Everything should be made as simple as possible, but not simpler. ~ Albert Einstein
For nearly two decades of trading, I’ve come to realize that the above quote from the great Albert Einstein is so true in life and in particular in trading. Simple is best, to strip away everything as much as you can, but by trying to keep things simple, we don’t accidently take away some important aspects of trading which without, success is just that much harder.
The following five aspects of trading are what I believe are the foundations of all trading success. Take out any one, and the likelihood of you succeeding long term is remote.
Combine all five, and your trading success is almost guaranteed.
- Trading Psychology, Mindset and Personality
My main mentor on the work of trading psychology has come from two people, Mark Douglas, made famous from Trading in the Zone and Dr Van Tharpe, of Trade Your Way to Financial Freedom’. I like to give credit where credit is due and these two have been pivotal in helping me develop the trading mindset I have today. Having spent 2 whole weeks many years ago and fortunate enough to become friends with Dr Tharp while in New Zealand with him has made me appreciate how much trading psychology had to do with my ultimate trading success.
Many numbers have been thrown around in regards to the importance of psychology to trading success. For example Dr Tharp believes that up to 90% is psychology and the rest systems.
Then there are others who totally disagree and only put psychology down to 10%. For me, the exact percentages really can’t be proven but just understand that it is a very significant part.
Another aspect of psychology is your personality, and you need to fit your personality to your trading style. This I believe is the main reason why over 90% of traders fail.
They attend weekend seminars, armed with trading techniques and styles of a particular guru and aim to replicate their trading to their ‘guru’, but after about 90 days, have lost over 90% of their entire account. Why?
Simply because the way their ‘guru’ traded didn’t suite their personality and style. For some, it exactly matched and hence they took off from day one while the majority suffered.
You are not alone. I went through the same phase when I began all those years ago.
At first I tried so desperately to emulate my hero Warren Buffett with his value investing approach, trying to be Warren Buffett. That itself is a joke. I’m sure others try to emulate him as well so I am really not alone. What they, including me fail to realize is that we are not Warren Buffett.
I, for example could in no way understand the dynamics of a company inside out, including every competitor out there and their numbers because I am don’t go to the level of work and depth Warren does. Not just through financial reports but going through industry journals and publications, having access to industry experts and then combining all that information into a framework. I actually have no interest in that and although I tried and tried, it was an effort and I began not to enjoy investing because of emulation.
I also tried day trading. For those who aren’t familiar with day trading, it is simply being in front of the trading screen all day, buying and selling securities like stocks, options, forex and closing out all positions by the end of the day.
That also was not me because I didn’t have the eye and hand speed and I didn’t particularly enjoy being in front of the screen all day long. I longed freedom and I knew day trading could never fulfill that goal.
- Risk Management
Here I talk about portfolio risk management, how to manage risk so that no position could ever make you or could ever break you.
The majority of traders risk far too much on ideas and potentially leverage their accounts that can have disastrous effects.
What every trader needs to do is look at their portfolio as a whole and not just focus on an individual position and deciding to place far too much risk on that idea.
- Position Sizing
Portfolio risk invariably leads to position sizing risk.
Numbers such as the 2% and 6% rule made famous by Dr Alexander Elder, which I also learned from, I believe is still too high.
For very small accounts say less than $10,000, it is probably ok due to high brokerage costs buying and selling positions less than that but at 2%. But if you were to get say 4-5 in a row wrong which by the way does happen and recently has for me, you would have lost over 10% of your account which means you now need to make that up just to be back to where you were previously.
Personally I for most risk between 0.1% to 1.25%, depending on market risk, which I will speak about later. So far less than 2% on even my best ideas at any point in time.
I’ve been told that this is far too little because then you also make very little. What they forget is that opportunities do come in abundance when the time comes and it is the combination of a lot of these type of great trades which go right, add up to significant market beating returns without ever the risk of a disastrous outcome on any particular idea.
- Trading Systems
Psychology and mindset and even risk management amounts to nothing if you have either taken onboard or developed your own trading system which as a negative expectancy.
What do I mean by that?
It simply means that over a large number of trades in all market conditions, your system is a money loser, even if you perfect the execution of every trade.
Positive thinking, personality match, and portfolio management all help, but only help to lose money much more slowly unless your trading system has a positive edge or positive expectancy over a large number of trades.
So find or develop a trading system with a positive edge which fits your personality I spoke about earlier.
- The Market
Finally, most traders have a myopic view of just the trade without accessing where the market environment is at and if they should be participating.
A rising tide lifts all boats is a common saying and it is very true to trading. Swimming hard against the current gets you nowhere, because you are trying to eke out tiny returns for large amounts of risk you take.
Sometimes it is just better to stand aside and not trade at all for a period until the markets become a safer environment for your trading system to operate well in.
For example, if during the GFC, you trade long and at the same position size as if the markets are safe, was simply a bad idea. What would have been better would be to either totally stand aside, or in high markets risks to dramatically reduce your position size so when a high probability of the trades go wrong do, the trade losses do not add to much.
By combining these five key elements of trading will take your trading to a level of professional hedge fund investing.
This is how I operate everyday and hope to inspire you to do the same.
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