Day Trading Art or Science

Day Trading Art or Science?

"Truth lies within a little and certain compass, but error is immense."

HENRY ST. JOHN

Anyone who has traded the futures markets for a reasonable amount of time realizes fairly early in the game that method and technique go hand in hand; that art and science are inseparable. While much may be said in support of a purely mechanical approach to day trading, there is also a great deal of anecdotal evidence to support the fact that a good portion of success as a day trader depends upon the art of the science of day trading. I am not implying by this statement that anyone who is artistic in trading terms can succeed. I also believe that when closely examined, what may be considered artistic or intuitive is actually an internalized scientific approach.

Rather than accepting this possibility at face value, I'd like to explore, in some considerable detail, its ramifications for the day trader. While it may be unpalatable to the rigid day trader to accept the possibility that there is some art to the science of day trading, the fact remains that there is, to a certain degree. Let's explore the art of the science that will be analysed and explained in this book.

An Issue of Discipline

The first and foremost area where art and science diverge is the issue of discipline. The simple fact is that discipline in trading is not inborn or easily acquired. Every trader has a penchant to subvert and pervert his or her market discipline. This occurs because of the involvement of ego and pride. Few traders are willing to admit to being wrong. Although it may be their timing methods that are wrong, they take the loss personally, and this ultimately prevents them from acting in a disciplined fashion.

Now enter hope and fear. These are the two emotions that ultimately transform a disciplined trader into an undisciplined trader; a good trader into a bad trader; a successful trader into a losing trader. And here is also where science becomes art.

If all traders were perfectly disciplined, then there would be no need for this commentary or analysis. But the simple and undeniable truth is that traders lose their discipline and revert to art, emotion, sensation, intuition, and random response. Were this not the case, the number of losers in all types of trading would not be as large as it is. Hence, we have no choice but to accept the fact that the trader can and will make mistakes based on his or her emotional, intuitive, and psychological responses to the markets. The real issue is what can be done to overcome the negative effects of such behaviors. Following are a few of my thoughts regarding the above issues.

Where Art and Science Diverge

First, let us be perfectly clear where art and science part company. Rules are rules. They are specific, operational, mechanical, and exact. Anything that diverges from these rules constitutes a change and/or violation of the trading system, method, or indicator. Therefore, it should be perfectly clear when a trader has violated the rules of his or her trading system. Note here that trading systems that are not perfectly clear in terms of their rules, are sitting ducks for rule violations that may go undetected. Hopefully, the methods and systems I have presented in this book are sufficiently clear, precise, and operational to allow a clear and concise determination of when rules are being violated. Therefore, any change in the rules constitutes a violation of the system and is clearly a step into art as opposed to science.

Art and science diverge when trading rules are changed, when trading boundaries are overstepped, and/or when specific procedures are altered. What were method and system now become art and intuition. The ability to discern and distinguish between art and science will be facilitated if your trading rules are specific and highly operational. Hence, I advise you to devise and follow precise and concise rules that are defined as clearly as possible. In both the long and short run this will be a great benefit to you. I do not discount the role of intuition; however, I assign it minimal importance.

When Science Has Been Transformed into Art

Clearly, the lack of specific and operational trading rules will precipitate the crossing over from methodology to mythology. In the long run this will not serve the trader well. It will prompt an emotional and intuitive trading style that will likely have losing results. There is, therefore, no choice but to do the following:

• Be aware of when your trading rules have been altered, violated, or circumvented.
• As soon as you are aware of the above, act accordingly to remedy the problems.
• Attempt to deal only with specifics when it comes to trading. Matters of opinion, expectation, and prediction are useless and counterproductive in a successful approach to day trading.
• Above all, maintain a fully disciplined approach to your day trading.
• No matter how intuitive you may be, remember that a methodological and operational approach to trading will ultimately prevail. Minimize your reliance on intuition.
• Refer to your trading rules frequently.
• Remember that even the slightest change in your methodology could have a major impact on your results.
• Know that just because a change in your system that has violated the rules has worked for you in the past, it is by no means an indication or a carte blanche that the same change in rules will work for you again.
• Refer to your trading rules as often as necessary in order to make certain that they are literally burned into your conscious and unconscious mind.

Art Versus Science: What to Do?

Note that I have no complaint against art in trading. There are, in fact, many traders who are excellent artists and who are quite capable of using their intuitive powers in successfully trading the markets. They are capable of doing things that the vast majority of traders cannot do. They are talented, psychic, and gifted. As long as they are able to make money consistently with these skills, they are to be commended.

If, on the other hand, their skills are not capable of generating consistent profits, then they must question their methods, asking specifically if they are trading for profits or trading to make a case in favor of their intuitive abilities. Odds are that the vast majority of individuals who trade intuitively will be consistent losers. I am not denying here that clairvoyance exists. Nor am I denying that some individuals have an uncanny ability to predict the future (or futures). I am merely saying that for the overwhelming majority of us this method simply does not work.

The Best Place to Be

While I have the utmost of respect for those traders who have been able to achieve consistent success using their intuitive powers, it's clear that this does not apply to the vast majority of traders. Most of us are relegated to using our limited powers of intuition and psychic abilities. The best place to reside as a trader is in the home of discipline and operational methodologies. While I could likely write an entire book on intuition and psychic skills in the markets, this is not the subject of the present book. Nor is it my intention to imply that intuitive traders cannot make money. However, I will state clearly and without hesitation that if you want to succeed, you will follow the rules— whether these rules are mine, yours, or those of another writer or system developer. It's that simple, and it's that complicated. Follow the rules and, in the long run, you will come out ahead. Attempt to be psychic and, in the long run, you will lose money. If you are successful as an intuitive trader, then you are to be commended for being able to achieve what few traders have ever accomplished.

Day Trading: The Good, the Bad, and the Ugly

As a child I thought that life was blissful, that there was no evil in the world, and that somehow all of life's needs would be magically fulfilled. As an adolescent I was convinced that good triumphed over evil, that the more education I had the more money I would make, and that government exists to help us. As an adult I have come to realize that life is full of little disappointments, that things rarely turn out as we expect them to, and that the brutal, cold realities of life prevail.

But I have also realized that there is good news and bad news in almost every situation and every event. And futures trading is no different. Here are some of my thoughts on the good news and the bad news of futures trading. In reading my commentary, please remember the following: New traders are coming to the futures markets in droves; many of them lured to the trading arena by promises of sure profits from small investments. Take a little time and listen to the heating oil options ads on the radio and on television. Read the ads in trade publications offering guaranteed profits, and you'll see what I mean. (Before you put money into any course or trading program, make certain that they contain the proper risk disclosures.) Next time you get some futures advertising in the mail, read it carefully. Look at the claims and then reach your own conclusions about what the newcomer to trading is being told or promised.

Within this context, it's no wonder that so many people are dis-illusioned about what they actually experience when they become traders. But even veteran traders are not immune from the teachings of cold and hard experience with the futures markets. Here are a few of the brutal realities of futures trading as I see them. Take issue with them if you like, believe them if you find them familiar, or take your anger out on me for telling it the way it really is in the world of trading.

Most Trading Systems Just Don’t Work

No matter how you look at things, the simple and painful fact is that the vast majority of trading systems work well in certain types of markets but not so well in other types of markets. The good news is that there are a few systems that have worked consistently over the years. The bad news is that their accuracy isn't very high. A system with 60 percent or more accuracy that has been a consistent performer for over 20 years is a rare find indeed.

What to do? You can abandon systems altogether and use timing methods and intuition. But this will work for you only if you have iron discipline and can take your losses when they're relatively small while riding your profits. Or, you can develop your own style.

Commissions Can Eat You Alive if Your Trading Method Is Marginally Successful

Paying reasonable commissions for your trading is important. To pay too much is to engage in a futile exercise. If you pay for service, then you must get service. If you do not need service, then do not pay for it. This is especially true for options trading. Some firms charge a percentage of option premiums as their commission.

Be very careful of these firms. If you buy an option that costs $2500 and the commission is 25 percent of the premium, then you pay $625 commission. This is outrageous! You could pay as little as $14 for that option at the right brokerage house. Even if you pay $75 for full service (which will get you a broker's input), you still come out way ahead.

Professionals Win, the Public Loses

It's that simple, that direct, and that predictable. It's like playing poker with a table full of professionals; the beginner will most likely provide grist for the mill. If you want to play the game with professionals, you will need to act, think, and trade like a professional. The bad news is that it's hard to do, but the good news is that it can be learned.

Do you Have Protection against Bad Price Fills?

The good news is that there are rules that will work for you on occasion. The bad news is that most of the time the rules don't work in favor of the public. Furthermore, the regulatory agencies that supervise futures trading will rarely be of assistance to you, since they are most often more concerned with making examples out of people with high visibility than they are in going after the insidious crooks.

Therefore, if you have a problem with an order fill, with a broker, or with an exchange, don't wait for help from the regulatory agencies; take matters into your own hands and complain directly to the firm's management or to the exchange itself. While it may be difficult for some traders to be forceful when they've been wronged, the fact is that the squeaky wheel gets the grease.

Misinformation and Disinformation Run Rampant

The computer age has made it even simpler for savvy operators to fool the public by creating seemingly perfect trading systems. The systems appear to be very good on paper but in reality are optimized to show the best-possible back-test scenario. In reality they have very little probability of going forward successfully in real time. Let the buyer beware. The good news is that systems are plentiful; the bad news is that most of them don't work.

Traders Love S&P Trading, but Most Traders Lose in S&P

Why? The reasons here are simple indeed. First, most traders don't want to hold S&P overnight because the margin is too high. Hence, they day trade S&P. What makes their S&P trading a losing proposition is the fact that traders use very small stop losses in this market. My work suggests that even a 500-point ($1250) stop loss in S&P is, at times, insufficient. When a market trades in an average range of 600 points daily, a 500-point stop loss is needed to take the daily range into consideration. The good news is that S&P futures offer great trading opportunities, particularly for day trading. The bad news is that a large stop is required and the odds of being stopped out, unless you use a wide stop, are very high.

Futures Options: Reality and Myth

As many of you may know, the good news with futures options is that your risk on a long position is limited to the cost of the option plus commission. Risk is, therefore, well defined and limited on long positions. However, although you will lose only a predator-mined amount of money, the odds are that you will lose it. This is a variation on the theme of "if you buy you lose; if you sell you lose; but if you don't trade, you're missing a great opportunity."

At first blush, the idea of futures options seems reasonable and rational. After all, since most traders lose their money by staying with a position too long or by thinking too much, the idea of a fixed loss is very appealing. However, there are three important issues that many traders fail to consider and that many promoters of options fail to address: delta, premium, and time decay.

Premium is the dollar amount of the option. All too often, the premium on options is higher than it should be, based on the length of time the option has remaining and the value of the underlying market. Floor brokers mark up the premiums so that they can profit. In other words, they buy their options or create their options (by taking a short position) at wholesale prices, yet they sell them to the public at retail, making money on the difference.

Time decay is the perennial enemy of the options buyer but the eternal friend of the options seller. Since the vast majority of options expires worthless, it's the options seller that makes the money, while the options buyer watches his or her trade slowly lose value over time. Unless you are timely with your options entry and unless you pay a reasonably low premium for your option, your odds of success are relatively low.

A third and equally important options concept is delta. Very few traders have ever heard of delta and fewer yet understand its implications. Delta, in simple terms, is the degree with which an options contract fluctuates with its underlying futures contract. A delta of 90 percent (0.9) means that the option will go up or down about 90 percent of the amount that the futures market goes up or down. Options with low deltas tend to be options that have a very low probability of becoming profitable unless the market makes a relatively fast and large move in the desired direction.

An option for which you paid a high premium, that is close to expiration, and that has a low delta is, therefore, highly unlikely to be profitable other than in the most unexpected of circumstances. Yet such options are low in price and often attract the unsophisticated trader. Mind you, I am not saying that money cannot be made in options trading. I am merely stating that being a buyer of options is not where you will experience the greatest odds of success.

Mined amount of money, the odds are that you will lose it. This is a variation on the theme of "if you buy you lose; if you sell you lose; but if you don't trade, you're missing a great opportunity."

At first blush, the idea of futures options seems reasonable and rational. After all, since most traders lose their money by staying with a position too long or by thinking too much, the idea of a fixed loss is very appealing. However, there are three important issues that many traders fail to consider and that many promoters of options fail to address: delta, premium, and time decay.

Premium is the dollar amount of the option. All too often, the premium on options is higher than it should be, based on the length of time the option has remaining and the value of the underlying market. Floor brokers mark up the premiums so that they can profit. In other words, they buy their options or create their options (by taking a short position) at wholesale prices, yet they sell them to the public at retail, making money on the difference.

Time decay is the perennial enemy of the options buyer but the eternal friend of the options seller. Since the vast majority of options expires worthless, it's the options seller that makes the money, while the options buyer watches his or her trade slowly lose value over time. Unless you are timely with your options entry and unless you pay a reasonably low premium for your option, your odds of success are relatively low.

A third and equally important options concept is delta. Very few traders have ever heard of delta and fewer yet understand its implications. Delta, in simple terms, is the degree with which an options contract fluctuates with its underlying futures contract. A delta of 90 percent (0.9) means that the option will go up or down about 90 percent of the amount that the futures market goes up or down. Options with low deltas tend to be options that have a very low probability of becoming profitable unless the market makes a relatively fast and large move in the desired direction.

An option for which you paid a high premium, that is close to expiration, and that has a low delta is, therefore, highly unlikely to be profitable other than in the most unexpected of circumstances. Yet such options are low in price and often attract the unsophisticated trader. Mind you, I am not saying that money cannot be made in options trading. I am merely stating that being a buyer of options is not where you will experience the greatest odds of success.

Mined amount of money, the odds are that you will lose it. This is a variation on the theme of "if you buy you lose; if you sell you lose; but if you don't trade, you're missing a great opportunity."

At first blush, the idea of futures options seems reasonable and rational. After all, since most traders lose their money by staying with a position too long or by thinking too much, the idea of a fixed loss is very appealing. However, there are three important issues that many traders fail to consider and that many promoters of options fail to address: delta, premium, and time decay.

Premium is the dollar amount of the option. All too often, the premium on options is higher than it should be, based on the length of time the option has remaining and the value of the underlying market. Floor brokers mark up the premiums so that they can profit. In other words, they buy their options or create their options (by taking a short position) at wholesale prices, yet they sell them to the public at retail, making money on the difference.

Time decay is the perennial enemy of the options buyer but the eternal friend of the options seller. Since the vast majority of options expires worthless, it's the options seller that makes the money, while the options buyer watches his or her trade slowly lose value over time. Unless you are timely with your options entry and unless you pay a reasonably low premium for your option, your odds of success are relatively low.

A third and equally important options concept is delta. Very few traders have ever heard of delta and fewer yet understand its implications. Delta, in simple terms, is the degree with which an options contract fluctuates with its underlying futures contract. A delta of 90 percent (0.9) means that the option will go up or down about 90 percent of the amount that the futures market goes up or down. Options with low deltas tend to be options that have a very low probability of becoming profitable unless the market makes a relatively fast and large move in the desired direction.

An option for which you paid a high premium, that is close to expiration, and that has a low delta is, therefore, highly unlikely to be profitable other than in the most unexpected of circumstances. Yet such options are low in price and often attract the unsophisticated trader. Mind you, I am not saying that money cannot be made in options trading. I am merely stating that being a buyer of options is not where you will experience the greatest odds of success.

Insiders Still Reap the Rewards

Although legislation and regulations have been enacted to keep the markets fair, the fact is that insiders are still the big winners in futures and options trading. By insiders I mean commercial traders and pit brokers. The good news is that futures trading still represents the last bastion of capitalism—the place where anyone with persistence, discipline, and some knowledge can make it big.

The bad news is that it's getting harder and harder to win as the markets become more competitive and as insiders grab onto opportunities before the general public has had a chance to do so. Fortunately, the basic rules of profitable futures trading still apply.

Therefore, if you follow the rules, you will improve your odds of success, even though they may be less than they would have been 15 years ago.

Your Odds of Success Are Worse Now than Ever

I'm certain that this assertion will cause many of my readers—particularly those who are professionals in the futures industry—to bristle. But my opinions are based on good, solid, and lengthy experience. Can I prove what I'm saying by using hard statistics to back me up? No, I can't. But my experience counts for something, and it tells me, without a doubt, that there are fewer winners today, on a percentage basis (i.e., out of the universe of traders), than there were 15 or 20 years ago.

Believe me, I'd like it to be otherwise, but I just don't see it. The question is why. The answer is several fold. First, there are many more green traders today than ever before. They've been attracted by the lure of advertisements for trading courses that pander. They've been promised that they can make a year's worth of income in the futures markets by starting with only a few thousand dollars. And they've been shown how they can generate several hundred percent of their money by buying heating oil call options for a seasonal play. None of the above is true. Still, they come to the markets like lemmings to the cliff.

Second, the markets today are more volatile than ever before. S&P futures trading is so volatile that a 500-point daily range ($1250) is commonplace. Given the fact that many traders have less than $5000 in their accounts and they want to trade S&P futures, the odds of their making money are slim to none.

Consider also the wide swings in virtually all other markets, and you have the necessary ingredients to small-trader ruin.

The third reason is based on an overabundance of information. While you may think that today's computer power and intensive research has helped create better traders, I disagree. The reality of this situation is that it has created an excess of information, which thoroughly confuses the novice trader and undermines discipline. The end result is that the average trader today is more confused and actually less educated than the new trader of 15 or 20 years ago. While good information is important, an excess of information will likely lead to confusion and obfuscation, as opposed to clarity and direction.

The fourth reason is that when traders finally do have profits in a trade, they are often scared out or stopped out of the trade(s) before the big move has taken place. Again, this is a function of volatility. While the nimble and experienced trader can use volatility to his or her advantage, the average trader and the new trader are only hurt by it.

Computers: Help or Hindrance?

In many cases and for many traders, the use of a computer for the purpose of generating trades won't help. In fact, it may hinder. Let's face it; most people aren't computer-literate. They have a very poor understanding of what a computer can and cannot do for them as a vehicle for generating trading profits. Only after a trader has defined his or her direction can a decision be made about the value of a computer in the trading program.

So if you're new to the futures markets and you can't afford several thousand dollars for a computer and software, then you need to put your efforts toward using simple systems that don't require the added expense. The fact is that there are many ways to trade without a computer.

Summary

This chapter reviewed the major issues and obstacles that await and confront the day trader. Specific answers were given as suggestions for overcoming the limitations and roadblocks to success.

I stressed that day trading, more than any other form of trading, should be considered as a science and not as an art. While the day trader has the advantage of not being concerned about overnight moves, the limitation of day trading is clearly that there is a limit to the profits one may make within the time frame of a single day. However, if the trader is careful to operate only in volatile markets, then the problem of limited profit potential will be overcome. Since day trading occurs within a strictly circumscribed time frame, there are rules and operational procedures that are unique to the day trader.