Random Entry Trading
There is a famous trading book that ‘proves’ you can enter the market with a random entry and still make money. Or did it prove that? There are some important lessons to be learnt when we take a deeper look.
The trading strategy was simple:
1 – Enter the market at random
2 – Use a trailing stop loss to exit the trade
Now, of course, the authors didn’t actually trade the system, they just showed how it would have worked on a number of markets over a 10-year period. In that period, the system made a profit.
So, can we stop learning anything else about trading, use these 2 rules and retire to an island somewhere?
Probably not.
Let’s have a think about what this strategy does. First, we enter the market. It doesn’t matter if we go long or short. We have a trailing stop loss order that will follow the market if it moves in the direction of the trade and will sit where it is if the market moves against us.
If the market is trending, then the random entry trades that are against the market will quickly get stopped out. On the other hand, the trailing stop will ensure that the random entry trades that go with the market will ride the trend. So, of course, the winners will be larger than the losers. That’s where the profit comes from.
So, what’s the problem?
Well, the problem is that this is not a profitable system, and it’s not really a completely random system. It’s a trend following system. It makes profit when the market is trending, and it loses money when the market isn’t trending. In the book, the back-test showed markets that were predominantly trending.
Don’t agree? There are options strategies that do the same thing. The “Long Straddle” is a strategy where you buy a call and a put option with the same strike price. Effectively, you are saying “I know it’s going to move, I just don’t know which way”. It’s not a random entry, it’s a ‘prediction’ that volatility will increase. There’s nothing random about that. The system described in the book is doing the same thing. If the market went into range mode as it did for most of 2016, your random entry system would lose.
So what?
There are a few lessons to learn from this. First, the fact is that it’s your overall strategy that makes you profitable (or not). The decisions you make to get into the market may not be the most important element.
The reasons that a strategy is making or losing money may not be obvious. In this case, we had 2 authors who wrote a chapter in a book “proving you could trade at random”. In fact, they’d just proved you could follow a trend. Let’s give the authors the benefit of the doubt and presume they were not trying to fool people. They effectively fooled themselves. They were so focused on the entry being random that they missed the fact that the exit made it a trend following system.
Of course, the chapter mentioned nothing about trend following. The most important part of any trend following system is how to know if the market IS trending. Without that, a trend following system will fail (unless, like the authors, you were lucky enough to test only in trending markets).
Playing with numbers
If you have access to any back-testing software, you will find that if you enter at random with a 9 tick stop loss and a 1 tick target, it will result in an amazing 90% win rate. The problem, though – even with the 90% win rate, you would not make any money. There is no edge in the system. When your stop is 9 ticks away and your target 1 tick away, that alone will see you hitting your target far more frequently. You will win more trades than you lose, but the system will break even before spreads/commissions.
This is an important thing to keep in mind. If you play with your stops/targets too much, randomly introducing different numbers to improve your strategy, you risk negating your edge. For example, let’s say we trade a strategy that looks for trapped traders on Crude Futures, something that will typically give us a 10-20 tick bounce. Then say your back-testing found that a 10-tick target and a 200 tick stop loss gave you the best results. What you’d have is some trades that hit your target because of the trapped traders and some trades that hit the target because although the trap failed, the target is so much closer than the stop. You are left with something quite random and that won’t play out well in a live market.
Nuance
Randomness isn’t all about trading at random. Any entry signal will have a finite scope. The 10 tick bounce we see when we have trapped traders in Crude Futures will occur in minutes, and it’ll be over after the market has moved 10-20 ticks. If we are still in that trade 3 days later, then we aren’t trading the reaction to those trapped traders any more. We are in the market because it carried on moving, not because our analysis told us it would carry on moving. In other words – it’s random.
Then there are times when we ‘feel’ we are trading at random because people think a trading strategy is all about the entry. Yet what you do after the entry is as much a part of the strategy as the entry itself and will dictate under which circumstances you do and don’t make money.
Trading can be random when you think it isn’t and vice-versa. Something to keep in mind next time you shout “Eureka!”.
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Order Flow itself is simply information. Just like charts, it can be used in a number of ways, some good and some bad. But let's first break down order flow into it's components so we all agree what we are talking about:
Order Executions/Tape Reading - This aspect is the real flow of orders. It's the information we see in Time & Sales, Footprint Charts, Cumulative Delta. It is looking at market orders, either as they execute or historically. I guess this is the "true order flow". Every trade is a buy and a sell. We look at market orders because we consider them to be more aggressive. When someone trades with a market orders, they are giving up a price to get an instant fill. Limit orders on the other hand just lazily sit there waiting for a market order to hit them. Often these are market makers with no directional conviction. So we see market orders as being more significant.
But we don't use these in isolation.
Volume Profile/Positions - The tape reading part helps us assess various things like momentum, traders getting stuck, balance of trade BUT the volume profile helps us understand where people are positioned and likely to get stopped out. I sometimes call this "Order Flew". It's important to know when trades will be "washed out" - for example - if we have a volume cluster on the S&P500 Futures and the market moves up 100 points and back down to it, it's unlikely short term traders on either side that were positioned there will still be there. But recent, nearby volume helps us assess areas of positions.
Market Depth - The bids and offers, the lazy passive orders waiting to be hit. This is part of the story but in terms of overall importance, I'd put it at around 20% at most. For example - if you return to the high of the day on any market, the offers will be quite large directly above the high. It means nothing at all. It's just a quirk of the market. It does not help you tell if a price will hold. On the other hand, if you see large depth and as we approach it, we see more added to the depth in front of that price, it means others are front running that depth and that is a useful bit of information.
This is the key - it is all just information. Just like price charts are information. When people look at Order Flow, they consider it to be a technique more than a set of information. They look for things like iceberg orders and decide to make a one rule trading system to fade every iceberg, For these people - yes, order flow trading is overrated because they are trying to ignore everything else going on in the markets and construct a trading system a chimp could execute.
For those looking to improve a decent trading approach, the best thing to focus on in Order Flow is momentum. Once you can read momentum you can:
- Avoid getting into positions when momentum is against you.
- Confirm trades are working after entry when momentum goes your way.
- Exit trades in profit when momentum fades.
That's perhaps the easiest way to use order flow because momentum is easier to read. It's about the market continuing to do what it's already doing. On the other hand, reading a turn in the market with order flow takes a higher level of skill and a little longer to learn.
Order flow can't put lipstick on a pig. It won't help you 'improve' something that doesn't work anyway, which is why whenever someone calls me, the first thing I ask is what they are currently doing and we discuss whether they need a reset or whether it will actually help.
When Jigsaw started back in 2011 - we were one of the first in the space and certainly had the best education. It was always going to attract the underbelly of the trading education/tools world and now we see stuff out there that is so complex but so impressive and futuristic that new traders are drawn to it like moths to a flame.
So here's my advice when looking at Order Flow
- Order Flow can't improve something that doesn't work.
- Order Flow can be used on it's own, without charts to enter and exit the market but you also have to be able to recognize different market states that need different/altered setups. There is nothing magical about this.
- Don't start jumping at shadows and take 50 trades an hour in your first week looking at Order Flow, be selective. It can be exciting to see cause and effect play out in front of you for the first time but don't overtrade.
- Do drills to learn how to read it before you trade it.
- Markets can only go up and down. Don't overcomplicate it. If you have too many Order Flow tools on your screen - you will not be able to make consistent decisions. Less is more.
- Take time to choose a market with a pace you like. Interest rates might send you to sleep, the DAX might give you a heart attack.
It is hard to see how a set of information could be overrated. It is true that some methods of presenting this information are better than others. It is also true that some people simply get on better with different tools (e.g. Footprint vs DOM).
There's a middle ground between complexity and simplicity that will leave you making consistent decisions where you improve over time. For those people, Order Flow will be way underrated because they will be the one's getting the most out of it.
Those that jump in with both feet on day one and those that have 100 different tools up, for those, it's a painful experience.
Keep it simple and manageable. Start with momentum reading and build from there. You will never look back.
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