“Rolling It Forward” for Profitable Trading (Part 1)

I have been teaching professional traders to become better since 1987, both at well-known institutions (JPMorgan Chase, Goldman Sachs, and Commodities Corporation) and at various exchanges. Over the past 23 years of teaching professional traders, it's become pretty easy to classify what trading practices will drain a trading account:

1. Not planning your trade before you enter it
2. Trading and not using hard stops
3. Using too much leverage
4. Using stops that are too large (similar to number 3 above)
5. Being too anxious to find trades…overtrading
6. Trading with risk/reward ratios too small for your winning percentage
7. Not sticking with your plan after the trade begins: Don't take profits because you are nervous. Never move your stop to a “worse” level!

Traders are people, and they tend to share the same human strengths and weaknesses. I like to say technical analysis is 80% science and 20% art (though that 20% is quite large!), and in this case, I'd say that keeping your thoughts and emotions under control when you trade is much more than half the battle.

I like to plan my trades before I enter them and write the plans on paper with a pen (writing the plans on Excel spread sheets on my computer do not evoke the same feelings in me). This allows me to have the plan in front of me, and I can then follow along, or “paint by the numbers,” as the trade unfolds. If I get anxious, or walk out of the trading room and then come back and need to refresh my mind, the plan is there in front me. I simply look at the plan, find my place, and go back to executing the original plan. Plans, if you stick with them, take many of the emotions out of your trading.

Last year, I had the good fortune to host a daily pre-market morning session, sponsored by the CME Group; and I recently moved from Chicago to Arizona, so this year, the daily pre-market morning sessions became the Market Geometry mid-day mini-mentoring sessions. Our goal at Market Geometry, and one we try to foster in each mid-day session, is to help each trader become more consistently profitable. For over an hour each day, we work hard on reading market structure, trying to identify the current frequency (or trend and speed of trend in any given market). We always stress the importance of solid money management and good risk/reward ratios. As each session unfolds, we never know where we are headed and where we are likely to end. The goal is to foster good trading practices and help members become more consistent in their trading.

One of the techniques we have been talking about recently has really struck a chord with some of our members, and it has helped their trading immensely. I call it “Rolling It Forward,” and it's a technique that can help take the pressure of making money out of your trading. If you are new to trading or you are not a consistently profitable trader, you constantly feel pressure to have a winning trade. This constant pressure clouds your judgment and often makes you take trades you would not have taken if this pressure weren't there. Or worse, this pressure causes you to change your trading plan, exiting trades early because you “must” have a winner!

Though I hadn't started talking about “Rolling It Forward” to the mid-day session members until a few months ago, the idea came about when I mentored about 350 Chicago Mercantile Exchange members that were trying to learn to trade “off floor,” or out of the pits, in 2005. Even though I had been a CME member in the 1990's, I was surprised just how impulsively most of these professionals traded once they were off the floor. If the bars on the chart on their screens started to turn up, they'd often get long at the current price, with no thought about the where they would get out if the trade were profitable, and no thought about where they'd get out if the trade turned against them. They bought or sold however many contracts they felt like trading at the time—sometimes ten, sometimes 25, sometimes five—there was no rhyme or reason. This meant they might make a wonderful trade using five contracts and follow it up with a losing trade using 25 contracts and lose all they had just made, and more! In short, most of them came off the floor and did whatever felt right, and it just wasn't working. And so they came to my CME seminars looking for guidance.

The idea of “Rolling It Forward” is simple: If you use relatively constant position sizes and have a positive winning percentage, it's pretty easy to find yourself halfway through the month with enough profits in your account to nearly guarantee a winning month, assuming you keep trading the same style the rest of the month.

But if you trade helter skelter, varying your position sizes and moving your stop loss orders when your emotions overcome your better judgment, you'll soon be looking for work as something other than a trader! There are many tips and tricks I developed to help off-floor traders during that period, but this is one I had completely forgotten about until someone in one of the online mid-day sessions asked me about position sizing (increasing the size of your positions as you accumulate more profits in your account.)

I initially answered that the first and foremost goal was to become consistently profitable, and we still had too many people attending that weren't consistently profitable. I explained that “consistently profitable” meant that if you looked at the new profits and losses of the past five or six months, one or two months should stick out—and those should be the losing months, not the winning months. Having profitable months had to be the norm before you could even begin to think about increasing the size of your positions. And so I re-dedicated all that we do at Market Geometry to making its members more consistently profitable. And that reminded me of the “Rolling It Forward” exercise I had used with the CME members and just how powerful a concept it can be.

Let me walk you through it.

First, I went back and chose the results from a CME professional member who was just beginning mentoring. These are the first five actual consecutive trades he brought to his first session for me to look at, in summary form (presenting them in a chart-by-chart form would not aid this discussion).

Click to Enlarge

Looking at his composite spreadsheet, you can see his trade parameters as he planned them, the results, and my comments.

He started out alright. My only advice to him was that in general, five S&P points was a little large for an initial stop because if he wanted to reach a 3:1 risk/reward target, he'd have to take his profits 15 S&P points past his entry, and fifteen points was at or around the entire day's average recent range, so he would have to catch most or all of the range on a normal day if he constantly used five-point stops. I also noted that his original plan had included a 1:1 risk/reward. In general, a trader would need to have a winning percentage of over 75% to trade with a 1:1 risk/reward ratio, after you factor in slippage and commissions.

I suggested he use slightly smaller initial stops and look for trades with risk/rewards that were at 2:1 or higher. I personally do not take trades with initial stop losses larger than three S&P points, and I never take a trade with a risk/reward below 2:1. I am much more comfortable in the 3,4, or 5:1 area when intraday trading. I don't find these trades that difficult to find once you get used to looking for them, and if I have to wait to find a trade that fits my acceptable profile, that doesn't bother me at all. I want to be consistently profitable and it costs me nothing to wait for an acceptable trade.

He had a good plan for his next trade: He used a smaller initial stop loss and the risk/reward was greater than 2:1. The trade started out as a nice winner and looked like it was going to run straight to his profit target—it was already five S&P points in his favor! But when it began to turn back lower, he let his emotions get the better of him. He had that feeling that the market was going to continue to head lower and hit his stop loss, and he didn't want to take a losing trade. This was the pressure of making money talking to him, and he threw his plan out the window. Rather than risk having this trade become a loser, he panicked and took the two S&P points still left in the trade. If you are curious, he would not have been stopped out and price would have reached his original profit target if he had stuck with his plan. Once the trade was closed, he realized he had two winning trades for his first two trades. He was riding an emotional high. This off-floor trading wasn't hard!

The next day, he saw his third trade opportunity right after the S&P open, when the market gapped open lower. Most floor traders know the market loves to fill open gaps, so that gave him his trade idea. He already had two winning trades and was feeling good about his trading, so he decided he would go back to using looser stops for this trade. The market had just opened and the economic numbers that had come out before the opening— which caused the market to gap open lower—had left this market volatile, and with fairly wide range bars. He didn't want to get stopped out and then have the market turn around and fill the gap!

This trade had nothing going for it. The initial stop was too large, the risk/reward was poor, and he was taking an entry right after the open that was fighting against the trend. And he made matters worse when price got near his initial stop loss level and he looked at the screen and the size of the buy orders shown by his platform. Then he watched price hesitate and turn just a bit higher. He was certain the buyers at this level would keep price from going lower, but price was so close to his stop that he cancelled his existing stop and moved it five S&P points lower. Remember, he just had two winning trades in a row and was running on an emotional high. He was certain price would never break through this level and hit his new stop loss order.

But price did break through the lows and quickly stopped him out for a rather large loss. On this single trade, a trade he was certain was a sure winner, he had lost all he had made on the prior two trades and quite a bit more. If you eye up the first three trades, you should be able to see the usefulness of same-size maximum stop losses per contract, as well as what damage you can do to your account if you move your initial stop loss order to a worse level.

By Tim Morge of MarketGeometry.com