The Benefits of Strategy Trading

The Benefits of Strategy Trading

I believe that a trading strategy, which has been properly developed and tested,

can make you more money than trading any other way. However, this is not the

only reason that strategy trading is the method of choice for most successful

traders. There are other benefits as well. One of the most important benefits is

that you can sleep well at night knowing that you’re trading a strategy that has

been tested and re-tested, and is proven to be successful. No matter what happens

in the market during the day, the confidence you have in your strategy makes this

type of trading easier on you.

Another advantage is that you can choose a market and a trading strategy that

compliments your personality. The basic idea is that the trading strategy you select

is based on the type of market action you are the most comfortable trading.

Those who desire to always be in the market will select a different strategy than

people who prefer short-term positions. If you get a thrill out of riding the big

trends, then you will select a different type of strategy than someone who enjoys

going against the trend.

Have you ever received an unexpected call like this, “Hi, Joe. This is Stan, your

broker. We need to settle the margin on your account. Looks like the market

really went against you this week”?

If you are a strategy trader, this is not likely to occur. Strategy traders always know

where they stand financially. They know this from the financial results of the

historical tests. If you do get a call like this, you will most likely be expecting it and will have planned for it. You have creatively designed a strategy based on the amount of money you have to work with. As a part of knowing the maximum

equity drawdown associated with your strategy, you can determine the strategy’s

capital requirements and make adequate provisions to provide enough capital to

maneuver through the eventual drawdown. There will be no financial surprises.

I’ve been talking at length about why strategy trading is the most viable way to

make money in the markets and what type of skills and knowledge are necessary

to be a successful strategy trader. I showed you a study that in my view gives very

solid proof that strategy trading (objective decision making) is the most successful

way to make decisions. If there was ever any doubt in my mind, this study cleared

it up. I hope you are now convinced that if you want to make money you should

be a strategy trader.

OBJECTIVE LINEAR MODEL (STRATEGY TRADER)

OBJECTIVE LINEAR MODEL (STRATEGY TRADER)

For the Objective Linear Model, the researcher developed an objective model

based on historical tests and observations to predict results. This is defining and

using quantifiable data, running historical tests, and then using the results of the

tests to predict future outcomes.

For instance, the researcher would look at reams of physical data from cancer

patients, and correlate the data with how long the patient lived. After running the

historical tests, the researcher would then obtain the physical data from a cancer

patient, and using the historical test data, attempt to predict how long that cancer

patient will live.

This is exactly what a strategy trader does. He runs historical tests and then uses

that data to take a position in the market. He uses objective, quantifiable data

tested historically to make his trading decisions. Table 1 shows the results of the

tests.

SUBJECTIVE LINEAR MODEL (TECHNICAL TRADER)

SUBJECTIVE LINEAR MODEL (TECHNICAL TRADER)

A Subjective Linear Model is a much more complex decision making process. It

starts with interviewing experts in a field and learning how they make decisions.

The researcher literally asks the expert how he or she makes decisions and they

respond by explaining how they make their predictions. Although these experts

are not using quantifiable data, they have enough experience and knowledge in

their field to be successful. This decision making process is then outlined by the

researcher.

For instance, a physician, highly experienced in treating cancer, probably has

become fairly adept at predicting the life expectancy of his patients, even without

using any objective data. The researcher interviewed the physician and attempted

to determine exactly how the physician made this assessment. Then the researcher

put this newly quantified data into a regression model and attempted to predict

the life expectancy of cancer patients.

This is very similar to how our technical trader makes decisions. He goes to

seminars and reads books to learn how the experts make decisions using technical

indicators. He then takes what he learns and attempts to trade like the experts. In

a sense, he does his own regression model of the expert’s process to make trading

decisions.

INTUITIVE PREDICTION MODEL (DISCRETIONARY TRADER)

INTUITIVE PREDICTION MODEL (DISCRETIONARY TRADER)

Intuitive prediction is defined as making a decision without the use of any

objective or quantifiable data. For instance, in trying to predict the academic

performance of graduate students, the researches asked their advisors to do so

without seeing their grades and just by talking to them. The decision-makers had

to rely on their intuitive impressions and any other factors they thought relevant

(how the students dressed, their language skills, grooming habits, etc.).

This is the same way our discretionary trader makes trading decisions—using

intuition and gut instinct. Although he might think he does, he does not use any

objective criteria. In predicting the stock prices, it is highly likely that the

researcher engaged a discretionary trader to predict the future prices of stocks.

Decision Models

Decision Models

I have always been interested in the science of how we as human beings make

decisions. Life is really all about making decisions. If we can improve the way in

which we make decisions, it stands to reason that we will be more successful in

life. If we can improve the manner in which we make our trading decisions, we

will become a more effective trader and hopefully make more money.

In my early years of trading, I always wondered whether there was statistical proof

that strategy trading was inherently more profitable than other types of trading. I

knew from my own experience that it was but I was unable to prove it statistically.

I then picked up a book called Decision Traps. This is a book about the process

3 of decision-making and I picked it off the bookstore shelf when I was attempting

to learn how to become better at trading. I didn’t know at the time that it would

put forth the notion that objective decisions (i.e., strategy trading) produce far

superior results than other non-objective forms of decision making.

In this book, nine different types of decisions were tested using each of the three

different decision methods. The accuracy of the decisions was then compared and

analyzed for effectiveness in predicting final outcomes. The investigator looked at

different types of decisions, predicting grades, predicting recovery from cancer,

performance of life insurance salesmen, as well as predicting changes in stock

prices. He used three different decision making processes: an Intuitive Prediction

Model, a Subjective Linear Model, and an Objective Linear Model. Interestingly

enough, these can be compared to our 3 types of traders: discretionary, technical

and strategy.

TRADES MULTIPLE STRATEGIES IN EACH MARKET

TRADES MULTIPLE STRATEGIES IN EACH MARKET

Our strategy trader has also learned to recognize that every market goes through

different types or phases of movement. He is finding out that it is possible to

define what that movement is and develop a strategy to profit from that action.

He may say, “I used to only make money when a market was in a trend; I am

basically a trend trader. But a few months ago I added a Volatility Breakout

strategy to compliment the trend strategy. When a market is not trending, I can

still get some money out with the VB strategy. This money to some degree funds

the trend-following strategy drawdown in a non-trending market, and levels out

my overall cash flow.”

As you can see, our trader is now talking an entirely different language. He has

become a sophisticated money manager, intent on maximizing the profits of his

business. He has come a long way from being a seminar junkie, consumed with

Indicator Fascination. He realizes the value of technology, and the immense

capacity of software like TradeStation. He adds, “I really don’t know how I would

do this without today’s software and technology. It would be like trading blind.”

Or like being a discretionary trader.

TRADES MULTIPLE MARKETS

TRADES MULTIPLE MARKETS

Our strategy trader has observed that to maximize his return, he must trade

multiple markets. At any given time there may be only one or two sectors moving.

If you are only trading one market, you will have to wait for the next big move

and fund the drawdown. The more markets you trade, the greater the chance that

one will be in a big move. It is also likely that the profits in the markets that are

moving will be greater than the drawdown in the markets that are not. That is the

ideal situation because you can then reduce the fluctuation in equity and have a

more predictable cash flow.

Our strategy trader now understands the age-old notion of market diversification.

With back testing, he is now able to test the combination of strategies and

markets and how they integrate into a comprehensive trading strategy. An overall

strategy is now coming into focus that includes trading several markets.

CASH MANAGEMENT & RISK CONTROL

CASH MANAGEMENT & RISK CONTROL

Our strategy trader is now spending a lot of time using TradeStation to focus on

cash management. He has found a group of indicators that he trusts, has back

tested, and has worked with for enough time now so that he knows their

strengths and weaknesses. He’ll tell you, “I have finally realized that there is no

Holy Grail. There is only so much money in the markets and most indicators can

be rigged to catch most of the moves. The real task is to manage your money

efficiently to take advantage of market moves.”

Our trader is now focused on refining techniques concerned with how to scale

into a potential big move, and how to scale out as the market moves in his

direction. He is focusing on the value of pyramiding a position to maximize the

leverage of his open equity. He is using his accumulated net profit to be able to

trade bigger positions without risking his own capital. The successful strategy

trader focuses his TradeStation testing on the percentage of his account that

should be risked with each trade, so as to maximize his profits and minimize the

drawdown.

Don’t underestimate how critical the size of your trade is, and how important it is

to add to a position at the right time. This may be more important than the

strategy itself!

The Complete Strategy Trader

The Complete Strategy Trader

The complete strategy trader has learned to use advanced cash management

principles, trades multiple markets, and may trade multiple strategies in each

market.

The successful strategy trader realizes that the key to long-term profitability is

how the cash flow is managed, not what indicator is used. He is done with trying

to predict the markets and has stopped looking for the Holy Grail indicator. He

understands that strategy trading is not unlike most other businesses and, as a

result, has turned his trading into a sophisticated business based on sound

business principles.

Remember the great fish restaurant that I mentioned in Chapter 1. It opened and

immediately received rave reviews; it was ranked four stars (out of four) by all of

the restaurant critics. It was hard to get in at peak times because you always got a

great meal. Again, it is not the food that makes a successful restaurant.

Of course a restaurant needs a good chef and good food. But to stay in business it

needs much more than good food. Costs, service levels, and cash flow need to be

managed effectively. I realized that many successful restaurants have mediocre to

poor food (just visit any fast food joint). But they stay in business because the

management has mastered restaurant management, which has nothing to do with

the taste of the food.

Trading is really no different. Traders become successful because they understand

trading management. Trading management has nothing to do with indicators, but

has a lot to do with the details of managing trades and cash flow effectively. The

complete strategy trader can say, “Of course I need solid indicators, and I have

my favorites. But I think with what I know about trading now, I could make any

indicator profitable.”

Successful traders understand that to be successful and stay in business more is

needed than simply a great indicator.

HISTORICAL ANALYSIS

HISTORICAL ANALYSIS

For some time now, our strategy trader has been using TradeStation to develop

trading strategies. He has learned rudimentary EasyLanguage and is actively

testing various trading strategies. He has learned that just because something

looks good visually and is profitable over a short period, it might not make money

over a long time frame. He has also experienced the confidence that comes from

knowing that a particular strategy has been profitable in the past.

Even though he knows that the market will never quite replicate that past, it is

much more comfortable to trade a strategy that has been historically tested than

to trade intuitively. He knows that the success of a strategy is not directly tied to the indicator, but to other factors: exits, money management stops, and cash flow

management.

Because of the extensive time he has spent working with TradeStation, he also

knows the ins and outs of risk control. He has done extensive back tests and

found out that if he puts his stop losses too close, the strategy takes too many

trades and makes less money. He has studied set-up and entry and how they work

together to get you in the market. He knows the difference between exits and

money management stops. He can now historically test any indicator or technique

and immediately know how profitable it was in the past. He doesn’t have to rely

on anyone but himself to make trading decisions.

The strategy trader has also learned much about himself in this process. For

instance, he has learned how much money he is willing to risk on any trade. He

knows he can’t take a hit for, say, more than $1,500. He knows that he can only

take a certain amount of drawdown and can only stomach a certain number of

losing trades in a row. He may refuse to trade a strategy that has more than four

losing trades in a row. He just knows himself, and he knows he wouldn’t be able

to handle it. He adjusts any strategy he develops to account for this. However,

maybe he can watch his account go through a $12,000 drawdown if he knows that

he won’t have a lot of losers in a row; especially if he has the historical

information that confirms that a $12,000 drawdown is not unusual for his

strategy.

The key is that he has learned to customize the parameters of his strategies to fit

his personality. There is no point in designing a great, profitable strategy if you

won’t be able to trade it!

QUANTIFIABLE DATA

QUANTIFIABLE DATA

One of the first things a strategy trader needs to understand is quantifiable data.

This is the data that he will correlate to the market and use to develop his trading

strategy. Without quantifiable data, he would be unable to trade a strategy.

Quantifiable data is measurable data. Stock and commodity prices are

quantifiable, as is volume. All technical indicators that are derived from price

and/or volume are quantifiable and useable in designing a strategy. Are phases of

the moon quantifiable? Yes, as are the location of the planets. They occur in a

regular pattern, and each occurrence is measurable and predictable. What about

earnings per share or the price earnings ratio of stocks? Yes. These are also

quantifiable and can be used in strategy trading.

Once you understand what quantifiable data is, it is easier to spot non-quantifiable

data. Non-quantifiable data usually consists of random events that cannot be

reduced to a number and that cannot be predicted. For instance, speeches by

politicians are not quantifiable, although we know that they can have a profound

effect on stock prices. Opinions of our broker are not quantifiable. Are earnings

surprises quantifiable? No, but quarterly earnings reports are, and they usually

have a significant effect on stock prices. Are weather patterns, droughts, or

freezes quantifiable? No, although we know they too have a considerable effect

on commodity prices, it is not possible to quantify droughts and correlate them to

Soybean or Corn prices.

A strategy trader thus moves into a mode of acquiring and testing quantifiable

data as it relates to historical price activity. This is a marked difference from a

technical trader, who tries to correlate data to price but usually through

observation and intuition, and from the discretionary trader, who doesn’t use

quantifiable data at all or feels he needs to in order to make money.

It is this acquisition and use of quantifiable data, along with the software to test it,

that enables the strategy trader to investigate trading techniques historically and

begin to put some rational and enlightened business practices to use in his trading.

It is this process that enables him to start finally making money.

The Strategy Trader

The Strategy Trader

A strategy trader trades a strategy—a method of trading that uses objective entry

and exit criteria that have been validated by historical testing on quantifiable data. Strategy traders are restricted by a set of rules. These rules make up what is

known as the strategy. As a strategy trader, you will not deviate from your

strategy’s rules at all, unless you have decided to use a different strategy

altogether. When your strategy tells you to buy, you buy. When your strategy tells

you to sell, you sell. And you buy or sell exactly how much your strategy tells you

to. You read

The Wall Street Journal

and talk over the markets with your broker, but

you don’t make trading decisions to override your strategy because of something

you read or heard from your broker.

The reason you are restricted by your rules is that your rules are sound. As a

strategy trader, you've spent a lot of time and research in creating those rules.

Your rules have been hand-designed by you and tested and re-tested on years of

historical data. This testing has given you positive results and the conviction that

lets you know it’s time to take your strategy into the future. Your emotions might

still fly as high and low as the market, but at least they are not causing you to

make bad trading decisions.

Our strategy trader has now left behind the gurus, the hotlines, and the broker

recommendations, and has stopped trying to predict which wave the market is in

and how far it will go. He has purchased and learned how to use TradeStation. He

is becoming knowledgeable about computers, data and technology. He has

realized the value of quantifiable data and back testing, and starts to put on trades with the confidence that comes with knowing the historical track record of the same strategy for the last 10 years. He is slowly learning the business of trading.

HISTORICAL PROBABILITIES

HISTORICAL PROBABILITIES

It finally occurs to him that he should back test some techniques and see how

some of his indicators would have worked historically; he reasons that if he can

do this, he would have more confidence and discipline in his trades. He begins to

understand that no one (including himself) can predict the market. He starts to

realize that he needs to have some confidence that the techniques he is going to

use have worked in the past. He now knows that he can’t predict the market. He

thinks, “All I really need to know is what the probabilities are when I put on a

trade according to my rules, and I should make money.”

Our technical trader has now passed the second big initiation and begins to sense

the need for trading a strategy. He realizes that there is immense value in

historical strategy performance data. He purchases TradeStation and dives into

learning how to design and trade strategies.

PREDICTING THE MARKETS

PREDICTING THE MARKETS

Discontinuing the use of the old technical indicators, our technical trader now

begins to flirt with the Elliot Wave theory, W.D. Gann techniques, and

Fibonnacci Targets and Retracements. These techniques generally claim to help

you predict when the market will be choppy and where and when it should be

bought and sold. He does all of this studying so he can learn to stay out of

choppy markets. It makes a lot of sense. Someone out there must know when the

markets are going to go sideways and then step aside waiting for the next big

trend. When the trend comes, they get on it and ride it for big profits. They then

exit and wait for the next trend. He hears promises that he should be able to

forecast all of this by using these predictive techniques.

Unfortunately, after several seminars, our trader tries to predict a corrective stock market and ends up mistaking it for the next big wave up. He explains to his

friends, “I missed the big move because I thought we were in Wave B but the

market was really in Wave 2 ready to start Wave 3. If I had just used my old trusty

indicators instead of trying to predict the move and waiting, I would have made

big bucks.”

INDICATOR FASCINATION

INDICATOR FASCINATION

The first assumption that our trader makes is that someone out there must know

how to do this. There must be an expert, someone who knows how to make

money, that has created the magic indicator to do it. This is the Holy Grail

syndrome and our trader now embarks on a search for the Holy Grail Indicator.

He knows intuitively that there must be an indicator that will give him the

information he needs to make profitable trades…that there must be teachers out

there that know how to make money trading. He thinks, “All I need to do is find

him and his indicators.”

This is the indicator fascination phase. How are indicators calculated, what do

they represent, and are they the “secret” to making money? All of these questions

need to be answered so he becomes a seminar junkie, travelling the country on

the quest for that great technique, the one that everyone uses to make the big

money. He visits Chicago one month…L.A. the next…followed by a visit to the

Chicago Mercantile Exchange. He watches the CNBC expert technicians and

surfs the net looking for that magic indicator.

Now he’ll only buy when the ADX is moving up and the MACD is positive, and

he’ll sell only when the RSI gets overbought and turns down. His trading becomes

more indicator-based and he listens less to his broker. For example, he may tell

his broker, “No, I won’t buy Apple Computer until the Earnings Momentum

Indicator is over 80!” Unfortunately, even with all of this information, and all the

assurances of his seminar leaders, he still is not making money. He even begins to

wonder if he will be able to continue trading with all of these losses. He thinks,

“If I could only control the losses, I will probably be able to trade a little longer before my money runs out.”

It is at this stage that he learns the value of stop losses, known as

stops. He learns the importance of managing the risk on each trade. He gets a hint that there is more to trading than just the indicator, and his ears perk up when people mention the concept of controlling risk and conserving capital. He thinks, “I just want to stay in the game, to keep enough money to make the next trade. I don’t want to quit a loser!”

But even with the newly found indicators, and controlling his risk with stops, he

continues to lose money, although he also consummates some winning trades that

keep his capital from depleting too quickly. And here he has another major

revelation—markets can be trending or choppy. It is at this point that he realizes,

“If I could only predict the choppy markets, where I lose most of my money, I

could simply stay out of the market and get back in when it starts to make the big

move.” So he starts another quest, that of leaning how to predict choppy markets.

The Technical Trader

The Technical Trader

A technical trader uses technical indicators, hotlines, newsletters and perhaps

some personally defined objective rules to enter and exit the market.

As a technical trader, you are beginning to realize that rules are important and that it is appropriate to use some objective criteria such as confirmation before making a trade. You have developed rules, but sometimes you follow them and

sometimes you don’t. It depends how confident you feel today and how much

money you are making or losing. If an indicator gives you a buy signal, you may

override it because your broker told you the earnings report was going to be

negative. Or maybe the bonds are up, which means interest rates are rising, and

you better see how high rates go before you commit more money to this already

overpriced market. You may think, “I have a profit, hmm, I just may take it now.

Even though the Stochastic is not overbought, the markets are tough. It’s not

easy to make money. Like my father said, ‘you can’t go broke taking profits.’ At

least now I have a winning trade. I’ll sleep well tonight.”

Our trader now begins to realize that using the intuitive and hot tip approach will

not lead to profitability. He now begins to focus on the technical indicators

themselves. There are so many! Moving Averages, Exponential and Weighted.

The MACD, Momentum, P/E Ratio, Rate of Change, DMI, Advance/Decline

Line, EPS, True Range, ADX, CCI, Candlesticks, MFI, Parabolic, Trendlines,

RSI, Volatility Expansion and Volume and Open Interest, just to name a few. So

much to learn and so little time!

This whole new world of technical books, seminars, newsletters, and hot lines

now begins to preoccupy our trader. He learns all he can about indicators. He

wants to find the one indicator that will ensure profitability. He surrenders to

what I call Indicator Fascination.

DISCOVERS TECHNICAL INDICATORS

DISCOVERS TECHNICAL INDICATORS

Once the discretionary trader discovers technical indicators, he or she

incorporates some rudimentary ones into trading, usually as additional

justification for making the trade. “Not only did Ralph (my broker) tell me to buy

Gizmo Corp. but Gizmo has great relative strength. Gizmo’s moving averages are

bullish, and the Stochastics are oversold and giving a buy signal as well.”

These newfound technical indicators give the discretionary trader a new lease on

trading. Now our trader has a whole new world in front of him—the world of

technical trading. For a while, this newfound world combines with intuition and

the discretionary trader views himself as a strategy trader. He says, “I trade a

strategy using moving averages and Stochastics with a dash of daily news and tips

from my broker. I am now a real objective strategy trader.” While the trader may

view himself as a strategy trader, this could not be farther from the truth. The

discretionary trader’s style is still undisciplined, based on newly educated guesses,

and he is probably still losing money.

For a moment, these technical tools were thought to be the answer, and while

they add a little more rationale to his trades, the losses continue to pile up.

Despite his continuing angst, our discretionary trader is now on the way to

becoming a technical trader.

CRAVES EXCITEMENT

CRAVES EXCITEMENT

What a discretionary trader loves is the excitement. He loves being “in the

markets,” playing with the big guys. He craves the risk, the excitement of trading,

and the gambling rush that he gets from calling his broker and putting in the

order to buy. He loves being able to sell Gyro Corp. based on the news story of

the health hazards of their top selling Gyrometer. He has a real obsession for

buying Cotton based on the hot tip from his broker that the upcoming crop

report was going to be bullish, and he covets the tip from his friend who called to

say that he just bought Techno Corp. because the latest quarterly earnings were

going to be a surprise on the upside.

Discretionary traders retain the flexibility of changing their buy and sell criteria

from moment to moment, and change they way they trade from minute to minute

and day by day. “Well, that last trade was a disaster, so tomorrow I will buy

McDonald’s only if it opens up from yesterday’s close.” They don’t have any

discipline, nor do they think they need any. They use their intuition and their gut

instinct, and feel justified in doing so. They think, “Making money is easy, you just have to be smarter and quicker than the next guy.”

I personally don’t know anyone who has made money by discretionary trading.

They may have been lucky and won on a few trades, but overall, over time,

discretionary traders always lose money.

It is after enough money has been lost that the discretionary trader in some way

stumbles across technical indicators. It may be from the chart book he just looked

at where there was a Stochastic Indicator underneath the chart. Or he may have

gone to the latest

Make a Million Dollars Trading the Stock Market

seminar and found out that using the Relative Strength Indicator is the sure way to stock market profits. He thinks, “So this is how they do it!” These indicators look like magic.

They add some rationality to an otherwise irrational trading style. He thinks, “This

must be how the big money players make the big money—they use technical

indicators!”

INTUITION & HOT TIPS

INTUITION & HOT TIPS

The discretionary trader uses several sources for his trading decisions. One is

intuition, for example, “I see a lot of people in stores, so I think the economy is

good, and earning will increase, so the stock market should go up, and I should

buy Sears.” He usually spends a lot of time talking to his broker. “What do you

think Joe, isn’t Woolworth’s going to turn around?” Another is reading and

watching the news, “Retail sales are looking strong and Woolworth’s is closing

stores to lower their overhead.”

Hot tips are a common way that a discretionary trader gets ideas. A call from his

broker or good friend, or a tip from a discussion at a cocktail party are all places

the discretionary trader gets his trading ideas. “Hey George, HTECH Corp. has a

hot new product in the works, here’s a stock you can pick up cheap.” If it gets dry

in the summer, our discretionary trader may decide to buy Corn, Beans or Wheat.

However, when he looks out the window and notices that it’s raining, he sells the

position immediately. A news story on the nightly news may cause a discretionary

trader to short the airline that has just had a crash.

The Discretionary Trader

The Discretionary Trader

A discretionary trader uses a combination of intuition, advice and non-

quantifiable data to determine when to enter and exit the market.

Discretionary traders are not restricted by a concrete set of rules. If you are a

discretionary trader, you can make buy and sell decisions using whatever criteria

you deem to be important at the moment. For example, you can use both a

combination of hot tips and relevant news stories from

The Wall Street Journal , and enter or exit the market based upon this information. If you begin to lose money,

you can immediately exit the market and change your trading method. You don't

have to use the same techniques day in and day out. It's a very flexible way to

trade that you can customize based on what you think the market is going to do at

any given moment.

For the discretionary trader, trades are made using gut instinct and intuition.

Unless a computer is generating a buy or sell signal and you actually follow the

signal, your emotions will

affect your trading. I explained in the introduction what

problems instinct and intuition could be in trading. Remember fear and greed? In

discretionary trading, technical tools such as indicators are sometimes used;

however, when they are put to use, they are utilized sporadically as opposed to

systematically.

Fascinated by the markets, the discretionary trader is ready to put on a trade at a

moment’s notice. The most uncomfortable part of trading for the discretionary

trader is when there is no action. So he will jump on any piece of information,

anything that will permit him to take a stab at the market. Above all, he craves

the action.

The Path to Successful Trading

The Path to Successful Trading

In the broad category of “trading the markets,” there are basically three types of

trading: discretionary, technical, and strategy-based. When I sat down to write this

book, my intent was to write only about strategy trading. But then I realized that

to fully describe strategy trading, it was also necessary to discuss discretionary and

technical trading. It’s important that you understand the difference between them,

which is not always clear. I’ve met many people who believe they are strategy

traders when they’re actually technical traders, and vice versa.

I have known and taught many traders, and have observed that there are four

distinct stages of trader education: discretionary trader, technical trader, strategy trader, and complete strategy trader. All successful traders have gone through them. It is almost impossible to be a successful strategy trader without going through all of these stages. My goal with this book is to help you understand and move through the stages at much less cost in both time and money.

Every trader usually starts out as a discretionary trader. The amount of money lost

generally determines how long it takes the individual to start using technical

indicators to make trading decisions. Eventually, as even employing technical

indicators fails to move the trader into profitability, the trader moves into the

third stage and starts to write strategies based on quantifiable data. It is at this

stage that the trader ordinarily starts to make money. Finally, the strategies and

money management approaches are refined and the individual becomes successful

as a strategy trader.

Buy High - Sell Low

Buy High - Sell Low

Probably the most interesting rule for successful trading is to “Buy High and Exit

Higher, and Sell Low and Exit Lower.” This is counter-intuitive to what we all

have a natural inclination to do, which is buy low, sell high. Most great trading

strategies are counter-intuitive. They are not based on our normal human nature

and the normal human reaction to the markets. They consistently make money

because they are designed with market sense not human common sense.

In the final analysis, any market is just a collection of individuals making decisions

and placing money in the market based on these decisions. Most of these

individuals are doing what comes naturally to humans, buying low and selling

high. Statistics show that 95% of these people lose money.

To be a successful trader, you have to do the opposite of what this 95% is doing.

It isn’t easy, because it goes against your human nature. But any strategy that is

successful over time will most likely follow the rule of “Buy High, Exit Long

Higher and Sell Low, Exit Short Lower.”

Always Be In the Market

Always Be In the Market

I have always characterized trading the trend as “keeping your costs down while

waiting for the big move.” We know that to trade profitably, especially for trend

traders, you need to be in the market for the big move. Many traders stay out of

the market when it’s quiet and try to predict when the big move will occur. These

people invariably miss the big move.

Instead of trying to predict when the big move will occur, your task becomes to

minimize your losses and drawdown while you are waiting for the big move to

occur. This is a different way of looking at trading that focuses on managing cash

flow and risk rather than finding magic indicators and making good predictions.

Trading thus moves from a hobby to a business.

The only way to ensure that you won’t miss the big move is to always be in the

market.

Concentrate on Execution

Concentrate on Execution

All of your market and strategic analysis should be done before the markets open.

The strategy design should be clear in your mind. You should have the historical

Performance Summary of your strategy at your fingertips to remind you of the

personality of the strategy, how much money it has made over time, and what its

largest string of losses in a row has been. You should know what kind of orders

you are going to place, and how you are going to communicate this to your

broker.

The last thing you should have to worry about during market hours is where the

market is going, and whether to be long or short. Your strategy will tell you all of

this. You should not be concerned about the news, or even if you are making or

losing money. You should not be concerned with analyzing the market, always

reserve this for when the market is closed.

The only thing you should be doing during market hours is concentrating on

effectively executing your strategy. If you can’t execute your strategy effectively,

there really is no point in trading. There are two sides to trading, strategy

development and trading execution. During market hours is when you should

concentrate on execution and nothing else.

Don’t Trade for the Money

Don’t Trade for the Money

I have met many successful people, and the one thing that they have in common

is that they love what they do. Many have told me they can’t believe that they

actually get paid for doing what they do. They have so much fun they feel guilty

taking money for doing it. Many successful people will tell you that they would do

what they do even if they weren’t paid at all.

SUCCESSFUL PEOPLE DON’T WORK FOR THE MONEY

Work hard and love what you are doing and the money will follow. Successful

people work first and count the money later. Sometimes they don’t ever count it,

and some don’t even know (or care) how much they have. They just know that

they have enough to allow them to continue what they are doing; working hard

and having fun.

LOVE TRADING FOR ITS OWN SAKE

I know that many individuals want to trade because they think that they can make

a lot of money easily and quickly. Because of the low start-up costs for trading as

compared to other businesses, they think that trading should be the easy road to

riches. Their goal is to make a lot of money fast. These are the people who come

to seminars and want an indicator that will guarantee profits. They don’t want to

learn the ins and outs of the business; they want the magic indicator that will get

them the money they desire. They are doomed to failure.

I remember a guy named John walking into a seminar I was about to teach. He

threw up his hands and said, “Ah, Traders! I am glad to be home.” This individual

was a successful trader. John loved going to seminars, not so much for the

techniques and indicators, but for the camaraderie. He loved being around traders,

talking with traders, analyzing trading strategies and techniques, and learning

about the latest and greatest trading technology. He loved learning the latest

features added to TradeStation and finding out a new way to use EasyLanguage.

He loved designing new indicators, and spent countless hours working on new

and different ways to exit the market. He was excited about getting up early in the

morning to monitor the overnight market information and checking what the S&P

was doing in London. He looked forward to calling his broker and putting in his

orders. He loved watching his strategy run on TradeStation. He was exhilarated

when he had to call his broker and give him a lot of grief for the latest bad fill. He even loved losing trades. Even when he had to take a losing trade, he was still

doing what he loved to do—trade.

John is a successful trader. He loves what he is doing. And as long as he can keep

on trading, he will be happy. The money he makes is secondary, but he makes a

lot of it. He can’t believe that he can have all of this fun and make money as well.

Understand the Psychological Keys of Trading

Understand the Psychological Keys of Trading

There are many people who teach the psychology of trading. There have been

many books written and effort spent on seminars trying to teach the discipline

needed for trading. I don’t think trading is that complex. I have developed a few

simple psychological rules for myself, and once you accept them, they should

greatly enhance your ability to trade effectively.

ACCEPT LOSSES AS A COST OF DOING BUSINESS

Most successful traders will tell you that the most difficult thing about trading is

accepting the losing trade. We all have the desire to be to be right, to be correct all of the time. For novice traders, the losing trade means that something is not

working and that you have somehow made a mistake. For experienced traders,

losses are just a cost of doing business.

Some of the best traders in the world lose money on more than half of their

trades. If you look at the performance results of the best traders and money

managers, you will see that they all have a large percentage of losing trades. If you trade, I guarantee you that you will have losing trades. Learn to love losing trades.

They should be your friend because you will be spending a lot of time with them.

USE HISTORICAL STATISTICS

I don’t think anyone has ever traded without first looking at historical statistics.

Even some traders who deny they are strategy traders have used historical data.

And before EasyLanguage and TradeStation were available, most good traders

developed a strategy’s history by hand. I can remember countless hours pouring

over charts spread out on the kitchen table, writing down trades by hand. Before I

would trade it, I absolutely insisted on knowing what the strategy’s personality was

and how much money it would have made.

Using historical statistics gives you great peace mind, particularly in learning to

love losing trades. Knowing the history of a trading strategy can give you

tremendous psychological comfort during those tough periods of losing trades

and drawdown. Historical statistics tell you how much money the strategy has lost

in the past, how many losing trades it has had in a row, and the largest losing trade the strategy has experienced. This is very important information if you are learning to accept losing trades. Comparing historical data with the current string of losses and drawdown can give you much comfort that what you are experiencing now is not unusual and has happened before. Maybe not in exactly the same manner, but

it has happened before.

LET THE MARKET AND STRATEGY DETERMINE THE PROFITS

Don’t have an opinion, don’t try to predict the market, and don’t try to second-

guess your strategy. It’s human nature to have an opinion about things, but this

opinion can become a stumbling block if we let it affect our trading. One of the

alluring aspects to having an opinion on the market is the exhilaration of being

right. Even though we know that the chances of being right are slim, we

nonetheless want to prove our intellectual prowess by being right.

Your trading strategy is ultimately a little business. You have developed and tested

the product and are now operating the business in the real world. Let the strategy

be the strategy. Let it make the money you know that it can. And know that if the

market doesn’t move in the manner that will allow the strategy to make money, it

won’t make money. Ultimately, the market determines the profit through its

movement. If it doesn’t make that move, there will not be profits.

Put the responsibility of making money on the strategy and the market. When they

work together, you will have a profitable business.

Have a Healthy Time Horizon

Have a Healthy Time Horizon

One of the biggest problems new traders have is that they think they will make a

large amount of money right away. They think they will get rich quick. This type

of reasoning is very similar to the short-term thinking in American business in

general, usually managing for the current quarter’s profits, focusing on short-term

earnings at the expense of long-term investment and profit growth.

TRADE FOR PROFITS OVER TIME

Traders tend to get wrapped up in current market conditions, the news of the day

and the current trade, usually at the expense of the big picture and profits over

time. My grandfather used to have a saying, “You can’t go broke taking profits.”

He was very wrong. You can go broke taking profits. If you take profits before

the market tells you to, or you succumb to fear and close out the trade before its

time, you are focusing on the short-term and forgetting how to make money over

the long haul. Close out no trade before its time.

GIVE YOUR TRADING STRATEGY ENOUGH TIME TO WORK

We tend to be impatient, and we sometimes think that we should get instant

gratification. This will not work in trading. The only way you will really know

whether you are a successful trader is to be successful over time. A week or a

month will not be enough time to tell you how you are doing. You should be

trading with the objective of making money in the long run, consistently, and with

the confidence that your strategy will make money given enough time.

One of the benefits of trading with a strategy is that having done the requisite

historical testing, you should know how long it should take you to start making

money. You should have an idea as to the length of time that the strategy has lost

money in the past, how much money it has lost, and how long it will take the

strategy to become profitable. If the strategy has proven profitable historically, it should be profitable in the future. You just need to give it the necessary time to do its work.

Be In Harmony with the Market

Be In Harmony with the Market

We make money trading when we are in harmony with the market. We are long

when the market is going up, and short (or out of) the market when it is going

down. If we bring an opinion with us while trading, we will end up fighting the

market. We keep trying to go long as the market is declining, or we keep shorting

a market that it is in a bull phase.

DON’T FIGHT THE MARKET

Fighting the market is not good for two reasons. First, we lose money. How much

we lose depends on how well we are managing our money and controlling our

risk. Second, fighting the market affects our judgment, and causes us to try to

confirm that our judgment is correct, or persist in fighting a trend so that we will

eventually prove to be correct. We figure that if we persist long enough, no matter

how long it takes, we will eventually be right.

The same can be said for being in a canoe in a river. There is a reason for leaving

your car downstream, launching your canoe upstream, and paddling downstream.

It is much easier and eminently more fun to go with flow and paddle downstream.

We could do the opposite and paddle upstream. Eventually we may even get to

our destination, but the cost would be substantial. It would take much more time,

more physical and emotional stamina, and we would be constantly fighting the

current. Reaching the goal would not be worth the cost.

Even if you ultimately make money fighting the market, it is not worth the price

you have to pay, both financially and with peace of mind.

LET THE MARKET TELL YOU WHAT TO DO AND WHEN

The correct attitude for successful trading is to let the market tell you what to do.

If the market says to go long, buy, and if it starts to go down, sell. This sounds

easy but it is much more difficult than you think. We always like to believe that we

can be in control. We want to be in control of our trading and of the market. If

you accept the notion right now that you cannot control the market, that all you

can control is your execution of trades, you will take a great step toward being a

successful trader.

Instead of trying to control the market, let the market tell you what to do. Let the

market and your strategy take you long rather than you personally trying to predict

or decide when to go long. Let your strategy take you out or get you short. Once

you realize that you can’t understand the market, and that you can’t predict when

the market will move, you will move into that detached state of mind where you

let the market take you where it will when it wants to.

THE MARKET GIVES AND THE MARKET TAKES AWAY

To remove your personal biases and let the market tell you what to do is to give

up control, to give up the notion that you are actually in charge of how much

money you make. For profitable trading, you need to move into the mental state

of letting the market determine the profits, not you. It won’t be whether you

predict the market correctly that determines the profits, but whether your strategy

is in a profitable mode or drawdown mode as determined by the market.

So, let the markets tell you what to do based on your strategy. Let it get you long

and put you short. Let the market determine how much money you are going to

make. Trade your strategy and let the market do the rest. And know that the

market gives money and the market takes away money. Your goal should be to

develop a strategy that gives you more money than it takes away.

Know that Market Experts aren’t Magicians

Know that Market Experts aren’t Magicians

Some of the experts that try to predict the markets actually make money trading

the markets; however, they don’t make money because they have predicted the

market correctly, they make money because they have traded the market correctly.

THEY DON’T PROFIT FROM THEIR PREDICTIONS

There is a huge difference between trading correctly and making an accurate

market prediction. In the final analysis, predicting the market is not what’s

important. What is important is using sound trading practices. And if sound

trading habits are all that is important, there is no reason to try to predict the

markets in the first place. This is the reason strategy trading makes so much sense.

THEY HAVE LEARNED TRADING DISCIPLINE

I have watched many market gurus continually make incorrect market predictions

and still break even or make a little money because they have followed a

disciplined approach to trading. More importantly, they used the exact same

principles that I will show you how to use in creating your strategy. It is these

principles that make the money, not the prediction.

To be a disciplined trader, you have to know how and why to enter the market,

when to exit the market, and where to place your money management stops. You

need to manage your risk and maximize your cash flow. A sound trading strategy

includes entries, exits, and stops as well as sound cash management strategies.

Even the market gurus and famous traders don’t make money from their

predictions, they make it from proper trading discipline. Over the years, they have

learned the discipline to control their risk through money management. They have

learned to take the trades as they come, and not forgo a trade because they are

second-guessing their strategy or the market. These are the same practices that you

will learn to include in your trading strategy.

THEY PROFIT FROM SOUND CASH MANAGEMENT & RISK CONTROL

Sound money management and risk control are the keys to being a profitable

trader. I will say over and over again, it is not the prediction or the latest and

greatest indicator that makes the profit in trading, it is how you apply sound

trading discipline with superior cash management and risk control that makes the

difference between success and failure.

I often tell the story of the great fish restaurant that opened up just down the

street from my office. It opened with great fanfare and was ranked in the top five

restaurants in the city. The food was outstanding. But it only took a little more

than a year and this great restaurant was out of business. Why? Because the key to

running a good restaurant is not the food…it is cash management and risk

control. It is making sure your business is run efficiently, keeping your costs (risk) in control, and managing your staff effectively. If you believe that the taste of the food is what makes a great restaurant, think of how great the food is at your favorite fast food restaurant. But, someday, watch how well that restaurant is run.

Just as in the restaurant business, the key to profits in trading is not in the

prediction or the indicator, but how well the trading strategy is designed and

executed. The ability to achieve risk control and cash management will make the

difference between a successful trader and an unsuccessful trader. If you ever have

the opportunity to watch a successful trader, you will see that they don’t worryabout where the market is going or about predicting when the next big move will

take place. They aren’t looking to tweak their indicator. They are worried about

their risk on each trade. Is the trade being executed correctly? How much of their

total account is at risk? Are the stops in the right place? And so on.

THEY DON’T HAVE SUPERIOR PERFORMANCE NUMBERS

If you want to have some fun, look at the performance of a successful market

expert, one who is known for his or her market predictions and trading expertise.

You will find that their performance numbers really aren’t any better than an

average trading strategy. The percentage of profitable trades, the return on the

account, average profit to average loss, number of losing trades in a row…all of

these trading parameters are within the average trading strategy performance

parameters.

Why is this? Because you can’t predict where the market will go and when it will

move. But if you use correct strategic trading disciplines, you will make money

whether you try to predict the market or just trade a good strategy. You might as

well save yourself a lot of time, energy, and mental anguish and trade a good

strategy.

The Principles of Successful Trading

The Principles of Successful Trading

Over many years of trading, I’ve found certain principles to be true.

Understanding and using basic principles provides an anchor of sanity when

trading in a crazy world. Whenever I find myself under stress, questioning my

judgment or my ability to trade successfully, I pull out these basic trading

principles and review them.

Don’t Try to Predict the Future

I used to think that there were experts and geniuses out there who knew what was

going to happen in the markets. I thought that these traders and market gurus

were successful because they had figured out how to predict the markets. Of

course, the obvious question is that if they were such good traders, and if they

knew where the market was going, why were they teaching trading techniques,

selling strategies and indicators, and writing newsletters? Why weren’t they rich?

Why weren’t they flying to the seminars on their Lear Jets?

NO ONE KNOWS WHERE THE MARKET IS GOING

It took me a long time to figure out that no one really understands why the market

does what it does or where it’s going. It’s a delusion to think that you or any one

else can know where the market is going.

I have sat through hundreds of hours of seminars in which the presenter made it

seem as if he or she had some secret method of divining where the markets were going. Either they were deluded or they were putting us on. I have seen many

complex Fibonacci measuring methods for determining how high or low the

market would move, how much a market would retrace its latest big move, and

when to buy or sell based on this analysis. None has ever made consistent money

for me.

NO ONE KNOWS WHEN THE MARKET WILL MOVE

It also has taken me a long time to understand that no one knows when the

market will move. There are many individuals who write newsletters and/or

books, or teach seminars, who will tell you that they know when the market will

move.

Most Elliott Wave practitioners, cycle experts, or Fibonacci time traders will try to

predict when the market will move, presumably in the direction they have also

predicted. I personally have not been able to figure out how to know when the

market is going to move. And you know what? When I tried to predict, I was

usually wrong, and I invariably missed the big move I was anticipating, because “it

wasn’t time.”

It was when I finally concluded that I would never be able to predict when the

market will move that I started to be more successful in my trading. My

frustration level declined dramatically, and I was at peace knowing that it was OK

not to be able to predict or understand the markets.