A Study in Momentum Trading:
Determining Exactly What to Trade and Why
Develop a Trading Plan
The main message I want clients to understand is how important the disciplined execution of a well thought out trading plan is in today's markets. Nobody knows for sure what a given market will do next. Having a plan of attack will allow you to successfully cope with the uncertainty that is an inherent part of trading. I think it makes good common sense to have a well thought out plan of attack for trading the futures markets.
Make time to study and organize a trading plan for each and every trading day. This is a serious business that requires dedication and discipline to succeed. Arm yourself with the best tools you can find and make sure your own personal armor has no weak points. Mark Douglas, in his excellent book, The Disciplined Trader, insists that you trade with the goal of doing the right thing (sticking to rules!!), not making money. Paul Tudor Jones sees his strengths as a "trader who is able to take losses quickly and think defensively." Larry Williams once said that one of his main winning characteristics is that he could follow a trading system faithfully to the letter.
Discipline is the Key
You will need discipline in several areas to be successful. First you'll need the discipline to make a plan, rather than shoot from hip. Without discipline, many approach the markets like a craps table . . . and they can expect the same results; short-term successes based on luck and long-term losses based on randomness. Second you'll need the discipline to follow the plan. If you change your strategy at the first setback, did you really have a plan in the first place? You must not second-guess your strategy. Take every trade according to the rules. Third, you'll need the discipline to evaluate your plan. If it isn't broke, don't fix it, but be honest enough after some time to be able to admit to possible flaws. Anything you do gives you experience. As a result, you can look at your decisions and resolve to change them in the future. Use them as a learning experience, rather than accepting the setback judgmentally by thinking 'I have failed.' Discipline is the key word.
How to Get Started
I've seen many different trading plans. Whether they're 7 sentences or 7 pages long, they put forth a way of looking at the market and they attempt to create some framework for approaching these potentially chaotic markets. A good plan will include a well-tested strategy or trading method. Having a positive expectation should allow you to have the confidence to start trading your strategy. Confidence in your strategy will lead to the discipline necessary to continue trading despite occasional losing periods. Disciplined execution of your strategy leads to returns over time that can be consistent with your testing.
But you may ask, "How do I get started?" First you'll need a well-tested trading method. There are several ways to accomplish this. You can take a course on trading, or buy a commercially available trading system. You can subscribe to FutureSource and use their charting and analysis software to start sifting through the available indicators until you find a combination that works. Or, you can work with a professional who has already done the work and can help point you in the right direction.
Diversify
Next, you'll need to choose which markets to follow. Diversification is one of the crucial factors in the success of a trading plan, and may in fact make the difference between success and failure of the plan. Putting all your eggs in one basket is not a good idea. Rather than trading ten contracts in one market, look to trade smaller amounts in several different markets. The aim of diversifying is to substantially lower the draw down, minimize the equity swings and hopefully increase the overall profit. This can represent a more efficient use of equity capital. Avoid highly correlated markets to increase your chance of success. To me, trading Soybeans, Soybean Oil and Soybean Meal does not represent three different trades, but one trade. A trader who puts on such highly correlated trades may have a bigger draw down and increase their chances of ruin. Different markets trend well at different times. Traders who trade only one market may become so frustrated with the losses, or the time lost, or the trading strategy that they will give up before the market becomes tradable again. So pick a good handful of unrelated, diversified markets to build a portfolio, which can lead to a lower maximum draw down, and generally more consistency.
Follow the Market
After you've determined your strategy and your portfolio, you can start following the markets. In the following examples I'm going use actual charts from my newsletter, Momentum Trader. It is important to follow each market consistently and see the trading opportunities as they develop. Jumping around from one market to another often leads to missed or late execution of your method. I think it's important to let the market tell you what to do. I'm sure many of you have heard the saying, "The trend is your friend." Below is an example of trading with the market following the direction it wants to go.
Corn Futures Example
Above, we see the December Corn in a down trend as prices are below the trend average (green line). It's easy to see with hindsight that it was profitable to be short this market. But prices never go straight up or down. Many are tempted to trade against the trend. I've found that it is often better to offset trades when the trend stalls or if the market moves significantly against my position and then wait for the next move to develop. You can see that at points 2, 4, 6, 8, and 10 above that there is very limited opportunity against the prevailing trend. These corrections can become new trends so it is critical to have a way of differentiating between the two. Below is an excellent example of this transition in December Bean Oil.
Corn Futures Quotes + Charts
Bean Oil Futures Example
The price of Bean Oil had been moving down into August. The shallow correction early in the month was followed by another move higher. I still consider this part of a correction until at point 1 several things concur: Price crosses and closes above the trend average (green line) and the long term down trend line (red line), and the momentum indicator (lower pane in red) turns positive. After this point the correction higher has turned into an up trend and prices move higher into September. At point 2 the market breaks the near term up trend line but is still a correction lower until point 3 when it closes below the trend average and momentum turns negative.
Bean Oil Futures Quotes + Charts
Japanese Yen Futures Example
I like to use momentum to help filter out some of the choppy trading that can be seen from time to time. In the Japanese Yen example below, a trader could get whiplash following the market back and forth across the trend average (highlighted in blue).
Japanese Yen Futures Quotes + Charts
Waiting for the momentum indicator to confirm direction would keep you out this market. Waiting for this confirmation also keeps you from buying long after getting stopped out at point 2, which would only have added another loss to your ledger. I feel more comfortable taking trades once the market moves away from this congestion area.
Sugar Futures Example
In the following March Sugar futures example, the momentum filter keeps you on the right side of the market, passing the false breakout to the down side and buying as price turned back up (1).
Sugar Futures Quotes + Charts
Please note that I've plotted an objective or expected move for this trade (A, B). Here I've simply added the amount of the congestion (high - low) A to the top of the range to arrive at an objective price B. I don't generally concern myself a lot with how much a market is going move and I'm satisfied with being on the right side of the trade. However, I'm constantly asked; "Where do you think X is going?" or "When should I get out of Y?" My answers are usually; X will probably move in the direction of the trade." And "Get out of Y when it quits going your way." The objectives are most useful when you are trying to decide which of several different markets to trade or when figuring how much to allocate to a particular trade.Stay on the Right Side.
So you see it is important to stay on the right side of the market, buying when it is going up, selling when it is going down, and staying out when it is not going anywhere. This is often easier said than done.
British Pound Futures Example
Sometimes, as in the British Pound above, despite the best set ups, the market does not cooperate.. These are the times that try a trader's patience and can have them questioning their strategy. You must realize there will be periods like this and plan accordingly. Remember not to over trade by allocating too much to any single position and you can s till come out the other side.
British Pound Futures Quotes + Charts
Australian Dollar Futures Example
In the Australian Dollar example below, the down trend has little true direction and the two attempts at being short are unrewarding (1, 3). Again, remember, the key is discipline.
Australian Dollar Futures Quotes + Charts
Rather than giving up on this particular market, you can get on the right side of the trade and be rewarded when the up trend is established (5).
Sometimes you'll have to be pretty nimble to stay on the right side of the market.
Gold Futures Example
In this case the down trend in Gold never develops at all. However, by buying long the same day you were stopped out of the short position (2, 3) you are able to profit as the market makes new highs. It's important not to be committed to a direction when the market tells you otherwise and be willing to allow that the market is never wrong.
Gold Futures Quotes + Charts
Manage the Trade
Once you get into a trade, you must eventually get out. Some argue that this is more important than where you get into a trade. I'll take the middle ground and contend they are equally important. As I follow the markets, I find there are two reasons to get out of a trade: 1. the market moves significantly back against my position or, 2. the market stops moving in the direction of my trade for a time. Either condition can likely be followed by a further correction and as we saw above, these corrections can turn into new trends.
To manage the first condition, a market moving back against my position, I find it is a good idea to use a stop order. In fact I would say trading without a stop is like walking a tight rope without a net. You should always place a stop, not because you expect the market to go against you, but to protect against the unexpected. The worst losses I've seen have resulted from a trader not having a stop order in place and the ensuing deer-in-the-headlights paralysis that sets in once losses start to mount.
If you are fortunate enough to get into a market that moves in the direction of your trade, it is also important to move your stop with the market to eventually protect some profits. Below is an example of December Copper where the market has continued to move up after the initial buy.
Copper Futures Example
As the Copper market moves up to each higher level, I recommend moving the stop up also (horizontal red bars). I've seen that many times traders are too quick to take profits when they get them. Note that the projected level was reached (A, B) and the momentum flattened out at that time, but price never set back significantly and the market was able to penetrate to new highs. This method can keep you in the market during big moves. Unfortunately most trades don't turn out this way, but instead move in stages as in the next example.
Copper Futures Quotes + Charts
Canadian Dollar Futures Example
In this case you would buy as the Canadian Dollar moves in the direction of the trend (1, 3, 5) and get stopped out to take profit as the market corrected down after making new highs (2, 4).
To manage the second condition, where the market stalls for a time, I look at two moving averages, a short-term average of the high and another short-term average of the low. When a market is unable to penetrate the average in the direction of the trade, I say that it has stalled or found support/resistance.
Canadian Dollar Futures Quotes + Charts
Cocoa Futures Example
In the Cocoa chart above, the high average is plotted in red and the low average in blue. The market is in a down trend but finds support near 1450 and the movement stalls in that area (2, 4, 6). I would recommend that a short position be offset at these points and then would wait to see how the move develops before putting on a new trade.
Cocoa Futures Quotes + Charts
Conclusion
It is critical to develop a well thought out and organized trading plan. It is then key to have the discipline needed to follow it. Diversify your trading into several unrelated markets. Trading futures and options on futures is not typically a long-term investment that you can just buy and forget. They require consistent monitoring on at least a daily basis because of the large impact a small price move can have on your account. You should strive to stay on the right side of the market and manage every trade. It is also important to work with a professional who can help you to develop your plan and to stay alert to important market changes. In fact, the charts provided in this article are all examples of how I help my clients to "do their homework" and stay on top of the markets.
Momentum Trading is a method of trading commodity futures that was developed to help users view the daily action of the markets and to improve the chances for their success by making trades in the direction those markets may move. Momentum Trading strives to give you more control. It focuses on markets that may be on the verge of momentum swings and teaches you to get out of markets and into new trades when they change direction.
PLEASE NOTE THAT THERE IS AN INHERENT RISK OF LOSS ASSOCIATED WITH OPTION CONTRACTS. OPTIONS TRADING IS NOT SUITABLE FOR ALL INVESTORS. OPTIONS CAN AND DO EXPIRE WORTHLESS. IF YOU PURCHASE A COMMODITY OPTION, YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIMUM AND OF ALL TRANSACTION COSTS.
