Exploring Averaging And Hammer Trades

[Predictor 11]

Averaging down or simply averaging is the idea that a trader can achieve a better overall price by working orders over time. The basic idea is that it is approximately but not precisely possible to bound price.

 

Averaging does allow a trader to improve their entry and refine it as the market moves against them. However, there is a cost to naive averaging which is that the traders risk increases with the improved position. This large increase in total risk at the worst time is generally why averaging is frowned upon among professional traders.

 

Even so, the benefits to achieving a better cost basis would help many traders. If a trading method could somehow be developed that would allow a trader to improve their cost basis without increasing their directional risk then such a method could form a powerful method for trading. The goal would be to find a method to constantly revise our opinion of value without increasing our directional risk and without the risks of taking realized losses that occur with stop losses.

 

One discretionary method that I developed to achieve this purpose was a method that I called Hammer Trading (or Hedging) which involved trading correlated instruments both long and short at the same time. First, I do not think this method as I originally developed it worked well. It required too much skill and may have appeared to work simply because it kept me in the game longer, working harder. Let me warn you that the technique that I'm sharing is extremely difficult to make work and most would lose if they were to try this method. I caution against it.

 

First, it is assumed that one can predict the market's direction. The method doesn't provide an edge in itself but assumes that one already has an edge.

 

The idea for the hammer trade is that I have a directional bias and enter a normal directional trade. But, imagine the trade starts to go against me. Instead of taking a stop loss, I will take an opposite trade in a correlated instrument. In an ideal world I could just clone the original instrument. The idea is that I can hedge out the directional risk against my open position while booking closed profits. Some say this is the equivalent of being flat, and they have a point. But, my perspective is that at least when it works it allows the trader to improve their entry without increasing the risk. In essence when this technique works, the closed profits offset the open drawdown making it such that even the slightest recovery will result in booking a net profit.

 

This is a great method in theory but remember requires an extreme level of trading performance. I named the technique "hammer trading" because closing out one side results in taking a directional risk on the other side, aka dropping the hammer.

 

Hammer Trading Gotchas

 

Ballooning

There are many things that can go wrong. For example, I may change my overall bias from long to short. This means that I have to change the ratios of my short and long exposures. But, let's say I change my mind again which means I must increase size yet again to get the a directional exposure on the "other side". This overloading can easily lead to an out-of-control phenomena I've termed ballooning. The effect is to increase the risk and make it harder to exit the trade gracefully. Ballooning can be controlled by capping the max size regardless of the delta.

 

Pinning

Pinning occurs when both positions get trapped in a loss. This is a stressful situation even though one rationally knows that one side must yield a profit.

 

Spread Widening

Sometimes the spread between the instruments can widen. On some days, I've seen the NQ/ES spread widen to over 1%. This is a danger because it means that losses on both sides can grow unexpectedly and larger then anticipated.

 

Failed Hammer Drop

The failed hammer drop means that I fail to close out the scalp profits at the proper time. In other words, the original trade starts to work but I wasn't able to get out of the scalp. The hedge loss can grow larger then the original trade if not careful

 

Bad Hammer Drop

The bad hammer drop means dropping the hedge and the trend continuing to run against one. Again, the method is not an edge if my analysis is wrong.

 

Extreme Trends

This method is not as suitable for markets that show strong trends, such as crude oil. The reason for this is that its not possible to book the profits fast enough during strong sustained trend direction.

 

The "Hammer Trading" technique does work beautifully when it works but there are just too many things that can go wrong. The method may work but it doesn't work very well.

 

The concept of averaging does allow one to refine their entry position without the risks of taking realized losses that occur with traditional stop losses. However, the cost of this averaging is the proportional increase of risk. A trading method designed to take advantage of refining ones position without increasing directional risk could form a powerful structure for short term trading. I imagine such a structure would have to involve going long and short multiple instruments such as to achieve a degree of delta neutrality. It would require finding a way of offsetting new long positions with new short positions.

 

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Curtis

http://themarketpredictor.com