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Two Best Practices I'm Observing Among Active Traders

One of the joys of working with traders at different kinds of hedge funds and trading firms is the opportunity to see common threads among those finding success.  Here are two best practices that I'm observing across a range of talented money managers and traders:

1)  The smart use of options to express views - A very common problem that I observe is that traders see the opportunity for medium-to-longer term market moves, but cannot tolerate the volatility of price movement over such a time horizon.  Often, this leads them to exit sound ideas at inopportune times.  A different way to participate over longer time horizons is to express some or all of a view as an options position.  In purchasing a limited number of puts or calls, you define up front the amount of money you're willing to lose in the trade; stops become far less relevant.  I notice that Ivanhoff has a recent book available on using options to capture swing trading moves, with a number of examples.  Among experienced options users, I find a savvy ability to use options structures (such as spreads) to capture market movement while limiting the premium paid and the impact of decay.  Even more experienced traders use options to express volatility views, profiting from price breakouts without the need to define which way that breakout will occur.  This provides an entirely different edge from the usual directional trading.  A valuable overview of options and their practical use can be found on the Investopedia site in an article edited by James Chen, head of research at Forex.com.  The smart use of options gives a trader multiple ways to win, and it can provide superior risk/reward expressions of trading ideas.

2)  Quick adaptation to market conditions - A few savvy traders talk about different instruments having their own "personalities" and also talk about the "personality" of a given trading day.  The best traders quickly size up the environment we're in and adapt their trading accordingly.  Some of the things they focus on is volatility and the relative volume of the instrument they're trading, to size up the potential for moves to extend.  They are quick to notice when volume dries up in a move, when volume expands at key price levels, etc.  As Jim Dalton's work has found for years, it's not enough to track price changes on charts.  Understanding who is in the market and what they are doing is key to anticipating extensions and reversals of moves.  This can change from day to day, week to week, and indeed even within the day.  Smart hedge fund managers track themes that cut across markets and that often frame specific trading opportunities.  For example, the chase for yield due to falling interest rates around the world has created underlying demand for stocks, especially sectors offering sound, high dividends, such as utility shares.  Many times, we can detect themes to market movement even during a trading day, giving us an opportunity to quickly adapt and add to positions, limit losses, and find fresh opportunities.  In the stock market, such themes can occur as sector rotation moves, where the opportunities can't be found in the broad market but do show up as trends in the relative strength of one sector versus another.  The same occurs when we see movement in calendar spreads in commodities and flattening or steepening curve moves in rates.  We limit ourselves when we view trends solely in terms of flat price.  The relative movements of assets often define the opportunities in otherwise flat market environments.

The common thread here is thinking multidimensionally about opportunity.  Many traders focus on playing the game better when they should be stepping back and asking which game they should be playing.

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