1-risk management or how to avoid the risk of ruin
The paramount principle of any good trading system is to implement a draconian risk management set of rules that limit as much as possible the risk of blowing up your trading account.
Since you will never know the outcome of each individual trade you should limit the risk per trade to a maximum of 1% of your available capital and the total overall risk of your portfolio to less than 5% of your capital.
These figures may vary according to your risk tolerance, but it is often said that beyond a risk of 2% per trade, you expose yourself to the risk of ruin sooner or later.
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“You have to consider trading in terms of probabilities and not to see each trade in isolation.”
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For my part, I try to limit my risk to 0.5% of the capital per trade. I would rather get out of a trade quickly and eventually enter the same trade again rather than suffering too big a loss on a single trade.
You have to consider trading in terms of probabilities and not to see each trade in isolation but as part of a whole system whose long term results depends on a succession of many independent trades.
The idea is to never experience a trading loss as a personal failure but as a prerequisite to success.
Moreover, I suggest to go a little beyond basic (but paramount) risk management practice by reducing your position size at a fastest pace than your losses do during a drawdown.
If my drawdown is -10%, I cut my position size by 20%, if my drawdown becomes -20% I cut my position size by 40%. As soon as I recoup the former thresholds, I rebuild my position size accordingly.
It allows me to adjust my exposure to unfavorable market conditions vs my trading edge.
The good news here is that losses compound at a decreasing rate when gains compound at an in creasing rate.
30 consecutive losses of 1% lead to a total loss of -26,03%, not -30% (0,99%) at the power of 30.
Conversely, 30 consecutive gains of 1% lead to a total gain of 34,78% not 30% (1,01%) at the power 30.
The bad news is the gain you need to recoup a given loss must be more than proportional.
You need a gain of 25% to recoup a loss of 20%, a gain of 66% to recoup a loss of 40% and so on.
Conclusion: you would better cut dramatically your position size during a drawdown to limit it as much as possible according to the latter rule because your will recoup your losses at a faster pace according to the former rule.
2-The trading gain expectancy
Many new traders approach trading without understanding what an edge means and/or how to develop it and what it requires in terms of work and persistence.
The trading gain expectancy is defined as follows: ((% of winning trades * the average gain in percentage) - (% of losing trades * the average loss in percentage)) * (position size).
If the result is 0,8% for example it means that on average a single trade add 0,8% to your performance.
Some say you can have an idea of if you an edge after a sample of 30 trades. For my part, I think that a hundred transactions under different market conditions are more reliable.
There are several components which define the Trading gain expectancy.
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“the hit-ratio is often inversely correlated with the trading gain expectancy.”
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The first component of our trading gain expectancy is the percentage of winning trades, that is the hit-ratio. For example, a 30% hit-ratio means that 30% of your trades are winners and 70% of them are losing trades.
Most of us, before discovering that markets are highly contrarian, that is what generally prevails in "everyday life" does not work in the markets, consider that a winning strategy must have a very high payout percentage (the hit-ratio).
However, the hit-ratio is often inversely correlated with the trading gain expectancy. Just watch the "trend followers" on futures contracts who are winning about 30% of the time and yet have performed remarkably well for decades.
Intuitively we can consider that a strategy that wins 80% of the time will benefit from small variations (variations of 2 to 5% are "easier" to capture than variations of 20 to 50%), the risk being that the 20 % of losing trades erase many small wins.
The real problem with a strategy having a high hit-ratio is that it has no room for adverse market conditions. The higher your hit ratio you need to make money, the higher is your breakeven point.
The debate remains open but a very efficient and regular trader can win 40 to 50% (or even less) of the time and achieve a significant positive gain expectancy.
The second component is the risk-reward ratio.
This is the ratio of the average gain to the average loss. In short, how much I win relative to how much I lose on average.
A ratio of 1 means you risk 1 to win 1. Without any background in probability or trading experience no one in his right mind would accept such a bet. Some people write or say that from 1.5 the ratio becomes interesting.
For my part below 5, the operation is not interesting.
I like the idea of a 5/10% risk per trade (relative to the trade amount not the capital amount) for an expected payoff of 50%, 100%, or more.
Here again , this depends on your strategy, objectives and risk tolerance .
The last paramount component of our famous gain expectancy is the fraction of the capital allocated to a single trade, the position size. It is often logically deduced from the maximum risk per trade and the price level where the stop is placed.
3-Thinking in terms of probabilities
Once you have determined your advantage (a positive gain expectancy), you have to apply your trading strategy with regularity and consistency without attaching more importance to one trade than to another.
Like a casino, you want to play your edge in full and trade only the trade that your strategy commands you to trade in order to profit from interest compounding the famous but underrated eighth wonder of the world according to Einstein.
This does not mean that you should "force" your strategy by "over-trading" but execute your strategy in a mechanical way, playing your edge.
4-The importance of volumes
The "purest" and often the most robust strategies, that is, those that stand the test of time, use the least numbers of variables.
Nevertheless, on the stock market "volume" appears to be of prime importance. It indicates the interest or disinterest of traders for a specific stock at any given time.
At key moments volume coupled with price action, allow you to "read" the line of least resistance, a term created by the great trader of the first half of the 20th century, Jesse Livermore.
Significant increase in volume (for example an increase of more than 50% vs the moving average of the volumes over the last 30 days) in sync with price action, is an objective sign of interest for the stock by traders and investors.
The appearance of such a pattern when breaking a sound and contained base, for example, can provide an interesting entry point.
Likewise, a stock attempting to break new high after a significant multi-day rise on declining volumes may show the stock losing steam.
Finally, a drop of several percent accompanied by an increase in volumes may be an indication that institutional investors are loosing interest for the stock and that it might be advisable to exit as well.
Or the biggest price/volumes increase after several days of trending may be the sign of the end in what we call an exhaustion gap.
5-The pivot point
The pivot point can be defined by an upward or downward “key” price bar accompanied by significant volumes which presides over the continuation of the movement initiated.
Il is has a threefold advantage:
First, it allows you to enter at the very beginning of a trend.
Second, this is the place where the risk of adverse movement is lowest.
Third, if your trade doesn’t work at this key point, this a very good reason to get out of it immediately.
6-Moving averages
It can be used as a tool for determining support and resistance.
As such, they make it possible to refine the entry and exit strategy.
They are very useful for determining the exit point. Some traders use the moving average exclusively to exit a trade.
There are many different moving average. The 50 and 200 MA are closely scrutinized but it depends on the time frame you use.
Some stocks can obey to the 10-day moving average while other to the 50-day moving average.
For my part, even though I have used them for a while, I have "cleaned up" my strategy by now using only price and volume.
7-The fundamentals
An extensive and in-depth study of major market leaders with spectacular performance of several hundred percent on each market cycle for over 100 years was carried out by renowned trader William O’Neil. It shows with precision that all of these super stocks had some outstanding fundamental characteristics in common.
A significant increase in revenue accompanied by a significant increase in earnings per share and cash flow are some of them.
Another characteristic is that these companies were investing in new and expanding markets offering their customers products or services with high added value.
Coupled with price/volume patterns analysis, even a brief fundamental approach can provide you with an undeniable advantage.
Here again, I broke away from the fundamentals because they induced a detrimental psychological bias into me and prevented me from taking advantage of movements completely uncorrelated with them.
It's up to everyone to find something to rely on...
8-Go with the trend
When the market enters a phase of correction, 3 values out of 4 will drop with it. You can see your accumulated gains during the previous bull run evaporate in a few days if you don't react quickly.
There is therefore a need to be in tune with the market and avoid unwanted positions that go against it.
If you trade, like me, breakouts either on a daily or weekly time scale you will find that few of them will work in a weak market.
You will also notice that the market leaders who drove the earlier rise will stop advancing and in some cases flash sell signals.
In these cases, it is preferable to consider significantly reducing the size of your positions or even switching to cash and possibly examining possible short opportunities.
Once again, while market analysis is important I prefer to rely on the behavior of my stocks that meet my buy or sell criteria…
9-PSYCHOLOGY
It is common to read and hear that psychology is essential in trading. So it can be considered as a cliché to repeat it here again.
But I do think that psychology is both the most important obstacle in trading, but also our best ally when we have become aware of this.
One of the common mistakes made by newbies is to be unable to take a loss and take their gains too quickly so that they naturally build a consistently losing strategy. They regularly become losers.
On the other side, a winning trader is willing to take small losses and let his gains run for as long as possible.
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“psychology is both the most important obstacle in trading, but also our best ally when we have become aware of this.”
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Between these two profiles with perfectly symmetrical behaviors, the first remunerating the second with metronomic regularity, there is a world.
And this world has absolutely nothing to do with the strategy used.
You can do scalping, swing trading, position trading or long-term investing in the markets.
The only fundamental thing that will put you in the category of winners is your ability to last long enough to break the psychological biases that have prevailed from your youngest age and realize that you have to think differently than you do in your daily social and professional life to be successful in trading.
If we have to be a little simplistic, the technical part is not that difficult to grasp, as long as we specialize naturally and the trading strategy that suits us best.
An asset always goes down or up in the same kind of way if we observe these price sequences recurring over and over again.
So the reason for failure or success in trading logically lies elsewhere.
What keeps us from becoming a winner is inside ourselves.
The price of an asset is the translation at a given moment of the more or less pronounced interest or disinterest of the crowd for it.
We can recognize price sequences that are reproduced in the markets because the behavior of the crowd is constant.
It is very difficult to model the likely behavior of a single person.
The individual is unpredictable but the crowd is much less.
The crowd has a life of its own and is not the mere sum of the individuals who compose it.
The market evolves by itself with or without us.
Like Marks Douglas in Trading in the Zone points it, the crowd follows its leader, the price and is often pretty irrational.
Our goal as individual traders is to develop a rational behavior to profit from the irrational and recurring patterns of mass psychology.
10-Getting the proper mindset
How is it that finance (trading, investing, asset management) attract maybe the most intelligent people on earth, mountains of money…
…And that so few of us reach performance, consistency and excellence.
Because trading requires emotional attributes that very few of us can acquire. Trading requires developing a mindset that we were not trained to develop. Trading goes against everything we were taught about money, the power of losing, responsibility for what we do and the consequences all of our actions.
Good Trading requires to think differently than the mass, accepting failure and leverage them up to reach, sometimes, massive success. Either trading enable to unleash the best of what we are: « become who you are » or it magnifies all of our weaknesses.
As a conclusion, to succeed in trading is nothing more than developing the mindset of a champion and has nothing to see with « good strategy », « account size », « diplomas », « former successes in previous endeavors », or « tips from so-called genius mentors ».
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