John Murphy's ten laws of technical trading explain the main ideas to beginners and streamline the trading methodology for experienced practitioners. The precepts define the key tools of technical analysis and show how to use them to identify buying and selling opportunities.
1. Map the trends
Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale 'map of the market' provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer term trends.
2. Determine the trend and follow it
Market trends come in many sizes - long-term, intermediate-term and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term trend for timing.
3. Find the low and high of it
The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words the old 'high' becomes the new 'low'. In the same way, when a support level has been broken it will usually produce selling on subsequent rallies - the old 'low'becomes the new 'high'.
4. Know how far to backtrack
Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum is usually two-thirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.
5. Draw the line
Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes.
6. Follow that average
Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if existing trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4 and 9 day moving averages, 9 and 18 day, 5 and 20 day. Signals are given when the shorter average crosses the longer. Price crossings above and below a 40 day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market.
7. Learn the turns
Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for stochastics are 80 and 20. Most traders use 14 days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. Those tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used for intra-day charts.
8. Know the warning signs
Trace MACD. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel) combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. An MACD histogram plots the difference between the two lines and gives even earlier warnings of trend changes. It's called a histogram because vertical bars are used to show the difference between the two lines on the chart.
9. Trend or not a trend?
Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX line favors oscillators. By plotting the direction of the ADX line, one is able to determine which trading style and which set of indicators are most suitable for the current market environment.
10. Know the confirming signs
Include volume and open interest. Volume and open interest are important confirming indicators in futures markets. Volume precedes price. It's important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising open interest confirms that new money is supporting the prevailing trend. Declining open interest is often a warning that the trend is near completion. A solid price uptrend should be accompanied by rising volume and rising open interest.
John Murphy's ten laws of technical trading explain the main ideas to beginners and streamline the trading methodology for experienced practitioners. The precepts define the key tools of technical analysis and show how to use them to identify buying and selling opportunities.
What to buy:
-buy only stocks whose macd is above zero
-buy only blue chip stocks
-buy only when the stock is above the rising 10, 20, 50, 100, & 200 day moving averages
-buy only a stock that has a favorable risk reward ratio
When to buy:
-buy only when the general market is trending up
-buy the stock when it breaks out above a major resistance area
-buy the stock when it crosses above the rising 20 day moving average
-buy after a stock bounces from a correction, when it closes above the highest high of the previous day's close.
-buy after a stock bounces from the 50 day moving average after a correction
What to do after buying:
-place a stop loss
-sell if stop loss is hit
-hold if the stock moves in the upward direction
-sell 15% of position if the stocks moves 5% above your cost, use the profit as buffer if the stocks immediately goes back and hit your stop loss.
-if the stocks continuous to rise after buying, activate your trailing stop. Raise this stop as your stock rises
-Don't ever sell unless your trailing stop is hit
When to sell:
-sell if your stop loss is hit after buying
-sell if your trailing stop is hit
-sell if you see a bearish reversal pattern OR
-OR wait for the candle confirmation the next day if the sell order is to be executed or not
-OR ignore any bearish patterns and let the stock correct and sell only if the trailing stop is hit
If a stock is trending up, it is advisable to hold so as to maximize profits? So if it will corrects, how do you know if it's just a mere pullback or a start of its trends reversal and should sell on a rally ?
So how does one know? There are many techniques to determine it but none can accurately does so with 100% accuracy and precision.
Many books and successful traders will recommend to let your profits run. Others however will suggest to always stick to your targets. The next question could be how to do it? That is, how to make profits run? What are the details to do it? There are many techniques to make this happen. The concepts below will explain some of them.
-First determine the time frame you are using, monthly, weekly, daily or 60 minute time frame if applicable in your market. Remember the definition of a trend, uptrend is when a stock continuous to make higher highs and higher lows (lower highs and lowers lows in a downtrend). As soon as a stock fails to make a higher high or a higher low or both, a trend reversal might be forthcoming and you may want to sell some of your positions or all of them, depending on your trading system. A trend reversal means a stock may go down or go sideways. A technique that some use is scaling in or out in a position in percentages. For example, in scaling in, one may buy a 3rd of the position in anticipation of a breakout, a 3rd on the breakout and a 3rd on the retracement of the stock. You can do the same in selling, sell a 3rd upon reaching your original target (e.g. 20%), a 3rd on the next target and hold the 3rd as long as the trend is not violated. You can make many variations of this technique as to your liking.
-By using the concept of different stages of a stock, determine the stage of your stock whether it is in the accumulation, markup, distribution or decline stage. (basing area, advancing phase, top area, declining phase). Base on its stage, you will have a good idea of how to deal with your stock.
-Using the Elliot Wave techniques can also try to tell you what your stock could possibly behave in the future. Elliot Wave theory shows how many highs and retracements a stock could make in a particular run.
-Fibonacci retracements can also be used as guides to determine the retracements or targets of a stock.
-Trading Chart patterns is also one technique to determine target prices. This is in correlation with the state of general market.
-You can also use the moving averages as guides. For example, if a certain moving average you are using starts to go down or the prices crosses below it, it may be an indication that the stock's trend is starting to reverse.
-Indicators can also help you to try to determine if your stock is starting to reverse. Common indicators are ADX/DMI, MACD, CMF and others can show weaknesses in the stock's trend and a price break of a support or trend line could be your signal that the indicators could be right.
-Determine if a major support is violated. You can determine supports by previous highs (daily and weekly time frame) , moving averages in the daily, weekly or monthly time frames. A break of a major support could signify the start of a downtrend or sideways movement.
-Use a trailing stop. So that you won't worry about giving back too much profit when a stock corrects or starts to reverse its trend. A trailing stop could be designed to allow reasonable corrections so you won't be stopped out early. See the SAR indicator or search about trailing stops. There's a bunch of systems that use this technique from the simple to the complex.
"How do you compute for the correction it should only make, is it from a support of an uptrend line or a certain percentage down from its high?"
-Corrections could be allowed as long as it does not violate the higher highs and higher lows concept of a trend. The corrections can be deep or shallow depending on the behavior of the stock. The scaling out technique can help you preserve profits if you can't give back profits of deep pull backs.
-Use Support/Resistance analysis, Elliot wave and fibonacci techniques to try to determine the range of possible corrections. Try to remember that these techniques are usually tied with money management and trading systems. I don't think they are recommended to be used on their own.
-A break of an uptrend can also be used to sell a position or a portion of a position if that is part of your trading system. A trend line break does not always signify a trend reversal, it could just be a slowing down of a trend.
1.Plan your trades. Trade your plan.
2. Keep records of your trading results.
3. Keep a positive attitude, no matter how much you lose.
4. Don’t take the market home.
5. Continually set higher trading goals.
6. Successful traders buy into bad news and sell into good news.
7. Successful traders are not afraid to buy high and sell low.
8. Successful traders have a well-scheduled planned time for studying the markets.
9. Successful traders isolate themselves from the opinions of others.
10. Continually strive for patience, perseverance, determination, and rational action.
11. Limit your losses – use stops!
12. Never cancel a stop loss order after you have placed it!
13. Place the stop at the time you make your trade.
14. Never get into the market because you are anxious because of waiting.
15. Avoid getting in or out of the market too often.
16. Losses make the trader studious – not profits. Take advantage of every loss to improve your knowledge of market action.
17. The most difficult task in speculation is not prediction but self-control. Successful trading is difficult and frustrating. You are the most important element in the equation for success.
18. Always discipline yourself by following a pre-determined set of rules.
19. Remember that a bear market will give back in one month what a bull market has taken three months to build.
20. Don’t ever allow a big winning trade to turn into a loser. Stop yourself out if the market moves against you 20% from your peak profit point.
21. You must have a program, you must know your program, and you must follow your program.
22. Expect and accept losses gracefully. Those who brood over losses always miss the next opportunity, which more than likely will be profitable.
23. Split your profits right down the middle and never risk more than 50% of them again in the market.
24. The key to successful trading is knowing yourself and your stress point.
25. The difference between winners and losers isn’t so much native ability as it is discipline exercised in avoiding mistakes.
26. In trading as in fencing there are the quick and the dead.
27. Speech may be silver but silence is golden. Traders with the golden touch do not talk about their success.
28. Dream big dreams and think tall. Very few people set goals too high. A man becomes what he thinks about all day long.
29. Accept failure as a step towards victory.
30. Have you taken a loss? Forget it quickly. Have you taken a profit? Forget it even quicker! Don’t let ego and greed inhibit clear thinking and hard work.
31. One cannot do anything about yesterday. When one door closes, another door opens. The greater opportunity always lies through the open door.
32. The deepest secret for the trader is to subordinate his will to the will of the market. The market is truth as it reflects all forces that bear upon it. As long as he recognizes this he is safe. When he ignores this, he is lost and doomed.
33. It’s much easier to put on a trade than to take it off.
34. If a market doesn’t do what you think it should do, get out.
35. Beware of large positions that can control your emotions. Don’t be overly aggressive with the market. Treat it gently by allowing your equity to grow steadily rather than in bursts.
36. Never add to a losing position.
37. Beware of trying to pick tops or bottoms.
38. You must believe in yourself and your judgement if you expect to make a living at this game.
39. In a narrow market there is no sense in trying to anticipate what the next big movement is going to be – up or down.
40. A loss never bothers me after I take it. I forget it overnight. But being wrong and not taking the loss – that is what does the damage to the pocket book and to the soul.
41. Never volunteer advice and never brag of your winnings.
42. Of all speculative blunders, there are few greater than selling what shows a profit and keeping what shows a loss.
43. Standing aside is a position.
44. It is better to be more interested in the market’s reaction to new information than in the piece of news itself.
45. If you don’t know who you are, the markets are an expensive place to find out.
46. In the world of money, which is a world shaped by human behavior, nobody has the foggiest notion of what will happen in the future. Mark that word – Nobody! Thus the successful trader does not base moves on what supposedly will happen but reacts instead to what does happen.
47. Except in unusual circumstances, get in the habit of taking your profit too soon. Don’t torment yourself if a trade continues winning without you. Chances are it won’t continue long. If it does, console yourself by thinking of all the times when liquidating early reserved gains that you would have otherwise lost.
48. When the ship starts to sink, don’t pray – jump!
49. Lose your opinion – not your money.
50. Assimilate into your very bones a set of trading rules that works for you.
Don’t Try to Predict the Future
NO ONE KNOWS WHERE THE MARKET IS GOING, NO ONE KNOWS WHEN THE MARKET WILL MOVE
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 weregoing. 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.
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.
Know that Market Experts aren’t Magicians
THEY DON’T PROFIT FROM THEIR PREDICTIONS, THEY HAVE LEARNED TRADING DISCIPLINE, THEY PROFIT FROM SOUND CASH MANAGEMENT & RISK CONTROL, and THEY DON’T HAVE SUPERIOR PERFORMANCE NUMBERS
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 soundtrading 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.
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.
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.
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.
Be In Harmony with the Market
DON’T FIGHT THE MARKET, LET THE MARKET TELL YOU WHAT TO DO AND WHEN, and always remember THE MARKET GIVES AND THE MARKET TAKES AWAY
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.
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.
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.
Have a Healthy Time Horizon
TRADE FOR PROFITS OVER TIME and GIVE YOUR TRADING STRATEGY ENOUGH TIME TO WORK
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.
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.
Understand the Psychological Keys of Trading
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.
Don’t Trade for the Money
SUCCESSFUL PEOPLE DON’T WORK FOR THE MONEY, instead they LOVE TRADING FOR ITS OWN SAKE
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.
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.
In financial markets, the “majority is always wrong.” When the investing majority or the crowd is overly bearish, this is the best time to be buying stocks. When the crowd is overly exuberant, this is the time to be selling stocks. The financial markets work in this ironic way because not everyone can win in the market.
The Start of a Bull Market
The bottom of the market starts at a time when the stock market is weak and the general population is pessimistic. At this point most investors sell after having endured a long and torturous bear market. This extreme pessimism found at a bottom is always irrational and undeserved. Now the market is undervalued and is a bargain. Savvy investors, the “smart money”, buy bargain stocks knowing that they will be able to sell them higher in the near future. Smart money buying, called accumulation, causes stocks to rise.
The smart money often consists of operators, and corporate insiders (promoters of companies). These traders have access to information that the general public does not.
Rising stocks eventually gain the respect of institutional investors, as billions of dollars of capital is introduced into the market place. Mutual fund investment causes the stock market to advance in a powerful manner. Much of the steady large trends are powered by institutional investors. After the stock market has gained, stocks are now fairly valued and are no longer considered bargains. The smart money is now sitting on a large profit, as well. The average investor is still skeptical, however.
As bull market events unfold, retail investors begin to take interest in stocks. Retail investors, or the unsophisticated little guy, make up the vast majority of investors. This group does not invest for a living. Retail investors often make investment decisions based on what they read in financial magazines, from their brokers and from tips from friends. As the flood of retail capital is invested, the market soars, causing great euphoria. At this point in the cycle, many companies become public, or launch an IPO. Companies go public when investor sentiment is most optimistic so as to gain the highest possible stock price. IPO’s generate even more optimism as unsophisticated investors buy into the fallacious thoughts of instant riches. Now is the time when many small investors become wealthy. In this phase, stocks are doubling and tripling as the media cheers on the advancing bull market.
At this point, the smart money sells, or distributes, the now overvalued stocks to overconfident retail investors. The smart money knows that overvalued stocks are no longer worthy investments, and will soon drop in value. Widespread greed always occurs, in some form, at stock market tops. Sometimes this greed takes form as stock market scams and fraud. These immoral activities can take place because irrational retail investors will buy a stock simply because it is glamorous. To compound the problems, investors will now start to use margin, or leverage, to further accelerate gains. All caution is thrown to the wind as investors think “the old rules don’t apply”.
The Start of a Bear Market
After mutual funds and retail investors are fully invested, the market is overbought. This means that there is no more cash to fuel the rally. The market can only go in one direction: down. All it takes is just a hint of negative news and the market collapses under its own weight. Investors quickly realize the market is made of smoke and mirrors, as frauds or other scams come to light.
When panic selling starts, a market will always fall quicker than it had risen. Oftentimes, as everyone heads for the exit at the same time, there isn’t anyone willing to buy the stock. This can be especially disastrous for margin users as they grow deeply indebted to their brokers. Bankruptcy is the usual result for these foolish gamblers. The majority of retail investors don’t sell even as the market is plummeting. This crowd keeps holding on to stocks in hopes that the market will recover. As the market plummets 25%, then 50% the average retail investor foolishly holds on, in complete denial that the bull market is over. Finally retail investors sell every stock they own plummeting the market even further. This mass exodus is called capitulation.
The Cycle Starts Again
It is at this point that stocks are undervalued once again. The smart money is accumulating and stocks rise. The majority of retail investors bought at the top and sold at the very bottom. This is the very essence of the “dumb money”. They are perpetually late into the game. This cycle continues over and over. Only the smart money actually “buys low and sells high”. After trading in this manner, the dumb money will adhere to adages such as, “the stock market is risky”. In reality, however, the stock market is only risky if you trade like the mindless majority!
There is an old saying in business: “Fail to plan and you plan to fail.” It may sound glib, but those who are serious about being successful, including traders, should follow these eight words as if they were written in stone. Ask any trader who makes money on a consistent basis and they will tell you, “You have two choices: you can either methodically follow a written plan, or fail.”
If you have a written trading or investment plan, congratulations! You are in the minority. While it is still no absolute guarantee of success, you have eliminated one major roadblock. If your plan uses flawed techniques or lacks preparation, your success won’t come immediately, but at least you are in a position to chart and modify your course. By documenting the process, you learn what works and how to avoid repeating costly mistakes.
Whether or not you have a plan now, here are some ideas to help with the process.
Disaster Avoidance 101…
Trading is a business, so you have to treat it as such if you want to succeed. Reading some books, buying a charting program, opening a brokerage account and starting to trade is not a business plan – it is a recipe for disaster. “If you don’t follow a written trading plan, you court disaster every time you enter the market,” says John Novak, an experienced trader and developer of the T-3 Fibs Protrader Program.
John and his wife Melinda, who is also his business partner in Nexgen Software Systems, run a number of educational trading chat rooms to help traders learn how to use their software and, more importantly, learn how to trade. In a nutshell, their software identifies Fibonacci areas of support and resistance in multiple time frames and provides traders with specific areas to enter and exit the market. Once a trader knows where the market has the potential to pause or reverse, he or she must then determine which one it will be and act accordingly.
“Even with the best program, market data and analysis, odds for consistent success range from slim to none without a written plan,” says Novak. The Nexgen website offers examples of trading plans and useful market information for the benefit of both clients and non-clients alike.
“Like the markets, a good trading plan evolves and changes, and should improve over time,” says Melinda Novak.
A plan should be written in stone while you are trading, but subject to re-evaluation once the market has closed. It changes with market conditions and adjusts as the trader’s skill level improves. Each trader should write his or her own plan, taking into account personal trading styles and goals. Using someone else’s plan does not reflect your trading characteristics.
Building the Perfect Master Plan
What are the components of a good trading plan? Here are 10 essentials that every plan should include.
Skill assessment - Are you ready to trade? Have you tested your system by paper trading it and do you have confidence that it works? Can you follow your signals without hesitation? If not, it’s a good idea to read Mark Douglas’s book, “Trading in the Zone”, and do the trading exercises on pages 189–201. This will teach you how to think in terms of probabilities. Trading in the markets is a battle of give and take. The real pros are prepared and they take their profits from the rest of the crowd who, lacking a plan, give their money away through costly mistakes.
Mental preparation – How do you feel? Did you get a good night’s sleep? Do you feel up to the challenge ahead? If you are not emotionally and psychologically ready to do battle in the markets, it is better to take the day off – otherwise, you risk losing your shirt. This is guaranteed to happen if you are angry, hungover, preoccupied or otherwise distracted from the task at hand. Many traders have a market mantra they repeat before the day begins to get them ready. Create one that puts you in the trading zone.
Set risk level – How much of your portfolio should you risk on any one trade? It can range anywhere from around 1% to as much as 5% of your portfolio on a given trading day. That means if you lose that amount at any point in the day, you get out and stay out. This will depend on your trading style and risk tolerance. Better to keep powder dry to fight another day if things aren’t going your way.
Set goals – Before you enter a trade, set realistic profit targets and risk/reward ratios. What is the minimum risk/reward you will accept? Many traders use will not take a trade unless the potential profit is at least three times greater than the risk. For example, if your stop loss is a dollar loss per share, your goal should be a $3 profit. Set weekly, monthly and annual profit goals in dollars or as a percentage of your portfolio, and re-assess them regularly.
Do your homework – Before the market opens, what is going on around the world? Are overseas markets up or down? Are index futures such as the S&P 500 or Nasdaq 100 exchange-traded funds up or down in pre-market? Index futures are a good way of gauging market mood before the market opens. What economic or earnings data is due out and when? Post a list on the wall in front of you and decide whether you want to trade ahead of an important economic report. For most traders, it is better to wait until the report is released than take unnecessary risk. Pros trade based on probabilities. They don’t gamble.
Trade preparation – Before the trading day, reboot your computer(s) to clear the resident memory (RAM). Whatever trading system and program you use, label major and minor support and resistance levels, set alerts for entry and exit signals and make sure all signals can be easily seen or detected with a clear visual or auditory signal. Your trading area should not offer distractions. Remember, this is a business, and distractions can be costly.
Set exit rules – Most traders make the mistake of concentrating 90% or more of their efforts in looking for buy signals but pay very little attention to when and where to exit. Many traders cannot sell if they are down because they don’t want to take a loss. Get over it or you will not make it as a trader. If your stop gets hit, it means you were wrong. Don’t take it personally. Professional traders lose more trades than they win, but by managing money and limiting losses, they still end up making profits.
Before you enter a trade, you should know where your exits are. There are at least two for every trade. First, what is your stop loss if the trade goes against you? It must be written down. Mental stops don’t count. Second, each trade should have a profit target. Once you get there, sell a portion of your position and you can move your stop loss on the rest of your position to break even if you wish. As discussed above in number three, never risk more than a set percentage of your portfolio on any trade.
Set entry rules – This comes after the tips for exit rules for a reason: exits are far more important than entries. A typical entry rule could be worded like this: “If signal A fires and there is a minimum target at least three times as great as my stop loss and we are at support, then buy X contracts or shares here.” Your system should be complicated enough to be effective, but simple enough to facilitate snap decisions. If you have 20 conditions that must be met and many are subjective, you will find it difficult if not impossible to actually make trades. Computers often make better traders than people, which may explain why nearly 50% of all trades that now occur on the New York Stock Exchange are computer-program generated. Computers don’t have to think or feel good to make a trade. If conditions are met, they enter. When the trade goes the wrong way or hits a profit target, they exit. They don’t get angry at the market or feel invincible after making a few good trades. Each decision is based on probabilities.
Keep excellent records – All good traders are also good record keepers. If they win a trade, they want to know exactly why and how. More importantly, they want to know the same when they lose, so they don’t repeat unnecessary mistakes. Write down details such as targets, the entry and exit of each trade, the time, support and resistance levels, daily opening range, market open and close for the day, and record comments about why you made the trade and lessons learned. Also, you should save your trading records so that you can go back and analyze the profit/loss for a particular system, draw-downs (which are amounts lost per trade using a trading system), average time per trade (which is necessary to calculate trade efficiency), and other important factors, and also compare them to a buy-and-hold strategy. Remember, this is a business and you are the accountant.
Perform a post-mortem – After each trading day, adding up the profit or loss is secondary to knowing the why and how. Write down your conclusions in your trading journal so that you can reference them again later.
“No one should be trading real money until they have at least 30 to 60 profitable paper trades under their belts in real time in real market conditions before risking real money,” says Novak.
Successful paper trading does not guarantee that you will have success when you begin trading real money and emotions come into play. But successful paper trading does give the trader confidence that the system he or she is going to use actually works.
The exercises in “Trading in the Zone” walk the trader through trading a system based on a simple indicator, entering the market when the indicator gives a buy and exiting when it gives a sell. Deciding on a system is less important than gaining enough skill so that you are able to make trades without second guessing or doubting the decision.
There is no way to guarantee that a trade will make money. The trader’s chances are based on his or her skill and system of winning and losing. There is no such thing as winning without losing. Professional traders know before they enter a trade that the odds are in their favor or they wouldn’t be there. By letting his or her profits ride and cutting losses short, a trader may lose some battles, but he or she will win the war. Most traders and investors do the opposite, which is why they never make money.
Traders who win consistently treat trading as a business. While it’s not a guarantee that you will make money, having a plan is crucial if you want to become consistently successful and survive in the trading game.
by Matt Blackman, the host of TradeSystemGuru.com , is a technical trader, author, keynote speaker and regular contributor to a number of trading publications and investment/trading websites in North America and Europe. He also writes a weekly market letter.
Let’s begin with the markets themselves, and with fear and greed. We have all heard the cliches about fear and greed. They rule the markets. In fact, that’s all the markets are—a reflection of these emotions. In order to make money trading, you must learn to control your fear and greed.
Overcoming Fear and Greed
We all have to deal with our runaway emotions at various times in life, and these emotions really begin to run away when we trade. Bill Williams1 used to say in his seminars that trading was the clearest window into your own personal psychology, clearer than any other endeavor. I think he was right.
UNDERSTANDING THE MARKETS
We give in to our fear when we don’t take the next trade because we’ve just been through a string of losers and fear losing again. We give in to our fear when we put our stop loss too close and get stopped out of a trade without giving the trade enough room to develop. We give in to our fear when we freeze as a trade starts to lose money, and we don’t take the exit signal because we’re afraid of losing money.
We give in to our greed when we take a profit early, before the regular signal, because we don’t want to give back any of the profits. We give in to our greed when we trade more contracts or shares than we normally would because we feel good about this trade.
So we start with the question, “How can we understand the markets?” If we understand how they work, we can get a better understanding of ourselves, and inturn be better traders.
Controlling greed takes discipline. As far as fear, Peter Steidlmayer2 explained in his work with Market Profile that markets exist for one purpose and one purpose only—they exist to facilitate trade. Facilitating trade means that the markets will do anything they can to get individuals to participate in the market. How they do this is through movement. Markets move up and down searching for buyers and sellers.
The crucial point here is that markets must move for their survival. Understanding this literally changed the way I thought about the markets. Think about it. Markets have to move! This concept is major for anyone who has had to sit through a trend-following strategy trading in a sideways market. The knowledge that the
market has to move eventually changes the way you look at trading. It gives you confidence that the string of losses can’t continue indefinitely. It eliminates the fear!
You see, Steidlmayer explained that if a market does not facilitate trade, it will die. If it does not continue to bring traders in, to lure the buyers and sellers, the market will cease to exist. And the prime directive of a market is survival. To keep traders interested, the market has to move. It cannot remain in a small trading
range or traders will lose money, become disinterested and leave. Eventually there will be less and less liquidity, traders will stop trading, and the market will die.
Knowing that a market must facilitate trade and move, or else die, has given me great confidence in trading. When I am forced to trade through quiet markets, I remember this principle. This principle has reduced my fear and increased my confidence immeasurably.
STRATEGY TRADING: MAKING GOOD BUSINESS SENSE
For me, strategy trading is the only answer to the problem of fear and greed, and it is the only logical way to take advantage of the concept of Market Facilitation.
First, trading a strategy provides the discipline necessary to begin overcoming fear and greed. Trading a strategy that has been back tested on historical, quantifiable data is a major way to inject discipline into your trading and to begin to control your fear and greed. If we think of a trading strategy as a small business, we can design our business to make money based on historical simulations. Then, our job becomes the implementation of the strategy rather than the interpretation of the market. If the strategy loses money and busts, we change the strategy. It’s a matter of good business sense.
Second, if we know that a market must facilitate trade to stay alive, we can devise strategies that guarantee that we will always be in for that inevitable big move. If we know that the big move will eventually come, and devise the strategy accordingly, our task becomes to minimize the drawdown (investment) while we wait. I have never been able to predict when the market was going to facilitate
trade and get in for the big move. Instead, I have devised strategies to ensure that I will be in for the big ride and my losses will be minimized while I wait. It’s just a matter of good business sense.
As a businessman, I have concluded that the only rational way to trade the markets is to trade a strategy. All of the hocus-pocus about predicting when this market will move, and how far, is just that—hocus-pocus. The people that make the big money are the ones who don’t try to predict tops and bottoms but who
consistently take a little out of the middle. The only logical way to do this consistently is through a well thought-out, well-designed strategy. It’s a matter of good business sense.
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.
The Discretionary Trader
A discretionary trader uses a combination of intuition, advice and nonquantifiable 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 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.”
The technical 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.
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.
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 understandm 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.
Kim has entered a long position in crude oil after carefully studying as many factors as she could reasonably include while making her decision to trade. She has entered the trade because her study of the underlying fundamentals has her convinced that crude oil prices must soon begin to rise. Then Kim turns on her television set and begins to watch one of the financial news stations.
An “expert” in crude oil is being interviewed. He begins to talk about how crude oil inventories are almost certain to drop this year because oil companies are not doing as much exploration as they have in previous years. Kim listens intently to what he has to say and then begins to doubt her decision about the trade she has entered. The more she thinks about it, the more panicky she becomes. She considers abandoning her position even though she will end up with a loss. The fact that an “expert” has decided something else completely shakes her confidence. She exits the trade intraday and takes a $400 loss. Prices have not come near her protective stop, which was $700 away from her entry. The market never moves sufficiently far to
have taken out her stop. By the end of the day, her crude oil futures have made a new high, and in the following days explodes into a genuine bull market. Instead of a magnificent win, Kim has a loss. The loss is more than money, she has lost confidence in herself.
What should be done?
You should set your own trading guidelines and trade what you see. Forget about opinion, your own and especially that of others. Unless you are one of a very rare breed whose opinions are sufficiently good for trading, do not trade on them. Make an evaluation based on the facts you have and then go with the trade. Just be sure you have a strategy for extricating yourself before losses become big. Had Kim stayed with her original strategy andstop placement, she would have ended up a happy winner instead of a regretful loser.
There is a huge difference between being risk averse and fearing losses. You must hate to lose. In fact, you can program your brain to find ways to not lose. But not losing is a logical thought-out process, rather than an emotion-based reaction.
Two human-based tendencies come into play. The first is the sunk-cost fallacy and the second is the exaggerated-loss syndrome.
You are in a trade that begins to go against you. You reason that you have already spent a commission, so you have costs to make up for.
Moreover, you have spent time and effort researching and planning this trade. You reckon that time and effort as cost. You have waited for just such an opportunity and you are afraid that now that it has come you will have to miss this trade. The time spent waiting for opportunity is something you also count as cost. You don’t want to waste all these costs, so you decide to give the trade a little more room. By the time you realize what you’ve done, the pain is almost overwhelming. Finally, you have to take your loss which is now much larger than it might have been. The size of the loss adds to your fear of ever losing again. The end result is brain lock and inability to pull the trigger on a trade.
You give the importance of losing on a trade two to three times the weight of winning on a trade. In your mind, losses have greater significance than wins. In reality, neither is more or less important than the other. In fact, wins do not have to be as numerous as losses as long as the wins are significantly larger in size than the losses. Of course, best is to have more wins than losses with the wins greater in size than the losses.
What should be done?
Evaluate your trades solely on their potential for future loss or gain. Ask yourself, “what do I stand to gain from this trade, and what do I stand to lose from this trade?” Think the matter through. “What is the worst thing that can happen to me if I take this trade, and do I have a plan and a strategy for extricating myself long before it happens?” “If I begin to lose, is there a way I can turn things around and come out a winner?” Learn to look at the costs of a trade as part of your business overhead. Try to have a mind set that you will not throw good money after bad. When you give a trade more room, you are doing just that – often throwing away money.
Marketers call this preferential bias. Preferential bias exists among traders. Once they develop a preference for a trade, they often distort additional information to support their view. This is why an otherwise conscientious trader may choose to ignore what the market is really doing. We’ve seen traders convince themselves that a market was going up when, in fact, it was in an established downtrend. We’ve seen
traders poll their friends and brokers until they obtained an opinion that agreed with their own, and then enter a trade based upon that opinion.
A student of ours, Fran and her husband, John, decided they wanted to go to live in the Missouri Ozarks. Everyone told them that there was no way for them to make a living there.
Everyone they asked advised them not to do it.
Finally, a minister in the Church they proposed to attend told them that they were to serve there. Out of twenty or thirty people they asked, that minister was the only one who told them to come. Of course, it was exactly what they wanted to hear. They sold their home and most of their possessions accumulated over a lifetime. They moved to the Ozarks and went broke within a year. They had to leave and begin all over again. John, who had been semi-retired, now had to find a job. So did Fran. She had to give up a promising start as a trader to go out to put food on the table.
What should be done?
Look at each trade objectively. Do not allow yourself to become married to your opinion. Learn to recognize the difference between what you see, what you feel, and what you think. Then, throw out what you think. Lock out the input of others once you have made up your mind. Don’t let your broker tell you what you want to hear. Never ask your broker, your friends, or your relatives for an opinion. Turn off your TV or radio, you don’t need to see or hear what they have to say. Take all indicators off your chart and just look at the price bars. If you still see a trade there, then go for it.
Your business plan is your personal blueprint for trading success. It includes not only your goals, but a detailed plan of how you plan to get there. This plan should go far beyond the details of your trading methodology. It should include structuring not only your trading environment, but your whole life. Your mind and psyche are your main trading assets. How do you plan to protect them throughout the year?
Your business plan should be structured to motivate you to make higher highs in your account equity. This sounds like a given, but you must truly fight to come back from each drawdown. You must have allowances in your plan not to give back more than a minimal percentage of profits. Your trading plan must include all the details such as which markets you will trade, which strategies you will follow, and what type of leverage you will use. Only by having a trading plan will you be able to avoid emotional trading decisions.
I am of the belief that it is never too late to start thinking about working on a business plan for the current year. It is also never too early to think about putting together a business plan for next year. This is because it will take you some time to think about the things that I am going to say, and work on your own program.
Trading is abstract and there are so many questions and decisions to be made that come up during the day. Your goal as a trader is to execute your plan and leave the thinking out of it. A daily plan helps to aid in providing ritual, organization and structure.But before you think about how to construct your daily game plan, you need to first put together a broader annual business plan. In setting up your larger business plan, you will be designing a trading program for yourself. Many of the questions our office receives pertain to what type of trading patterns to follow, what time frames to trade on, how to place orders, and which markets to trade. Your business plan should address these issues.
When you setup up your program, you should think of yourself as your own best client. Your account is a client. Your goal should ultimately be to design the type of program you could trade several accounts on, or, think if you wanted to add just one client. You would need a very specific type of program to present to that client, and then, assuming they would be monitoring your trading activity everyday, you would be more conscientious about following your program. Leverage and money management issues would be addressed in this “program”, as would markets traded, drawdowns, types of trades made, etc. I will share with you some of the ways I design my program. Before I do, the business plan includes so much more. It must also include goals and motivational factors, as well as rules, guidelines, and plans to keep you away from trouble areas or spots that you are weakest in.
I find that as a trader caught up in the markets, it is hard to take time off. So it is easy for me to hit the burnout point. I have a tendency to put too many positions on. Taking positions into the last day of the quarter seems to be my achilles heel and bite into my bottom line. So, I am making a very clear provision in my business plan for 2000 NOT to have big positions on going into the last day of the quarter. If you want to give yourself the liberty to take several weeks as you develop your plan to still break a few rules, think about it as you do it. Think which rules are really going to serve you best. This is why I said it might take some time to mull over a few things.
I will give you the essence of my program and then you will see how easy it is to design your goals around your plan. I have separate accounts, one for scalp trades, and one for position trades. Now It is easy to design different goals for each program. For example, if the SPs are the only market you are trading, one goal could be to include a range of expected activity level in making SP scalps. This could comprise your core program or be designated as supplemental activity. By having a goal to make a certain amount of scalp trades a week, you will challenge yourself a bit.
Will you include position trades, index options or GLOBEX activity in your program? Look at you past trading performance. It is easy to break down if you are more profitable sticking to short term scalps, or how much holding longer-term positions really adds to your bottom line. I like to keep my SP scalping activity separate, so for longer-term positions, I like using the NASDAQ futures or SP options as a separate trading vehicle. For trades made in the domestic futures markets, I try to hold trades anywhere from 2 – 8 days. Occasionally I will day-trade the bonds, but I try to play for overnight follow-through in most markets. This was my basic program carried over from my CTA program.
So, I essentially have three separate programs: SP scalping, short term swing positions based off classic chart patterns and 2-period Rate of Change pattern recognition, and long-term positions which can also include stocks, options, mutual funds, etc. You need to think about your mix that will work for you and be CLEARLY organized as to how you are going to manage your money. Each account should have a specific level of funding and number of contracts that can be traded in it.
There should also be leverage guidelines and money management rules for each type of trade. Most of the time I do not use my full line. I trade 1 contract per “x” number dollars in my account. Determine a unit size for yourself. As your account grows, you can add another contract. These things should all be spelled out in your business plan.
As for goals, you can structure those two ways. Some people set a dollar amount goal for their trading activity. I have actually avoided doing this in the past, instead choosing to focus on maintaining a certain amount of activity level. I figured if I just did the best job I could each day, the profits would take care of themselves. Sometimes setting a dollar amount can be discouraging during drawdown periods or encourage you to force trades when nothing is going on. This year, I want to have my biggest trading year ever, so that is my goal.
But for some people, a better goal might be to do “x” number of trades on a regular basis, or try for “x” number of SP points per week. This helps to reach the larger goals. I would like to reach half my goal from my daytrading account and half from my position account. Now the question has come up, sometimes gains are unevenly distributed. If you set a target for yourself to make 3 SP points per day for each contract you trade, than do you quit when you make these three points? It doesn’t quite work that way. When you are hot, you are in synch and should keep trading. If your 3 points come easy to you, than why would you quit on the day? You could very easily have a scratch day the next day…or even a losing day.
But you must have SOME sort of guideline. This will serve as your motivation to make a trade in the first place! You must have some reason to pull the trigger in the first place, because so many times it is too easy to hold back on being aggressive. Set a goal that you can not only reach, but that you can exceed. So again, if you are a newer trader starting out with a small account, perhaps your goal will be to take 8 SP points out per week. How are you going to achieve that? If you have a smaller amount of capital you do not want to trade on a longer time frame. You need to find 1-2 spots a day where you can go in and try for 2 points.
Now you are breaking your goal down into bite size pieces. How much can you risk on each trade? When I make “short skirt” type trades, I automatically risk no more than three points. If you decide that you can’t risk more than 2 points, you are going to have to be very careful on picking your spot. You must be able to see your risk point before you go in. See the market turn and then enter “at the market” or as close to that turn as you can. So, that might be a “program” that you can start out with. Now, what might happen if you start out with your scalping program, is that for a few days, the markets might be dull, choppy, Perhaps you feel like you are behind your goal a bit. But then one day, your 2 point trade turns into a 5 point one…or, you get motivated and make a few more trades and exceed your goal. OK?
Don’t put pressure on yourself to make x-amount everyday, but you must have a guideline for what you would like to achieve on a monthly basis. Then at the end of the month, you ask yourself, how is your performance standing up to your business plan? If it is falling short, what needs to be adjusted? The biggest things that keep a trader from meeting their plan are: getting sloppy a few times, forgetting to place a stop, or getting stubborn on one trade. These are the things I see. One mistake waiting to bite you in the rear.
But guess what…it is possible to make all these mistakes and yet STILL make money. Astonishingly, the markets can be more forgiving than we think. It just takes a bit of persistence. So, each month, set your goal to do a better job than the month before. All you have to do is work on making fewer mistakes.
OK!…on to some more parts of the plan – record keeping and structure. THIS IS AN EQUALLY IMPORTANT PART to your business plan. Here is why. Routines and rituals keep things automatic. Additionally, they help set up the daily Game Plan (which we will get to next). A trader needs to get to the point where picking up the phone is just one more thing he does during the day. At the end of the day, I log all my daily numbers. This might seem a useless endeavor since this data is already listed on my computer and I am merely writing it down on paper. But this ritual brings a certain amount of relief to me because I can shut down making all decisions and do some therapeutic grunt work. I thrive on menial tasks and grunt work because I do not have to think during this time. It is a ritual that wipes my mind clean of all the good and bad that happened during the day.
I also have sheets where I log each trade, and lately I am becoming more diligent about doing my P&L at the end of each day. I used to do this during the eighties but stopped the last few years. Part of my business plan for this year includes becoming even more involved in record keeping. I am monitoring the amount of slippage on each trade and the average holding time for each type of trade. You see, you must make it into as much of a detailed game as possible to draw yourself into the game, increase the intensity.
The object is not to burn yourself out either – wrong idea. You do not have to focus on every tick, but rather the opposite. Keep your monitoring of the markets a Zen type of thing, meaning stay loose and relaxed. Sometimes the best trades will happen out of the corner of your eye. For example, perhaps you have been watching a market for a few days. You have been doing your nightly homework watching a particular setup unfold. Then, when the market starts to act a certain way that confirms your analysis is correct, you should be all over it.
You can’t force the trades, but when you are relaxed you will see them better. The best way to stay relaxed and loose is to be involved in some sort of ritual. Like the tennis player who bounces the ball up and down a few times before he serves, does a dance with his feet and wipes his brow – these are all rituals to keep his serve loose. The same tricks apply with trading. You can doodle and make swing charts on paper during the day, write down periodic readings of the ticks, or note extreme price levels.
I hope you are getting the basic idea so far, because I do not want to elaborate to the point of overkill. But here is one more example. The person I worked for when I first traded on the Philadelphia Exchange had been a physicist. He spent 1 1/2 hours at the exchange before the market opened and would be there for an hour and a half after the close. He was very methodical and organized, writing out tickets and orders in advance. He was quiet and unassuming, and as I found out later, he was also one of the most consistently profitable traders down there. The person who first backed me when I traded in San Francisco taught me to chart the 3/10 oscillator every night using Security Market Research charting service. He also taught me to log the daily trin, tick, breadth figures, etc., in addition to writing out orders for the next day. Both these guys are still trading today.
These are some of the common traits I have noticed among those traders who succeed. They all have daily routines and rituals. You must balance out the abstract conceptualizing process the market requires with some tangible activities.
Your business plan should include making a daily Game Plan for each day’s trading. What type of strategy are you going to use for the next day? Is the market due for a consolidation type day, one that starts to form a small trading range? Or is it poised for a breakout, a potential trend day? Is there an opening play for the morning? For example, if there is an early morning sell off, will it setup a buying opportunity? Or should rallies be shorted? Your game plan could include looking to sell a test of the previous high or buy a pullback to the hourly moving average.
At night, it is easy to note where the hourly grail patterns might be in other markets. Write down imaginary orders…”Buy Silver at such and such a price if it retraces to EMA “. You will be more likely to make the trade if you follow this practice. Perhaps there is a particular market you have been following with a directional bias. Write down the previous day’s high or low and use that as your pivot.
When managing longer-term trades, you will be more likely to stay with them if you write out clear instructions for trailing a stop. Write down your stop level and continue to move it as the market moves in your favor. My favorite way to trail a stop is to use a two-bar channel stop, or to use hourly support and resistance levels. In a downtrend, I will trail it just above the last hourly swing high, but in an uptrend, I will give it more room and trail it beneath the hourly low of two levels ago. Trail your stop not on the last swing low but the one before that one. This is because up-trending markets are more prone to A-B-C type corrections. There is not a perfect way to trail a stop – they all have their flaw. A 2- bar trailing stop works well, on paper, but personally, I hate the give back on any trailing stop and usually look to exit on some sort of buying or selling climax.
Sometimes, trading in another market can be a good diversion to keep you from taking profits too early on a position that is working. You have to let time work FOR you in winning positions.
Game plan – Business plan – overall trading environment structure…just start thinking about the way you really go about things. Get yourself down to a one day at a time type of process. Even if you are a position trader, your job is not to think about too far into the future, it is still to take one day at a time, even if it is just a monitoring process. The tape is always in the here and the now. Your goal should be to do the best job you can that DAY . Follow your rules and your game plan for that day. If the market moves in ways that were not in your game plan, that is OK. The wrong game plan is always better than no game plan at all. At least if your game plan is wrong, you will know it fairly quickly and that in and of itself has forecasting value.
It is OK to miss a million trades, but it is not OK to miss one that setup on your game plan you have been waiting for. You can also adjust your game plan midday . Perhaps you were looking to sell a rally back to the hourly moving average, but the market blasts on through. It is OK to say, “because the market failed at that benchmark, it might mean there is a stronger move in the opposite direction”. Perhaps then it would signal to switch gears and start looking for the first 5-minute grail buy. You get the idea!
Here is a list of some of the types of things you can include in your annual business plan. This will give you something to work on. Start thinking about putting together a professional program, comprised of bite size pieces.
What methodology or patterns are you going to trade? It is OK to have a “library” of setups, but most people do best concentrating on a niche or particular technique. Learn to do one thing consistently well instead of trying to master too many styles.
Which markets are you going to trade? If you trade equities, think about keeping a “stable” of stocks to follow. Don’t get caught up in scanning a database of too many issues that you are not familiar with. It invites unfortunate situations where there may be pending issues or reports in the company that you are unaware of. If you have not had much success trading soybeans or silver in the past, why try to continue to trade them in the future?
How much capital are you going to put into your trading accounts? Something I have to add here, stay away from looking at percentage returns when evaluating performance statistics, such as percent return or drawdowns, on your personal account. Concentrate instead on dollar amounts. What is your dollar amount tolerance? My stomach turns at a specific dollar amount drawdown. Percentages vary too much according to how much money you keep in your account. You might have a net worth of 1 mil and keep 100,000 in your trading account and your situation will be entirely different than a person who has 5 mil and keeps 100,000 in trading account. The person with the higher net worth will feel freer to use a different type of leverage. So think in terms of dollar amounts…how much are you willing to draw down to?
How do you plan to enter, exit, and manage trades? I like dividing my contract size into two units. Sometimes I go all in and then scale out in halves. Other times I put half on and look to add the other half. Some positions I keep half on as a core and use the other unit as a scalping unit. Whatever style you choose, it should be written down into your plan.
What is your plan to manage drawdowns? How will you evaluate when you need to take time off?
What are your monthly goals? Are you going to strive to make a certain number of trades each week or perhaps a certain number of SP points? Remember, these are guidelines by which to measure your progress. Some months will be better than other months. The end of the month is a good time to do a periodic review. Most businesses do this on a monthly or quarterly basis.
Include a daily routine in your overall business plan. How are you going to evaluate your performance each day? Keep a notebook of the things you do RIGHT. Pat yourself on the back for small moral victories, such as exiting a losing position in a quick fashion. Note the small incremental improvements you make.
Create an office environment designed to facilitate performance. Eliminate distractions and outside influences. Reduce glare and get a comfortable chair. Invest in good equipment. Invest in an excellent data feed.
Include a provision that will keep you from trading if outside circumstances create an unusual stress, such as health, divorce, or a major move. You might as well just write a check out of your trading account and kiss it goodbye. This is a hard thing to recognize before it is too late. People LOSE money during times of 10 major stresses: death, taxes, divorce, moving, health…you get the point. Trading is a performance-oriented discipline. If you can’t perform well, cancel the show… If a tennis player severely sprains his ankle, he cancels the match. Why do damage to your ratings? Why mar your statistical record with sub-optimal performance?
Record Keeping – Rate yourself on your routine and structure and nightly homework. Do you do research or have way of logging results? What type of research is included in your program or plan? My problem is I stack too many projects up on back burner. I need to streamline this area for myself. Or, I get diverted doing research, go off on a tangent late at night and stay up way too late. Then I am not in optimal condition the next day. My business plan includes a bedtime. I promise myself to adhere to it.
Rewards! All work, no play makes Jack a dull boy. You must have outside interests or hobbies to get your mind off the markets at the end of the day. You must treat yourself to something you really want. If you spend money on your self you will eliminate subconscious poverty thoughts. I am serious. Treat yourself like a million bucks and you will be worth it soon. Maybe after a good week you treat yourself to a massage, or buy something you really want. I already have something in mind that I will do for myself if I meet my goals next year. It is something that does not cost too much but that I could never justify spending money on because it might seem frivolous. But the money comes from my trading account so nothing is frivolous!
LASTLY, what plans do you have to continually improve yourself? See yourself as a top-notch person, health-wise, performance wise, and attitude wise. How do you keep advancing in life? You know the old saying, if you are not going forward, you are going backward. Educational pursuit such as books and study courses are important, but don’t neglect spiritual pursuit, or outside projects… or working with a charity.
m n the above subjects are more important to your long-term success in staying in this business than any trading indicators or setups! People do not lose money from entering on bad setups. They lose money from getting sloppy in their trading and sloppy in their habits and life. They allow emotional trades to creep into their program because they have not done their homework and are not prepared.
Your business plan is a contract with yourself. It is a contract to treat yourself as your own best client. Surrounding yourself with guidelines, rules, and an overall structure can be the vehicle that brings you freedom from performance anxiety and gives you the confidence that you can take your trading to the next level.
Interviewed of Linda Raschke in the New Market Wizard Book. (transcript from a LBR Online Trading Room class)