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3

The challenge then becomes one of effective placement of our stop loss orders. If we are incorrect in the prediction of an anticipated trend we must have a plan in place that will recognize this fact and get us out of the trade with the least possible damage to the bottom line. There are again multitudes of methods to accomplish this task. One can use an absolute stop, which will risk only a given dollar amount, be it a fixed figure or a percentage of the amount of capital available. Stop losses can also be generated by the same market activity that produced the entry signal. For instance, if one were trading the classical opening range breakout from the long side, having entered on the breakout of the high of the early range, the stop loss order could be placed at the bottom of the early range. Yet another effective stop placement routine involves the use of stops that are adjusted throughout the trading day, gradually reducing the traders risk exposure and eventually locking in successively higher levels of profit. These stops are often referred to as trailing stops and can be calculated from a wide variety of formulas.

Effective stop placement can arguably be the key to any effective trading strategy. The primary use of stops is obviously to limit the exposure to trading losses that occur when we find ourselves in a bad trade. Placing these stops at levels that will prevent large losses from occurring while at the same time allowing the anticipated trade to develop properly is the challenge faced by every trader. Stops that are placed too close to our entry point or critical chart point will certainly limit our trading losses to an acceptable level. However, the close proximity of this point, despite the resulting comfort to the trader that he or she wont lose a significant amount of trading capital on this trade, carries with it a major risk. Placement of close stops often has the result of stopping us out of a trade on a minor correction and eliminating the profits that could have resulted had we been able to maintain the position through the correction. There is another danger, though, if one places the stop at a point much further from the entry point or significant chart point in an attempt to stay in the expected trend for the entire day. If the stop is indeed hit by market activity, the resulting losses may be greater than the system can tolerate and still produce an acceptable trading profit over time.

Figure 1.1 illustrates the result of placing your protective stop too close to your point of entry. On this chart we are simulating trading the breakout of the early-morning range of the Nasdaq 100 index fu-

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Figure 1.1 Placing protective stops close to the entry point, while certainty limiting the size of a potential loss, often resultsin missing the big trade. Chart created with TradeStation® 2000i by Omega Research,Inc.

tures contract. Note the two horizontal lines marking the range established during initial trading. Our short position is taken as the market trades through our sell stop as indicated on the chart. Our trader, being conservative in nature, places a protective stop at the halfway point between the high and low of the early breakout range, thinking that if this point is violated the trade will be in trouble. This will limit the potential loss on the trade to a level acceptable to the conservative trader. Unfortunately, the market violates this level approximately 45 minutes later, resulting in a loss for the trader.

Figure 1.2, displaying the identical trade, depicts the result of the trade with a more logical stop placement. In this case the trader has placed a protective stop slightly above the high of the early range, recognizing that a break of this level by the market could result in a significant rally and thus an unacceptable loss for the trade. The net result for the trade is what is expected from the long-term day trading strategy as the trade is maintained for the remainder of the day and is closed out on the close of the day for a substantial profit.

Although this is a hypothetical trading example, it illustrates the importance of proper placement of protective stops when using the more aggressive long-term day trading strategy. If one is too conservative, the



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Protective Stop placed slightly above the high of the early range.

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Figure 1.2 A more logical stop placement strategy allows the trade to realize its full potential.

Chart created with TradeStation® 2000i by Omega Research, Inc .

likelihood of a greater number of losses exists. If one takes a more aggressive stance regarding stop placement, the danger exists that the losses accumulated by this strategy will be too great to allow a net profit in the final analysis. It is necessary to evaluate stop placement thoroughly over a significant amount of historical data if one is to formulate a profitable long-term day trading strategy.

The adjustment of the stop placement routine is indeed critical to the ultimate performance of any long-term day trading strategy. Only when these stop levels have been accurately determined are you ready to trade the system.

Once you have determined the optimal placement for your stops and are comfortable with the profit levels generated by your system, you may notice another "feature" of this type of day trading method.

The majority of long-term day trading systems by their very nature must depend on the big winning trade to generate the majority of profits for the trading method. Since there are usually more sideways, trendless days than the type of big trending day on which these systems depend, it naturally follows that there will be a significant number of days during which losses will occur. It is not uncommon for systems of this nature to experience less than 40 percent profitable

trades over time. Therefore 60 percent of the trades from the system may generate losses. For one to be successful in the everyday trading of a system such as this, the trader must be willing to absorb multiple smaller losses while waiting for the big trade to develop that should wipe out the losses and generate profits for the system. While this seems to be a simple concept to understand, it can be quite difficult for many traders to tolerate the successive losses that precede the winning trade.

Becoming frustrated by successive losses, often traders will attempt to pick and choose trades generated by the system in an attempt to avoid a few of the small losses that get to be quite annoying. Traders are usually successful at avoiding some of the losses generated by the system. After all, there are more losing trades than winning trades from such a system, and simple probabilities make it likely that some trades that would lead to losses will not be taken. However, over time the net result of this approach usually results in the trader missing the one or two big trades generated by the system. Even though the trader was successful at avoiding some of the associated losses, the result of missing the big winning trade or trades more than wipes out the gains realized by avoiding a few small losing trades. It is for this reason that many people are unsuccessful in their attempts to trade a longer-term day trading system. Only traders possessing significant confidence levels regarding their systems and who are able to maintain the emotional traits necessary to absorb multiple losses while waiting for the big trade to come along will be successful with these strategies.

Since this class of day trading strategy must depend on the occasional big trade for its ultimate profitability, it logically follows that the equity curve tracking the progress of such a system will display a rather erratic pattern. Several consecutive small losses will cause the graph to course steadily downward, only to be suddenly propelled significantly higher with the appearance of one of our highly profitable trades. Then again the line depicting the profits of the system will usually slide lower, preparing for the next big trade. This tracing of the systems results in many instances could also be a representation of the emotional state of the trader who is actually taking these trades for his or her personal account. The ability to endure these swings, in terms of both system profits and the mental health of the trader, is certainly a factor that bears upon the ability of the individual trader to trade such a system successfully. These methods are often referred to



as roller-coaster systems due to the unique shape of the equity curve that traces progress.

Figure 1.3 shows the equity curve of the Cyclone System, a long-term day trading method that is designed specifically to day trade the Standard & Poors 500 futures contract.

Although the system did generate over $9,700 in profits for the September 2000 contract in 80 trades over three months, the roller-coaster ride was certainly not a comfortable one for those trading the method. Note that the system went from a net $5,000 profit to a net $5,000 loss before finishing strong with a profit for the contract. Such a ride is quite typical for a long-term day trading system when applied to a volatile stock issue or commodity contract.

SHORT-TERM DAY TRADING

In sharp contrast to the longer-term methods just outlined are the short-term strategies that many people use to day trade. These systems generate a greater number of trades each day, therefore causing them to be more sensitive to transaction costs such as commissions and slippage. This type of trading activity requires, by its very nature, considerably more time during the trading day to successfully implement and monitor trades.

Figure 1.3 Since many longer-term day trading strategies must depend on the big trade for most of the profits for the system, it follows that multiple, Smaller, consecutive losses occur. This equity curve of the Cyclone System demonstrates the gyrations one must endure when trading such a system. Chart created with TradeStation® 2000iby Omega Research,Inc.

These strategies, also occasionally referred to as scalping systems, are primarily designed to capture several small moves in the market throughout the trading day. A variety of technical indicators and other theories are used to generate these trading signals.

The equity curve resulting from this type of trading activity will usually be of a steadier nature than that which describes the historical behavior of the longer-term approach. This is a direct function of the fact that both the profitable trades and the losing trades arising from the short-term trading approach are closer in value than the trading results from the long-term method.

Figure 1.4 represents trading in eBay during a 30-day period ending October 27, 2000. Note that the Cluster System, a short-term day trading strategy, displays an equity curve showing a much smoother progression than the equity curve from the long-term day trading system in Figure 1.3. The system report from a one-minute chart of eBay trading 100 shares per position that was used to generate Figure 1.4 indicates that 67.88 percent of the trades were closed at a profit.

Unlike the long-term strategies discussed earlier, the objective for trades from this type of system is to take a series of small profits, usually entering and exiting several times through the trading day. This is in sharp contrast to the longer-term approaches that try to stay in a single position for most of the day, attempting to capture the big winning trade. To gain the edge necessary to have a net profitable result when using the shorter-term approach, it is usually necessary to build

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Figure 1.4 The Cluster System, as applied to a random 30-day period of eBay data, demonstrates the more consistent pattern of trading that can be expected from a shorter-term day trading strategy. Chart created with TradeStation® 2000iby Omega Research, Inc.



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