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Philosophies of Trading (16:11)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 16, No. 11 on June 15, 2007. 

At the end of most of my seminars, I give a few general tips or principles that one should use. One of those is, “Only trade in accordance with your personal philosophy.” By that, I mean that you shouldn’t indulge in styles of trading that cause you to worry, gnash your teeth, or lose sleep.

There are lots of ways to make money in the markets, and one will generally do best if he selects a method that is in sync with his psyche. For example, some people might make good money selling naked options, but that strategy isn’t for everyone. Plenty of traders would lie awake at night, worrying about a huge gap move in an adverse direction, that could cause devastating losses for a naked option account. It is my contention that, if you worry unnecessarily about such moves, you are not cut out to be a naked option writer. Find another option strategy that you can feel less apprehensive about.

In this article, we’ll look at some opposing philosophies and strategies. My opinion may differ from yours, but I will strive to be fair and impartial in the various descriptions. In some cases, I feel there is literally no choice – one of the two is clearly better. But, in others, rational arguments can be made for both.

In these comparisons, if you do not know which approach is best for you, perhaps you should take some time to think about it. Traders with a plan – and a plan needs to be related to a trading philosophy – are going to be much more successful. Traders who jump from system to system, drifting between methodologies, are likely to be losers – stumbling upon the worst traits of each approach.

Speculating vs. Hedging

This is at the crux of most people’s approach to the market. Should one be buying puts and calls on individual underlying instruments, attempting to profit handsomely when a favorable move occurs. Or, should one use a hedged strategy – covered writing, straddle buying, spreads (calendar or vertical)?

Speculation produces large swings. Even a profitable speculator will suffer large drawdowns from time to time. It takes a great deal of discipline and fortitude to press on in those cases – to have the confidence in one’s trading system to continue to take new trades, even during a losing streak. A speculator is destined to see quite a bit of volatility in his daily, weekly, or even monthly, returns.

Hedgers, on the other hand, earn money (hopefully) at a steadier rate. The fact that there is a hedge in place usually means that large market moves are muted – even adverse ones. Of course, profits are generally limited as well, and so that is the tradeoff.

We keep very detailed statistics on the trades made by this newsletter – and have for the past 15 years. On page 4, at the bottom, you can see that our speculative recommendations have profited at the average annual rate of 40.2% while hedged strategies have earned only 12.6%.

With only that piece of information, one might rightfully ask, “why bother hedging? Let’s just speculate.” However, upon closer examination, one finds that in some years, there have been tremendous drawdowns when speculating. Last year (2006) was one of them, where we were only profitable on about 30% of our speculative recommendations and lost nearly $200 on average on each of them (the average investment was about $2000 in each one). This year, however, our speculative recommendations are doing much better – above the average returns posted over the years.

Hedging, on the other hand, produces much steadier returns – and a 12% return is nothing to trivialize. Money doubles every 5-1/2 years at 12%. In the history of this newsletter, our hedging strategies – combining the results of spreads on futures, indices, and stocks – have produced a positive result every year except one, 2002.

Thus, hedging produces steadier but less spectacular returns. In either case, there will be drawdowns at certain periods of time, but those drawdowns are smaller and less frequent when hedging. So which approach is correct? That is an impossible question to answer. Most traders do a bit of both, although the most serious option traders that I have known do more hedging than speculating. Still, many successful traders such as John Henry, Paul Tudor Jones, and Richard Dennis were primarily speculators.

Trend following vs. Swing trading

Within the area of speculating, there are two broad fields – following the trend, or attempting to catch changes of direction. Proponents of either style generally do not utilize the other style much. Moreover, each has fairly strong feelings about which is the proper way to approach trading.

Trend followers are normally not concerned with catching exact tops or bottoms. Rather, they wait until a direction is clear and then climb aboard what they perceive as a trending market. They will then try to ride the trend until it is apparent that the trend is over. There have been some extremely successful trend traders over the years, including John Henry and Richard Dennis (and his Turtles).

Trend followers hope to carve out a good deal of the middle of a trend, realizing that they will always be leaving some money on the table when the trend ends or reverses. Trend followers use trailing stops (more about that later).

The opposing philosophy is that of swing trading – attempting to catch tops and bottoms as accurately as possible. Swing traders often rely heavily on short-term overbought and oversold indicators to guide them. In a strongly trending market, they may take several losses attempting to catch the turn (swing) in the market. But, once they do, it is usually a very satisfying and quickly profitable trade.

One swing trader described his approach and use of predictive short-term indicators something like this: “I’d rather have my indicators tell me what’s about to happen than to use some that tell me the market was down yesterday.” That’s a rather cynical view of intermediate- or trend-following indicators, but it does demonstrate the fact that practitioners of the two strategies often don’t see much merit in the others’ approach.

We are trend followers in most of our speculative recommendations. Why? First, because it’s an easier approach for a non-professional speculator; one only needs to attend to positions once per day (using closing stops). Second, because we have had good success with it. There is no way that swing trading can capture the large gains that enduring trends produce.

However, we do keep track of some short-term indicators (our breadth oscillators, for example). It’s just that we don’t use their signals as primary catalysts for making a trade; rather, we use them as confirmation for our longer-term indicators. Whereas, a swing trader would often attempt to buy an oversold condition or sell an overbought one almost as soon as it occurs.

There is merit in either approach, but I suspect that most traders feel much more comfortable with one approach than the other. For example, I was able to make some very good profits by riding the trend in rapidly declining bear markets (1974, 1990, 1998, 2002) – all the while riding massive oversold conditions all the way down (oversold conditions that caused swing traders to repeatedly buy, get stopped out, and buy again). I have no desire to be fighting that kind of trend. I’d rather be riding it. As a result, I feel much more comfortable with a trend-following trade in place than I do with a swing trade, even though I do employ swing trades from time to time – our “Fade the Dow” system, for example.

In general, though, I do not like “trying to catch the falling knife,” which is what swing traders often do. Yes, it is exhilarating to pick the exact top or the exact bottom. But, to me, the losses associated with trying to do that in an extremely overbought or oversold market – and most markets that are at extremes continue at those extremes for quite some time – is too wearying.

Practitioners of either method can often delude themselves as to the state of a market. Swing traders do best in trading range markets, but often attempt to see trading ranges where none exist. Trend traders do worse in trading range markets, and are often guilty of trying to ferret out trends that don’t materialize, resulting in whipsaws.

In summary, most traders probably utilize both methods from time to time, but tend to primarily trade the one they feel most comfortable with.

Trailing stops vs. targets

Some might say that one’s use of stops – or even his expectations of profits from his trades – is really related to his mentality as a trend trader or a swing trader. Perhaps that is true, but not all trend traders use trailing stops, nor do all swing traders use targets.

We use trailing (closing) stops on our speculative recommendations. As we’ve often said, the old adage to “cut your losses and let your profits run” is quite easily accomplished by 1) setting a stop when you enter a position, and 2) using trailing stops as the position progresses. Of course, this presupposes that you want to let a winning position ride to its maximum. This approach eschews taking small profits (unless one takes partial profits), opting instead for the large – perhaps extremely large – gains associated with a long-running trend. Also, when the trend ends, some money will be left on the table, as the trailing stop will get one out of the position at a certain distance from the actual maximum profit that once existed.

On the other hand, traders using targets tend to have a different line of thinking. They figure that they will take somewhat quick profits, thereby avoiding the aggravating situation of seeing a position start out with a small profit, only to end with a loss if the underlying reverses direction. By doing so, however, these traders can never realize a large profit on a particular trade (unless there is a surprise gap move). These traders also have a initial stop in place to limit losses – just as trend traders do.

Frequency of losses vs. size of gains

In general, these methodologies relate to a broader principle: frequency of winning trades and the size of the average profitable trade. As a rule of thumb, the higher the frequency of profitable trades in a system or methodology, the smaller the average gain. For example, consider a naked option writer who sells puts trading at 0.05. These would be considerably far out of the money, with not too much time to go until expiration. In the early days of option trading – when the smallest price that an option could trade at was one sixteenth of a dollar (0.0625) this system was called “selling the teenies.” These traders found that such options expired worthless a vast majority of the time. However, there was the occasional “problem” – a takeover at a much higher price or the Crash of ‘87 or whatever – that would wipe out the entire trading account. Simi l a r systems are often advertised today – selling put credit spreads well out-of-the-money for very small credits. You may have seen systems advertised that show “96% winners” or some such outlandish percentage. The question is, what happens in the other 4% of the cases? If these are 5-point credit spreads, for example, and one is making 25 cents, say, on 96 trades, but losing 4.75 on 4 trades – that’s not a very profitable strategy.

There are many specific trading systems with verifiable track records – showing average gain, average loss, frequency of winning trades, and so forth. In my experience, trend traders tend to show 40% to 50% winners, but the wins are much bigger than the losses. For example, a system that wins 40% of the time but has average wins twice the size of average losses, is a very profitable system. Average gain = 0.40 * (2W) – 0.60 * W = 0.20W, or 20% of the average win.

On the other hand, a swing trader might have a system with, say, 75% winning trades, but the average gain is only one half the size of the average loss. This, too, is a profitable system. Average gain = 0.75*W – 0.25 * (2W) = 0.25W, or 25% of the average win.

Summary

Which is better? Only you can answer that question, taking into consideration your own risk tolerances, preferences, and the amount of time you can devote to trading (swing trading needs more attention than does trend trading).

Even with all of these comparisons, we have not touched upon what many consider an important philosophical difference: fundamental vs. technical analysis. I find most fundamental analysis virtually worthless for the purpose of trading because of one crucial flaw: if one buys a stock for fundamental reasons, and the stock declines in price, isn’t it now more attractive fundamentally? Shouldn’t one buy more? Hence “cutting your losses” is at odds with the fundamentals. To me, that is a trader’s recipe for disaster.

This article was originally published in The Option Strategist Newsletter Volume 16, No. 11 on June 15, 2007.  

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