Evidence Based Trading

In this past Friday's day trading session in our chat room many subscribers asked me to explain in detail my approach to short term trading. So I could think of nothing better for an end of the year column then sharing with you my evidence based approach to the markets. Before I begin let me preface by saying that I am the first to admit that this trading technique is far from bulletproof. Markets at their core are simply pools of sentiment and can therefore be wildly irrational and unpredictable. Nevertheless, over the long run trading is a game of probabilities and I try to put the odds in my favor every time I trade. As Daymon Runyan once said, "The race is not always to the swift, nor the battle to the strong, but that's the way to bet."

My philosophy of trading is relatively simple.

1. Have a bias
2. Let price confirm your bias
3. Manage the risk

For me, my evidence based approach starts with Kathy's Economic Calendar. Every week she combs through all the upcoming economic data isolating the most probable economic surprises using a host of proprietary analytic techniques to beat Wall Street at its own game. Over the course of the year she has been accurate approximately 65% of the time - an edge that I will take any time.

More importantly Kathy's calendar calls provide me with an intelligent, logical, well researched foundation for my fundamental view. Often currency markets will start moving in the direction of her call hours in advance of the economic event, bringing me to my second point. The fundamental bias is worthless if price action does not confirm the thesis. In trading your opinion does not matter. The only opinion that counts is the opinion of the majority of market participants. Ultimately our job as traders is to figure out the opinion of the majority and join the move before it runs out of steam.

There are a hundred different ways to generate a signal for technical entry using my approach, but my most favorite one is simply to let the price fall (if my bias is short) or rise (if my bias is long) through the 20 period simple moving average on the 5 minute chart. The key point for me is that I never sell on a green candle and I never buy in a red candle. Guessing tops or bottoms is a mugs game and I need evidence of strength or weakness before I put on a trade.

Of course price can lie. Sometimes breakdowns are instantly reversed and break outs fade faster than Vanilla Ice's career. That's when risk control becomes paramount. Again there are a hundred variations on proper stop and take profit placements but I prefer two basic approaches.

Approach One - trade with 2 units. Make the take profit target on half the position 1 times risk (usually 20-30 points). Once T1 is hit trail the rest by 10-15 points back.

This is generally the better risk control model because it allows you to capitalize on occasional large break out moves. Alas I have no patience and frequently opt for approach two.

Approach Two - trade with 1 unit and make your Take Profit target 75% of your risk stop (15 points TP on a 20 point stop) This is negative risk reward ratio, but it works if you have a high probability set up with 70% accuracy rate or better. When I adhere to my evidence based rules I often achieve better than 70% rate of success. When I deviate - I pay the price.

Trading is one of the few human enterprises where you can do everything right and still fail. That's why evidence based trading does not always work. But as Churchill once said about democracy -it is the worst type of government except for all others. Evidence based trading forces you to be aware of and utilize every aspect of the currency market - fundamentals, technicals and money management and I hope it provides you with the same edge that it has given me.

Boris Schlossberg