Description: Playing the game

Speculative strategy

     Learn the discipline to be able to be many times, and right once, yet be profitable.

     On beginning a speculative trade, a risk/time metric exists. A good trade almost immediately shows a profit, and then it continues that way. Even so, on ever starting any trade a participant is exposed to the fact that the market is unpredictable. Price action can move against even the most excellent reasoning for an unknown period of time, which will eventually force a trade to close once the trading budget is exhausted, the only exception being when a defensive hedge (stop) is triggered. That risk/time metric is always there, and to prevent small losses turning into overwhelming losses, any speculative trade must be insured.

     So beginning a speculative trade risks a specific amount of capital at the market, with risk limits determined by tolerance for trading budgets, until insurance kicks in by means of an option, or a stop. With insurance in place, usually only measured losses are likely, so when excellent reasoning is proved wrong by the market only the premium is lost. Indeed the only measurable certainty is how much money you can lose. You could lose all the money in the world on insurance premiums if continually trades began wrongly. Chance will have it that you're right some of the time, so that is unlikely. In any case, this essay is not just to investigate how to lose money in small amounts, but how to take profit when you get it right.

     Experimenting with properly beginning a speculative trade is a combination of your choice of security, timing, volatilities and insurance. Initially there is a binary outcome: your trade is either proved right by the market, or proved wrong by the market. We can see that the speed at which the market shows its proof (I am told a wise economist always predicts tomorrow will be the same as today) depends on the volatility of underlying market action. A highly volatile market is quicker to show its hand than a less volatile market, but I suspect both are as unpredictable.

     So on beginning a trade, if you are proved wrong, you lose your insurance premium because the market hits your stops, or you exercise your option or some other hedging instrument. But if proved right, you can immediately 'breakeven' by moving your stop to the opening level, or hedging with an equivalent options position. If the market later turns against you, you lose nothing, but only confirm the lesson that today's market is unpredictable.

     Well fantastic, but there's far more trouble ahead. With a crucial first discipline of risk management applied you can trade without losing all of your money all of the time, but like a growing business other problems start happening. It makes it alot easier to begin right, but even if you get in a position supported by the market: How can you keep up a position? As the market gyrates, how do you ensure some kind of profit on a trade? Essentially, how do you win? It follows that any trade is not only insured but there is also some kind of "take profit" exit signal in mind. The target performance signal will perhaps become clearer with market action, but with a directional position there is always risk that if you do not find a signal, a high volatility market in a short time or a low volatility market a longer time later simply reverses and removes you from the picture. Even though a "good decision" was made to begin with, you are only ever marginally profitable. You don't lose, but you don't win.

     Let's say your trade shows a profit. With hedges ready you're unlikely to lose all your money right away. A relief indeed, but how does your trade achieve some target signal? A trend started in a day may end in a day. Reactions derived from only one event, like say one particular month's employment report, only last as long as that one event affects market conditions. Volatility comes through having in the past discounted the future (as it was then forseen in the past) until actual conditions are confirmed or denied in the present. Then there may - or may not - be a correction of the past model, depending on risks with other random future conditions. The numberless forces behind volatility build or destroy basically random trends. Longer underlying trends are built up by event after event, each profile interpreted in some unpredictable way. So I suppose is that finding profit targets is something to do with managing volatility.

     It makes little difference whether you risk £100 or many £mio when you begin a trade because every position suffers the risk/time metric.

      So how to win? It follows that at some point the volatile nature of the speculative trade changes from defensive (insured) to offensive (attack). It does not do to risk a trade, breakeven, then follow some random trend for a while, let alone a long while, only to find that the market reverses and reduces your once many points profit all the way back to breakeven. If you just defend then you won't grow your portfolio. It follows that like music or literature consider that a trade has a beginning, a middle, and an end.

      To win, the trade must be managed so defense becomes offense. Sounds a bit like American football, a good knowledge of the US national sport may be useful. We know one approach to offense is to set some performance signal, which in a random market is essentially a random target, but offense in itself is usually against an opposing team. So what about the guy on the other side of our trade? As a market maker he has covered his risk almost immediately, or he has collected the spread between an opposite party (bringing together buyers and sellers). So either your trade is cancelled out, or hedged. If it's hedged then the hedgee is going to re-hedge with someone else as soon as it gets anywhere near their position management tolerance. And that someone else is just as ready to move it on to another, and another and another, and so on, and just look which way the market's now going... and who knew? I think it follows that if you ever win big on a trade then your winning performance is actually made up of lots of small losses from many others who are hedging the opposite side.

      So that's how opposing teams work, which I suppose has little impact on the approaches available for offense. Some of these are:

     1. Take many small profits yourself, hoping your profitable trades outweigh your losing trades.
     2. Add risk to your winning trades on random trends, supposing that a trend continues.
     3. Constantly increase stops above breakeven, letting trends run until the hedge gets hit.
     4. Measure volatility, and when it rises or falls then if your trade shows a profit it's a take profit signal.

      It appears that the higher the quantity of positions you can begin and be sure to defend, the more chance you have of picking a winner. In a random portfolio some trades will turn out to be good. However, more positions you begin, the more chance you have of losing, and many small losses turn into one large loss, destroying your trading budget. For any ‘take many small profits’ strategy to work, you must have take profit signals further away from the initial market level than where you set your stops. Then in order to win at all, you have to hit as many profit targets as stops, which probably won’t happen consistently in the long run.

      Tighter stops means less insurance bills, so more budget to get onto a winning trade, but things are still very tricky: let's say you open - beginning properly - a portfolio of 50 positions and you manage to get 20 positions defended. So on 30 you have to pay the insurance premiums, but on 20 you breakeven. These 20 now (probably) cannot lose. However, if you do not soon get offensive, there is every risk that at some point (perhaps even in a very long while), the market moves against your portfolio castle and kicks down the portcullis. Along with the insurance premiums you paid, each protected trade eventually makes no profit, for all your risk and hard work. Very amusing!

      So losing trades always expire in the moat of your well insured, but so far unproductive, financial fortress. How could you be less arbitrary and extend your offensive?

      With winning trades you carefully extend your protective stop orders, as if you were a Baron expanding his borders. But besides meaning a nobleman, the word Baron is latin for 'fool'... is just extending defensive positions really a successful offensive strategy? It is conservative, and attractive because you are beyond defeat. Turning stops into limits acts like defensive profit targets, and one does not exit from the market during any prolonged trend (and also cannot lose any money). Yet difficult problems remain, like just how much space do you allow for market reactions, and just when do you roll your stops? What if there is never any trend? It's disappointing to see a good paper profit actually realised at a defensive level because the market chaotically reversed, and you never took that profit. Moving hedges is such a random strategy, and given the costs of all the sure loser trades taken to get things going, then by itself it will all probably amount to nothing. See On setting stops for some view on the experience of stops.

     So not setting stops is a losing strategy, and so is never taking profits. There is this dynamic between the situations of defense and offense. If there was a kind of profit signal you could take the offensive, and potentially maximise the risk/return ratio of a trade. With rolling stops, you remain in the market until you are forced out by chance, but you have defended a small profit. The trick is how to play these two parameters, which may be “the middle” of the trade.

      A further offensive strategy is to pyramid trades into winning trends, if there are any. Each new directional trade exposes your capital to the risk/time metric and the chance of a loss, requiring insurance, but then also the chance to profit on a trend that is apparently going on. If you start using a small fraction of your trading budget you can watch the market prove you right or wrong with a small amount before you commit more capital to any trend. This is an offensive strategy with one great advantage: the market has already proved you right in the trade, at least - randomly - for a certain amount of time.

      On some trades sitting tight is easy. The market indicates you are right, and market retracements are ineffective. But markets are too volatile for these lucky trends.

      Finally, there is setting a take profit signal according to volatility rather than price. By knowing the general condition of the market when the trade was placed may help signal when to take profit, when the general condition changes. Then again, a change in conditions may go even further in your favour. If there is a take profit signal perhaps it's a measure of volatility.

      Reviewing offensive strategies: We know we need offense because just leaving defences as they are will not make the distance in the long run. Extended winning trades are rare because reactions are often aggressive, so you have to attack in small steps to win. The game is a mixture of defence and offence. Begin rightly, with small "indicative" trades. If any are successful, both roll the stops, add some risk, and set a volatility based profit taking signal, getting out when conditions change rather than at some random price level.

      In conclusion, the end to any DEFENSIVE trade is 1 of 3 situations:

     1. an opening defensive play is breached, costing the insurance premium (trade loses).
     2. a protective defensive play is compromised at around breakeven (trade covers costs).
     3. an offensive defensive play is thwarted (trade makes small profit after rolling stops are randomly hit).

      The end to any OFFENSIVE trade is a market signalling a profit target, and other situations:

     1. The market storms through a random profit target on some bizarre trend far higher or lower (big lucky profit).
     2. The market randomly hits a profit target before a reaction (profitable trade).
     3. The market just catches a profit target before reversing within some trading range (profitable trade).

      Successful speculative trading, then, is to separate defence from offense, and be ready to renegotiate new campaigns. It is like playing tennis or squash, where you ought never to play to 'no mans land' in the centre of the court. Defensive positions have to be defensive, until you can aggressively take the opportunity to make an attacking move. This means setting loose rolling stops that give the market the right amount of room for movement according to local volatility, before you decisively take some profit. But nobody can tell you what's a winning shot! A winning strategy is to serve well in the first place, meaning to begin rightly. Then play safe, waiting until your opponent makes a mistake you can take advantage of, which means pay the insurance premiums, but then watch for a change in volatility. Raising your stops to cover premiums and breakeven too soon, or to take an experimentally offensive position too impatiently is like playing a dolly shot to the middle of the court. However not taking a targeted profit is failing to take the advantage when you find yourself in a position to hit a winner. Finally, after one point is played the next point then begins. How do you master this? By playing the game...

     If you have enjoyed reading this, and have any comments, please get in touch!