Avoiding the Risk of Ruin from a Draw Down

Having a sound money management strategy is very important in order to avoid the risk of ruin from losing streaks and drawdowns.

However, please bear in mind that although you might have implemented strict money management rules, you still cannot avoid drawdown at all. Drawdowns are inevitable.

Therefore, you need to know how to stop the drawdowns, so as to avoid the risk of ruin and allow you to survive a period of losing streaks and drawdowns.

However, the good news is, to stop a drawdown is simple. All you need to do is just stop trading. That’s it!

But, what’s next? What can you do when you stop trading?

You can still continue to monitor the markets, your favourite stocks and indicators.

By not being in the markets, you will be able to sit back and analyze the situation without the emotions.

 Here are some of the things that you can do while you stop trading:

 

1) Make sure that you fully recognize and understand all of the reasons that caused your drawdown.

There are 2 possible reasons:

a) Yourself

When you experienced a drawdown, you should always look within yourself first and review your recent trades or trading journal, to ensure that nothing has recently changed.

Ask yourself questions, such as:

* Have you been following your trading system/rules and manage risks properly? Did you break or modify any of the rules knowingly or unknowingly? Did you “force” any trade?

* Any changes in your trading styles recently?

* Is there any major life event that affects you, physically or psychologically?

* Any distractions that hinder you from focusing?

 b) Market Conditions

Market condition may affect the performance of your trading style/methodology.

Sometimes, there are some market conditions that are more favorable to your style/methodology and give you a better chance to be profitable, or vice versa.

But when the market changes, it becomes more difficult for you to trade in an unfamiliar conditions.

When that happens, you may need learn and understand the market condition better and be extra careful / selective in your trading in the sector or stock selection, market timing, etc. Sometimes, it is even wiser to stand in the sideline and watch the market, rather than jumping in an unfamiliar market condition.

 2) Once you have identified the causes of your drawdown and made some plans / strategies / rules to tackle the problems, you can start again by doing paper trading to test it. Remember to keep records for every single trade you made in paper trading.

Note:

You can find some useful tips for paper trading from the earlier article: 5 Tips For A More Effective Virtual / Paper Trading

3) When you’re consistently profitable in paper trading for some time, you can then slowly start with real trades again to engage your emotion into the trading. Start with small trades first. When the trade is profitable, you can gradually and slowly increase your position size.

If you encounter losses again, then scale back in your trading, or go back to paper trading, if necessary.

 

4) Repeat the above steps until your trading performance improves.

Remember to always keep records for every single trade, including the notes about market conditions. Learn from the past experiences, so that you can avoid the same mistakes and would be better equipped to tackle the future drawdowns.

To view the list of all the series on this topic, please refer to: Money Management / Position Sizing 

Related Topics: 

* Understanding Implied Volatility (IV) 

* Understanding Option Greek 

* Understanding Option’s Time Value 

* Learning Candlestick Charts 

* Options Trading Basic – Part 1 

* Options Trading Basic – Part 2

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Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

In setting money management/position sizing rules, you should also consider:

1) How long your capital can last, or

2) How long your account balance will drop to the risk tolerance you’re willing to take after going through a series of successive losing steaks.

The answers to these questions will depend on:

* The initial capital/account balance

* How much to risk per trade

* The percentage risk tolerance (for Qtn 2)

 

Suppose your initial capital is $10,000.

If you money management rule is that you would risk maximum 5% of the initial capital (i.e. 5% x $10,000 = $500) in each trade, your capital will be all wiped out after 20 successive losing trades.

Suppose your risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), your balance will reach this level after 5 losing trades in a row.

Notice that the above rule is different from what has been discussed as Option 2 in the previous article.

In the Option 2, the maximum risk in each trade is 5% of the remaining account balance.

Hence, with the initial capital of $10,000, after losing 5% (i.e. 5% x $10,000 = $500) in the 1^st trade, the balance will be $9,500. Then, the 2^nd trade will risk 5% of the remaining balance (i.e. 5% x $9,500 = $475), the balance will be $9,025, and so on.

Using this rule, to answer the above questions is not that straightforward. However, this rule is more common to be used by traders.

Hence, let’s try to formulate it.

Trade 1:  $10,000 x (1 – 5%) = $9,500

Trade 2: $10,000 x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^2 = $9,025

Trade 3: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^3 = $8,573.75

Trade n: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) x …… = $10,000 x (1 – 5%)^n

Putting in a formula form:

Where:

C = Initial capital (Initial account balance)

R = % Risk for each trade

n = Number of trades

B = Remaining capital/account balance

To answer the above two questions, we need to solve n, which can be done through the basic principles of logarithm, as follows:

Please note that, to answer Qtn 1, we CANNOT set the remaining account balance as zero, as logarithm function will never touch zero line. Hence, we should assume a certain amount, which is small enough and can be deemed as “no more money for trading”.

For example:

Assume we deem $100 as small enough to approach a situation of “no more money for trading”.

Continue with the above case, the values of each variable are:

C = $10,000

R = 5%

B = $100

To find how long the capital can last, we solve n:

Note: Always round down the result.

Likewise, to answer Qtn 2 where the risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), the values of each variable will be:

C = $10,000

R = 5%

B = $10,000 - $2,500 = $7,500

Solving n:

Alternatively, we can also use another method to answer the questions, which is using Tabulation, as what has been done in the previous article:

Using this way, after inputting the formula in MS Excel accordingly, we just need to “drag the row” to copy the formula until we reach the desired account balance.

From the above table, the answer for Qtn 1 is highlighted in yellow, whereas the answer for Qtn 2 is in green.

For reference, the following are the formula used for both methods:

Go back to: Things To Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

To view the list of all the series on this topic, please refer to: Money Management / Position Sizing

Related Topics: 

 * Understanding Implied Volatility (IV) 

 * Understanding Option Greek 

 * Understanding Option’s Time Value 

 * Learning Candlestick Charts 

 * Options Trading Basic – Part 1 

 * Options Trading Basic – Part 2

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Things to Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

In setting a suitable money management, you should also consider the maximum drawdown you are willing to accept, which depend on your risk tolerance.
In this case, do take into account the reasonable percent return required to recover to breakeven when you experience a certain percent of losses (drawdown), as discussed in the previous post.
Then, set money management rules based on your risk tolerance (expressed in terms of percentage of the total account/capital).

Just a simple example:
If you are willing to suffer from losses of maximum of 25% of your total capital, this means your risk tolerance is minus 25%. In this case, you should set money management rules and/or choose trading strategy that has a maximum drawdown statistics of 25% or less.

Consider two options of the following money management rules:
Option 1: Maximum of 2% risk (of the remaining account balance) in each trade
Option 2: Maximum of 5% risk (of the remaining account balance) in each trade

As can be seen from the above table, using Option 1 (max 2% risk for each trade), your account will drop to a level that is close to your risk tolerance of maximum 25% drawdown only after 14 consecutive losing trades.
In contrast, using Option 2 (max 5% risk for each trade), your account will even exceed that level only after 6 losing trades in a row.

Looking at another perspective, Option 1 will suffer 26.1% loss in the case of 15 consecutive losing trades, which would require 35.4% gain in order to be back to breakeven.
On the other hand, with the same scenario of 15 successive losing trades, Option 2 suffers 53.7% drawdown and will need 115.8% gain, which is much harder to achieve, to be breakeven. Although losing 15 times in a row is quite an extreme case, in reality it is still possible to happen.

Remember that although you might have implemented strict money management rules, losing streaks and drawdowns are inevitable.
Hence, you should set a sound money management strategy that aims to avoid risk of ruin at all cost, can survive a period of losing streaks, and also still reasonable to rebound to at least break even.

Continue to: Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

Go back to: Things To Consider in Setting Money Management Rules - Part 1: DRAW DOWN

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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Things to Consider in Setting Money Management Rules – Part 1: DRAW DOWN

One important part of money management/position sizing is the ability of a trader/investor to avoid large draw downs or limit the draw downs to a certain percentage of the trading capital/portfolio.
If the traders/investors always take high risk in their trades, they are more likely to experience disastrous drawdown. Therefore, the way to avoid it is by limiting the size of what you are prepared to lose / risk in any single trade to a certain percentage of your total trading capital/portfolio (i.e. proper position sizing).

A draw down is defined as a reduction in the account/portfolio from its highest point resulted from a losing trade or series of losing trades during a certain period.
A draw down is measured in terms of a percentage between a recent peak to a recent trough of the account/portfolio.
If all your trades were profitable, you will never experience a drawdown. The calculation of draw down would begin only with a losing trade, and continue so long as the account hits new lows.

With regards to drawdown, it is important to understand that the percentage return that you need to make in order to get back to breakeven is bigger than the percentage of losses you experienced.
So, if you lose 10%, you cannot gain back to breakeven by getting 10% return in the next trade, but it would be more than 10%.
For example:
Suppose your initial capital is $1000. If you lose 10% ($100), the remaining capital will be $900. If in the next trade you make 10%, your capital will only reach $990, still losing $10 (or 1% loss from the initial capital). In order to recover to breakeven, you will need to make $100/$900 = 11.1% in your next trade.

The following table shows the percent return required to recover to breakeven when you experience a certain percent of losses (drawdown).

From the table, we can see that as drawdown increases, the percent gain required to recover / get back to breakeven increases in a much faster rate.
For instance, when you lose 20%, you would need to make 25% return on the remaining capital to get back to breakeven. However, if you lose 40%, you have to gain 66.7% to breakeven.
Further, a 50% drawdown would require a 100% return, and drawdowns above 50% require huge returns in order to recover to breakeven.

From here you can see that the more you lose, the more difficult for you to make it back to your original account size. When you risk too much and lose, your chances to recover your capital fully would be very slim. It is not only because you are merely left with much less money in your account, but also you have to deal with the negative psychological impacts of the drawdowns.

Therefore, it is extremely important that you have good money management rules, so that when you experience losing streaks and suffer from drawdowns, you will still have enough money to stay in the game.
With a proper money management, you should only risk a small percentage of your account in each trade, so that you can survive your losing streaks and also avoid a disastrous drawdown in your account.

Continue to: Things To Consider in Setting Money Management Rules - Part 2: RISK TOLERANCE

Go back to: The Importance of Money Management / Position Sizing

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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The IMPORTANCE of Money Management / Position Sizing

The main reason why money management / position sizing is extremely important is capital preservation ….. to avoid the risk of ruin from a losing streak.
So long as you have the money / capital to trade, you would still have a chance to recover your losses. However, if your capital is gone, you would have no chance at all to recover, as you have no more money for trading.

You may have a high probability trading system that gives you 70% probability of winning. But without sound money management system, you might still get wiped out of the game after unfortunate losing streaks.
A 70% win in 100 trades does not necessarily mean you would win 7 out of every 10. You will not know which 70 out of the 100 trades will be the winners. It is possible that you lose the first 30 trades consecutively and then win the remaining 70, which still gives you a 70% winning system. However, when that happens, will you be still in the game if you lost 30 trades in a row?

This is the reason why money management is very important. No matter how good your trading system is, you could still be facing a losing streak. Hence, you need to set a sound money management system, which will still allow you to stay in the game even if you go through a horrible losing streak.

In view of the above, there are at least a few basic things that you should consider when setting Money Management rules:
1) Draw downs.
2) Considering your Risk Tolerance.
3) How long your capital can last.

In the next posts, we’ll discuss the above topics further.

Continue to: Things To Consider in Setting Money Management Rules - Part 1: DRAW DOWN.

Go back to: OBJECTIVES of Money Management or Position Sizing.

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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Money Management or Position Sizing – Part 2: OBJECTIVES

Basically, there are two main objectives of Money Management or Position Sizing:

1) Preserve Capital
Preserving your capital should be the first and the most important objective of Money Management / Position Sizing for a trader.
In order to be able to trade, you’ll need capital. As long as you have the money / capital to trade, you would still have a chance to make a recovery from your losses. However, if your capital is gone, you would have no chance at all to recover, as you have no more money for trading.

In order to be successful in trading, it's not about making the big wins on every single trade, but rather, how to minimize the losses in order to live another day to trade.
For example, you may have a very good month and make 200-300% on every trade. Each time, you are putting 70% - 80% of your total capital/account balance into each trade. However, it is possible that all your gains, or perhaps even your whole capital, get wiped out by just one losing trade. That is why proper money management is extremely important!

No doubt, losses are always part of trading. However, if you are only risking a small percentage of your account in one trade, then that is the most you can lose on any one trade.
Therefore, Money Management / Position Sizing can also be considered as “Risk Management”, because it’s basically also about managing your risk for every trade by limiting how much you put into each trade, so that you won’t get wiped out so easily just after a few trades.

Why do we need that? Doesn’t putting a Stop Loss serve the same purpose of limiting our risk in a trade as well?
Yes, putting a Stop Loss can protect your trade. Nevertheless, there is always a risk that a position may go bust even before your stop loss can be executed.
For example:
A stock can significantly gap down at the market opening due to sudden negative news (e.g. lower than expected earnings, fraud / lawsuit cases, etc.). When this happens, the price may go down way below the Stop Price.

As Dr Alexander Elder suggested in his book, Come Into My Trading Room:

Technical analysis helps you decide where to place a stop, limiting your loss per share.
Money management rules help you protect your account as a whole.
The single most important rule is to limit your loss on any trade to a small fraction of your account.

2) Grow Capital
Other than just preserving your capital, Money Management / Position Sizing has another objective: to grow your capital at a steady pace.

With Position Sizing, you can improve your gains during winning streaks, while you can limit your losses during losing streaks.
How this can be done will be discussed further in the future articles.

Basically, the Position Sizing seeks to balance between the two objectives: preserving vs. growing your capital.
If you risk too little per trade, you win little, and hence it will take much longer time to grow your account. If you risk too much, it will put your account into danger. Ideally, it should be somewhere in between.

Continue to: The IMPORTANCE of Money Management or Position Sizing.

Go back to: WHAT is Money Management or Position Sizing?

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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Money Management or Position Sizing – Part 1: WHAT IS IT?

As frequently mentioned earlier, Money Management is one of are the most important aspects of a trading system, along with positive expectancy and self management (trading psychology), which many professionals even believe that these aspects are the “holy grails” of trading.

While Money Management is extremely crucial, it is important to note that having a trading system that gives you a positive expectancy should be in the top priority when you are developing a trading plan. Because if your trading system has a negative expectancy, no matter how well your money management strategy is, you’ll still lose money in the long term.

This is like what Alexander Elder said in his book, Come Into My Trading Room:

A good trading system gives you an edge in the market.
To use a technical term, it provides a positive expectation over a long series of trials.
A good system ensures that winning is more likely than losing over a long series of trades.
If your system can do that, you need money management.
But if you have no positive expectation, no amount of money management will save you from losing.

What is Money Management?
In his book “Trade Your Way to Financial Freedom”, Dr. Van K. Tharp define “Money Management” as the part of your trading system that answer the question of “how much?” throughout the course of a trade.
How much essentially means how big a position you should have at any given time throughout the course of a trade.
Therefore, he refers to Money Management as “Position Sizing”.



The purpose of Position Sizing is to limit the size of what you are prepared to lose / risk in any single trade to a percentage of your total trading capital.

Some people may also call this as “Bet Size”.
Hence, Money Management, Position Sizing, and Bet Size are basically referring to the same thing, which is to answer “how much” in your trading system, as discussed in this post: Trading System: What Is It and Is It Important?

To be continued to: OBJECTIVES of Money Management or Position Sizing.

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

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GARTMAN’S RULES OF TRADING – Part 2: Trading System & Money Management

Go back to Part 1: Trading Psychology

TRADING SYSTEM & MONEY MANAGEMENT

7. Never, under any circumstance add to a losing position.... ever!
Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

8. Trade like a mercenary guerrilla.
We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

9. The objective is not to buy low and sell high, but to buy high and to sell higher.
We can never know what price is "low." Nor can we know what price is "high."
Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

10. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral.
That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

11. Sell markets that show the greatest weakness, and buy those that show the greatest strength.
Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily.
In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

12. Do more of that which is working and less of that which is not.
If a market is strong, buy more; if a market is weak, sell more.
New highs are to be bought; new lows sold.

13. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly.
In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

14. Be patient with winning trades; be enormously impatient with losing trades.
Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

15. To trade successfully, think like a fundamentalist; trade like a technician.
It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

To be continued to Part 3: Technical Trading System

Related Articles:
* FREE Trading Educational Resources You Should Not Miss
* Trading System: What Is It and Is It Important?
* Why Being Right In Your Trading Does Not Necessarily Mean Making Money
* The Psychological Need To Be Right vs. Making Money
* The Fear Of Losing Money

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Some Trading Wise Words

I found quite a number of good trading quotes from Trading & Motivational Quotes blog.
I think this blog tries to compile the words of wisdom or trading principles from many sources or books.
You can check it out on you own for the whole collections.

Here are some of the quotes from that site that I really like and I hope it can be useful for my readers:

Turtle Trading Principle
Trade with an edge, manage risk, be consistent, and keep it simple.
The entire Turtle training, and indeed the basis of all successful trading, can be summed up in these four core principles.

Curtis Faith, Way Of Turtle

Why Chart Patterns Repeat Themselves
All through time, people have basically acted and re-acted the same way in the market as a result of: greed, fear, ignorance, and hope.
That is why the numerical formations and patterns recur on a constant basis.

Jesse Livermore, How To Trade In Stocks

Stick To Your Trading Rules
Successful trading is about finding the rules that work and then sticking to those rules.

William J. O’neil

Perfect Speculator
Perfect speculator must know when to get in;
More important he must know when to stay out;
And most important he must know when to get out once he’s in.

Source: Trend Following: How Great Traders Make Millions in Up or Down Markets

Emotional Makeup Is More Important
I haven't seen much correlation between good trading and intelligence. Some outstanding traders are quite intelligent, but a few aren't. Many outstanding intelligent people are horrible traders. Average intelligence is enough. Beyond that, emotional makeup is more important.

William Eckhardt

Emotional Discipline: The Key To Trading Success
The key to trading success is emotional discipline. If intelligence were the key, there would be a lot more people making money trading.

Victor Sperandeo

Human Emotion In Trading
Human emotion is both the source of opportunity in trading and the greatest challenge.
Master it and you will succeed.
Ignore it at your peril.

Curtis Faith, Way Of Turtle

What We Can Learn For Trading From A Fable
A monkey was carrying two handfuls of peas. One little pea dropped out. He tried to pick it up and spilt twenty. He tried to pick up the twenty and spilt them all. Then he lost his temper, scattered the peas in all directions and ran away.

Fables, Leo Tolstoy

Read More

Follow Your Trading System

Previously, we have discussed the important components of a trading system.

When you have built or found a trading system that suits you, it is recommended that you test the trading system through paper / virtual trading before you trade it using real money.

Once you’ve had a proven & tested, profitable trading system, you yourself & your discipline will be the key determinant whether the system will be a success and a failure. Successful traders are those who are psychologically prepared and have the discipline to stick with their system through good times and bad times. You can never reach your goal as a trader if you can’t maintain the self-discipline to trust and stick to the rules you’ve chosen.
Follow the rules of your system, no matter what your emotions are telling you.

Mark Douglas, the author of The Disciplined Trader: Developing Winning Attitudes suggested:

As a trader it is more important to know that you will always follow your rules than it is to make money, because whatever money you make, you will inevitably lose back to the markets if you can't follow your rules.

Dr. Alexander Elder in his book, Come Into My Trading Room: A Complete Guide to Trading, also suggested likewise, as discussed in this post.

However, there is a caveat to this concept. You need to have a proven & tested trading system with a positive expectancy (average gains higher than average losses) which will produce a positive expected return over the long term.
If your system has a negative expectancy (not profitable over the long term), then sticking to your system would only lead you to your ruin. That’s why it’s also important to always monitor your trading performance over time. That’s where trading journal plays an essential role.
Sticking to your system doesn’t mean you cannot refine it.
As what Trader X suggested:

Don’t jump from strategy to strategy, timeframe to timeframe - pick something and stick with it! That does not mean you cannot refine it - you SHOULD constantly refine and improve what you do. But that is different from changing things completely.

Related Posts:
* Why Trading Psychology Is Very Important
* Why Being Right In Your Trading Does Not Necessarily Mean Making Money
* The Psychological Need To Be Right vs. Making Money
* The Fear Of Losing Money

You might also be interested in the following topics:
* Learning Candlestick Charts
* Learning Charts Patterns
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

Read More

Book Review: Come Into My Trading Room by Dr. Alexander Elder

One of the books that I read when I began learning trading is: Come Into My Trading Room: A Complete Guide to Trading, authored by Dr. Alexander Elder.

In my opinion, this is one of the best books for beginners, as it provides a comprehensive introduction to trading essentials as a solid foundation to build upon.

In this book, Dr. Elder shares three important pillars of trading: Mind, Method, and Money (3M).

The first M, Mind, refers to your trading psychology. Here he stresses the importance of discipline in trading,
In order not to let emotions (fear and greed) to lead you astray, you must instill discipline to stick to your own trading system and follow your trading plan prepared beforehand. Dr. Elder explains how to develop discipline in trading and avoid the traps caused by emotional trading, and also the importance of trading diary.

Discipline means designing, testing, and following your trading system.

It means learning to enter and exit in response to predefined signals rather than jumping in and out on a whim.

It means doing the right thing, not the easy thing.

And the first challenge down the road to disciplined trading involves setting up a record-keeping system.

The second M, Method, discusses how you about finding the trades and making entry and exit decisions. Basically, in order to achieve long term success, you have to develop a good system that gives you an edge over the market, and you must trade consistently based on your system.
In this section, Dr Elder covers technical analysis and trading indicators, and how to use and combine them to develop your own trading system.
He also shows using various examples on how to identify good trades and determine entries and exits (i.e. stops & targets).

The third M, Money, refers to how you manage your trading capital for long-term survival and success (i.e. money management).
Here Dr. Elder explains the importance of money management. Basically, a successful trader always manages his risks properly.
He then lays down the rules / formula of a good money management and provides the detail steps of proper money management.


Good quotes from the book with regards to how important the 3M is for trading success:

Every winner needs three essential components of trading: a sound individual psychology, a logical trading system and a good money management.

These essentials are three legs of a stool – remove one and the stool will fall together with the person who sits on it.

Losers try to build a stool with only one leg, or two at the most. They usually focus exclusively on trading systems.

Your trade must be based on clearly defined rules.
You have to analyze your feelings as you trade, to make sure that your decisions are intellectually sound.
You have to structure your money management so that no string of losses can kick you out of the game.

In addition, Dr Alexander Elder also provides some ideas on how to how to set up a good trading diary. Trading diary is very important from a trader. Because by having a good trading diary, you can learn from your own trades & experiences, both good & bad.

At the end of his book, Dr Elder discloses his own trading diary, which shows the details of some of his real trades (charts & indicators, trading signals, entry, stop, target, exits, etc.).

The bottom line is that, I HIGHLY recommend all beginners to read this book.
As I said earlier, this book can equip you with a complete introduction to trading essentials, which would serve as a solid foundation to build upon.

In case you’re interested, for your info, another popular & excellent book from Dr Alexander Elder is Trading for a Living: Psychology, Trading Tactics, Money Management

Related Post:
* Why Trading Psychology Is Very Important
* Book Review: When The Market Moves, Will You Be Ready?

You might be interested in the following topics:
* Learning Candlestick Charts
* Learning Charts Patterns
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks

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The Best Trading System For You

In previous post, we discussed the components & the importance of a trading system.

There are many trading systems / strategies around. No trading system is right for everybody. Often we heard that one trading system is working very well for some people. They can trade for a living with that, and even have made them millions. However, it is also very possible that the very same system can lead others to lose money. Why? Because although people learn exactly the same system even in every component of it, there is always one component that is different – the trader itself, with his personality & emotions.

So, now the question is: Which trading system / strategy is the best for you? The answer is it’s the trading system that best suits you! The one that you’re most comfortable with.

I remember an interview with Trader X by Stocktickr quite some time ago. Here is a part of the interview:

StockTickr: What single lesson did you learn along the way that helped you the most in your trading?
Trader-X: I learned to pick a style of trading and stick to it. I think most traders and prospective traders get lost by jumping from strategy to strategy and timeframe to timeframe. If something does not work one day, they are looking for something completely new. Pretty soon they have burned through a few dozen strategies (or different ways to trade) and have not made any money.
So I learned to pick a style of trading (or strategy) and stick to it. And I am always studying, learning, and refining it. …..

StockTickr: What advice can you offer traders who are just starting out?
Trader-X:
* Don’t jump from strategy to strategy, timeframe to timeframe - pick something and stick with it! That does not mean you cannot refine it - you SHOULD constantly refine and improve what you do. But that is different from changing things completely.
* Don’t try to copy someone - even me! Read, study, and learn. And then apply it to your trading. Tweak it, and make it your own.

Dr. Van K. Tharp in his book Trade Your Way to Financial Freedom also mentioned that the search for the Holy Grail is actually an “internal search”.

If you don’t know who you are, the stock market is an expensive place to find out.
- George Goodman

So, in order to find the best trading system for you, it’s crucial to know yourself first. Do take inventory of yourself: your objectives, personality, strengths, weaknesses, limits, emotions, risk appetite & tolerance, etc. Then pick a trading system / strategy that best fits you. Adjust the system and make it yourself. Stick to it and from there, always refine and improve your system along the way.

Don’t forget that the most important aspects of your trading system are positive expectancy (average gains higher than average losses), position sizing (money management), risk management, and self management (yourself, your psychology, fear & greed, emotions, discipline, etc.). Work harder on that. Yes, the key is HARD WORK & DETERMINATION. With hard work and determination, you could create the best trading system, the holy grails for yourself.

Related Posts:
* Why Being Right In Your Trading Does Not Necessarily Mean Making Money
* The Psychological Need To Be Right vs. Making Money
* The Real Purpose Of Trading

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Trading System: What Is It and Is It Important?

What Is Trading System?
A trading system is a systematic system or a set of rules which should be able to answer the following questions:

a) What stock to enter.
b) When to enter (Entry strategy).
c) How much to enter per position (This is called position sizing, or money management, or bet size).
This is meant to limit the size of what you are prepared to lose / risk in any single trade to a percentage of your total trading capital (risk management). If you risk too little per trade, you win little, and hence it will take much longer time to grow your account. If you risk too much, it will put your account into danger. Ideally, it should be somewhere in between.
d) When to exit (Exit strategy).
Many people emphasize too much on the entry, but have no idea when to exit. Actually, you should pay more attention to exit strategy than to entry strategy. Exit strategy is far more important than Entry strategy.
There are 2 types of exits you need think about:
* When to exit on your losing position (i.e. Where to put your initial stop loss).
* When to exit on your profitable position (i.e. When to take your profit).

Is It Important To Have A Trading System?
Although, as Chris Perruna suggested, trading system is not the holy grail of trading, it does not mean you don’t need to have a trading system at all.
Trading system is still important and necessary, as it can guide traders to be more consistent in how they are trading as well as help keep emotions away from trading.
But rather, what it means is that there is no one trading system as the only winning system. You can make money by trading any systems. What’s more important in a trading system is that it must have a positive expectancy (average gains higher than average losses) and good money management (position sizing) / risk management. These are the most crucial aspects of your trading system, which many professionals believe as the holy grails of trading.

Related Posts:
* Why Being Right In Your Trading Does Not Necessarily Mean Making Money
* The Psychological Need To Be Right vs. Making Money
* The Real Purpose Of Trading
* Why Trading Psychology Is Very Important
* The Fear Of Losing Money

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The Psychological Need To Be Right vs. Making Money

In my previous post, I picked one simple example from the book Trade Your Way to Financial Freedom by Dr. Van K. Tharp to illustrate that being right does not necessarily mean making money.

Yes, in trading, you can be right most of the time, yet still lose money in the end. On the other hand, you can be wrong most of the time, but still making money over the long run. It depends on “how much” you gain when you’re right & how much you lose when you’re wrong, more than on the “how often” you’re right or wrong.

Basically, “being right” is represented by frequent / majority small gains but with occasional large losses, which results in a losing money overall in the long run.
In contrast, “making money” corresponds to frequent / majority small losses but with occasional large gains, that causes the trader to make money overall in the long run.

Dr. Brett Steenbarger showed that many people prefer “to be right” in the short run to “making money” over the long run. The psychological need “to be right” (frequent wins) inhibits traders to let the profits run or to accept losses.
As he suggested, “the desire for frequent wins causes traders to take profits quickly; the aversion to losing leads to holding losers in hopes of converting them to winners.”

Yes, it’s not easy to overcome the psychological need to be right. Even if one does know that he has a trading system with positive expectancy, which will make money in the long run if he’s consistent, it may not be easy to accept when consecutive, frequent small losses happen in the row. His pride & self-esteem may be hurt. He may also lose his confidence of himself or the system. All this could negatively affect his subsequent trading performance.

This is another good example why trading psychology is important. Professionals even say it’s the most critical aspect of trading success. It’s not the trading system / strategy, market indicators, fundamental / technical analysis, or your outstanding market knowledge that will bring you success in trading. It’s you yourself that matters the most for your trading success.

Related Posts:
* The Real Purpose Of Trading
* The Fear Of Losing Money

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Why Being Right In Your Trading Does Not Necessarily Mean Making Money

I like the discussion in Corey’s Afraid To Trade blog some time ago on the topic of “Should I trade to be right or should I trade to make money?”

"Being right" does not necessarily mean "making money". In that post, Corey also gives some examples why it is so. But what interests me more is the discussion in the comments of that post, in conjunction with the post from Chris Perruna on “Position Sizing and Expectancy”.

The discussion in that post has triggered me to refer back to one of the favorite books of mine, which is also a popular book among many traders: Trade Your Way to Financial Freedom, by Dr. Van K. Tharp. A “must read” book if you want to create or improve your trading system.

And in that book, I found the following sentences with regards to “being right” that I’d like to quote here:

“There is a strong psychological bias to be right about we do with our investment. In most people, this bias greatly oversides the desire to make a profit overall in our approach, or it inhibits us from reaching our true profit potential. Most people have overwhelming needs to control the market. As a result, they end up with the market controlling them.”

To illustrate that being right does not necessarily mean making money, the book shows one simple & extreme example:
Say, there is a system with 90% winning trades (i.e. you get it right) with the average winning trade of $275, and 10% losing trade (i.e. you get it wrong) with the average losing trade of $2700.
Can you make money with such system that is 90% accurate, and only 10% of time you’ll be wrong?
Let’s count the Expectancy of this system:

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)
Expectancy = (0.9 * 275) – (0.1 *2700) = -22.5

The expectancy is negative. This example shows us how a system which can get you to be right most of time (90% of the time) may eventually lead you to lose money trading it.

A quote from one article in turtletrader.com summarizes this very nicely:

The irrelevance of winning percentage is nicely summed up by another legend named George (Soros): it doesn't matter how often you are right or wrong - it only matters how much you make when you are right, versus how much you lose when you are wrong.

Corey himself has recently written a great article about “Frequency vs Magnitude in the markets & in life”, as highlighted in my post "Links Of Reflections".

Therefore, what is more important in a profitable trading system is not the frequency of “being right” (which is normally linked to entry & exit strategy), but whether the system has a positive expectancy and how many opportunities (i.e. number of trades) the system presents, as well as how much to trade on each position (i.e. position sizing / money management), as discussed by Chris Perruna in the abovementioned article.

Entry & exit are important, but they are actually only small parts of the trading system. Hence, we shouldn’t focus too much on entry & exit strategies only, but rather should concentrate more on risk management (i.e. how much to risk per trade), money management / position sizing (i.e. how much to trade or how many shares / contracts per position) and positive expectancy (i.e. average gains higher than average losses).
And many professionals say that those are actually the holy grails of trading.

Related Posts:
* The Psychological Need To Be Right vs. Making Money
* The Real Purpose Of Trading
* Why Trading Psychology Is Very Important
* The Fear Of Losing Money

Read More