In my last blog post, I made an argument that the details of patterns do not matter–get the idea and the big picture right, and everything else is much easier. While I firmly believe that this is true, it does leave some important questions unanswered: mostly, exactly where, when, and how do I get into and out of trades? And, if the details of patterns don’t really matter, why do I make these choices and how do I know they are the best choices. These are important questions, and we cannot trade without having some answers.
Strategy vs. tactics
It’s useful to take a few words to make sure we understand the difference between strategy and tactics. (This applies to business and to many other areas other than trading.) Simply put, strategy is what we want to accomplish and tactics covers how we are going to do it: what vs. how. In a military situation, perhaps we have the strategic goal of achieving air superiority over a region. To accomplish this, we need to have our fighters over the contested area without them being shot down, and shoot down anything else that comes into that area–that’s the strategy. Tactically, how will we do that? Well, we need to suppress opposing air defenses, and we have a choice of going after radar sites or SAM sites (what about the portable SAMs?), and have some choices of weapons platforms to get munitions on target, then we need to think about taking out airfields or planes on the ground probably at the same time we get planes out of the sky. Then we need to think about having someone fly CAP over the region and the logistics of refueling and rotating those fighters on and off station, flying those big, expensive AWACs platforms somewhere they can keep an eye on the airspace while we also keep escorts in the area… and this is only a tiny slice of the things that must be considered and accomplished in service of the strategic goal.
In chess, perhaps we want to focus on strategic elements like pawn structure, king safety, or control of space, and we’d do so through tactical moves that might (threaten to) attack two enemy pieces at once, attack a piece through another piece, or force the other guy to make a move he’d rather not make. In business, perhaps we want to increase our social media presence, and we’d do so through tactical elements of email, blogging, tweeting, etc. It’s very useful to force ourselves to think about the divide between what we want to accomplish and how we plan to achieve that goal.
Strategy in trading
It’s also worth mentioning that many writers and bloggers use “tactics” in trading in a nonsensical and imprecise way. It’s a word that has come into vogue as writers try to avoid terms like “technicals” or “timing”, and some writers use it in an effort to sound smart (or “erudite” if we’re trying to use big, ostentatious words lol!) In this case, we need to be very precise: tactics refer to how, where, (and maybe why) we execute at the specific prices we choose. Strategy, on the other hand is the big picture perspective. First, get the strategic view right.
That was the point of the previous article; I do not think that the minute details of patterns are important, at least conceptually, as traditional technical analysis would have us believe. Rather, an approach that looks at the broad outlines of the market is probably both more useful and more faithful to the realities of the market–that reality being that the market includes a lot of noise and random price movement. Useful strategic tools might include swing analysis (are upswings larger than downswings?), some looks at momentum and volatility, and perhaps even a quick, heuristic glance at a chart. Some legendary traders have famously said things suggesting that a child could do chart analysis, simply answering “is this going up or down or sideways?” I’ve also advocated an approach where we basically glance or squint at a chart to hide the details, and simply take the first impression. This can be useful for creating a bigger picture, technical, strategic view, but you do need a solid grounding in chart analysis to develop this intuition. This “first glance” is probably not enough, but it’s a good start.
Don’t underestimate the value of that first glance. If you can get the big picture direction right, a lot of the rest falls into place. However, we still have to execute at specific places, and having some “reference levels” or prices to consider may be useful. If I’ve successfully identified a market that is going up, then I need to buy that market. Where I buy it almost doesn’t matter: I can buy the high of the previous bar. I can buy the low of the previous bar. I can buy when moving averages cross. I can buy at some silly magical level. I can even calculate my retracements and ratios completely incorrectly (ahem) and still be ok if I have the big picture right, but I still need some rules to govern my behavior.
Sometimes when I’ve talked about patterns I’ve gotten some angry notes from traders who feel that I’m hiding some secret piece of the puzzle. They think I’m saying “here’s a great pattern to buy and if you only had my super secret entry trigger you could buy yourself an island next year.” What I’m actually saying is that the precise choice of execution point doesn’t matter so much–perhaps if you can identify the right environment (strategy, context) then nearly any tactic can be effective.
To continue with the example from the previous post, looking to buy a strong market, how might we execute that? Here are some ideas:
- Buy a breakout of the previous bar’s high. If not triggered, roll down to the high of this bar and continue until either the pattern is violated or the entry is triggered.
- Enter at some other breakout level, perhaps based on the patterns of the last 5-10 bars. The same principle will apply.
- In either case, apply a “fudge factor” based on current volatility. If buying a breakout in the S&P futures, perhaps add 2-5 points to the level.
- Another possibility is to require a certain amount of time (on an intraday basis) above the level. In other words, we’d only buy above our breakout level after the market had been above it for X minutes. This will, in most cases, mean that we buy a worse price than expected.
- Just to show the exact opposite concept, buy a failure test of a previous pivot low. This is an example of buying weakness, and can be done on the trading timeframe or on a lower timeframe.
Where to put our stops? Here are some ideas:
- A reasonable distance away from the entry, so that we are quite likely wrong if the market trades to that point. This level could be 3-5 ATRs on the trading timeframe. (This will likely seem wide to many people who are focused on using very tight stops.)
- At the low of X previous bars, with our without the “fudge factor” added. This will likely be a tighter stop.
We could go on, but here is where behavioral factors start to take control: you can do almost any of these things as long as you do them consistently. There’s the key–choose your tactical toolkit, but use the same tools in the same way as consistently as possible. This is also where there’s room for overlap between systematic and discretionary approaches–perhaps your strategy is dictated by a discretionary synthesis of market factors, but your tactics could be purely systematic. (Example: execute a trend following system only when you have a bullish or bearish bias in a market.) Ideally, both your strategic and tactical pieces should have a statistical edge (and I spend a lot of time in my own work to make sure that this is so), but there could also be room for using a tool that is essentially arbitrary as one piece of the puzzle, especially if it disciplines behavior and creates a tactical framework for effective trade entry and exit within a valid strategic directional bias.
I think there’s more to explore here, but, at the very least, start teasing out the difference between strategic and tactical thinking in your own trading and analysis.