailed analysis of the equilibrium state where supply and demand intersect.
3.    Exploring how the equilibrium state is influenced by new information and exogenous shocks, assessing the probable price impacts of shifts in the supply/demand balance.

As the world has become more complex, generating a serviceable fundamental analysis of even a small market space has become increasingly difficult. Information density rises as the volume and sophistication of transactions increase, adding to the analytical burden. At the same time, newly forged intermarket causality chains can disturb what, in a vacuum, would seem to be stable and persistent equilibrium states. Analysts (and their traders) must evolve to become more efficient at both processing core market data and responding to secondary and tertiary stimuli from tangentially related products. 

The emphasis in the chapter is more on using analysis than on creating analysis, mostly because this book is called Trader Construction Kit, not Analyst Construction Kit. Actual market-based analysis involves a tremendous depth of subject matter expertise. A trader will tend to be more of a consumer of analysis than a producer, and as such the necessary skills are more analogous to those of a food critic than those of a chef. It is not essential to be able to produce the dishes, but to be familiar with the concept, ingredients, and process. The process starts with the ingredients (data) that are prepared (processing and post-processing manipulation) into a finished dish (information) for the trader’s consumption. And as with all cooking, it is impossible to end up with a good dish without starting with the best possible ingredients.

 

From Chapter 3 - Fundamental Analysis, Pages 71-72.

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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.