China Futures Daily Q&A: Part 1 – Q1 to Q7
Al Brooks will visit China for a lecturing trip next month organized by the publisher of Al’s Trading Price Action books (Chinese versions). The exact schedule is not yet finalized and details will be published soon to help anyone interested in joining Al.
To help promote Al’s visit, the China Futures Daily News website invited Al to answer a series of questions, and an audio recording and transcript is below. This is part 1 (Q1-Q7), and part 2 (Q8-Q12) will be published next weekend.
Audio recording – Questions 1 to 7
Audio duration: 27min 06sec
Question #1: You said you were an eye doctor. We know it’s hard to be an eye doctor, and it’s a highly paid and stable job. Why did you decide to start a new career and be a professional trader? Were there some special experiences and stories?
A trading career
I went to the University of Chicago for medical school. I got my M.D. degree there. All of the time, I wondered if I should have been downtown at the Chicago Board of Trade, or the Chicago Mercantile Exchange, trading futures.
When I was a child, we grew up poor. There were six of us in a two-bedroom house. We had one bathroom and no shower. I did not have my first shower until I was 14 years old and in high school.
My father dropped out of school when he was 8 years old. I did not have guidance as to what to do with my career. My mother thought it would be wonderful if her oldest boy would become a doctor. She told me that she would like me to become an eye surgeon.
My grandparents were immigrants from Quebec, French-Canadian immigrants. Our culture was one of having a lot of respect for elders. When my mother told me that she wanted me to become an eye surgeon, I did not give any thought to what I might like to do. I thought the appropriate thing for me to do was to do what she wanted me to do.
As a result, I became an eye surgeon. Yes, it was highly paid and it was a very stable job, but all of the time when I was in medical school and in my residency at the University of Chicago, I kept wondering if I really should be downtown trading futures. I’ve always been fascinated by financial markets, and Chicago was the futures trading capital of the world. It was only a few miles away, but I was too afraid to give up what was a sure career path to a lot of money.
A few years later, I briefly taught eye surgery at Emory University in Atlanta, Georgia, and then moved to Los Angeles. After 10 years in practice, I had a daughter, and then 15 months later I had identical twin daughters. I thought this was a perfect excuse to quit my career and stay at home and raise the girls. I had enough money saved up so that I could stay home, trade, and raise my girls.
My hope was that I could train them to have great careers right from college and not have to wait 15 or more years the way I did. I did a great job. My girls graduated from Berkeley, Yale, Harvard, and Stanford. They all have excellent careers and they’re doing very well.
I started trading a few months before the 1987 stock market crash. I remember, the day of the crash I had 13 S&P futures contracts that were short, thinking that the stock market was going to go down big on the morning of the stock market crash. That is the equivalent of 65 E-Mini contracts today.
When I got to work, no one knew for sure how far the stock market had fallen, but I had to close out my positions before I went to work because I had a full surgery schedule. Had I stayed home, and if I had stayed in my positions, I would have made $400,000 on the day. That would be about a million dollars in dollars today.
That was the day that changed my life and made me believe that I could make a lot of money as a trader.
Unfortunately, I came from a medical background, and the paradigm was that you learn from the people who went before you. You spend a lot of time studying, reading books, and learning your trade. However, the futures industry back in the 1980s was filled with dishonest people. I spent a lot of time reading every book that I could find and taking a lot of courses, yet I ended up consistently losing money. This went on for about 10 years.
It wasn’t a disaster; I had a lot of money saved up, and I was having a good time raising my daughters. However, it was clearly the wrong path. Every day at the end of the day, I would print out a chart of the stock index futures and see that there were obvious opportunities to make a lot of money. I would ask myself, why didn’t I take those trades?
The reason I did not is because everything that I learned from reading books told me not to take those trades, and much of what I learned told me to do the opposite. I began to get rid of all of the indicators and only look at a bar chart, a 5-minute bar chart. I began to notice all kinds of relationships and patterns, and I began to trade them. Over time I quickly learned that I could become very profitable – very consistently profitable – by simply looking at charts and ignoring indicators, and ignoring the news, and ignoring what anyone else writes or says. That was the turning point in my career.
Over time, I began to observe more and more things about the stock market. Now, I trade mostly E-Mini futures. I also trade the bond futures, crude oil, gold, and stocks and stock options. But most of what I do is trade stock index futures, in particular, the E-Mini.
There are 81 bars during the day session on the 5-minute chart in the E-Mini. On an average day, I see about 40 trades that are reasonable setups for 1 point scalps in the E-Mini. I think a 1-point scalp is the smallest size scalp that a person should ever trade. If you trade for smaller than that, you have a problem with commissions, slippage, execution, so that it becomes very difficult to be profitable.
For most traders, even trading for a 1 point scalp is too small. Most traders should look for swing trades. In the E-Mini, when I talk about a swing trade, I mean a trade that moves at least 4 points, has at least 2 legs, and lasts at least 10 bars.
Now, as I said, I see about 40 trades during the day for 1 point scalps and about 20 trades that are good for 2 point scalps. I also see two to five trades a day that are good for 4 point scalps. If you do the math, it doesn’t take much to realize if a trader can consistently make 3 or 4 points a day, he can make a very good living by simply increasing his trading position size.
Question #2: How did you set up your trading system, step-by-step?
Setting up a trading system
Well, like I said, I began printing out charts every day and looking for every possible setup and every possible relationship. I need more than just entries; I also need stops and profit targets. I began to study the mathematics, and I realized that everyone was talking about risk-reward ratios, but there was an equally important variable – that is, probability.
Risk-reward is meaningless unless you also think about probability. For example, if you have a trade that has a reward that is 10 times greater than the risk, would you take the trade if you only had a 5% chance of success? Think about that. That is a losing strategy. You will lose money.
For me, I think about trading in terms of what I call the Trader’s Equation. That means that I need the probability of a profit times the size of the profit to be greater than the probability of a loss times the size of the loss. As long as that equation is positive, then a trade makes mathematical sense.
I also realized that when I looked at charts, setups that looked really good were not as good as they looked. In addition, setups that looked terrible were often fantastic, and that led me to conclude that during 90% of the bars on the chart, the probability of a profitable trade if you buy is always between 40% and 60% and the probability of a profitable trade if you sell is also between 40% and 60%.
I said 90% of the bars on the chart. During 10% of the bars on any chart on any timeframe in any market, the market’s in a strong breakout. When that is the case, you should only trade in the direction of the trend. The risk is far greater because the stop is further away, yet the Trader’s Equation is profitable because the probability of making a profit is so high.
During 90% of the bars on every chart, the chart is either in a channel or in a trading range. When that is the case, a trader can make money at any minute buying or selling if he uses the appropriate stop and is willing to scale in properly and uses an appropriate profit target.
That’s how I trade today. When there is a strong breakout, I only trade in the direction of the trend. The probability is high that I’ll make a profit. However, I often take a profit that is relatively small compared to my initial risk. During the other 90% of the bars on the chart, I can buy or sell and make money if I manage my trade correctly.
If the market is in a fairly tight channel – for example, a bull channel – I prefer only to buy. If it’s in a fairly tight bear channel, I prefer only to sell. If it’s in a broad channel – for example, in a bull channel, I’ll sell at new highs and buy pullbacks. If it’s in a broad bear channel, I’ll buy new lows and sell rallies that go up about 50% of the height of the prior leg down. If it’s in a trading range, I buy low, sell high, and I scalp.
Question #3: Your first book has been widely praised in China. Many traders think that your book is valuable. In your opinion, what’s the biggest difference between your book and other trading books?
In particular, they should ignore “experts” on television. Most of the experts on television are not traders; they are analysts, and they do not know how to trade. If they could make money trading, they would be trading. In general, it’s very difficult to find a very good trader on television because they’re busy trading.
One of the problems with most of the books is that the logic simply does not make sense. If you look carefully at what they’re writing, there’s no profitable way to make money. There’s no mathematical basis for what they’re doing. Most of them rely heavily on indicators. All indicators are derived from price charts. I’d rather look at the price charts directly instead of converting the information into an indicator and then looking at the indicator. Price charts contain an incredible amount of information; a lot of it is hidden if you concentrate on indicators.
Heavily traded markets, like the E-Mini futures contract, a lot of the big ETFs, bond futures, gold futures, and crude oil futures, are heavily computerized. The vast majority of the volume is traded by computers using algorithms. The algorithms are logical. That means that every little tick, movement up or down on every chart is there for a reason. Therefore, there’s information coming to me with every tick on every chart.
One of the things that annoys me when I read work by other people is they often talk about “noise.” That implies that there’s something random about the markets. That is total nonsense. Every little move that you see during the day on every chart on every timeframe takes place because of a reason. If the market goes up even 1 tick, it’s because at that instant, more dollars believe the market is priced too low and has to go higher to find enough sellers. If it goes down even 1 little tick, that means at that, instant, there are not enough buyers at that current price. The market’s too expensive. It has to go down lower to find more buyers.
With experience, if you look at enough charts, there is evidence before the market goes up a tick or goes down a tick that it will make a move up or down. That’s true on all timeframes. My goal as a trader is to try to find a mathematical advantage. I want some combination of probability and risk and reward that allows me to structure a profitable trade.
I look at what the market is doing and try to assess buying pressure and selling pressure. If the market is going sideways or mostly sideways, I try to determine, is it more likely to go up or go down? If I formulate an opinion, I then try to structure a trade. Do I buy, do I sell, where’s my stop? If the trade requires a stop of a certain size, what is a reasonable profit target?
I think most of the books out there and most of the websites out there do not spend enough time thinking about what the markets are doing. I think most of the work that I read is written by people who really do not understand the function of markets and the behavior of markets. My emphasis is always on trying to understand what the market is trying to do.
Question #4: What’s the difference and interrelation between a trend move and a range move?
Trends and trading ranges
I look at every bar on every chart as either a trend or a trading range. A bar, if it opens on its low and closes on its high, I view that as a bull trend bar. If it opens on its high and closes on its low, I view that as a bear trend bar. If there’s a big tail on the top or bottom, if it closes somewhere in the middle, I view that as a 1 bar trading range.
The market is constantly probing up and down. The fair price, best price, the price where most buyers and sellers will want to trade, is never known and it’s always changing. However, there is a range of a fair price, and the market always is probing up and down to find where that range is. It usually has to go too far up before it knows that it’s gone far enough up, and then it reverses and it probes down. It usually has to go too far down before it concludes that it has gone down too far and it has to reverse and start probing up.
This is true on all timeframes on every chart. As I said a few minutes ago, during 90% of the time the market is in a probing pattern. It’s probing up and down. A trading range or a channel. When that is the case, a good trader can make money buying or selling at any instant if he structures his trade properly and manages his trade properly.
Only during 10% of the bars on the chart is the market quickly moving up or down. That is a breakout. That is a time of consensus between the bulls and bears that the price is wrong. They both agree that the market has to quickly move to a new price level where, again, the market will be confused and balanced. The goal of every market is a range – that is, an area of confusion, an area where both the bulls and the bears feel that the price is appropriate.
I have lots of ways to estimate how far a breakout will go. I call them measured move projections. I do not have enough time to talk about all the ways right now, but there are many ways. For example, based upon the height of the breakout, based upon the trading range from which the market broke out, there are Leg 1 = Leg 2 measured moves. There are measured moves based upon gaps. I use a very broad definition of a gap. What I call a gap, many traders would not think of as a gap.
Question #5: For a trend trader, what are the difficulties in combining trend analysis with trading rules? What’s the key point?
Trend trading and rules
In general, most traders should be swing trading. You used the word “trend.” When I think of a trend, I use that term in a very specific way. On any chart, the screen cannot have more than two trends. There can be a trend up and a trend down, or only a trend up or only a trend down. If there is a third trend on the chart, I don’t use the term “trend”; instead, I use the term “swing.” There can be four or five swings on any chart on any timeframe.
If you’re talking about a true trend – in other words, the market starting in the lower left and going to the upper right, or starting in the upper left and going to the lower right, or a chart that has two trends on it – it’s usually pretty clear. Either the market is in a breakout phase or it’s in a very tight channel. If it’s in a breakout, then it has a series of consecutive trend bars up or down. If instead it’s in a very tight channel and you look at the next higher timeframe chart, that tight channel is a breakout on a higher timeframe chart.
For example, if there’s a very tight bull channel on the 5-minute chart, then there’s a breakout on the 15-minute chart. I therefore trade tight channels the same way I trade breakouts. For example, if there’s a very tight bull channel, I know that it is a breakout on a higher timeframe chart. I only want to buy. If there’s a very tight bear channel or if there’s a strong bear breakout, I only want to sell.
This is not difficult. There are simple tricks that traders can use to determine if a trend is strong. For example, if the market’s in a channel and you cannot tell if the channel is tight, then you should only buy. If the market’s in a bear channel and the channel is very tight and you cannot tell if it’s broad enough to buy, then only sell. Always assume that if the channel might be tight, only trade in the direction of the trend.
A simple way to determine that is just look at the chart from the perspective of a trader trying to do the opposite. For example, if the market is rallying, is there any way that a bear can make money selling? For example, if the bear sells at the prior high, which might’ve been 3 or 4 bars ago, will he make money? If it’s very difficult or impossible for bears to make money, then a channel is tight, and therefore a trader should only look to buy.
Question #6: How should we understand your trading concepts, such as a tight stop, early entrance, and second entrance?
Tight stops, early and second entries
A tight stop means that the risk is less. The risk reward ratio is therefore good. That immediately tells you that you will probably lose. If one institution gets good risk/reward, the institution taking the other side of the trade gets a high probability of profit. This is because perfect trades cannot exit. A perfect trade is one where there is a high probability of making a big profit while risking very little. This cannot exit because no institution would take the opposite side. The opposite is a trade with a low probability of a small profit while risking a lot of money. In general, the smaller the risk, the lower the probability of profit. However, there are often several good choices for a stop. The tighter stop will lose more often, but the losses will be small. The wider stops will result in fewer, bigger losses. It does not matter which approach a trader takes as long as his stop is reasonable.
If a market is in a trading range, traders should look to buy low, sell high, and scalp. In a trading range, the market often falls below support, a prior low, before it reverses up. At the top of the range, it often goes above the top of the range before it reverses down.
If a leg up looks particularly strong and starts to reverse down, it’s usually better not to take the first entry. It’s usually better to wait for a second entry, like a micro double top. The same is true at the low; if it reverses up but the bear leg was down very strongly, it’s usually better to wait for a second entry. That would have a higher probability. That would also be a micro double bottom.
A lot of times traders are not sure where the bottom is or where the top is when they’re trading in either a broad channel or a trading range. In that instance, if they’re willing to scale in – for example, in either a broad bull channel looking to buy a pullback, or in a trading range looking to buy near the bottom – it’s usually better to use a wide stop, trade small, and scale in.
The key is knowing where to put the stop. Usually it’s better to put it just beyond some kind of measured move projection below where you’re entering. The stop often has to be further away than what you think is reasonable. If you’re thinking about scaling in, your initial entry has to be very small. The total risk of your first entry plus your second entry has to be within your comfort zone, and that is determined by how far your stop has to be.
If you cannot trade small enough to use the appropriate stop and if you cannot handle the emotion of the market trading against you after your first entry, do not take the trade.
I think the important point is when the market is in a broad channel or a trading range, knowing exactly when the bottom of a move or the top of a move is, is difficult. As a result, a lot of traders take what they think might be a reasonable entry, but they’ll use a wide stop and they’re willing to add on more if the market continues before reversing.
However, beginners should not do that. A trader has to be able to use the appropriate stop. They have to be comfortable having the market go against them after they first enter, and they have to be able to add on to the position at the appropriate time. That is a lot to expect from a person starting out. However, experienced traders regularly do that.
Question #7: Could you please talk about your money management in trading? [I’ve already talked a lot about money management.] How much money would you invest at first when you decide to start a trade and take a position? What’s the proportion? When you put on a heavy position, first time, second time or third time, what is the most valuable signal in the system when you decide to increase your position while you are trading? How do you deal with them usually?
This is all about position size. I think the important concept is the mathematics of what you are doing. In general, a trader should try to avoid risking more than 2% of his entire account on any one trade. If a trader is planning to scale in – let’s say he’s planning to add on to his position if the market goes against him – the combined risk if his stop is hit has to be 2% or less of his entire account size. If he cannot risk less than 2% of his account size, he should not take the trade – or he has to trade a smaller position.
I sometimes take a bigger position when I’m extremely confident of a move. Initially, if I’m taking a bigger position, I’m taking it as my first entry. Usually when I take a bigger position, I’m not planning to add on. I’m taking it usually because it’s already a second or third entry after the first or second has failed but were very strong signals. I might not have taken the earlier entry because I often wait for a 2nd or 3rd entry because I want a higher probability of profit.
For example, if I’m looking to sell, I want to see the market reverse down two or three times at very important resistance levels – usually a combination of several types of resistance – and I want to see a lot of signs of selling pressure before I take the trade. Additionally, I want a strong sell signal bar, and I need good targets below. There has to be a magnet below that will pull the market down.
Once I’m in the trade, I manage it like any other trade, except that if I’m trading a big position, I am not planning on scaling in. That usually means that I’m going to be putting a stop just beyond my signal bar. For example, if I’m taking a second or third entry short, I’m going to place my protective stop just above the high of my signal bar.
I hope that you found this helpful. I’m Al Brooks. Thank you for listening.