Sunday, September 30, 2012

Entries and exits are NOT the priority

Although I am passionate about trend following as a method to generate profits in the markets, it would be totally wrong for me to say that it is the only way to consistently make money over the long term.

In the overall scheme of things, the three aspects of a effective trading method ranked in order of importance are:
  • Risk management;
  • Self management;
  • Trade management.
The actual method of determing entry and exit points is the least important of the three. I happen to believe in trend following because:
  • It works both in uptrends and downtrends;
  • It tells you when to get in a position;
  • It does not require a lot of time to monitor your existing your positions or look for new ones that meet your criteria;
  • It tells you when to exit a position;
  • Most importantly, it means you are working in line with the general trend (or as some would call it, the line of least resistance).
HOWEVER, such a system will only work if:
  • You have appropriate risk controls in place, determing the amount your are prepared to lose on an individual trade;
  • You also determine how much you have at risk in terms of your overall portfolio at any one time;
  • You have the necessary psycholigical skills and confidence to stick to the system during periods of suffering losses;
  • You have the mindset to accept that you can lose of any given trade;
  • You accept that in a lot of cases you will be going against what the majority of investors or traders may think;
  • You have the discipline to exit a position when you get an appropriate signal;
  • You accept that you can lose on more than 50% of your trades, yet can make profits overall;
  • You have the commitment, confidence and discipline to carry out the above steps, over a large number of trades, over a prolonged period of time.
A trader utilising a trend following system needs to view his portfolio as a mini hedge fund. You need to ensure that you are at worst competent in all three areas, and that all three are inter-related. Risk management is a given - if it is not in place, then even a small run of losing trades (or maybe just one bad trade) can cause significant damage to your trading equity. Not having confidence in the entry and exit method means that you will be unable to faithfully follow the system rules - this can be exacerbated if you are trading too large relative to your equity. You will enter positions at the wrong times, as well as exiting at the wrong time (for example on a minor pull back or retracement) for fear of losing profits when an exit signal hasn''t been given. This again messes up the mindset you need to follow such a method.

The traders who succeed can make any of the errors in terms of risk control and self control, but they quickly learn from it, bank the experience and resolve not to do it again. Good judgement comes from experience, and experience comes from bad judgement.

If you are losing as a trader, then it is a deficiency in any or all of these three aspects that is causing the issue. These need to be identified and eradicated as soon as possible.

It is the this reason that I do not believe that backtesting is the be all and end all that some like to believe. At the end of the day, if a trader has an issue that prevents them from following all aspects of a system, they will not be able to duplicate the results of the backtest. And in practically all cases, the only way to prove whether YOU can generate profits from such a system is to actively trade it with your own money on the line. Because it is only then when you will be able to determine whether you have the necessary risk control and self control to faithfully follow the system.

The bottom line is, you can have the best system in the world in terms of selecting trades, giving entry and exit points etc. Yet, if you are unable to faithfully follow the system rules, OR apply proper and rigorous risk control, then you will be destined to fail as a trader.

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