interplay between expected (hoped for!) profits and likely periods of capital drawdown. Historically, my average annual rate of return has been a multiple of two to three times my worst annual drawdown. There are several acceptable methods to express the relationship between return and risk (including the Sterling ratio, the Calmar ratio, the Sortino ratio, and the MAR ratio). For any given year, my modified Calmar ratio (the annual return divided by worst month ending drawdown) has been all over the map, ranging from a negative number to as high as 30 to 1. The $100,000 asset increment is based on my desire to limit my expected worst-case drawdown each year to 10 percent of trading capital. This does not mean that my drawdowns will never exceed 10 percent—or that I will even be profitable, for that matter. The point is that my unit of capitalization is based on risk parameters, not on factors often used by novice traders in making decisions about their trading operations. I have actually heard novice traders say something like the following: “I have a $25,000 account and the margin for a soybean contract is $2,500; therefore I can afford to buy or sell 10 contracts.” As a general rule, I will trade no more than a single contract of soybeans per $100,000 of capital. My guess—and it is only a guess—is that many other professional traders consider a capital unit to be at least $100,000. Some of the better-known commodity trading advisors accept accounts capitalized by no less than $500,000 or even $1 million. These amounts obviously represent their standard trading unit. Overall Risk Management Successful trading operations are dictated primarily by how risk is managed. Many novice commodity traders assume each trade will be a winner. Professional traders manage their trading to assume that each trade may be a loser. Obviously, there is a major difference between the two perspectives. The Factor Trading Plan operates with several global assumptions, including: I have no idea where any given market is headed. I may think I know, but in reality I do not know. History has shown that my degree of certainty about a given market’s direction is inversely correlated with what actually happens. In fact, I think a trader with excellent money management practices could take the other side of trades in which I have a strong belief and make money consistently. About 30 to 35 percent of my trades over an extended period of time will be profitable. The probability of my very next trade being profitable is less than 30 percent. As many as 80 percent of my trades over shorter periods of time will be unprofitable. There is a high probability each year that I will incur eight or more losing trades in a row. There will be losing weeks, losing months, and even losing years in my trading operations. Important risk management guidelines have been incorporated into the Factor Trading Plan to address these global assumptions. The primary guideline is that the risk on any given trade is limited to 1 percent of trading assets, and preferably closer to half of 1 percent of assets. Because I think in incremental units of $100,000, this means that my risk per trade per unit of $100,000 is a maximum of $1,000. My trading assets committed to margin requirements rarely exceed 15 percent. I don’t recall ever receiving a margin call for the account used to trade my full program. If I risk 1 percent of assets per trade and am wrong eight straight trades at least once each year, it means that I will experience a drawdown of at least 8 percent with certainty, at least on a closed trade basis. A 15 percent drawdown is about as much as I can emotionally handle. I have encountered a drawdown of at least 15 percent in 9 out of every 10 years I have operated a fully implemented trading program. I find myself more risk intolerant as I grow older. At the present time, my risk management protocol attempts to limit the maximum annual drawdown to 10 percent (measured from week-ending peak to week-ending valley). I attempt to ignore intraday equity spikes because I have no desire to catch the bottom of each day’s high or low, and I do not want to waste energy in even thinking about it. In fact, as I will discuss in this book, I think it is unwise to pay attention to account equity levels on a day-to-day basis. I consider correlation between markets when determining risk. For example, a bearish trend by the U.S. dollar against the euro is also likely to be accompanied by U.S. dollar losses against the Swiss franc and British pound. A bull market in soybeans is likely to be accompanied by advances in soybean oil or soybean meal. In composite positions of highly correlated markets (grains, interest rates, stock indexes, currencies, precious metals, industrial commodities), I attempt to limit my risk to 2 percent of assets. All successful trading operations must be built on a foundation of overall risk management. Points to Remember The commodity and forex markets are highly leveraged. Unlike stocks and bonds, trading commodities and forex markets is a zero-sum game. For you to be profitable, someone else must lose money. Do you have adequate capital to trade commodities, and can you afford to lose it? Can you understand and manage the emotional swings of market speculation? Do you have the emotional or psychological need to be right on your trades? Can you accept an approach to trading that is wrong on the majority of trading decisions? Would your primary focus in trading be to find winning trades or to manage losing trades? Risk management must be given priority over trade identification to achieve consistently successful performance. Chapter 3 Identifying the Trades and the Trading Vocabulary Iwill now move to the mechanics of the Factor Trading Plan. The trading plan attempts to answer such questions as: What markets should I trade? Should I be long or short? Should I get in now or wait—and if I wait, what exactly should I wait for? These practical and tactical questions, and more, are answered by the components within the trade identification pillar of the Factor Trading Plan, as shown in Figure 3.1. FIGURE 3.1 The Trade Identification Pillar. This is an appropriate point to reemphasize that I have no pretention that my approach to trading is the best for everybody or that my trading operations cannot be improved. In fact, as you read through this book you will no doubt see many warts on my trading plan. The primary point I want to make by describing in detail the Factor Trading Plan is not that my trading is particularly clever, but that a comprehensive plan covering all of the important aspects is necessary for consistently successful trading operations. The process of trading is an important part of consistent success. A trader needs to anticipate as many contingencies as possible in his speculative maneuvers. The Factor Trading Plan is based upon the following set of assumptions: The likely direction of any given market cannot be determined by studying charts. Charts are a trading tool, not a predictive tool. Charts can provide traders with a slight edge, but should not be used to make price forecasts. Charts should not be used to maintain a constant opinion or position in any given market. Do not assume that the next trade will be profitable. More often than not a market will defy what its chart structure implies. Markets make enormous moves that can’t be explained by classical charting principles. With these assumptions in mind, Chapters 3 through 5 cover how the Factor Trading Plan works, focusing on the trading components. This chapter lays down the general concept used to identify trades and defines the terminology or “shop talk” used by the trading plan. Chapter 4 shows examples of the ideal types of trades sought by the plan. Chapter 5 details the types and frequency of trades engaged by the trading plan, discusses how trades are entered and exited, and explains the logistics of how the entire plan is managed. Trade Identification There are numerous methods used by traders to define a trade. The important point is that a trader must be able to know what is or is not a trading signal, event, or moment. This is true whether a trader uses a mechanical or discretionary technical approach, a supply-and-demand fundamental approach, or an economic model. Lack of certainty if a market is or is not setting up a trade is a cardinal sin. This is why I recommend that novice traders paper-trade or trade a small trial account for a year or two prior to placing real skin in the game. The Factor Trading Plan is based on a technical approach to market analysis. Technical trading approaches study price behavior itself to identify candidate trades and generate trading signals. In contrast, fundamental trading approaches are based on the supply-and-demand factors of a market and general overall economic conditions. It is not within the scope of this book to delve any deeper into different approaches to market analysis or trading. The technical approach used by the Factor Trading Plan falls into a category known as discretionary (as opposed to the mechanical approach used by many technical traders). A discretionary trading plan requires that the trader makes certain subjective judgment calls from one trade to the next, whereas a mechanical (some market operators use the term black box) system is programmed to generate precise entry and exit instructions in order to eliminate day- to-day human decision making. Using a discretionary approach is a personal preference, not in any way an indictment against mechanical systems. In fact, some of the more frustrating aspects of my own trading could possibly be resolved if I used a mechanical system. But, in general, I believe that a discretionary approach better fits my personality and understanding of price behavior and dynamics. More specifically, the Factor Trading Plan uses classical chart patterns as the basis for all trading decisions. A discussion of classical charting principles can be found in Chapter 1. Vocabulary of the Factor Trading Plan All industries and companies have their own shop talk to describe concepts and practices inherent in their business operations. While definitions of terms often appear in the appendix of a book, I believe it is very important to lay out the operating and tactical terms of the Factor Trading Plan at this point of the book. Understanding certain terms will enable you to follow my discussion of charts and trades during the remainder of this manuscript. The terms and definitions are not listed alphabetically but in the order I think through things during actual trading operations. Trading Unit As a trader, I think in units of $100,000. When I calculate risk and leverage, it is always in relationship to $100,000 blocks of capital. Thus, if I am trading a $500,000 block of money, I think about it as five trading units. Position Unit A position unit is the number of contracts or size of a position taken per $100,000 and determines the risk assumed on a trade. The risk is normally about six-tenths to eight-tenths of 1 percent. I refer to a position with less risk as an underleveraged position and positions with more risk as extended-leverage positions. Position Layering Often, I attempt to build a position by entering into a trade on multiple dates and at different prices. For example, if I establish a position in anticipation of a future breakout, I consider myself to have established the first layer. If I establish another position at the breakout of a major pattern, I become two layers deep. Perhaps a near-zero- risk opportunity to extend leverage develops at a retest; then I could become three layers deep. Now if I can find a pyramid opportunity, I will end up with a four-layer position. I do not add to a losing position, but put on layers only as earlier layers are profitable. Even in a multiple-layer position, my combined risk in a market rarely exceeds 1 percent. Multiple-layer trades are not the norm. Breakouts I am a breakout trader. But I define a breakout in two ways. First, all patterns have boundary lines that define the exact geometry of the patterns. Some traders and market analysts draw boundary lines precisely with a fine-point pen. I draw boundary lines roughly, often cutting through some highs and lows in order to provide the best fit of an area of price activity to a geometric pattern. I also use thick lines, not a fine-point pen, to establish the boundary. Of course, there are instances when I call a breakout too closely—and I often pay the price for doing this. Robert Edwards and John Magee considered a breakout to be a price penetration equal to or greater than 3 percent of the value of a stock. This is far too generous when trading commodities. For example, a 3 percent breakout in $1,000 gold would be $30 per ounce. A breakout is more complicated than simply penetrating a pattern boundary. All patterns are comprised of minor or intermediate high and low points. These high and low points define the parameters of the boundary lines. To be a valid breakout, I also want to see a market penetrate the most recent high or low price that defined the boundary. And to be most comfortable with a trade, I want to see a market penetrate the highest or lowest price within the completed boundary. Figure 3.2 show these chart points on a weekly graph of the British pound/U.S. dollar (GBP/USD). FIGURE 3.2 Pattern Breakout in the British Pound. Ice Line I use the terms ice line and boundary line interchangeably. The concept of the ice line is that once a market moves [...]... represents a one-day out -of- line movement, a premature breakout or a false breakout For this reason, I generally abandon any position that has a significant return to the pattern Horizontal versus Diagonal Patterns I greatly prefer to trade a pattern that offers a horizontal or flat boundary, such as the boundaries of a rectangle, ascending triangle, H&S, etc I consider such patterns to be horizontal The reason... Displays a Horizontal Chart Pattern Diagonal patterns, by contrast, have slanted boundary lines This creates three practical problems First, my experience is that there are far more false or premature breakouts of slanted chart lines than in the case of horizontal boundaries Second, the penetration of a diagonal boundary may or may not violate a minor or major preceding high or low Figure 3.11 shows a. .. target P&F charts measure the amount of price action over a period of consolidation and are not time related I use P&F counts several times each year when I believe that a period of consolidation (usually a large bottom or base) will produce a trend much more extended than indicated by the pattern target Important note: There is no guarantee that any market will reach its target Traders need to be alert... breakouts, but instead attempt to establish a position upon the retest of the completed pattern My answer to this question is an unqualified “NO!” Think about this matter logically By not taking a trade at the point of a breakout, but instead waiting for some type of retest, a trader is eliminating trades that work immediately and do not look back, which are exactly the most desirable trades A market... market that retests a pattern is inherently more likely to fail than a market that never has a retest A hard retest is shown in the U.S dollar/Canadian dollar (USD/CAD) in Figure 3.17 FIGURE 3.17 Hard Retest in USD/CAD Retest Failure Rule A hard retest of a pattern allows me to adjust my stop using the high or low of the hard retest as a new protective stop point Assuming that the initial stop was based... position as days or weeks go on Figure 3.12 shows a breakout of a falling wedge in gold followed by several days of retesting that put a breakout trade into a loss FIGURE 3.12 Diagonal Pattern in Gold The problems with the diagonal boundary become particularly acute when dealing with a trend line or a channel line In fact, I normally do not consider a trend line to be a tradable event unless the market has... patterns—and my feelings differ based on the duration of the pauses within the main trend Long pauses (more than three or four weeks) can wear down my patience I much prefer shorter-duration pauses in a main trend, especially if the move coming into the pause was strong and the pause takes the form of a pennant or flag Figures 3 .21 and 3.22 display continuation patterns in Australian dollar/U.S dollar (AUD/USD)... respectively Premature Breakout A premature breakout is different from an out -of- line movement in the sense that a premature breakout can close outside of a predrawn boundary line and even spend several days in breakout mode Prices then return back to the geometric pattern However, the initial breakout was only a harbinger of things to come, and within a few weeks a genuine breakout occurs I call these subsequent... times Last Day Rule The Last Day Rule is the principal method used in the Factor Trading Plan to determine the initial protective stop order once a position is entered If a pattern breakout is valid, then it logically follows that the day of the breakout is a significant event Ideally, I establish a position at the point of a price breakout and use the low of an upside breakout day or the high of a downside... rice market Note that the retest itself took the form of an 18-day flag FIGURE 3.16 Retest of H&S Top in Rough Rice Hard Retest A hard retest occurs when prices actually slice back into the completed pattern While a hard retest can test the patience of a trader, it does not in and of itself mean that the pattern will fail I have been asked over the years if it would be wise not to take a trade at the . that novice traders paper-trade or trade a small trial account for a year or two prior to placing real skin in the game. The Factor Trading Plan is based on a technical approach to market analysis operations are dictated primarily by how risk is managed. Many novice commodity traders assume each trade will be a winner. Professional traders manage their trading to assume that each trade may. Technical trading approaches study price behavior itself to identify candidate trades and generate trading signals. In contrast, fundamental trading approaches are based on the supply-and-demand factors of