Monday, November 30, 2015

Don't just work on your method

Studies have been carried out proving that, even with a completely random entry, traders can make money by adhering to good risk control and cutting losing trades quickly. In his book Super Trader, Van Tharp talks about one such experiment with Market Wizard Tom Basso.

Yet, when you talk to inexperienced traders, nearly all of them continuously focus on some form of 'holy grail' to get them in right at the start of a price move - be it based on fundamentals, technicals or some thermo-nuclear indicator they have developed.

For 99% of traders, concentrating on the twin pillars of good risk and emotional control will help far more than continually fussing over how to get in a trade.

I worked with a trader a while back who was stuck in a continual state of testing and refining a methodology, always looking to fine tune it. He was permanently stuck in a testing loop, and never actually got round to the actual business of trading. 

I finally managed to get him out of this, only for him to suffer a drawdown. Why was this? Because once he started risking real money in the markets, all the psychological factors which he never gave a consideration to, started to rear their head, leading to indecision, second guessing, and overtrading. He found it impossible to follow the rules he had created and extensively tested and refined.

So, what was his solution? To go back and test more changes to his entries and exits. The point is, the method wasn't the problem. The problem was the trader, his mindset and his lack of emotional control, but he refused to admit to it. The last I heard, he had switched methodologies (which I know had a positive expectancy) yet he was continuing to lose money.

Food for thought?

Reversing how you approach the markets, by placing far more importance on risk and psychology, and less on your method will generally work far better in improving your returns.

That said, what you want is for every part of your overall approach - method, mind and risk - to be solid. If you are deficient in one or more areas, then your overall performance will be compromised.

Think of it as a three legged bar stool - if you are deficient in your entries and exits, risk management or controlling your emotions then that particular leg will warp or break, and the stool will wobble or fall over.

If your chosen method of getting in and out of positions doesn't have a positive expectancy, then all that will happen is that you will lose money more slowly - the 'death by a thousand cuts'. You have to focus on all aspects critical to your overall performance. 

Not focusing on all of these main areas is why some people who use a really profitable method of identifying entries and exits actually end up losing money, whereas others whose method may only have a small positive expectancy can consistently make money.

It is commonly spoken that 90% of traders lose money. So, to avoid being in the majority, you should be able to work on all the various elements of your trading piece by piece, eliminate those deficiencies and improve your performance.

Finally, notice that I haven't talked about trend following or any particular style of trading - working on all three areas is universal to all traders. There are numerous methods that can and do generate positive returns in the markets. The trick is to find a method that matches your beliefs about the markets, and that you work within a basic framework to develop your own edge.

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