Over the
past ten years I tried a variety of trading styles before eventually finding my
niche. Throughout that time many mistakes were made during my development as a
trader.
Looking back
on a decade of learning I can identify five key areas that I wish I understood
better.
For new
traders, putting these principles to work now may expedite your path to
consistent profitability.
1) Spend more time studying your trades
Studying
your trades is simply one of the best ways to enhance your learning process.
After collecting enough trade data to analyze your strategy (typically, 50-100
trades), you will begin to see patterns in your decision making or in your
automated system that may be limiting your upside potential.
As a general
rule, trader and system developer Perry Kaufman advises the more data the
better when analyzing a system. In effect, the Law of Large Numbers states that
there will be less chance of randomness in your analysis when studying a large
enough sample size.
Additionally,
the more trades representing more phases within a full market cycle the better
you can get an understanding for how your system will perform during a
particular market regime. For instance, a directional trader running a stock-focused trend following program may incur a period of drawdown if equity markets go
sideways.
However,
periods of drawdown in one market-specific trading strategy, like a
stock-market trend following system, can be minimized by using a trend system in other markets like commodities, interest rates, or currencies. Additionally, diversifying your returns with complementary systems like mean-reversion strategies in other markets will create a more robust return stream for your entire portfolio.
As a trader
you can lose money for reasons other than drawdown – behavioral, psychological,
risk management, market idiosyncrasies – and identifying the area that is hindering
your returns the most should allow for you to improve your results going
forward.
For example,
loss aversion is a common behavior exhibited by traders. Nobel Prize winning
economist Daniel Kahneman and the late Amos Taversky defined loss aversion as
an individual’s tendency to avoid losses and accept corresponding gains. In
other words, traders can allow for a loss to grow larger than originally
planned during the initial risk management protocol employed using a position
sizing algorithm, while simultaneously opting to lock in smaller profits that
are short of reaching a target or before presented with a reason to sell.
The large
losses you find in your trade data will help you identify the cause of adverse
portfolio returns. In the preceding example, a behavioral mishap created a
disregard for good money management thereby letting a loss grow larger than
anticipated and increased the trader’s risk of ruin.
2) Keep costs low, trade less
Although you
have been warned about how excessive trading can cut your compounded rate of
return by increasing transaction costs, fees, and possibly taxes, the
temptation to trade often is very real for most developing traders.
There is a
fine line between trading too frequently and executing sound risk management. Adhering
to an initial stop loss at the position level is essential to avoid incurring larger
losses than anticipated.
Price is
extremely volatile and can cause traders to get whipsawed in positions with
tight stop losses.
However,
using a moving average or moving average cross-over system could provide a
solution to reduce the amount of trades executed in your system. Moving averages track historical price action over a specified time period and with
specific parameters. Common examples include arithmetic, geometric, weighted,
and adaptive moving averages.
Accordingly,
since a moving average is a derivative of price it is slower to react to price
movements which can allow for better signals to be generated and less whipsaw
in your open positions. In other words, a moving average will help you identify volatility to respect and volatility to ignore.
In the book “Reminiscences
of a Stock Operator” legendary trader Jesse Livermore observed that “The money
is made in the big swings.” Despite the simplicity of this comment, there is
great depth and wealth building opportunities behind its meaning. As a trader
you need to be patient with your positions and stay invested in your trade
until presented with a sell signal from your system.
Personally,
identifying ways in which I could slow down my decision-making and trade
execution from a discretionary and systematic perspective has allowed me to be
involved with trades for longer periods thereby capturing larger positive
outlier moves, known as positive fat tail events.
3) Use daily screens to expedite your search process
After
developing your trading system begin to find ways to systematize your daily
processes. You can use software such as StockCharts.com to save screening criteria
to identify trading opportunities.
Additionally,
try standardizing position risk management by tracking Average True Ranges
(ATR’s) if this is your preferred measure of price-based volatility. Similarly,
tracking your portfolio profit & loss (P&L) and outstanding risk on a daily
basis is mandatory.
In the end,
trading is just a business. As such, it should be run as efficiently and
automatically as possible. This will free up your time to focus on risk
management, process improvement, and back-testing new trade ideas.
4) Be patient. Trust the process
Don’t engage
in style drift. Provided you have done the requisite research and testing, stay
the course with your process. Become a master at your craft.
After doing
the research and back-testing needed to develop a profitable trading system,
you need to stick to the exact rules to see how the system performs with real
data. Your returns will provide excellent feedback for your system.
According to
Perry Kaufman’s writings, it is typical to experience half the expected rate of
return and twice the amount of volatility in real-time.
If your
actual results differ substantially and are very unfavorable then take a step
back to examine your system design process. It is possible that you may have
over-fit the data for a specific trading parameter or market regime by data
dredging. Or, you may have tested a somewhat viable concept that lacks
robustness since the rule only performs well in a few markets in real-time.
No matter
what trading style best fits your personality there will be periods of
under-performance even for the best trading methods. Well-known trader and
investor William O’Neill experienced his fair share of drawdowns throughout his
career. In the long run, sticking with his CANSLIM system with its proper risk
management allowed for O’Neill to achieve his seldom matched level of market
success.
5) Be a sponge. Learn from other traders
Read as much
as you can to learn about your strategy from those that have gone before you.
Don’t worry about the costs. It is far better to invest in yourself when you
are learning than to put that money into the market prematurely only to see it evaporate.
Personally,
my most valuable resources are a dozen books or so that I re-read often. For
example, the Market Wizards series is a great starting point to understand
unique trading strategies, risk management, and psychology. Each time I read
these works it’s as though I have a private mentoring session with one of these
traders.
In recent
years, social media platforms like Twitter and StockTwits have emerged as a
great place to share ideas with like-minded traders as well as see ideas in real-time from the best in the business.
These sites
can help you build a network, learn to think like a pro trader, as well as
develop a sentiment gauge for trade ideas.
There is
always something more to learn and always room for improvement.
“The secret to being successful from a trading perspective is
to have an indefatigable and an undying and unquenchable thirst for information
and knowledge” – Paul Tudor Jones
As a new and
developing trader, take time to review the aforementioned areas to improve your
results. Start by focusing on one area for a period of time before moving onto
the next. In doing so, you will give that particular area of your trading the
focus required to build the habits necessary to succeed going forward.
As always,
please feel free to contact me with any comments or questions. Thanks for
reading.
John
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