Our hero, Basket Case Bob, is not dangling by a fingernail from the ledge of a high rise in some exotic country, nor is he commanding an army in Afghanistan. Rather, he is
perfecting his trading system. It's not quite right. Another tweak here, a moving average crossover there, and he will be almost done.
In fact, he's been working on what he calls the Holy Grail system, one that never loses and makes big profits, since I have known him. He is using his unfinished system as
an excuse to avoid trading. Are you the same way?
Deep down, what is his problem? Is he secretly in love with his mother and hates his father? Of course! He's a basket case, after all, but his real problem is fear.
It all started when he
was a young farmer. Farmers are risk takers, to be sure, but his family equated trading the stock market to gambling. When he took an interest in the markets, they criticized him and
warned him about the risks of failure.
"Fred the Red traded the futures market," warned his dad, "and now look where he is. He lost his farm!"
"He's right," added his mom. "Benevolent Betsy was investing for her charity and now it's in foreclosure."
Those warnings and a difficult economy reinforced Bob's fears about trading for a living. And the longer he goes without trading the worse he is likely to do once he starts.
Why? Because all of that stored anxiety will burst through and compound the difficulty of making a proper trade. He'll be a nervous wreck.
Here is a list of problems traders and investors may come across.
Income risk. If you have a job from which you derive income, giving it up to trade can cause emotional issues. If you quit your job and lose all of your money trading,
what then? Do you really want to risk your nest egg that you have built up over the years to risky trades? Dealing with those types of issues confronts many traders when they start.
The untested system. Unless you actually use your system to trade, in real time, you won't know how well it works. It's the difference between paper trading and
real trading. Unless you have actual money riding on the trade, the psychological pressure may come as an unpleasant surprise. You may have a perfect system, but if you don't follow
its guidance, your system will be a failure.
The internal argument. Instead of moving forward and progressing from creating a system to testing it to using it, Basket Case Bob continually argues with himself. "What if
I lose all of my money? What will my family say? What will the neighbors say? But I want to trade, I really do!" He is afraid to risk his family's money until he knows that he will
be a successful trader. He won't become a successful trader until he risks the family's money. And round and round he goes, arguing with himself and accomplishing nothing.
Simple is best. I recall a novice trader than emailed me his rules for a trading system. It had over a dozen steps. "If this moving average crosses above that one and
the RSI is oversold, and stochastics are bullish and it's Friday ten minutes before the close and," well, you get the picture.
You may have read that the top traders have few parameters in their systems. Through testing and experience, they have found that the simple things work best. The more complicated
the system, the more things go wrong.
In college, a group of us submitted a grant application for hearing research for which we won a National Science Foundation grant. We spent a day at an institute to help
them do research on the quality of sound. "Use any scale you wish, like 1 to 10, to determine whether the sound you hear is different than the original."
They played the original sound and then about a dozen new ones. I ranked the sounds using the 1 to 10 scale as did most of us, but my friend used a binary test (that is, either the
sound was different or it wasn't).
Both of us scored near the top of the list for consistency, but he did slightly better because he used such a simple system. Simple is best.
The lost dream. Imagine that you dream of making a million and you work for years to achieve that dream. Then you finally make it. "What do I do now?"
Good question. Trading for a living risks achieving that dream of becoming a successful trader. Some don't want to risk losing the dream.
What did Basket Case Bob do? He studied the best traders in the company where he worked using the following methods.
Attitude. How did pros react to gains and losses? Were they optimistic at the start of the trading day and did that carry through to market close? What beliefs and attitudes
did the pros share?
Setups. Good setups are often closely guarded secrets. By observing their trades, he was able to define what led to their trading decisions.
Money Management. By watching the size of each trade and the number of positions outstanding, he was able to define money management rules.
Since the traders all worked for the same company, he could simply ask them how they achieved their success, but he also watched them in action.
Once he had analyzed several pros to understand why they were successful, he created a game plan of his own. He followed these rules.
Goals. Without setting goals, there would be no measure of success or failure. Within x days, y weeks, and z months, he would have monetary benchmarks to meet for each
Risk. How much was he willing to lose? How much was he willing to bet on a single trade? Answering these money management questions and others helped define his trading parameters.
Trading Style. When he studied successful traders, he found different mechanisms that worked best for their trading style.
Some traders preferred a quick in
and out, cut and run method, catching the swings from low to high and the reverse. Others preferred a more relaxed system that waited for the longer run of a breakout.
By assessing his own lifestyle, he tailored his plan to his personality. Those too impatient at stoplights might prefer the 1-minute scale with quick trades, catching each ebb and
flow of price. Those in the slow lane that drive the speed limit prefer to wait for the breakout from a trading range. They switch to the longer time scales on their charts to determine entry and
What Successful Traders Use
From his study of traders, he discovered the following.
Rules. The most successful traders followed their rules. When it was time to enter a trade, they didn't hesitate. When it was time to exit, they jumped out. They did
not deviate from their established rules.
KISS. Keep it simple, stupid! If your system has too many rules, it's too complicated to work. The best system are often the simple ones. Basket Case Bob settled on these:
Risk no more than 2% of total capital per trade.
Use the cross of an indicator to signal an entry.
Always use a stop loss order.
Manage the profit.
When to Sell. It doesn't matter when you enter a trade but rather when you exit. Focus your energy on managing the exit, not the entry. Basket Case Bob had two exit rules.
1) If he was stopped out or 2) if his system flagged another trade.
Emotions. The best traders learned to put their emotions aside while trading. Large gains did not excite them and large losses seldom occurred because they used stops. If
something unforeseen occurred, creating a loss, they dealt with it in a professional manner and moved on to the next trade. Losses are just the cost of doing business.
Patience. Only enter the most promising trades. That means having the patience to wait for the signals to line up properly before entering (or exiting) a trade. Never jump the gun
and never take a flawed trading setup (meaning a trade that is less than ideal). A perfect entry will come along, you just have to wait for it. You will suffer many small losses, but
it's the few big winners that power your gains.
Stress. Trading is stressful, so have a way to deal with it. This should not include drugs, alcohol, or other types of abuse. Meditate, exercise, or do whatever it
takes to reduce stress. Often stress is what causes traders to break their rules. If you reduce stress, you may become a more profitable and happy trader.
Psychology. Know your own limitations. If you are too angry or too happy, both can lead to trading disasters. Learn to recognize that you do not need to trade every day.
Sometimes the best trade you can make is none at all. Imagine that the next trade you skip is the one where you would have lost 50%.
Take the day off and go fishing, hiking, or visiting an art museum (or whatever). When I visited the local Japanese gardens, I came home and wanted to tear up my back yard. So I did!
The above photo is the result.