People new to trading often ask what are the key elements to trading, and many others who have been trading for awhile may not have been as successful as they can be because they are missing one of the three keys to successful trading.
What are these three keys? I've discovered in my trading studies that there are many descriptions for it, but they are largely similar no matter what they are called. Here is how I describe them:
The three keys are:
- Method / Trading Strategy
- Money Management / Position Sizing
- Psychological Management / Trading Psycholody
Method / Trading Strategy
Basically, your trading strategy tells you when to enter and exit a trade. While there are many trading methods that can be profitable, you must choose one that fits your trading personality.
"Basically, your trading strategy tells you when to enter and exit a trade."
Let me share my personal experience. When I first started investing, I started by trading stocks using fundamentals. I was exposed to views that technical analysis was hogwash and the buy and hold was the best approach because one cannot hope to time the market. So I studied Modern Portfolio Theory and dollar cost averaging, and learnt how to diversify. I later found that I require too much capital to diversify in the stock markets, that the minimum commissions were too high, and the returns were too slow and uncertain. With this buy-and-hold strategy, one had to a long time-horizon, often around the span of 5-7 years. I found this too slow, and that I needed more flexbility and control. Also because this approach was unidirectional (you generally only buy and not short the market) trading was limited.
So I started learning technical analysis and was exposed to the Forex (FX) markets which was much more volatile, provided leverage, and trends well. I started learning classical technical analysis, things like head and shoulders formation, double tops, double bottoms were fascinating to me. I found many patterns difficult to identify and apply real-time to the markets (at that point of time anyway) and gravitated towards a trend following strategy. I backtested (remember those days?) with lots of variables, playing with all sorts of indicators like Moving Averages, MACD, Stochastics and the like. Afterall, there are many trendfollowers who boast of great returns. I soon found that a trendfollowing strategy would encounter many whiplashes during market consolidation persons and do very well during nice beautiful trends. In fact, the trend following approach often depends on the few (larger) winning trades that more than covers the many (smaller) losing trades encountered before the trend. I discovered that while this worked for many people, I couldn't sustain the many small losses psychologically and end up missing the winning trades because of that. It isn't that the strategy doesn't work, it just doesn't work for me.
I then encounted Elliott Wave Analysis, and started doing some forecasting. And realised that this worked fantastic for me. To cut a long story short, I love using Elliott Wave Analysis and it has become my main means for trading the market.
"Your trading strategy has to fit your personality for it to work for you. It's all very personal! One size does not fit all."
Quick tips on building your trading strategy
These are my views on what's important in a trading strategy, there may be other views around
- Sometimes less is more, do not overload yourself with technical indicators.
- Remember that many technical indicators are lagging indicators, meaning what they tell you is "after the fact".
- Decide if you trade only certain times of the day, and if you avoid certain times of the day (e.g. news releases).
- Always know you initial stoploss level, even if you use an indicator as an exit signal. Without a clear stoploss level, it's much more difficult to do position sizing.
- Make a distinction between a trade setup, and an entry trigger. This can greatly affect the profitability of your trades!
- Always have a good profit/risk ratio before entering a position. Many people say it is best to have at least a 3:1 ratio. In anycase (and everycase), it should be greater than 1:1.
- Always ensure that your trading system has a positive expectancy before trading live. Expectancy = Probably of Wins * Avg Pips Won - Probably of Loses * Avg Pips Lost.
Money Management / Position Sizing
Once you have determined your trading strategy, you can now determine your Position Sizing strategy. Your position sizing strategy tells you how much to trade at each point of time.
"Your Trading Strategy tells you 'WHEN', your Position Sizing Strategy tells you "HOW MUCH'."Proper Position Sizing strategies help to preserve your capital and keep you in the game. This is extremely important. You could blow up your account using horrible Position Sizing Strategy even with the best trading strategy around.
Every trader should be extremely concerned with capital preservation. Remember that winning and losing is asymetrical - If you lose 50% of your capital, you need to make a 100% profit to get back to breakeven.
There are many approachs to position sizing, the most basic of which is to risk no more than 2%-4% on any one trade. Personally for me, I risk no more than 0.5% on any single trade, up to a maximum of a total risk of 4% at any one point of time. I also scale-in and scale-out of trades when required to manage my risk.
Quick tips on Position Sizing
- Don't focus solely on possible returns. The position size for the largest possible returns is usually the one with the highest probabilty of ruin. Be clear on the risk you are willing to take.
- Map out your R-Distribution and do a Monte Carlo Simulation. I've found this to be extremely useful and managing my expectations on how my trading strategy is performing. This will help determine how much risk I'm bearing. (Refer to my post on Trade Statement Analysis to see what I mean.)
Psychological Management / Trading Psychology
The third key is the ability to manage your own psychology when trading. There's no point in having the best trading strategy and position sizing strategy when you cannot put your plans into action. The most important thing is to "know thyself".
In NLP terms, I would say, be extremely aware of your state when you are trading. Identify your most resourceful state and put yourself in that state whenever you trade as that would impact your perception of the markets and how you trade it.
Be aware of your motivations for trading. There are many people who are trading not just to be profitable, but for the thrill of it. When this happens, they often get into unplanned trades when there hasn't been any trading signals for a length of time. Ask yourself two questions:
- What is my motivation for trading?
- What would happen if I stopped trading, or could not trade?
Quick tips on Psychological Management
- Have a short routine to put you in your most resourceful state before you trade. It could be listening to some relaxing music, setting off some anchors (for NLP practioners), or even reviewing your trading rules.
- Do a psychological stock-take before you start trading. Sometimes, it is best just to avoid trading altogether.
- Identify motivations (like need for excitment) that affects your trading negatively, and find other means to meet those needs (visit a theme park perhaps?)
- Identify stressors in your life and take active steps to reduce them as far as possible. This affects not just your trading, but your health as well!
So that's my take on what is necessary to be successful in trading. It's been a long journey, and I hope you found this useful. All the best for your trading!
