The Path to Successful Trading

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.



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