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This is all only my opinion. Perhaps someone will find some of this
insightful or simplifying.
It takes three things to be a winning trader:
I. Winning Methodology-The ability to forecast future price movement better
than random. This tells you 'What' and 'When'. This covers when to enter
or exit a given market. These entry/exit decisions must give one a
positive expectancy or market edge.
II. Money Management-The ability to size each position correctly. This
tells you 'How many'. Having a stop loss in the market is NOT money
management any more than placing an order is a winning methodology. Every
methodology has a point at which the amount risked is too high turning the
method into a losing proposition.
III. Discipline-The ability to follow consistently one's trading
methodology and money management parameters.
The big three do not work in parts. One must have all three to be a
winning trader. Trading without any one of the three will lead to the
trader losing as much money as he/she is willing to lose.
METHODOLOGY
Market Edge - Expected return per $ risked on a one contract basis.
Formula: W%*(avg. W/avg. L)-L%. Example- If you are paying me 6 to 5 on
heads of a coin toss, my edge is (50*1.2)-50=10%. Therefore, on 100 $5
bets I would expect to win $50 or 10% of the $500 I risked. Example II- If
I have a system that wins 35% of its trades and the average winner is $3500
and the average loser $1000, then the edge is (35*3.5)-65=57.5%.
When deciding on methodology, I think the trader has three major decisions:
fundamental vs. technical, systematic (by this I mean totally mechanical)
vs. discretionary, and shorter time frame vs. longer time frame.
Fundamental vs. Technical is a tired old battle continually waged by the
various practitioners' egos. There are numerous examples of people who
have used each style very successfully; therefore, I can only surmise that
both styles can be traded profitably. I think technical has two major
advantages. Firstly, technical trading is easier to systemize. Secondly,
one can trade a much greater number of markets. It would be very difficult
to become a fundamental expert in more than one market sector i.e. grains,
energies, financials etc. Technical trading should be profitable in any
market. (If your technical system only 'works' on certain markets, the
system lacks robustness and has probably been curve fitted. If slight
changes in the indicators' parameters result in large changes in returns,
the system, again, has problems with robustness.) Multiple markets (20 or
more) give one more diversity and more trades. More trading opportunities
result in higher returns for a given period, quicker compounding of the
investment, and performance closer to expectations. Do you think you would
be a more certain net winner on the 6-5 coin toss proposition after three
tosses or ten? How about 1,000? Would you rather have 2-1 odds on 50
tosses or 6-5 odds on 1,000? Notice that the larger number of trades makes
the inferior system (6-5 odds) much more profitable than the one with the
bigger edge (2-1 odds).
When discussing discretionary vs. systematic trading, I will begin again by
saying that vast sums of money have been made using each style. They can
be both traded profitably without question. The ultimate methodology would
be discretionary, as it offers the trader the opportunity to have a larger
market edge. It is possible (however improbable) for a discretionary
trader to make 'all the right moves' and rarely have a losing trade, week,
month, quarter, or year. The market edge of the best discretionary trader
will be much larger than the best system. A system, by its nature, will
have losing periods. By mechanically taking every signal, losing trades
are virtually built into any system. Nonetheless, if I were a new trader,
I would start with systematic trading, because it removes as much human
emotion as possible from the trading decision. Human nature wires us to be
losers in the markets. Problems at home, traffic, surroundings etc. all
affect our emotional disposition, which in turn usually affects our market
perceptions. It is rare to be able to make clear, consistent, rational
trading decisions under the circumstances of life. It is very difficult to
keep your 'mood', good or bad, out of your thinking process. Discretionary
trading can not be back tested, and it is very difficult to judge the
underlying theory, since the individual trader plays such a large roll.
For example let's say I am trading discretionary method X, and I am not
making money. Am I going through a normal down period? Am I bringing too
much emotion and inconsistency into my decisions? Are my problems or
triumphs at home influencing my trading? Or, does method X not give me a
market edge? How do you tell? Am I looking at the wrong fundamental
factors or am I nervous about my impending wedding? Systematic trading
avoids these paradoxes. Systems can be back tested and future performance,
therefore, estimated. Emotions are removed, and broken rules alert the
trader to their re-appearance. Discipline and consistency are much easier
to have and to track when one trades a system.
Time frame is the last hurdle to clear when discussing methodology.
Shorter term has an advantage by producing more trades, while longer term
trading' advantage is lower costs (commissions, fees, slippage, bid/ask
spread). Although an ultra-low cost short-term system would be the best of
all worlds, I think long term trading is better for virtually every
non-floor trader. In a day trading system that averaged $300 winners and
$150 losers before costs, the costs ($60 a round turn) reduce each winner
by 20%, increase each loser by 40%, and take the W/L ratio from 2-1 to
1.14-1, an 86% reduction. If one made two trades a day in a $25,000
account, he/she would need 120% in profits per year just to break even.
The costs would be greater than the original value of the account. As the
costs become a smaller percentage of the average winner and loser, the
necessary market edge of the method becomes smaller. It can be less
predictive with regards to future market movement and still be profitable.
I look at trading as a business, and drastically slashing costs will
generally make a business more profitable.
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