Not many may have heard about him,but during his trading career he has achieved a feat very few fund managers can boast about; his name is Monroe Trout. He is one of the very few traders who have been able to make consistent profits using minimal risk. According to the book, “The New Market Wizards”, after a survey carried out over a period of five years, Monroe Trout was found to have an average return of 67%. He was also profitable in 87% of all the months in consideration. This article is aimed at giving an insight into the mind of the great man called Monroe Trout.
Monroe Trout’s trading tactics involved pattern recognition backed by statistical data; essentially he studied price data and identified patterns that could be traded profitably. Some of the very well known candle stick patterns can be seen below.
Monroe did not blindly trade these price patterns, he selected patterns he felt were profitable after extensively testing them on past price behavior. Even after the systems gave indications of whether to buy or sell, all the trades were taken at his discretion; this is because he had to consider other factors such as fundamental announcements and data.
Monroe started his career as a floor trader, trading the stock index on the floor of the New York Futures Exchange. H e started out as a scalper (scalping involves taking positions for small, quick profits). One
of the reasons Monroe was so successful was his risk aversion. While in college, he wrote a thesis and its conclusion was “the probability of large price changes, while still small, was much greater than might be assumed based on standard statistical assumptions”.
I will explain this conclusion with an example. The EUR/USD is a pair which has an average daily range of 0 – 200 pips. This means that typically, the EUR/USD daily range does not exceed 200 pips. From the picture below, we can see some occasions where the daily range was clearly exceeded.
Monroe’s argument was that even though these price changes don’t seem like a possibility, they actually occur; so action should be taken to protect oneself from losses when these “large” price changes occur. Monroe's trading approach was very conservative.
Monroe Trout had a very strict money management policy with regards to losses. The maximum loss he was willing to accept on a trade was 1.5% of the available equity and a maximum of 4% loss in a trading day.
This money management technique is one that is used by a lot of professional fund managers; the logic is very simple, capital must be protected because there will always be many opportunities to make money.
Another reason Monroe was so profitable was because he kept his transaction costs as low as possible. He did this by using only brokers with fast execution, low commissions (spread) and minimal slippage.
According to Wikipedia, slippage is “the difference between estimated transaction costs and the amount actually paid”. He constantly monitored his brokers to find which ones executed his trades with low slippage, once he spotted a broker with high slippage, he stopped using that broker.
For example, if the EURUSD is currently trading at 1.3507, and I placed a buy trade at that price but my trade is executed at 1.3512, my trade would be 5 pips above my intended entry price. This is an example of high slippage; ideally my trade should be executed at 1.3507.
Monroe was a quantitative analyst, so most of his systems were based on previous price performance. However, he never committed his entire portfolio to one system. Putting it simpler, he never put all his eggs in one basket.
He employed different strategies,and ensured that his portfolio was distributed among these systems. So that in the event that one strategy performed badly, it would not cause a major dent on the entire portfolio.
TRICKS OF THE TRADE
Monroe was not a gambler; all his decisions were very rational and taken based on his systems. Monroe also took note of market liquidity. His trading strategies were all aimed at taking advantage of the market during its most liquid times. He believed market liquidity is highest during “market open” and “market close”, so he used those periods to build his positions. By gauging market liquidity, Monroe knew when to trade and when not to trade.
As a rule, Monroe never used actual stops to cut his losses. He preferred to mentally note where he would exit a trade. He did this to avoid stop-hunting. Using stops is a very effective way to curtail losses, but Monroe argues that if stops must be used they should not be placed in obvious areas.
For most traders taking short positions, their stops are usually placed a few ticks above the recent highs or above the most recent resistance areas. Monroe recommends placing stops either a few ticks below the high areas, so the losses are minimized or placing the stops several ticks above the high areas. His logic is not to make your stops too obvious.
Monroe was also a strong believer in round-number areas. Areas like 1.6000 in GBP/USD, 1.3000 in the EUR/USD, 0.9000 in the USD/CHF. These are just a few examples of round numbers. He believed that those areas held a great significance. He also believed that often times than not, when price approached a round number area, it would often get there. So he placed trades that targeted those areas, and watched price reaction when price got to the round numbers.
These are just some of the tricks and techniques Monroe Trout used, and his consistency and adherence to his systems made him a very profitable trader. A trader who wishes to be great must consider the works of other great traders before him or her.
“A child learns to walk by watching his father”.