The Tactical Trader
by Walter T. Downs
Trading can be compared to the game of chess -- a good player wins by implementing a tactical strategy that entails sacrifices when the sacrifice is justified. Here, a professional trader presents some tactical trading concepts.
In chess, a good player is able to accurately assess his position on the board and gauge the psychological mettle of his opponent. Victory is gained by implementing a positional and/or tactical strategy. Positional strategy is the accumulation of small advantages in terrain and the positioning of available forces in advantageous locations. Tactical play is a direct assault on the opposing army, usually highlighted by sacrificial combinations in which the attacking player is willing to give up certain material in order to gain a decisive advantage.
Trading is like chess. In trading, a long-term trader can be thought of as a positional strategist. He builds a strong position and holds it for an extended period. Short-term traders, in contrast, are the tacticians of the marketplace. Their methods often revolve around a short-term sacrifice of equity in the expectation of gaining an advantage sufficient to gain back the equity risked as well as a reasonable and consistent profit. Here are some key strategic issues for tactical short-term traders.
THE TACTICAL TRADER
Strangely, many short-term traders take risks that a chess tactician never would. The chess tactician is more than willing to sacrifice material, but only when he is able to calculate that the sacrifice is justified.
Of key importance to short-term traders is the realization that tactical combinations -- sacrifices of equity -- are only as good as the strategic validity of the calculations used (see sidebar, "Statistical paradigms"). With this in mind, we can design a four-part strategic guideline to ensure that we have met the requirements necessary to validate a tactical market play:
1) Mathematical edge: Building a mathematical edge is the statistical validation of a trading model. While this testing may not prove conclusively that success will continue, it does prove that the approach was successful in the past. This is an important step in building confidence in the system and in determining how much risk a trader might face in implementing the chosen trading tactic. Guiding rule: Find the edge.
2) Psychology: Short-term price fluctuations can often be ascribed to psychological bias. Understanding why market participants become bullish or bearish allows us to build an active rather than reactive tactic for the market. This allows us to trade the market in anticipation of an impending crowd reaction. Guiding rule: Act on what others do instead of reacting to what others do.
3) Logic: Logical trading means looking for logical reasons why our approach may or may not work. Guiding rule: Don't do anything stupid.
4) Simplicity: Simplicity is the cornerstone of the short-term trader. Recognition of the setup, timely action, and proper execution are necessary if the trader is to be successful. A plan that has many exceptions or is hard to recognize or implement spells disaster to the market tactician. Guiding rule: Kiss (Keep it simple, stupid).
Now that we have outlined a strategic framework, let us take a look at two examples that show how these ideas and trading models go together. The first is known as statistical prey and the second is called tactical patterns.
FIGURE 1: SOYBEAN GAPS RESULTS, 1968-96. Historical testing of the soybean gaps pattern. The overall percentages seem to be a reasonable testament to the validity of the pattern.
Excerpted from an article originally published in the January 1999 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.