After almost two decades of trading, I have come to the realization that trading simplicity is best.
When we make the effort needed to keep things simple, we avoid making the accident of taking away some of trading’s most significant aspects without which, success in trading would be even more difficult.
I feel that foundation of all success in trading must involve the following five aspects. If you remove any one of these five, your chance of long-term trading success is very slim. And if you put all five of them together, you are close to being guaranteed success in trading.
1. Trading Mindset, Psychology, and Personality
In the area of trading psychology, my major mentors have been Mark Douglas, whose fame comes from Trading in the zone, and Dr. Van Tharp, of Trade Your Way to Financial Freedom. I prefer to give credit where it is deserved, and these two people have been instrumental in assisting me in developing the trading mindset I now have. Numerous years ago, I spent two full weeks in New Zealand and became very good friends with Dr. Tharp, and this made me appreciate the fact that trading psychology was a very big factor in my ultimate success in trading.
There have been different numbers put into the arena regarding the significance of psychology to success in trading. For instance, Dr. Tharp thinks that as much as 90% of trading success is a result of psychology, while the rest has to do with systems.
There are other people, however, who completely disagree with his view, and think that psychology only impacts around 10% of one’s trading success. In my opinion, the precise percentage amount doesn’t matter. However, I know intuitively that psychology plays a very important part.
The question of the nature of your personality is another important component of psychology in relation to trading. I believe that personality is tied to why more than 90% of traders fail.
These traders go to popular weekend seminars, and use the trading techniques and styles particular to a specific guru, and try to copy their guru’s exact trading approach, but after around 90 days, their accounts have often been reduced by 90%. Why is this the case?
It is caused by the fact that the guru’s specific trading system did not fit the personality of the person. Some people were lucky enough to have a guru who had the same personality, but most are not so fortunate.
If this misfortune happened to you, be assured that you are not alone. I went through the same thing when I first started out.
In the beginning, I was determined to be exactly like Warren Buffett, my hero, and use his value investing approach. This was a problem, because I am no Warren Buffett!
Unlike Warren Buffett, I had no means of understanding a company’s dynamics inside and out, including information about every competitor on the market and their numbers, as I don’t have the same experience and ability to remember everything I read that Buffett has.
I also made an attempt at day trading. Day trading involves being in front of a trading screen all day long, buying and selling securities, such as options, stocks, and forex, and closing out all your positions by the day’s end.
This was not suitable for me, as I simply lacked the eye and hand speed you need to succeed in this, and I did not like having to be in front of a screen the whole day. I wanted freedom, and I knew that I could never have that kind of freedom with day trading.
2. Risk Management
In this section, I will discuss risk management. This has to do with managing risk so that no position you ever take will have the ability to make you or break you.
Unfortunately, most traders go way too far in terms of risk, and potentially leverage their accounts in ways that can have devastating effects.
It is necessary for every trader to closely examine his or her portfolio as a whole, and not only focus on an individual position, deciding to put on excessive risk on that one idea.
3. Position Sizing
Position sizing risk is invariably led to by portfolio risk.
Dr. Alexander Elder made famous the numbers 2% and 6%. I believe that those numbers are a bit too high.
For accounts with less than $10,000, it is likely ok as a result of high brokerage costs. However, if you were to get four five in a row incorrect, which actually can happen and has happened for me, you will have lost 10% of your account.
At the most, I risk between 0.1% and 1%, and this depends on market risk, which I will discuss later. Thus far, it is far less than 2% on even my best ideas at any given point in time.
People have told me that this is far too little, as you will make only a very small amount. These people, however, forget that there are abundant opportunities when the time is right, and it is a combination of these types of seemingly small but great trades which add up in the end, without the high risk of disaster.
4. Trading Systems
Mindset, psychology, and risk management will not give you significant benefit if you have a trading system with a negative expectancy.
What do I mean by a “negative expectancy”?
It indicates that over a significant number of trades in various different market conditions, your system loses money consistently, even if you execute every trade perfectly.
While it’s true that positive thinking, risk management, and personality match are all helpful, you will still lose money if your trading system lacks a positive edge, or a positive expectancy over a significant number of trades.
Therefore, you need to find or develop a trading system that has a positive edge, and which fits your personality.
5. The Market
Lastly, the majority of traders hold a myopic view of the trade, and are lacking in their assessment of the current market environment, and the question of whether they should be participating.
A popular saying that holds very true in trading is that a rising tide lifts all boats. It will get you nowhere to try to swim against the current, as you are attempting to squeeze out just tiny returns for large amounts of risk that you take.
At times, it is simply better to stand aside and refrain from trading at all until the markets are back to normality and safety for your trading system to succeed.
For instance, during the GFC, if you had traded long only and at exactly the same position size as you would have if the markets had been safe, this would have been a disaster. A better decision would have been to either completely refrain from any trading and stay in the safety of cash, or bring down your position size in order to ensure that if the trades do go bad, the losses would be limited.
Combining these five elements of trading will elevate your trading to higher profits with less risk.