4 Tools For New Prop Traders

There are 4 things that new and aspiring prop traders should focus on as they develop their trading models and their feel for the market. These are the same whether you want to trade stocks or commodities. Incorporate these 4 things into your daily routine, and you will have a much easier time managing risk.

1. Trend

You need to know the slope of the trendline. If it’s positive or upward sloping, you’ll be biased Long. If it’s negative or downward sloping, you’ll be biased Short. Don’t be cute early on – trade long in uptrends and be short in downtrends.

As important as the slope of the trendline is how you draw the line itself. As defined by Victor Sperandeo in Methods of a Wall Street Master, for an uptrend, draw a line from the lowest low, up to the highest minor low point preceding the highest high so that the line does not pass through prices in between the two low points. See the chart below from Methods of A Wall Street Master.


Drawing the correct trend line (Click to enlarge)

2. Volatility

Volatility, to me, is the personality type of the security. Every security has its own temperament if you will, and you should have an idea if there’s a drunk uncle coming over for dinner or not. Many professional traders measure a security’s volatility by using the Average True Range (ATR) – for starters, so should you.

Like any moving average measurement, you can set the duration of the average to what feels best for you. Shorter periods, like 20 days will respond faster to sharp price moves in the short term than longer periods such as 55 days. The 20-period ATR for Google (GOOG) is $11.88 on average in either direction. ATR is not a directional volatility measurement. So you can reasonably expect GOOG to move almost $12 every day in either direction.

It’s important to understand what the volatility measurement is telling you. The 20-period ATR for Google (GOOG) being $11.88 might seem high, but it is 2.24% of the price of GOOG which is $536 at today’s close.

The 20-period ATR for March NYMEX Crude Oil is $2.22 and since each contract is 1,000 barrels, that equates to $2,220 per contract up or down every day. Given today’s March settlement of $74.76 that would make the volatility for crude oil at 2.97% in terms of daily price swings – and that would be considered normal behavior for the contract.

So although GOOG is over 5 times more volatile than Crude Oil on a price basis, it is actually less volatile on a percent basis, and having too much of the more volatile security can cause for sleepless nights – in Seattle or otherwise.

If you look at several different technical indicators for owning one position, and several other technical indicators for owning the second and so forth, you probably are either a fundamental trader, or you haven’t lost enough money yet with this ethos to know that it’s what NOT to do.

Anyone want to tell me why? Email me what you think.

3. Position Size

You then use the volatility to calculate position size. The more volatile, the fewer shares or contracts in your account. Likewise, the less volatile the security, the more of it you can have in your account – subject to the volume. (If you trade Oats, you know what I mean.)

What you don’t want to end up with is a portfolio of 30 stocks each with 3.33% allocation like the fee-only asset management plans have or own 10 stocks in your portfolio, each with 500 shares. That is a huge rookie mistake that even famous managers make.

You want to own/short fewer shares/contracts to the more volatile names in the portfolio. It’s an inverse relationship.

4. Exit

As the volatility increases, you can cut the size down to mitigate the risk or stay with what you have, but absolutely enter a protective Stop Order to offset all or part of the position if the volatility suddenly jumps.

Final Thoughts

Admittedly, each of these four can be broken down into courses themselves. Trading in line with the trend will keep you trading with the forces of nature at your back and direct you to profitable trades more times than not. But more importantly, it will focus you on playing great defense, and the traders with more than 20 years of experience who are still trading because the focused on great defense and protecting their capital whether they traded stocks or commodities or both.

Please note: I reserve the right to delete comments that are offensive or off-topic.