The Basics Developing Your Foundation The Mentality of a Loser Preparing Body and Mind for the Long Road Ahead
The importance of knowing and remembering the basic principles of successful trading is often overlooked by beginning traders as well as experienced market veterans. There is a widely held belief that traders experience “beginner’s luck” when first starting out; and as a result of their successful operations early on, they end up losing large amounts of money once their luck has faded because their early success made them overly confident. There is an obvious reason behind that initial wave of so-called luck. To assume all beginners experience luck would be foolish. Instead, the beginner’s meticulous attention to risk, and their timidity in placing trades are the reasons why they are profitable early on. Since this aversion to risk is not premeditated, but rather the result of their lack of experience and fear of losing money, one can see why it is labeled as “beginner’s luck”. This is where the luck ends. Their initial success is the cause of their eventual failure. When a market participant generates profits, their natural tendency is to undergo an ego boost resulting in over-confidence and hence less risk control. When reduced risk controls lead to increased losses, the trader proudly recalls those earlier successes and maintains elevated confidence levels until their initial gains are wiped out. Paradoxically, as their capital decreases to the level they started with, they do not employ the same level of cautious determination they had when they began their first market operation. Instead, they continue trading with larger sizes until they finally lose a large chunk of their capital, if not all of it. This is about the time when the other widely held belief kicks in:
That all traders and investors have to pay “tuition” in the form of losses before they can learn the necessary skills required to succeed. Is it possible to avoid this entire sequence and therefore defy these “widely held beliefs”? It is my intention to assist you in employing what I believe to be the skills and strategies required to accomplish this objective. To do so, we must start with the basics. Especially if you are an experienced veteran, you know the importance of risk control. If one can continually employ the level of caution they started their market operations with, they will preserve their capital as they strive to achieve the most important element of trading and investing: Long-term success. 1. Capital preservation is the number one priority for all but a handful of super-traders that understand when to go for the throat and make big bets. In the early part of one’s journey to trading mastery, capital preservation takes precedence to seeking profits. Upon graduation to advanced trading, capital preservation takes a back seat to aggressive strategies designed with one thing in mind: PROFIT. I want to begin by first clarifying my use of the term “capital preservation”. I am not referring to the type of strategy advised by financial planners, nor the option available when filling out an online account application asking for the type of strategies being employed, such as Growth, Speculation, Income, and Preservation. I am referring to one of two critical factors involved in successful market speculation: minimizing loss and maximizing gain. The former is capital preservation. To succeed, the active investor must find a delicate balance between these two factors. A majority of market participants actively seeking above average returns feel the most important goal is to find profitable trades with very little concern for protecting the capital they currently have. Beginners must place preservation of capital as the single most important variable, followed by the pursuit of profits. In the early stages of one’s development as a professional trader, emphasizing preservation of capital increases the odds of avoiding massive loss from excessive use of margin leverage; the number one cause of death among aspiring traders. In the first few years of trading, the trader must voluntarily self-categorize as a “beginner”. The rules one must follow as a beginner are different from those adhered to by more advanced traders. Think of it as a “risk spectrum”. The farther along one travels on this spectrum over time, the more advanced they become. However, the success rate amongst new traders is extremely low in the early stages. By accepting that one remains a beginner for quite a while, conservative strategies specifically designed to increase one’s odds of surviving through this dangerous period can be employed. If the beginner attempts to prematurely cross over to
intermediate status, thereby increasing their appetite for risk, their odds of “blowing up” surge exponentially. Along that spectrum representing a trader’s lifespan, the “windfall profits” are achieved after the halfway point. Try to reach for those large profits too early and the halfway point will never be attained. There is no question that traders are tempted to swing for home runs every turn at the plate. This urge must be controlled while learning about the various intermarket relationships that exist amongst capital markets and financial instruments. As these skills are attained, and one’s knowledge base naturally expands through time, the odds of hitting that home run rise considerably. Therefore, one must work to get to that level, and then reap the rewards of hard work. The aspiring beginner is carelessly overzealous when it comes to taking risk. Because the negative consequences of undue risk have not yet been experienced, the trader has not been conditioned to avoid risky propositions. Many have heard the saying, “experience is gained through loss and wisdom is gained through bankruptcy”. My goal in presenting this discipline first is to recondition your thought process so that you immediately back off the throttle and instead focus on the fundamental principles of successful money management. As such, let go of the belief that success is only achieved by generating profits. On the contrary, the beginner achieves success by surviving through the early years with as little loss as possible. You must realize that by taking control of your trading, you are sacrificing the gains (or losses) from investing your funds in a managed product such as a mutual fund. Moreover, the benefits of this decision are to be realized in later years, when you are producing returns several times greater than that of the market averages, but more importantly, you are doing so with a much larger capital base. Financial speculation involves risk at the highest level. If you place the greatest emphasis on protecting your capital, you will avoid much of that risk until you learn the skills necessary to become a professional, at which point you will be able to seek out high probability trades. Individual traders and investors rarely succeed because they have not embraced the assumption that financial speculation involves enormous risk, and as a result, they give equal weighting to all trades. Professional speculators are engaged in the business of risk. As such, recognizing risk as distinctly as a wine connoisseur recognizes different vintages of the same wine becomes the business of the professional trader. If you can accept the assumption that every trade has a unique risk profile, then until you can accurately determine what that profile is, you must be protective of your capital. Once you are able to recognize a trade’s confirmation signal, you are one step closer to becoming a professional trader. 2. The single most important variable for effective capital preservation is the ability to recognize, accept and realize a loss. One’s inability to detach emotions from their trading is the key deterrent against this discipline. Trading must be done professionally and unwavering discipline needs to be employed instinctively. By improperly associating losses with feelings of incompetence, the trader is personalizing their market operations while introducing an emotional component to their trading. With emotions comes a great deal of baggage. If the trader personalizes one aspect, all aspects become personalized and professionalism is sacrificed. For example, an emergency room trauma doctor experiences the deaths of many patients that come in under emergency conditions. If this doctor
were to blame himself for every one of those deaths, the emotional burden would be overwhelming unless the doctor is desensitized to the outcome. If they were not able to detach, additional patients may suffer if the doctor hesitates out of fear. A professional must let go of their emotions in order to do their job effectively and with resolve. In the case of the trader, emotions can and do lead to dangerously flawed responses when faced with adverse market conditions. To overcome this mental affair requires a change in one’s perception towards loss. As you will learn in later disciplines, loss is a necessary cost of doing business. As important as it is for the trader to recognize profitable opportunities, it is equally important to recognize losses that have the potential to quickly get out of hand. Although money management is often mentioned as the most important variable behind a trader’s long-term success, few market participants actually employ a rigid set of rules when conducting market operations. For example, Arnold Schwarzenegger was once asked, “How do you feel about all the people that claim your movie was poorly made?” He responded by saying, “I have no idea how so many people could be saying that because nobody went to see the movie.” People tend to repeat what they hear publicly if it seems “appropriate”, but when it comes to actual application, they rarely practice what they preach. This is especially true in financial markets. Market “hobbyists” are very good at repeating investment proverbs. In the privacy of their own homes however, they fall prey to their instincts and make irrational investment decisions motivated by greed. Realistically speaking, this principle is rarely understood by the vast majority of retail traders. The most likely cause is not the trader’s inability to recognize a losing proposition. Although this could be a major contributor, it is not hard to realize a trade is going against them. The problem lies in their inability to admit defeat because to them, a loss is the same as “losing” would be in gambling. Whereas in gambling the loss is automatically taken for the player, in financial speculation, the trader can technically let the loss run indefinitely, or until the brokerage forces liquidation because of a margin call. The solution is to understand the notion that one should expect to be wrong in speculating about 60% of the time. This will make it easier to accept taking a loss as it “normalizes” the impact it has upon one’s psyche. Successful traders place a great deal of focus on proper trade management such that during the majority of their trades, the losses they actually realize are significantly less than the gains they experience on the 40% of trades they predict accurately. The equation is very simple: •
Opening Position = .25(full position) If position moves in favor of the trade; increase position. If position moves against trade; cut the loss.
By opening small, the potential loss is significantly reduced and flexibility is preserved. In ensuing disciplines, I will illustrate when it is appropriate to accumulate your position at better prices (i.e. if the trade moves against you after initial entry). When first starting out, it is difficult for the trader to assume being wrong a majority of the time. This assumption alone is enough to deter one from becoming a professional trader; but it is a powerful incentive to stay in the business once it is understood that because there are many inexperienced traders out there losing their shirts, we may actually end up taking the other side of their trades. To think that the only way of succeeding is by finding winning trades a majority of the time is an extremely formidable
task where the odds are highly stacked against the trader. Our goal throughout the remainder of this book is to find an alternative approach to successful trading, which does not require consistent accuracy. To begin with, let us explore the concept of “Money Management”. 3. The philosophy of professional money management is based on the precept that one should speculate using a portfolio of positions to represent their market exposure as opposed to individual trade management. When a portfolio is comprised of profitable trades as well as losing trades; by releasing the latter without prejudice, the trader is effectively increasing profitability by releasing positions negatively weighing on total return. Effective money management involves: i. ii. iii. iv. v.
Determining the various risks associated with a given trade. Determining the amount of risk one is willing to take on. Understanding the potential reward for this level of risk. Deciding whether this risk/reward relationship is acceptable or not. If the answer is yes to the final question, then implementation of the entire process becomes the final step.
The game of Poker is a strong analogy for the concept of money management. Consider for a moment the game of 5-card Draw, where each player is dealt 5 cards. The player attempts to put together the strongest hand according to a set of guidelines that determine the value of each combination. The player has one chance to turn in as many cards as they would like in order to exchange them for new cards. The player with the highest hand at the end wins the pot. Individual cards have little value by themselves, but when components of specific combinations, value can be established and weaker cards can be exchanged for different cards in hopes of acquiring a better hand. With respect to professional trading, less attention is paid to the results of individual positions in isolation. The objective should therefore be to build a solid portfolio of positions using a predetermined guideline for capital allocation. Regardless of the time frame one is basing their speculations on, a portfolio approach is much more effective and the psychological impact is easier to accommodate. For example, when the trader is focused on achieving overall profitability, they will look at the performance of the portfolio in real time and attempt to optimize their results. If the value of the portfolio is rising while a few of the positions are negative, the trader will be able to quickly cut the loss in those losing positions and rotate the capital into alternative trades, or increase the size of their profitable positions. By basing success on overall results and detaching from individual positions, the trader no longer struggles with the notion of “admitting defeat” when it comes to taking their loss on a particular trade; taking a loss therefore becomes pain free. When the objective is to optimize the portfolio, cutting a loss producing position becomes automatic. As opposed to the psychological issues illustrated in Discipline #2, the trader no longer needs to worry about any emotional impediments to taking the loss. Tediously looking for variables in the portfolio to adjust in order to improve performance becomes almost like an obsession (compare this state of mind with that associated with facing the reality of a losing trade, having to admit you were wrong, etc..). In comparison, I recall the days when I was younger and had just opened a savings account. At first, I was reluctant to save my money because I worked for it and felt I deserved to have fun
and spent all of it. However, as I started to see an impact on my total savings, I became completely obsessed with contributing to my savings and watching it grow further. I believe it was my experience with my savings account while in elementary school that planted the seed of becoming a financial speculator and accumulating wealth. Once the concept of “compounding interest” is discovered and applied to wealth accumulation, look out. By adjusting our “field of view”, we have changed the way we perceive a loss. The inexperienced trader focuses solely on the results obtained from each position. This opens the trader up to the potential of experiencing a “series of consecutive losses” when in fact, the impact of a losing streak on one’s overall performance should be irrelevant. The only damage a losing streak can have is upon one’s psyche. Managing an entire portfolio is strategic and calculated versus looking for individual trades without any structure. Portfolio results are a function of independent input variables (size, stops, stocks, etc...) that can be manipulated to maximize dependant output variables (profits). One’s ability to adjust the input variables in realtime is reflected in the portfolio’s overall profitability. This approach is noticeably more structured than simply scouting the market looking for random trades that “look good”. In professional sports, rarely will a team take the field with the objective of playing without a game plan, as they do in pick-up games. The semi-professional trader that only works from market open to market close, rarely spending time to study capital markets after hours, is the equivalent of an amateur looking for a pick-up game. The professional develops a campaign, and operates based on specific strategies until they are completely removed from the action. The “portfolio trader’s” objective is to evaluate risk vs. reward in a given trade while determining the most efficient use of investment capital. Therefore, the active rotation of capital intended to achieve an optimum combination of stocks reduces the frequency of “actual losses” and instead replaces it with a quantifiable measure of one’s overall performance, as reflected in their “total return”. There are multiple aspects to proper money management, all of which are dynamic and need to be considered at all times. Furthermore, all trading strategies require some form of money management doctrine that helps the trader get the best return for the money at risk. Through proper risk control and money management, the discretionary traders is able to achieve consistent profitability while maintaining an accuracy ratio of only 40% of all trades. By placing loss control ahead of profit motives, if the trader is right on 4 out of 10 trades and averages a gain of 15% on each trade, they will have a cumulative gain of 60% on invested capital, not counting compounded gains. With the 6 trades that end up being wrong, the maximum allowable loss is somewhere near 3% to 7%. Therefore, the cumulative total of losses ranges between 18% and 42%. If one is able to meticulously apply this approach to preparing for and accepting loss, one can see how the odds of achieving long-term success are quite favorable. You may say to yourself, “This sounds easier than it actually is.” You are correct. It is in fact much easier than most make it. Ironically, the fundamentals of risk control and the psychology associated with it is very basic in theory. In practice, individuals must constantly struggle with their own psychological demons, which make risk control extremely difficult until the psychological aspect is under control. The latter point is not something that “everyone” can attain. Unfortunately, it takes a certain type of individual to take control of their emotions and psychology. Ironically, almost everyone will claim to be in full control of these aspects of their
trading, when in fact, they are far from it. This is another weakness amongst the masses that the professional trader exploits on a regular basis for profit. 4. Size control plays an important role in capital preservation. Position size is determined by several factors unique to each individual position as well as being a reflection of overall market conditions. Many inexperienced traders use an arbitrary size for all positions, thus implying all positions have equal risk values, which is an obvious fallacy. Have you ever heard the cliché “I never have enough stock when I am right, and I always have too much stock when I am wrong”? The key to accelerating profits is the ability to increase position size at the right time. If size is not increased appropriately, capital will be underutilized. How is a trader to determine the amount of risk they should take and the number of shares to trade? Some would argue that the most appropriate time to increase ones trading size is after a major drawdown simply because the chances of scoring a gain are very high. That style of thinking is similar to the roulette player that says, “gee wiz honey! The ball’s landed on RED 12 times so we should bet on black. But honey, since it has landed on RED 12 times, there is an obvious pattern so we should bet on RED and go with the trend!” The reality is that the odds for the ball landing on red or black are always going to be slightly less than 50/50 (due to 0 and 00) on every roll in roulette, regardless of previous patterns. In trading however, a trend can continue for a very long time, which includes any winning or losing streak. To increase size during a major drawdown is suicide. On the contrary, when engaged in a losing streak, it is important to decrease size consistently on each new trade such that as the streak extends, size is reduced to the point where the only objective is to reverse the losing streak. At some point, the size will get so small that it becomes almost pointless to be trading. However, I am of the opinion that merely walking away from the market, although sometimes this can be effective, will not assist the trader in regaining confidence, which is often lost during a losing streak. At the same time however, if position size is not aggressively reduced at the onset of a losing streak, the trader is susceptible to major capital loss. By reducing position size and continuing to trade, the trader is giving herself the chance to recover while at the same time protecting capital. By continually decreasing size as the streak continues, the trader is theoretically trading with the smallest size when she is trading at her absolute worst. When it appears the streak has ended, one must gradually increase their size until they have consistently achieved several winning trades, which do not necessarily have to be consecutive wins. This provides the trader with the opportunity to regain confidence gradually while protecting capital from a possible resumption of the losing streak. A losing streak can be attributable to one of two things. Either the trader has lost the ability to anticipate market direction correctly, or the underlying dynamics of a given market have changed, thus warranting an adjustment in the trader’s strategies. In the former scenario, this can be caused by factors external to the market, such as problems at home, excess stress or other distractions. In the latter scenario, market dynamics are changing all the time. Therefore, adjusting strategy accordingly is a necessary objective. Furthermore, it may not always be easy to adjust strategy appropriately. As such, by reducing position size, the trader shields their capital from excessive loss until the proper strategy is discovered. If the trader fails at recognizing the appropriate strategy, then they can make the decision to walk away rather than
continue trading, even with a significantly reduced size. If the decision is made to walk away, it is important to continue monitoring the action in the event conditions become more recognizable and the appropriate strategy can therefore be determined. This does not necessarily mean to watch the market every day. Rather, keep an eye on general market news and review charts of the major indices occasionally to see if anything important has happened. In either case, when first initiating a trade, it is vital to use only a fraction of what is considered a “full” size. For example, if maximum size is set to 1000 shares, consider opening the position with 100-200 shares at the most. If the stop is then triggered, the net result is only a fraction of the potential maximum loss. However, if the trade starts moving in the right direction, increase size by a few hundred shares and continue to do so as long as conditions remain favorable. There are a few “sweet zones” during the year when everything is aligned, and the trader is going for the throat. By adding this simple component to one’s assumption of being right only 40% of the time, odds of success over the long run are exponentially increased and the amount of profits produced during winning streaks are maximized. (For further review, see Discipline 58) 5. Develop and focus on long-term objectives without being distracted by short-term successes or failures. Prolonged losing streaks are caused by negative emotional responses after the first couple of losses. Conversely, feelings of euphoria after a gain results in excessive confidence and reduced risk control measures. Most aspiring traders are easily distracted by their short-term gains and unwittingly sacrifice their long-term success as a result. This is why there tends to be a wave of initial success when first starting out, followed by consistent losses until capital levels are depleted to the point where trading becomes difficult if not impossible due to a lack of sufficient funds. Following a profitable trade, or series of trades, the trader is susceptible to feelings of excessive confidence. A euphoric response from amateur traders when they realize major gains causes them to “personalize” their trading. In other words, they tend to visualize the monetary aspect of their gains by picturing themselves buying a new car or a new house. As soon as they do this, they become attached to that material object, which then forces them into a position where they are fighting the market to earn their prize. Because it is easy to become attached to material objects, if the market starts to move against them, they find it hard to cut their losses because doing so means they are giving up their chances of winning their prize. Conversely, after a loss, the trader may get angry with herself or even the market. Once anger has overtaken the senses, logic and reasoning are abandoned and the trader ends up making irrational decisions. Furthermore, after a series of consecutive losses, the trader loses confidence and becomes timid. Hesitation can lead to poor execution, which immediately puts the trader at a disadvantage. In either scenario, poor performance in the short-term culminates into inferior long-term results. Aside from the tactical flaws with this type of behavior, which I will cover in depth throughout this book, there are obvious psychological problems that must be addressed. The most important is that if any individual constantly experiences euphoria or anger after each gain or loss, there may be long-term complications that arise such as depression. Furthermore, anger, sadness and fear because of poor trading could spill over into one’s personal life and cause additional problems, which will then turn around and negatively affect the trader’s performance in the market. Although this cycle is typical and happens more often than not, it can be avoided. Professional trading involves complete emotional detachment from the short-term results of
one’s trading operations. The professional market operator disassociates their trading from any material objects, and perceives their net result as a “score” that reflects the effectiveness of their trading. It never represents the trader’s self worth or qualities as a person. The emotional response from a professional trader after a record-breaking gain is the exact same as their response from a massive loss that could take weeks to recover from. Those readers working from a proprietary trading office often come across traders that yell and scream during the day with every tick in the market. There is no question as to when the trader is profitable and when they are not. These traders tend to also spend their weekends at Las Vegas or other gambling establishments. Trading to them is a “sport” like gambling, where they pursue the thrill of victory. They are not professional in their thinking, although they like to think that they are, even as they launch their mouse across the room. I have met many interesting people throughout my career. One in particular sticks out and is worth discussing. For the purpose of our study, we will call this person “Fred”. The qualities Fred has outside the market are wonderful, which makes him a good friend to have. In the early years of his career as a trader, Fred almost won the annual “World Championship of Trading” tournament, losing his enormous lead only on the last day because of over-confidence. In fact, his lead was so huge that all the other participants, as well as the judges, had assumed he would win and were instead focusing on who would take second place. The night before the final day, Fred told his girlfriend how proud he was of himself and how little surprise he felt at blowing away all the other competitors. He said he was looking forward to expanding his lead and setting a record in the history of the tournament; thus generating several trading offers from hedge funds. Of course, he would only consider offers from the top tier funds. On the final day of trading, he took an enormous option position and did not use a protective stop because he was full of confidence. The trade went against him by a mile; and by the end of the day, he finished in second place. The tournament organizers said it was the first time in the history of the tournament that the winning trader won because the trader that was in first place from the start of the tournament “blew up”. Fred certainly got his wish of breaking a record, but it was the wrong record. This event hung over Fred like a dark cloud that would never clear up. It would cause Fred to self-destruct in every trading situation he would put himself. When he would realize some success, he would recall his experience at the tournament and end up self-destructing again and again. Over the years, Fred decided he did not have the necessary character traits to succeed in trading. Instead, he decided to work as a recruiter for other firms, bringing in top talent. However, I noticed he kept changing firms every couple of months. Each time he changed firms; he would contact me and try to recruit me into his “new firm”. After a few weeks, he would start complaining about the firm’s management and business practices and would label them as incompetent. Like clockwork, as soon as the complaints would start, he would send an email telling me he “finally had enough and changed firms and was happier than ever”. He continued by saying, “I want you to know that I respect you as a trader and did not want to recruit you into the firm because I did not want you to suffer the way I was suffering. So the reason I did not make an offer to you was because I was watching out for you”. Not that I ever expressed any interest, but I would humor him and play along. After a few weeks, the same pattern would repeat again. I started to notice that whenever he would call me from his office during market hours, he was very distracted while talking. Finally, I found out that he was actually trading
when he was supposed to be recruiting. While I was on the phone, I could hear him cussing and swearing at the market, or when he had winning trades, he would call me and incessantly brag over and over, and would look for recognition from his fellow traders by saying things like, “Hey Joe, did you see me knock this one out of the park? Who’s the king?” It got to the point where it was quite disturbing to listen to him either cry and yell or brag and boast. I finally realized that whenever he would generate significant losses in the trading account given to him by the firm, he would all of a sudden notice flaws in the firm’s management and decide he could not get along with the others and would “leave”, sticking the firm with a debit balance each time. Finally, he ran out of firms that would take him and asked me if I would start a firm with him. As gently as I could, I declined the offer, but I maintained my relationship with him because he is a wonderful person and also a living case study of the qualities of a consistent market loser. The professional pays little attention to short-term results, and instead focuses on long-term performance. Each day is simply another day at the office. They conduct their market operations in a disciplined, controlled fashion. They employ rational thinking while consistently focusing on overall performance. They understand long-term success is achieved by an almost mechanical adherence to discipline and risk control. Regardless of the daily fluctuations in their capital, if they execute their strategies according to their model, they know the odds of generating sizeable profits by the end of the year are high. As such, they will rarely jump for joy or throw their keyboard across the room, as these are both acts of the immature novice with a short lifespan in the market. These emotionally charged individuals will rarely succeed past the first or second major correction of a bull market. If it is a bear market, forget about it. They are not getting past the first three months. 6. Trading strategy first begins with the proper selection of a method of analysis to be employed during market operations. This method can be a specific technique or combination of strategies and styles of investing. There must be form and structure so that one’s market campaigns are not disorganized, but more importantly, a “shoot from the hip” style of speculation is avoided. When working without a proper game plan, the trader is at a disadvantage to other traders who are more prepared, better trained and highly disciplined; ready to take on the novices that think trading is about buying a stock at the right time and then waiting for profits to just roll in. Prior to developing a trading strategy, a method of analysis must be decided on. Trading is a complex method of developing a trade process, employing money management and risk control principles and understanding crowd psychology, inclusive of the self. The most direct definition of successful trading is: the proper analysis and interpretation of supply and demand as well as crowd psychology in order to correctly predict future price behavior. I have seen much more complex and detailed descriptions presented by Doctors and Scientists, but most of them are sharing their concepts from a classroom and not from a trading floor. There are three types of methods employed by professional speculators: fundamental, technical and quantitative. Some may apply a combination of the three, while others may favor one method over another during certain market environments, always willing to change their methods if the market dictates. Fundamental Analysis is the study of the actual business environment, inclusive of the many factors and variables that may affect the company’s business.
Variables such as earnings, cash on hand, debt to equity ratio, and research & development play an important role in shaping the expectations of stockholders both present and future. These expectations, measured as an aggregate of all market participants, create a “prevailing bias” and in turn, this bias causes the price of the stock to move accordingly. Since the moods and assumptions of the masses are dynamic and will thus never find true equilibrium, fundamental analysis becomes quite a formidable task unless one has access to a resourceful research team. In other words, a trader may be a great fundamental analyst, but if their assessment of a company is counter to the prevailing bias, they may see the stock move against their assumption for a long time, leaving them to wonder why a stock is falling for example, when the research suggests otherwise. Thus, fundamental analysis is most often left for the major investment firms as it provides minimal advantage when applied to short-term trading, where actual market direction is of critical importance. However, fundamental analysis will always be an effective tool for all market participants to use as an additional filter mechanism rather than a primary deciding factor. Quantitative Analysis is specifically the investigation of mathematical correlations in price data to determine if any patterns may exist. Multiple markets and instruments that may appear to be unrelated are cross-referenced to seek out patterns in order to recognize similar correlations in future data. For example, the relationship between the Japanese Yen and the Nasdaq are studied to search for any correlations that occur more than once under the same conditions. Thus, if a certain response consistently follows a sequence of similar events, then the trader has an investment assumption to work from. Because of the vast complexity of this type of analysis, Quantitative methods only became viable with the use of powerful computers. Technical Analysis is the study of price and volume behavior in order to determine what the actions of buyers and sellers are at certain price levels. In other words, it is a study of supply and demand. In fact, most professional market operators employ some degree of technical analysis prior to putting on any position for the sake of timing their entry appropriately. The most commonly used data points are open, high, low, close and volume. There are multitudes of different ways one can interpret this data, or use it to create specific indicators that assist in better understanding price behavior. Fortunately, the evolution of the computer allows the analyst to spend their time focusing on interpreting the many indicators and periodicities that a given chart can present rather than doing manual calculations. I will attempt to cover some of the more important technical patterns later in the text, but the study of these patterns and indicators should be done independently to further expand your knowledge. Each trader will have a different approach and personal preference in creating their arsenal of indicators, while others may choose to stick with price/volume analysis. You must give yourself the opportunity to understand the indicators and from there, begin developing your own personal arsenal of tools, techniques and strategies. 7. The selection of particular trading methods and risk management strategies will be determined by one’s personal outlook on life, as well as one’s state of mind and overall psychology. Why do some traders believe in a particular method, while others choose a completely different approach? In fact, the majority of colleges and universities preach a concept called “Random Walk”, which implies markets are efficient and price movements are random. Therefore,
according to the theory, one cannot develop a superior method of picking stocks in order to outperform the market averages. Even though this theory has been definitively refuted numerous times over the years by professional traders whose performance in the market blows away the market averages, the educational institutions continue to present the material to their students, some with religious fervor, such as the University of Chicago. The only viable reason I could come up with borders on “conspiracy”, so take it with a large grain of salt. If the colleges and universities of this world were teaching students how to become successful traders (just imagine for a moment that this is possible), and this instruction was available to the general population, then there would no longer be “superior” returns because market opportunities would vanish. Curiously, I’ve met many extremely intelligent graduates of Ivy League institutions that preach Random Walk only because it has been drilled in their head. Almost as if they are repeating verbatim what their professors taught them, they fail to display any sign of independent study and flatly refuse to believe the market is anything but Random. When asked to explain the superior performance of many portfolio managers, they brush it off as “statistical noise”. Therefore, as long as the teaching institutions throw students off course, the truly successful investor will discover their method of analysis, in the same way as those of you reading this and other books in your journey to trading mastery. Furthermore, Random Walk ultimately suggests that the most prudent thing to do with ones investment capital is put it into “index funds” that are designed to produce identical returns to the general market while diversifying sufficiently to eliminate long-term risks. Funds are “indexed” against a particular stock market index, such as the S&P 500 or Dow Industrials, and the overall movement of the broad market is the net result of the index fund. The index fund industry is a multi-trillion dollar industry, and a major component of the global economy. Capital inflows into index funds played a significant role in the equity boom that began in the early 1980’s with the advent of the first index fund. Thus, index funds are not only a critical component of banking and finance by keeping the wheels of the economy greased, but also critical to the overall health of the economy and the continued appreciation of stocks over the long run. See figure 7.1. Index fund managers can thank the world of academia for helping their business thrive. Thus, one can logically conclude that the academic world’s insistence on preaching Random Walk is an attempt by very large financial institutions to maintain a steady inflow of capital into mutual funds, which ultimately furthers the goals of a capitalist society by providing capital for the private sector, allowing for retirement through pension funds and improving the standard of living throughout society. It is both normal and healthy for the market to have multiple types of operators using various types of analysis models, as this what makes a “market”. A quantitative trader may argue with a technical trader until both of their tongues are bleeding, claiming one method is superior over the other when in fact both methods may be profitable. The bottom line is that based on your individual personality, you will most likely end up being drawn towards a particular style or technique of analysis, which will fit well with the way your perceive not only the markets, but also the world and society in general. Most importantly, avoid an argument that attempts to prove one method’s superiority over another. This is simply wasted energy because there is no right or wrong when determining the method one is going to employ in their speculations. The only right or wrong that exists is in reference to the appropriate money management and risk control parameters employed, regardless of the method one chooses. No single method will
guarantee success over another method, but we will continue to see some traders swearing by their methods, and looking down upon other methods. The fundamental or “quant” analyst will bash technical analysis, usually claiming it is “pseudo-scientific”, while the technical analyst will insist all fundamental information is priced into the stock, therefore no amount of analysis will give the fundamental analyst an edge over other fundamental analysts. Depending on one’s individual perspective, both of these assumptions could be either false or true. So why argue? A trader may possess a perfect trading methodology and excellent money management principles, but may ultimately lack the requisite psychological traits required to become successful. I knew a trader that was both intelligent and highly experienced in the markets. He would come in every morning and produce profits in excess of $20,000 in the first 90 minutes of trading. He would then take a break, brag to everyone else in the office, and would then go in and give it all back in the afternoon session. This pattern occurred almost every single day, to the point where his colleagues would lock him out of his office so that he would not give back his gains. It was as if he was psychologically rejecting his success and was determined either to lose everything he made, or to parlay the winnings into a much larger score so that he could satiate his ravenous appetite for attention. Either way, no matter how good he was and how much he studied, he was never able to succeed in the end. 8. Money management and risk control are the central pillars of one’s foundation for success. This foundation will not stand until both pillars are firmly in place, and should one pillar ever fall, the foundation will surely collapse. The absolute essence of trading is ones ability to evaluate risk in any given trade, while correlating this with the potential reward while also weighing this against other possible trades that can be initiated with the same capital. A trader’s capital is finite. An efficient use of capital strives to achieve the highest return for a given level of acceptable risk. It is sometimes easy for beginning or even advanced traders to forget the value of the money they are trading because they never touch or see it directly. Although this is an ideal condition for the disciplined trader, the novice must not lose touch with the way their life may be affected if they were to lose a large amount of money, which is why it is so important to fully understand and appreciate the amount of risk one is taking on. Make sure the ratio of risk to reward is such that you are placing the odds of success on your side. To be realistic, the trader must look for trades that have a better than 3 to 1 risk/reward ratio. For every 1 point of risk, they are seeking 3 points of profits. This will allow the trader to be wrong 6 out of 10 trades, and still be ahead by 6 points [(6 * -1) + (4 * 3) = 6]. Although trading is not this simple, the methods of calculating ones risk/reward ratios are not difficult nor do time consuming. If you have to choose between a trade that has a potential to gain 15 points with a stop loss 5 points below entry, versus a trade that can gain 5 points but the stop is placed 3 points away, the proper choice is the former even though the latter has a smaller potential loss. The way to offset the higher potential point loss in the preferred trade is by using a smaller initial position and increasing size if and when there are some open profits. Therefore, combining money management with the proper trading methodology is crucial to long-term success. A trader may devise a profitable method but could still end up losing money without proper money management techniques in place.
The benefits of proper money management tend to be realized over time. Most retail investors and those that trade part-time set very shortsighted goals. They do not have the patience to wait for their profits and instead take unnecessary risks in hopes of reaping early rewards. Rather than slowly building up their capital, they are willing to risk most of it in an attempt to build it up quickly in order to take larger positions. There is obviously very little regard for money management principles when going for homeruns all the time. Inexperienced traders as well as some professionals tend to visualize the lifestyle change they will undergo if they are successful in their trades. However, rarely do they visualize the adverse consequences in the event the trade goes against them when they take those large risks. If the trader can get used to visualization of the negative consequences, they will take fewer risky trades and will naturally evolve towards a style of trading that is well thought out and controlled. This is especially important in the early stages of one’s journey to trading mastery. Unfortunately, this is difficult until one experiences the pain of a major loss. The more you concern yourself with risk control and proper money management, the stronger your foundation and in later years, you can reap the benefits of your hard work and strict discipline. 9. The actual process of trading for ones financial well being is an excruciating demand to place on the mind and body. You must learn to accept the potential negative consequences that can arise from your speculations. Therefore, it is essential to ask yourself what you expect to attain from your trading and why. Greed should not be the motivating factor behind one’s pursuit of professional trading. If you are looking for a mental and physical challenge of the highest order, where intelligence, emotions and endurance are all qualities that must be at peak performance, then you will feel right at home with financial speculation. Professional money management is one of the most highly rewarding professions in the world, ranking up there with professional entertainers and high power corporate CEO’s. In terms of average compensation, the professional trader is one of the highest earning individuals, making a disproportionate amount of money compared with other professions. Furthermore, an enormous gap exists between the upper segments of traders versus those farther down the totem pole, creating a significant earnings discrepancy between above average traders versus average traders. And unlike celebrities or high profile CEO’s, the professional trader is rarely talked about, rarely makes public appearances and tries very hard to keep a low, if not totally anonymous profile. A little understood fact is that approximately 90% of self-directed retail investors lose money. On the opposite side of the spectrum, 80% of all the gains made in the market go to the top 10%20% of professional traders. This is an enormous amount of money made by a handful of professional operators. Thus, the aspiring trader’s objective should be to work their way gradually into this top percentile of professionals. Moreover, entry into this group does not happen overnight, nor does it happen by luck. It happens because of a consistent, relentless pursuit of proper risk management and market analysis. The trader needs to accumulate their wealth over time. Every dollar earned should be preserved and treated like the money they started with. Novice traders tend to take greater risk when they have generated profits, declaring they have a “cushion” in case they are wrong, so that their “principle” is protected. This fallacy
serves as a major obstacle to continued success, and provides a “ceiling” as to the levels achieved by the trader. But the truth is that risk management and a trading method that generates consistent profits are the easier aspects of trading. They are mechanical and can be learned through study and practice. The formula for both aspects can be obtained from other traders, through books and mentorship’s. The most difficult aspect of trading, which serves as the filtering mechanism of the market keeping the weak out and letting the strong flourish, is one’s ability to live with their trading decisions and results. Professional trading requires a laser-like focus and indestructible psychological attitude. Unlike the mechanical variables mentioned earlier, psychology is unique to each individual, and regardless of how intelligent a person is, if they have a weak mind, there is little chance for them to succeed. They can study and learn every single rule, technique and pattern, but if their psychological condition is inferior, they will not survive. Because of this general weakness amongst most traders, professionals can deploy strategies designed to “shake the weak hands out”, or suck them into irrational positions only to be trapped when it moves violently against them. Not only are the superior traders exploiting the retail investors, but they are also waging war amongst other superior traders, which is where the fiercest battles are waged in financial combat. Having a clear mind, uninfluenced by the perils of greed and fear; the successful trader learns to stay clear of these battles, knowing it could result in a complete annihilation of their account in the blink of an eye without making much of an impact on the winning traders overall capital. To achieve the appropriate state of mind required to deal with one’s trading decisions regardless of the outcome, the trader must focus on three key variables: philosophy, intelligence and emotions. Philosophy refers to the trader’s outlook on life. The beliefs held by the individual have a significant impact on their overall success or failure as a trader. For example, many successful traders I know personally have a strict rule against general gambling of the type found in Las Vegas, myself included. I believe that if one were to gamble, they would develop a psychological character trait that is open to taking uncalculated, improbable risks. Furthermore, trading could evolve into a more advanced, higher stakes form of gambling. The second variable, intelligence, refers to the trader’s ability to understand money management strategies, market dynamics, and trading concepts. Intelligence is only considered in the context of speculation and not in general terms. In other words, it is irrelevant if the person is considered a genius based on their I.Q. or their G.P.A. Intelligence only pertains to the trader’s aptitude for market theory. The market is a wonderful environment in which individuals can prosper. It is the foremost example of capitalism in the free world. Any individual, with or without a formal education, has an equal opportunity to become successful, only needing some capital to start with. There are firms and investors out there that will provide the capital if we feel the individual has what it takes to succeed as a professional speculator. If one wants to be an investment banker, economist, or market analyst, they will most likely need to get a Master’s degree. But if one wants to enter the grind of professional market operations, where they are up against the best and brightest speculators in the world, then the market will provide the opportunity. But there is an innate flaw in trading someone else’s capital. If one is not mature, they will assume that since the capital is not theirs, they can take big risks and hopefully make large profits for themselves. If not, so what. This type of individual will be recognized for what
they are, a fraud, and will be weeded out, either by the firm or by the market. Either way, there is zero chance of success. Finally, emotions play a crucial role in determining the trader’s state of mind. How they deal with their results will determine the longevity of their operations. The less emotional they are, the higher their odds of sustainability. Quite possibly, of the three variables mentioned here, emotions play the most crucial role in determining how the trader ends up dealing with their results and whether or not they learn how to accept the consequences of their actions. It is crucial to understand and appreciate that trading will test one’s stamina, emotions and feelings of self-worth. Therefore, the trader has the opportunity to thoroughly evaluate them self. The results of this evaluation will be a reflection of one’s ability to rise above the masses, regardless of whether or not profits are achieved. If this can be accomplished, the trader will succeed, and profits will come naturally.