by Dave Caplan
We are going to analyze the following popular trading systems/methods in an attempt to determine which has the best chance of success:
1. Trend Following Systems
2. Fundamental Trading
3. Option Trading
– Purchasing Options Only
– Selling Options Only
– Option Strategies
4. Combination of the Above
We are not examining the innumerable other technical methods for several reasons. First, an in-depth examination of the multitude of systems could easily produce a 200+ page book instead of an article. Second, our studies have shown that the methods we have listed have been the most successful and popular. That is not to say that the new “sure-fire” trading system that you just received a brochure for – you know, the one with a 3-year hypothetical track record, and $1995 price tag – will not be successful. It’s just that it’s too easy now to “curve fit” a system using old data and a computer. The second problem is that a system can be successful for many years, but may be unable to adjust to current changing market conditions. We will discuss the importance of flexibility in adjusting to changing market conditions later in this article.
We don’t suggest you avoid all other or new systems, only that you evaluate them carefully. If you find one that you think you might like, ask for recommendations of others that have used it, especially in different times and market conditions; if it is traded by a CTA, he should receive most, if not all of his compensation through incentive fees (participation in the profits). If you trade it yourself, make sure you follow it completely – not modify it by taking only the trades you like, changing stops, etc. By doing this you will be making a completely new system, one whose performance will have no correlation to the original system.
Finally, you must have a plan that contains strict principles of money management and have the discipline to stick to it. Even a great plan that fails to provide for money management and disciplined trading is likely to fail.
TREND FOLLOWING SYSTEMS
“The Trend Is Your Friend” is the first item most of us learned in our trading education. It is also the most widely used method of trading today. Our conclusion is that long term technical trend following systems, when combined with rules that provide for strict money management, are still among the best trading methods. Trend following systems work particularly well in the currencies, which tend to trend reliably for many years.
However, there are several problems that trend following traders commonly run into that can produce poor results. These include:
1. Short-term trading where the average profit is too small.
2. Stops too close – causing the loss of a good position.
3. Failure of discipline – causing over trading. This commonly results from the boredom in long-term trend trading because of relatively few trades that are initiated.
Fundamental trading is more difficult to evaluate. This is because the results depend strictly on the knowledge, ability, and talents of the individual. At least with other technical or trend following trading systems some of it can be mechanized or computerized and less interpretation is required after the system is devised.
We have found that the results of fundamental traders vary as widely as the results of any other business. (Over 90% of businesses fail, while only a few become IBM or Disney. This is the same result that we see among traders). We have found the odds favor the knowledgeable fundamental trader, who also uses the strict principles of money management to manage his account. This type of trader seems to have a distinct advantage over others because of his inherent knowledge of what moves the market. In fact, the most consistently successful are those knowledgeable, fundamental traders who also use option strategies to complement their positions.
Purchasing Options Only
Many new traders begin by only initiating option purchases. This is because of the limited risk factor and it being the easiest type of trade to understand. Many brokers also seem to like recommending these trades to their clients because of their simplicity. However, unless options are purchased only when the right circumstances exist, a trader is likely to lose money even when the market moves in his favor.
We reserve purchasing options only for those markets that we feel will be in a long term trend, giving us substantial chance for large profits. We then use our “free trade” techniques to help us build a large position with the minimum of risk.
Selling Options Only
After learning about overpriced options and the time decay of out-of-the-money options, traders often embark on a program of selling options to collect the premium. This was an excellent trading method from 1986 through 1988 when option premiums were high. However, in 1988 option volatility began to decline which, with some exceptions, has continued to date. This has occurred in the light of futures volatility, which in many markets has remained almost the same. Lower option volatility with a potential for large moves in the futures make option selling inadvisable. Even though a trader could experience 75% or more winners, the potential for unlimited losses in turbulent times can quickly out strip all profits previously earned.
Remember, the only thing consistent about the market is change. The 90’s continued the trend of the late 80’s, toward larger institutional types of traders. Similar to program trading in the stock market, this can cause larger moves in relatively short periods and more volatility in turbulent times (e.g., crude oil in 1990-91). Also, since trading has become much more international, we have more large overnight moves – such as those in the currencies this year, where openings of +/- 100 are not unusual.
We believe that option selling is a viable strategy when used at appropriate times depending on the volatility levels of the futures and options market. However, this strategy, more than any, requires discipline and strict principles of money management to prevent large losses from occurring.
This is the type of trading that we recommend as it combines the best attributes of buying and selling options either by themselves or in combination with others (option spreads). The proper use of options can significantly improve anyone’s chances of success, by taking advantage of the many advantages found in options including limited risk, leverage, time decay, etc.
COMBINATION OF THE ABOVE
Up until recently, many of the best traders and money managers did not use options. This is because they were successful in what they were doing and did not want to institute another variable into their trading that they were perhaps unsure of. However, we are finding more professional traders are now instituting option strategies as they find the use of option strategies to hedge, add income, and at the appropriate time substitute for a future position, can greatly increase their returns. Almost every trader that we have found who uses options to supplement his otherwise successful future system has improved his results. We strongly recommend that every serious trader look at supplementing his trading by the use of option strategies at appropriate times.