Trading strategy first, trades later

Most traders spend much time and energy figuring out what they want to trade. Very few put in a similar effort to work out how they want to trade. Doing it the other way around is probably a better strategy.

One of the most successful day traders I know, uses a simple, almost mechanical way to select contracts. He focusses on the equity and index derivatives (F&O) segment of the National Stock Exchange. He knows how much margin he can put down. Given that limit he looks only at the 10 most liquid F&O contracts he can afford (he assumes a minimum position of 10 lots).

His filter for picking this set is the average trading volumes of the past 20 sessions, on a rolling basis. For this given set, he calculates the average daily fluctuations, the standard deviation of the average daily fluctuation, the biggest swing in the past six months, the correlations with the index for given stock futures, outstanding open interest, the liquidity in mid-month contracts, etc.

He has this data available at a mouse-click. He further calculates the percentage stop-loss he must set to enter any of these contracts, to allow for reasonable fluctuation while maintaining a decent risk-reward ratio. For example, with a stock future that averages a 2 per cent high-low swing a day, he assumes a stop loss of 0.5 per cent, to keep a positive risk-reward ratio.

Every morning, he reviews the trading pattern after the first half hour and isolates the three contracts out of his set of 10 that have seen the most action. He assumes that, whatever trend has been established in the first 30 minutes will continue for the rest of the day.

He sets stop losses based on what he thinks the fluctuations will be. Then he enters the given contracts, long or short, as the trend may be. If he is not stopped out, he lets the positions run.

Towards the end of the session, he takes a call on booking profits or losses. He ignores market khabar in general. He has no interest in tracking anything outside this set, regardless of what may be happening in the wider universe. He has no idea what the pundits think. I am not sure that he knows what any of his underlyings do in the way of business. He certainly wouldn’t be able to name any of the CEOs of his chosen contracts or quote balance-sheet ratios.

This is an extreme way to deal with information overload: ignore all superfluous information and focus completely on what you consider relevant. But it does seem to generate outstanding returns for my acquaintance. He does far better than the average trader, who has the khabar at his fingertips and follows the recommendations obsessively.

The author is a technical and equity analyst