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Jay Kaeppel has been trading for more than 2 decades and has designed a variety of well-known systems for trading stocks, options, mutual funds and futures. As a CTA and trading software developer Jay has been featured in Futures magazine and Barclay''s Managed Account Reports.

Jay has authored several books on trading, including The Four Biggest Mistakes in Option Trading, The Four Biggest Mistakes in Futures Trading and The Option Trader''s Guide to Probability, Volatility and Timing.

What a great time it was to question such a veteran and very successful trader like Jay Kaeppel. This is the final installment of my recent interview with Jay.

Optionetics: How would you characterize your technical approach to the markets?

Jay: In trading futures I used to be more of a trend-follower, using channel breakouts and that type of thing. Now it has evolved more into “trend-based” trading. By that I mean I follow certain indicators that suggest that the current trend for a given market or stock or index is “up” or “down.” Then I play that market only in the indicated direction using other timing methods. In stocks I look for the strongest industry groups and then assemble a basket of stocks to emulate the price action of that group.

Optionetics: What do you think are the greatest misconceptions beginning traders have about trading the markets?

Jay: That there is “easy money” to be made. Ironically, this can be true in the short run. When a trader gets on a roll it just seems so amazing how “easy” it is to watch the profits roll in. But this is never ever the case in the long run. No one makes money trading in the long run because he or she is lucky. Trading is like any other endeavor. The ones who succeed over time are those who are most effective at learning what works best for them and who then rigorously apply their methods, even when things aren’t going well.  

Optionetics: What kind of advice would you give a person just now beginning in trading the markets?

Jay: Don’t go into it expecting to “get rich quick.” Like anything else, when you are brand new to trading then you simply don’t know very much about it. So recognize that it will take time. If a person wants to be a pilot he (hopefully) doesn’t just jump into a cockpit, head down the runway and pull back the stick. It’s the same in trading. If you want to succeed there are things you must know, things you must do and things you must avoid doing.

You must also learn to be as honest as possible with yourself. This is especially true when you are experiencing losses. Virtually any approach to trading will generate losses from time to time, and occasionally those losses will be more than you were prepared for. The most vicious cycle for a new trader to watch out for is the following: Trader paper trades and watches three winning trades go by. Trader decides to jump in and suffers three actual losing trades. Trader pulls the plug believing “the method doesn’t work anymore.” Trader then watches three more winners go by.

One other word of warning. If your first three trades are winners, beware!  When this happens many new traders assume that they have “the touch” and really start to believe that making money is going to be “easy.”  Remember, in the long run it isn’t easy. You have to work at it to be successful.

Lastly, remember the critical importance of money management. Most new traders focus the bulk of their attention on generating buy and sell signals and don’t worry too much about money management until after they get whacked. But even a great buy or sell signal is only one part of the equation. Money management is the other. Ultimately it is the volatility of the fluctuations of the equity in your account that will determine your success or failure as a trader. If the downswings are more than you can handle emotionally or psychologically you will ultimately not succeed.

Optionetics: Can you describe what your average trading and analysis day entails from preparation to execution?

Jay: Tend to be an early riser. I like to be with my kids after school so I typically get up between 4 and 5AM Central time. No one bothers me then. Typically, I will look at what the futures are doing overnight and enter any orders for that day’s session. I will also look at some timing methods for trading options to see if anything looks really good. A couple of times a week I will scan low IV stocks looking for straddles, backspreads and directional calendars. Most of the industry group stuff I follow is updated only once a week at most.

During the trading day I rarely make any trading decisions while the markets are open. I have always tended to be too emotional when trading “live” markets, so I have tried to do my best thinking (such as it is) “up front” and then develop trading rules and just let the rules generate the trades. So during the day is when I do most of my research. After the markets close and I’ve hung out with the kids for a while I will go back and update data and such and plan out any futures trades for the next day.

Optionetics: What kind of decision-making process do you go through before deciding on a particular trade and a particular sector of the market that would be worthy of putting on a position?

Jay: It varies on the type of security being looked at. For options I typically look at implied volatility to find opportunities for straddles, backspreads and directional calendars, and at certain timing methods. If a timing method says “buy” and I find a call trade with above average profit potential, I may consider that trade. For the other strategies I mentioned the key is to find trades that can make a fair amount of money quickly if the stock moves, but which will not lose a lot of money if the stock doesn’t do what I expect.

For futures I look at certain objective indicators to determine the current trend for a given market, then look for pullbacks, patterns, reversals, breakouts and such to trigger an entry. The other key – in futures especially – is money management. First you determine your stop-loss point for a given trade before you get in. Then calculate how much dollar risk there is between your anticipated entry price and your stop-loss price. Next, determine what percentage of your trading capital you are willing to risk on one trade and equate that into dollars. Then divide that amount by the anticipated dollar loss on the trade you are looking to enter to determine how many contracts to trade. This process is not as “sexy” as trying to “buy at the bottom” or “sell at the top,” but it is a crucial step.

For stocks I primarily focus on industry groups and sectors and as I have detailed in a number of Kaeppel’s Corner articles on Optionetics.com, I generally like to stick with the strongest performing groups. Typically when there is a favorable change in the fundamentals for a particular group or sector it takes a long time to play out and the gains can substantially beat the major averages.

For stock indexes I look at a combination of trend-following, sentiment and seasonal indicators. I typically want to be long an index when the trend-following stuff is bullish and either the sentiment indicators signal an oversold condition or if the seasonal trends are favorable. Readers can visit the article archive on Optiontics.com for plenty examples of these indicators in past Kaeppel’s Corner articles.

Optionetics: Thanks again, Jay, for sharing your thoughts about the trading business with our Optionetics reading audience.

To read Parts I and II of this interview, please click here.


Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff’s Forum
Listen to Jeff at www.ProfitStrategiesRadio.com

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