This past weekend, I watched a true master practice his craft.
As I watched, I noticed the edge that separated him from others who are very good in his field. Put into practice consistently, this edge repeatedly made the difference between success and failure. And so I was reminded of trading systems (no surprise there!) where this same concept really matters. The consistent application of an edge, even a small one, can make all the difference between trading success and failure (or mediocrity).
The master I watched was Peyton Manning, the quarterback of the Indianapolis Colts football team. Manning is an absolute lock as a future Hall of Famer. He has been league MVP a record four times, holds numerous other records, and has a Super Bowl win to his credit.
Manning has earned respect for numerous aspects of his game. He’s certainly one of the best thinkers and strategist to ever play the position. He’s the only quarterback in the league who calls many (if not most) of his own plays. He’s also among the all-time league leaders for passing accuracy.
Manning possesses at least one other ability he has developed over time that gives him a true and important edge. I’m not talking about a major component here (e.g., his strong and accurate arm or his knowledge of the game). This edge is subtle while, at the same time, highly effective and valuable.
During a pass play, Manning rarely looks at his ultimate target until the last moment. Manning knows his plays and players so well that he doesn’t have to watch his target’s passing route develop. Instead he surveys the whole field and even looks away from his target to confuse the defense. At the last instant he glances back and throws the perfect spiral to a receiver who had full confidence that the ball would be in the right place at the right time.
Manning’s edge makes a huge difference and contributes to his successful performance in the highly competitive world of professional American football.
In a similar manner, often the less conspicuous areas of a trading system give a strategy an edge in the markets. Today I’ll talk about the one that has made perhaps the biggest difference in strategies that I’ve designed or reviewed.
Finding an Edge
Digging into trading strategies is one of my favorite pastimes. I’ve had the pleasure of doing it for household names in the trading industry as well as for traders and investors just getting started.
A useful trading strategy has several parts that work together:
the system’s beliefs about the market (i.e., why it works),
market conditions—where it works well and poorly,
set-ups, entry, stop loss, profit taking exit, and
a position sizing strategy.
A weak link in any one area will render the system ineffective. (Next week, we’ll dig into each of these components).
For today’s discussion, we’ll focus on entry and how to gain an edge there. Entry is the part of the system that tells us to pull the trigger now. (For clarity, the set-up is the part of the system that tells you to get ready to enter).
One entry strategy has paid bigger dividends in system design for me than all of the others. I love it because it’s truly effective and beguilingly simple.
It’s All About the Direction
The concept for gaining an edge with your entry is straight-forward: require the market to move in your desired direction before entering. Some readers may be thinking that this is too simplistic to be useful; however, my research and practice show otherwise. Let’s look at some proponents of the practice and some examples of when and why it works.
First, Van published the results from a study based on this concept in our book Safe Strategies for Financial Freedom. Van looked at a series of trades that Steve Sjuggerud recommended as investments for the Oxford Club.
With just Steve’s recommendation and no other entry criteria, the picks were quite good, averaging a gain of 2.5 times the initial risk or 2.5R. When Van added the entry condition that required the stock price to move up for one month before entry was allowed, the results were dramatic. Rather than earning 2.5R, the trades with the directional entry requirement returned a whopping 6.4R or 6.4 times the initial risk!
We felt that this entry strategy was so compelling that we made it one of the “six keys to investment success” presented in the book.
My good friend and systems maven Chuck LeBeau has always been a big fan of requiring the market to move in the direction of your trade as a requirement for entry. On several occasions Chuck helped me to improve already profitable trading systems by applying this simple concept.
A directional entry works not only for longer term trades like those that Van cited in our book but also in short time frames. We also reviewed an intraday trading system called the 10-Minute Trader strategy in the Safe Strategies book. It produced excellent results in large part because of the requirement that price moves in the direction of the trade on an intraday basis before a trade could be entered.
As with almost all trading system design choices, the trader has to consider the tradeoffs for a directional entry requirement. Waiting for confirmation of a price move in your favor means that your initial stops have to be a bit wider (farther from entry). Still, my research has shown that for most cases, this “disadvantage” is more than made up by the avoidance of strong momentum moves against the trade. It basically ensures that you won’t try to catch a falling piano for long trades (wait for it to bounce first!) or step in front of a freight train for short trades.
I hope you can use this simple edge in your trading and investing. If you’d like to understand how to apply this valuable concept and others, remember that there is a How to Develop a Winning Trading System That Fits You workshop coming up in October. You’ll explore different types of trading system concepts and find the ones that align with your beliefs. You study in-depth each trading system component as well as the entire system development process so that you’ll be able to transform trading ideas into profitable trading systems for any type of market.