Wednesday, April 18, 2012

For new and/or unsuccessful traders - a blueprint to follow

In my e-book I talk about the three areas that you need to consider when trading. All three are linked, and if you are lacking in one of those three areas, you will struggle to make money. Think of it as a three-legged stool - if you are missing one of the legs it will fall over. These areas are:
  • Money management;
  • Self management;
  • System management.
These three areas are often mentioned, yet a lot of trading novices simply focus on the system management (i.e. the entry and exit rules), with little regard for the other two areas.

I always have placed the greatest importance on money mangement, and here's why:

It is far easier to ingrain good trading habits when you are trading at your smallest. As Market Wizard Larry Hite says, you can have an 'emotional indifference' towards a position when your risk is under control. If you are trading too large a position relative to your equity, the mind can make you do funny things, such as exiting a trade when you should be staying in, or not closing a position when you get an exit signal.

Even the greatest traders (including some Market Wizards) cut back a ridiculous amount on their trading size after making a mistake (usually resulting in a significant loss), until they have re-ingrained good habits.

For anyone starting out trading, or those who have struggled to make money, I would suggest this approach:

1) Decide on a preferred methodology for your trading, that fits in with your personality and the amount of time required in front of a PC each day that suits you. If this is something you have devised yourself, you should have done some form of testing to ensure that it has a postive expectancy. If you are following somebody else's method, you should follow and log down some example trades WITHOUT committing any money, to ensure that you fully understand the method, and are following the entry and exit signals as required.

2) Once you have passed this stage, you can now start to think about committing money in the markets. As we all know, when 'real' money is on the line, the psychological aspect of trading comes to the fore. Because of this, you need to start trading using the absolute minimum required to trade that instrument. If you happen to spreadbet, for example, you can trade foreign exchange pairs from 50p per pip with IG Index, or stocks from £1 per point on UK stocks (This part is where a lot of people who try and trend follow struggle, closing trades when no exit signal has been given is a popular mistake - trading a very small position will help you stay in a position until that exit signal is given).

3) Only when you are happy that you are following your trading rules TO THE LETTER should you consider increasing your trading size to a more realistic level. What is that level? Well, the general rule of thumb is to risk no more than 1%-2% on each trade. I know of some very successful day traders who risk less than 0.5% of their equity on each position.

4) Maintain a detailed trading log recording all your trades, paying particular attention to any trades whereby you did not (for whatever reason) adhere to your rules.

If you have a day (we all have them) where we make a stupid mistake, or risk goes out of the window, cut right back again so that you regain your poise and start to see more black, rather than red, ink. For those who have read it, Marty Schwartz's story in his book Pit Bull of the day his wife was out of the office buying a mink coat highlights this very well. I also have read of day traders who, after having a bad day, will simply watch the following days market action all the way through WITHOUT placing a trade. Would you be able to do that?

In my opinion, money management has a direct effect on your self management. There are plenty of methods for trading successfully in the markets. I passionately believe in trend following, as this suits my personality best, coupled with the amount of time I want to spend in front of a screen all day. However everything stems from your approach to risk management.

If you can follow the basic blueprint outlined above, you have an excellent chance of becoming successful.

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