The best Money Management strategy

If I were to define the most important Money Management rule in one sentence, it would be this:

Make sure you have the money tomorrow to invest with.

It is that simple. Every day, do whatever you should according to your trading strategy (analysis and entry systems), but make sure that no matter what happens today, tomorrow there is money left for new investment opportunities.

I cannot emphasize enough how important this attitude is. Because we are making sure that we have money for investment tomorrow no matter what, we cannot fail. Of course, this simple rule is just the basic foundation for a robust money management strategy, because it implies some important points:

  1. In order to make sure we have the money tomorrow, we have to make sure that our maximum possible risk (and therefore our loss) is limited today.
  2. Because we must have the money tomorrow no matter what, we must also protect against force majeure situations, when all our trade protection can fail (15th of January was such an event, as stop losses were not honored by the market, since it traded thousands of pips away in just one tick). It implies that a complete loss of this trading account should still leave us with enough money to comfortably open a new account the next day and continue trading.

There are many ways how each trader will calculate his risks, position sizes, but in my opinion, if this one simple rule is not honored and he leaves even a distant possibility of losing it all, the money management strategy is not planned properly.

Accepting the Risk, Part 2 – Floating Profit

In the first part we discussed the risk we have on the market – our initial Stop Loss being hit.

I was lucky to have a natural fear of financial loss operating in me on a very deep level from the first days I started trading. Interestingly enough, because I was so cautious with any potential loss, I never let my trades show any substantial gain either. Any time the trade would go my way even slightly I would get nervous and was rarely able to resist taking the profit.

In one of the previous articles I illustrated a very common example, showing how the fear would cause us to look for any signs of the reversal on the market – anything that will allow us to justify taking the profit way before the target.

After we learn that the market will often disagree with our point of view we start accepting that sometimes it goes straight to our Stop Loss. Such situations are inevitable and happen to even the best traders. But what about these situations when everything seems to be going exactly according to our plan?

Managing the floating profit

When the trade is already showing profit many traders automatically identify with that profit subconsciously. They rationalize that the market already showed that they are right and this is their well earned money.

The market can easily reverse against our position, no matter how much profit we have in it.

There are a couple methods we can implement in order to deal with these situations. In this post we covered a couple important steps in order to decrease the risk and reduce the psychological weight of keeping the trades for a longer term:

  1. Enter the trade with a couple positions with the same SL but different targets. I like to set the first target at 3 times the amount of my SL.
  2. When the first target is hit and part of the trade is closed, move SL to breakeven. This will turn the trade into a risk free opportunity to follow the trend (in reality, there is still the risk of losing the floating profit which we can never exclude completely unless we close the trade, but the original risk of losing money is now removed).
  3. From this moment we need to keep reassessing the market and adjusting our SL higher as the market provides an opportunity to do so.

At this point it is extremely important to adapt a different way of thinking about your trade. Instead of looking at the paper profit, look at the amount of money you already accepted and at the value of your current Stop Loss. In other words, the current profit is not whatever is floating, but the amount you already taken plus/minus the amount that will be accepted when Stop Loss hit – not your Take Profit.

Aiming for big targets

When you have the conviction that the market has the potential of giving you 10 times the amount you risked, it is definitely worth it to let the trade go – after we’ve already taken the first profit and made the trade a risk free opportunity by adjusting stop loss to breakeven. Many times the market will not agree with our conviction and stop the trade, but with experience we can hopefully learn to read the market sentiment better and better. When having a longer term perspective (trading Daily and Weekly charts) I found it essential to understand the underlying fundamental reasons why the currency can appreciate or depreciate the way you expect it to.

I like to ask myself this question when I am hesitating whether to let the trade go or close it: “Based on where I can trail the SL in these conditions and where I have my long term target, would I enter the trade right now? Do I still have a good Reward to Risk ratio in this trade?”

In other words, I will first check where I can trail my SL based on the recent price action. After I trailed it, I look at the distance to my target and my SL. Would I place a trade at the current price with such SL and TP? Does it still meet my minimum Reward to Risk ratio criteria?

Let’s take a look at 2 different scenarios:

  1. There was a recent retracement to the trend we are in and we can trail our Stop Loss behind that retracement. After doing so, we have 100 pips distance to our Stop and still 400 pips to our long term target – a respectable 4:1 ratio that makes it worth it to stay with the trade.
  2. The price rushed to our target in an impulsive move, not reaching it by 50 pips. Our floating profit is 500 pips and our SL is set 300 pips lower relative to the current market price. Because the price spiked higher to our target so fast, the market does not show any techincally sound level where we can trail the SL to reduce our risk. If we were to place a trade at this level, we would have been risking 300 pips hoping to gain only 50 – a very bad 1:6 ratio to take. In this case it is a much better decision to close the trade in 500 pips profit, 50 pips before our target, than hoping to catch these final pips and risk giving away 300 pips of our paper money.

Finally, let’s take a look at a recent trade that I’ve been managing over the last 3 weeks. It happens to be a rare example of proper management throughout a couple retracements when I was certainly questioning whether to take the profit or let the trade go. In hindsight, scaling out of the trade in small parts as the market was making new highs, was crucial to lasting throughout the whole move to my original target – it allowed me to secure part of the profit and decrease the psychological burden of supporting the trade.

GN H4 Buy Trade
GBPNZD H4 Buy Trade

Accepting the Risk, Part 1 – Stop Loss

…most traders erroneously assume that because they are engaged in the inherently risky activity of putting on and taking off trades, they are also accepting that risk. I will repeat that this assumption couldn’t be further from the truth.

Accepting the risk means accepting the consequences of your trades without emotional discomfort or fear. This means that you must learn how to think about trading and your relationship with the markets in such a way that the possibility of being wrong, losing, missing out, or leaving money on the table doesn’t cause your mental defense mechanisms to kick in and take you out of the opportunity flow.

— Mark Douglas “Trading in the Zone”

Risk and reward are closely related as we cannot have one without the other. I wrote my opinion many times before that a trade should not be judged as amount of pips or dollars that it makes. It should only be judged as the ratio between what was at risk and what was gained (could have been gained). A trade that made 100 pips but had 1000 pips SL has extremely poor 0.1 RR ratio and it is relatively easy to make such a trade and reach profit with it, just by sheer luck. A trade that made $1000 but had no SL has 0.0 RR since the was no risk limit, and we have to assume that the whole account was put at risk.

In terms of profit it does not matter whether we win 10 trades out of 10 with 0.1 RR or just 1 trade with 1 RR. If we risked $100 in each trade, in the end we’ve made $100 in each case. However, it matters a lot in terms of risk – in the first case we risked 10 times $100 to make $100 in the end, while in the second we risked $100 just once and made the same $100.


 It is interesting that most beginning traders prefer to take a smaller profit, while setting a bigger stop loss (actually, most beginners prefer not to set any stop at all, being sure that the market will go in their direction at least a tiny little bit). I think there is some interesting psychology that we can analyze here.

First of all, there is always a balance on the market. If your trading system uses 1:5 RR and you are able to win consistently more than 80% of your trades, it can still work just fine – especially if that is what your find to be psychologically comfortable. The problem here is actually going with the market flow correctly more than 80% of the time – easier said than done.

On the other hand if you take 3 times the profit compared to your risk you only need to be “right” 1 time out of 3 in order to consistently increase your balance.

Let’s think about it from a different point of view. Imagine that you trade manually and you put 100 pips stop loss trying to make 20 pips. What kind of trading opportunites are you looking for? What is the market setup where you say “The market gives signs that it will go 20 pips in my direction, but it can first retrace 100 pips against me”? Imagine the trade goes against you by 90 pips. What should the market conditions be at that moment that you still keep your trade with confidence – now you want the market to move 110 pips in your direction, having only 10 pips breathing space on the other side.

It really seems to me that trading in this way is a very dangerous psychological trap. It’s like we want our trades to be perfect, we really hate when the market goes against our positions and forces us to take a loss. But we learned that trading without loss protection is a financial suicide, so we calm ourselves by setting a huge stop loss while trying to take a tiny profit – after all, we are protecting our account, right? It really comes down to truly accepting the risk of our trading.

Accepting the risk of losing money

When a trader puts on a trade with a stop loss, he immediately assumes that he is accepting the risk that comes with that trade and that he is in control over his trading. However, we are not benefiting in any way from the risk “acceptance” that comes from the overwhelming fear of losing money.

A trader can put a stop loss, but still hope or even assume that the market will never reach it. He likes to put a bigger SL not because he is ready to take a bigger risk in his trading but because he is afraid to take any loss at all. He hopes that the bigger SL will never be hit. If there is any fear in placing the trade it means that the risk for that trade was never truly accepted.

When seeing your trade being closed in a loss causes you any emotional discomfort it is natural that you will do anything to avoid taking the loss in the first place. The smaller your stop is, the more often it will be hit. It seems that most traders prefer to increase the distance to their stop so that they do not have to experience the emotional pain that comes with losing money as often. Accordingly, bigger stop loss will possibly lead to more emotional pain when it is hit, but there is another element that I find even more important – the pain of being wrong.

Accepting the risk of being wrong

When the trade is stopped out an average trader not only feels the pain of losing money. He also perceives that the market is making him wrong, and for many traders the pain of being wrong is even stronger than that of a financial loss. I would say that even though the pain of losing money can be similar in one big loss or many small losses, the pain of being wrong on any given trade is about the same.

From this perspective we can see that for someone trading without proper mindset (someone experiencing any psychological discomfort at all about his trades) it makes sense to avoid the losses at all costs. He will much rather take $10 profit 10 times in a row, increasing his confidence (and often his ego) and then have 1 loss that takes all $100 away, than experience the pain from losing $10 and being wrong 5 times in a row and then making $100 on the trade that is opened with the market flow. In reality, such trader is very unlikely to last through 5 losses in a row and still continue following his system to get to that 6th trade that makes up for all his losses and more.

The risk of being wrong is rarely acknowledged, which makes it much trickier to work with. Unless a trader specifically studies trading psychology, he is rarely aware that he is actually afraid to take a trade because it might not work out.

How is it possible not to accept the risk?

In other words, how is it possible to participate in an activity (trading) that is risky by its very nature and not to accept the risk? Mark Douglas provides a very good explanation to the underlying psychology in his book:

The typical trader won’t predefine the risk of getting into a trade because he doesn’t believe it’s necessary. The only way he could believe “it isn’t necessary” is if he believes he knows what’s going to happen next. The reason he believes he knows what’s going to happen next is because he won’t get into a trade until he is convinced that he’s right. At the point where he’s convinced the trade will be a winner, it’s no longer necessary to define the risk (because if he’s right, there is no risk). Typical traders go through the exercise of convincing themselves that they’re right before they get into a trade, because the alternative (being wrong) is simply unacceptable.

Such thinking is leading to many problems in our trading. Instead of looking at the market as the source of trading opportunities he can act on, the trader thinks of it as the enemy he needs to fight. He is trying to learn everything he can about the market so that he can build such a trading system that will not lose any trades. The only way such trader can be psychologically comfortable with his trading is if he can win all his trades, since any single loss causes a lot of psychological pain that makes him start questioning his trading system.

You can imagine how difficult and frustrating such trading will be.

On the other hand, it is simply a matter of adjusting one’s beliefs and expectations about the market in order to solve this problem once and for all. A good trader does not simply say that it is possible to lose money on the market, he expects to lose money on any single trade he makes. He never knows what trades are going to be winners and which ones will pay the market for the opportunity to trade. A good trader sees such loses as the cost of doing business, similar to a restaurant owner who has to buy food before he can serve it to his customers for profit.

Practicing flawless execution

In the previous issue we discussed how our Analysis and Entry processes help us to find trading opportunities on the market. However, even when the trade is clearly identified many traders will still hesitate to take it.

Convincing yourself to take the trade

After the trades are clearly identified during the analysis phase, we still have to act on them. These are not trades yet, these are only signals.

It is a big trading problem if we have to convince ourselves to take the trades. In reality we should jump at an opportunity to execute the signal and move towards success. The fact that we are hesitating can mean only that we are not confident enough at what we are doing.

So how do you become more confident at it? By acting on each and every signal, time after time, and seeing progressively better results as you refine your rules and your system. In order to act on each signal, we need a confidence of a different kind – the confidence that we operate from a safe environment where nothing is threatening us and we have nothing to fear.

Easier said than done, but nothing we can’t achieve with help of proper money and risk management.

Risk Management

We will follow a simple MM strategy, as discussed in issue 6.

The very first goal we must become 100% comfortable with, is the fact that we have to pay for our education on the market. You might have taken classes, seminars or self-studied many books, but that’s only part of the price you have to pay – this is the price for the theoretical knowledge of the market. The next phase is to pay for your education by practicing all this theory.

You have to define the amount of money you are absolutely comfortable paying the market each month for your education. It can be anything, but it must be real money.

It does not matter if you can spend $1000 or $10 000 a month practicing trading if you are not psychologically comfortable leaving this money on the market. You have to go down until the amount bears no emotional attachment whatsoever. Let’s say it is a very conservative $100.

Now that you know your monthly tuition fee, you have to make sure that you trade, you practice with it, and you don’t lose it all the next day. Remember, you are setting your monthly limit and you will have to stick to it. The next step, therefore, is to divide that amount by 20, making sure you have something to risk each and every trading day of the month.

In our example it will amount only to $5 a day. Fortunately, there are brokers that will allow you to open so-called cent accounts, where your $100 will be shown as 10 000 cents, and you can risk $5 as if it would be $500, but in reality you are risking just 500 cents. Once again, the amount is not important right now, because we are not trying to make money, but become confident executing the real trades.

It is very important that you are absolutely comfortable with paying the market for your education, so this planning phase is crucial. It is just as important to learn paying with real money. Reduce the risk until you can confidently say that you are happy to pay the market every single day for the opportunity to learn from it. After all, there is no better teacher for our trading than the market itself, and it is the only teacher that allows you to set the daily education fee as low as you wish. Make it $1 a day if you have to, but commit to paying that price without any emotional discomfort.

Now that the risks have been defined and truly accepted, we are ready to enter the practice phase.

Practice

The goal of our practice is very simple: every single day we try to find just one single entry opportunity with our trading system and act on it, paying the market the daily fee we predefined in the previous step. At this point we must have an attitude that will make gladly accept every single opportunity as soon as it is confirmed. We do not think about money anymore, we know our tuition fee for the month.

Of course, there are a couple disciplinary rules we must follow:

  1. The trading opportunity must be defined objectively by the rigid rules of our trading system. It means that any other person should see the same entry if we put the trading rules in front of him.
  2. We are trading only under our risk limit for the day and after a trade is placed that fills that risk allowance completely, no more trades can be opened. Whether we decide to take one trade a day with full risk or divide it between two trades is up to us.
  3. The trading must be documented

The last point is very important and it is worth going into it in more detail. As we discussed in Issue 7, trading organization is just as important to our success as trading system or proper psychology. I call it Trading Accountability, because we must make ourselves accountable (responsible) for all our actions. For the purposes of this exercise let’s define 3 accountability rules we will follow:

  1. Before placing the trade, we make a picture of the chart and annotate it, explaining why this is a good trade opportunity. The picture is placed into our “Analysis Diary”
  2. Right after taking the trade, we write all details into our “Trading Log”: entry price, time, stop and profit target, risk for this trade, expected return ratio, etc. We also write down our psychological state of mind about this trade: do we feel good about it, was there any hesitation before taking the trade, etc.
  3. When the trade is closed we update our “Trading Log” with relevant information and write down a short analysis of the trade and how we feel about it now.

In the end of each week it is crucial to analyze trading results so far. Now we can see how the market developed after our entry and we can analyze our mistakes with a benefit of hindsight. It is the most important phase of this practice.

When this exercise is done for the first time, chances are that performance will not be outstanding. Many traders will think that it is simply a matter of trading rules that we developed so far for this exercise – if the rules are not good enough to show us good entries, then we will not see profitable results. However, after actually doing the exercise, we may see many trades where the rules were not followed.

We need to take each trade and compare it with our original analysis and entry system description:

  1. Did we follow all the rules in our analysis system, meaning that this trading pair had a bias in the direction we traded?
  2. Did we follow the rules of our entry system, clearly seeing a signal before we took the entry?
  3. Did we respect money and risk management?

Question 3 is by far the most important. It is understandable if we miss some sign of changing or weak bias in real time in our analysis system that is obvious to us with hindsight. It will also happen many times in the beginning that the entry is far from ideal, because of the many factors we have to account for. But our Risk Management rules are always simple and straightforward.

We know precisely what position size we must open, we know that there must be a stop loss set immediately with our entry and we know our risk limit for the day. We can only break these rules willingly, talking ourselves into not putting a stop loss order, because we “need to give the market space to breathe” or taking additional trades today, after reaching our limit because “the market is showing a signal that cannot lose”. Such lack of discipline and awareness over our thinking will lead to the greatest losses on the market.

If we find ourselves breaking Risk Management rules during our first series of trades, it is not the end of the world, we still did not waste the time doing the exercise. We have found that there is a serious issue in our psychology that we need to work on and that is a great advancement towards success. After all, most traders are losing money on the market (sometimes losing it all because of such judgment errors) completely unaware of the crucial mindset issues that they have.

Flexible expectations

Finding the trades

While there are many parts of trading business that are essential to trader’s success, the core area is undoubtedly finding and executing the trades. There are two parts of our every day trading process that are designed with that purpose in mind: Analysis System and Entry System.

Analysis System is designed to understand the current market conditions. It helps identifying what we can do on the market. It does not tell us when to trade, but it should certainly tell us when NOT to trade. To me, the essence of market analysis is to identify trading pairs where there is a higher chance of the price going in one direction over the other. When such trading pairs are found, the Entry System comes to action.

Entry System is designed to look for specific entry patterns in the direction identified by our market analysis. Main question that a good Entry System should ask is “Where do I put my Stop Loss order?” No matter what entry parameters we use, what targets we set, there is only one variable we have control over, and that is the amount of money we are willing to pay the market to find whether our trade is going to work or not (see the article in Issue 3). There is always a certain point in any market, beyond which it is not feasible to hold a losing trade. Thus, finding this stop point is the most important task of the Entry System. Without good Stop Loss, there should be no entry in the first place.

After identifying a good technical place for the Stop Loss, we will see whether the price is too far away from it, preventing us from having a good Risk/Reward ratio. When we see that Stop Loss can be placed in a good location, which is not too far away from the current price, we are ready to look for the entry itself.

At this point we already know:

  1. The market bias, or the path of least resistance in which we want to trade, that was identified by our Analysis System;
  2. A good Stop Loss price, beyond which it is not feasible to hold the losing position;
  3. We also decided that the distance to our Stop Loss leaves enough room on the other side (that is, profit side), so that our target can be placed with a good Risk/Reward ratio (ideally the potential reward should be at least 3 times the predefined risk).

All that remains at this point is to find the entry trigger, defined in our Entry System. For some it can be a certain indicator signal – I personally prefer to use Price Action patterns.

Executing the trades

After both the Analysis System and Entry System processes are finished, we should be able to take a trade right at that moment, since we know everything we need to do that. Unfortunately, often it is not the case, as we start to think and hesitate, trying to find the best trade of the day or making sure that it is “truly” the right signal. More often than not such hesitation leads to consulting the information that we do not use in our trading system, and therefore do not know how to use properly. The result is almost universally losses, frustration and subsequent psychological breakdown, leading to even more trading errors.

Even though our trading process should give crystal clear signals what to do or not do right this moment, at the same time we are always facing a certain amount of subjectivity on the market, as we can never predict the price precisely. We are building certain expectations where the price will go, and such expectations should never be made rigid.

Market expectations

It is very important not to have any attachment to our market expectations, as it is one of the main reasons leading to frustration and consequently psychological problems.

Think about it as a weather forecast. While modern technology increased the precision greatly, the weather can still be unpredictable, especially in some parts of the world. When you read the forecast, you build certain expectations for your day, possibly you are planning your weekend according to that forecast. Now, you may be planning a family lunch in the park on Sunday and your expectation, according to the weather forecast, is for a sunny day. After you made all the preparations on Sunday morning, it suddenly starts to rain, and does not look like it is going to stop.

What are your reactions to this situation? Are you going to be upset because you have to change your plans completely? Are you somewhat angry at the forecast stations, since they obviously made such a big mistake? Or are you going to quickly adjust your plans and spend a pleasant day with your family at home?

I am using this example because the way we treat such life situations will be the way we treat our market analysis. If we are not able to stay flexible in simple life situations and adjust the plans, we are not going to be able to stay flexible on the market, where the real money is at risk. Just like the attachment to our plans for the weekend leads to anger and frustration, so will our attachment to market analysis, and even more so.

When you expect the market to break the resistance and go higher, but it doesn’t, how do you feel? What if you already opened a position on the break and now watching the price go against you? Not only you are watching your loss growing, but more importantly, you are dealing with being wrong. The market went against your expectations, making you wrong. Or did it?

Being wrong

In modern life there are not many things that cause psychological pain for most people more than losing money and being wrong. You will find a lot of discussion in various resources about the necessity of accepting the risk and being ready to lose money (I prefer to think of it not as “losing” but as simple expenses of doing business or tuition fee if you are only starting the education). While acceptance of monetary risk is extremely important, another risk in our trading is being wrong, and I think it causes much more grief than the loss of money itself.

Think about it, most people build their whole lives around trying to be right. They argue, they try to prove, they believe to hold the truth that others need to know. How many people do you know that will continue the argument beyond any reason, when it is clear to everyone but themselves that they are wrong?

There is a vicious cycle that is created from attachment to our expectations:

  1. We learn about the market and find a method of analysis that we like;
  2. We apply it and build some rigid expectations about the future price movement;
  3. We act upon our expectations, placing money at risk;
  4. The market goes against our position “making” us lose money AND “making” us wrong;
  5. Fear and anger arise and we continue learning more about the market, with only one purpose in mind: to find a method where the market will not make us wrong. To prove to the market that we are right.

In this situation a trader is personifying the market, assigning certain qualities to it that allow the market to “go against” trader’s position and to “make him wrong”. However, in reality the market is a collective entity, comprised of millions of traders just like himself, and all it does is simply follows the rules to try and balance supply and demand.

The problem here is not the loss that we experienced – after all I am yet to meet a trader who will state that it is possible to trade without losses and with no risk. The problem is our expectations being too rigid while our trading regimen is too flexible.

The thinking goes like this:

“I expect the market to break this level and go higher, so it MUST do that. If it doesn’t do that, it is making me wrong and that is unacceptable to me. I must refine my trading method so that the market follows my expectations precisely, then I will show it!”

In other words, there is no way the trader is willing to change his expectations and review his analysis – after all he believes that the market MUST follow it. However, he is very willing to change his trading rules to adjust them in such a way that the market always follows his expectations.

Now compare it with the opposite attitude:

“My current premise was not in line with the money flow on the market and so my position got stopped out. By going in the opposite direction the market is providing me with new information that I can now use to review my bias and find new trading opportunities”

This thinking will allow the trader to build a better premise, because he has been exposed to additional information about the money flow on the market. Not only will he be able to learn from a possible mistake he’s made when defining his original premise, but also he will instantly see additional opportunities that the market is now making available to him.

One attitude says “This is unacceptable, I resent the price going against my position. I will make sure this never happens again”, while the other asks “What other trading opportunities are available to me now with this new information the market provided me with?” It is not difficult to see what is more helpful to the trader’s development. The first trader is full of ego, he is looking for someone to blame other than himself. The second trader is humble and accepts full responsibility for all his actions, which empowers him greatly.

In my opinion these two attitudes separate consistently winning traders from everyone else.

Summary

The psychology and trader’s mindset are closely related to his trading method, his profit expectations and ultimately to his consistency and success. If trading system allows to trade randomly, without rigid rules to enter and support a position, it will lead to losses and frustration. If your risk management allows to overtrade, not controlling the amount of money you can allocate for trading every day or each month, sooner or later it will backfire and cause irreversible losses, when one day can lose more than was made in the past half a year.

It is up to us to create a trading system with rigid rules, and to have the discipline to follow these rules. At the same time we have to develop a high level of mental flexibility, letting go of our expectations easily and adjusting to the new information the market is providing us with.

We can also see a relation between our trading term and the amount of difficulty we will have to control our business properly. When trading intraday, the market is pouring new information on us with such a high speed that it is beyond most traders to absorb it and account for this information on the fly. It is much easier to overtrade when you watch the chart in real time and see one minute candle forming after another. Undoubtedly, there are traders who reached high degrees of success in short term trading, but I would argue that overall success rate is much higher for the followers of a longer term approach.

However, no matter how much we discuss the trading psychology and proper mindset, it is very unlikely to rewire our brain just by thinking about it. A great amount of everyday practice is necessary in order to change many beliefs we’ve been living with for years. In the next issue we will setup a practice routine that is designed to ingrain the new beliefs about the market, risk management, our expectations and trading execution. By following such routine we will be able to change how our brain operates, remove the hesitation and anxiety out of equation and develop the mindset that is most likely to lead to a consistent success in trading.

Trading Accountability

Handling complexity

In his book “The Checklist Manifesto” Atul Gawande shows how very costly mistakes are avoided using simple paper checklists. He provides a very detailed account that we can learn a lot from.

The truth about modern life is that it became way too complex for most people to handle by keeping information in their heads. We cannot account for all the variables of the modern life. The doctor is not able to concentrate on everything anymore, the modern operations are way too complex. The pilot cannot control a modern airplane and keep all the details in his head, no matter how good he is at remembering things.

It is not by accident that all modern pilots are required to go through simple paper checklists. In the midst of all technical complexity of their cockpit, they have to take a simple paper checklist and go through it for virtually every single procedure they are doing. Similarly, a nurse can stop the surgeon before the operation and remind him that some simple check has been missed in a checklist that nowadays is a requirement in most modern hospitals. No matter how good the surgeon is, a simple piece of paper has proven times and times again to be better in avoiding crucial mistakes that cost lives.

In trading we can exercise the power of checklists like never before.

I was always a big proponent of simplicity of trading. I was always defending the position that a mid to long term trader can simply spend an hour a day checking the entry conditions, taking the trades and then calling it a day. To be fair, the analysis and placement of the orders really does take a couple hours but somehow I was never able to make it to consistency by doing just that. The answer is that I was never a trader and I certainly never managed a trading business. I was an analyst at best, a market hobbyist at worst.

Analyzing the market and then trading your plan are two very important parts that we already discussed before but they are only that – two parts of the whole, only two elements of your trading business. A surgeon who learned the anatomy of human body and how to use the scalpel and stopped right there will never be allowed to work in any hospital. He must understand the management, the paper work, preparing reports, planning the operation, have critical thinking to decide the best course of action.

Whether you make money in trading or lose depends on how you manage your trading business as a whole. That consists of your monthly accounting and review, weekly goals and limits as well as review, daily plan, analysis schedule, trade management, recording all your trades in a diary, gathering statistics for different types of entries, timeframes, pairs, etc. As you can see, the problem is not in the complexity of a particular trading method but in the amount of work that has to be conducted regularly to maintain trading as a successful business.

More importantly, besides regular daily life of a trader, there is another crucial part to it. Just like in any other business you must advance in order to stay on top. You cannot start an endeavor in any competitive segment of the market and hope to make it, if your knowledge base always stays the same, if you never learn and never improve. Trading, being extremely competitive, is where one must advance every single day.

Do you know the problem areas of your trading business? If you lose money, do you have a clear picture HOW exactly you lose it? Is it a certain mistake you repeat times and times again or a trading timeframe you can never get right? If you are making money with a certain degree of consistency how do you know it will stay the same tomorrow? What can you improve to stay on top of the market even better?

There are stages to development of a trader: you are first oblivious to these questions, then you ask them and then you try to answer. After you find some answers all you’ve really done is built a theory on how to improve a certain aspect of your trading. The next step is to put that theory to practice and see how well it works in real life.

The real simplicity of trading

When you created a system of accountability for yourself in form of trading diary, log and various process checklists, you have made a big step towards consistently. If we have no clear idea what to do in our business we can still work hard and stay busy every single day, spending countless hours, but in the end we can only reach consistency by being extremely lucky.

Here is why creating an accountability system is so powerful: it lets you know clearly if you are doing your job or not. In the end of the day you look back and see your diary entries, trading log, start of the day checklist, daily summary checklist and you know what you accomplished today and where you fell short of ideal.

When you have a trading system with clear rules and accountability system with clear rules, all that is left is to follow them every single day. At this point, the trading is still not easy because of the amount of work you have to do, but now it became simple – in a sense that you clearly know every step that needs to be done every trading day. When you are not satisfied with the results of your trading, you can always look back and analyze what can be improved. You can make a couple changes and then see how well they work after another couple weeks.

One of the main reason why the traders are so rarely reaching consistent success, in my opinion, is that there is little to none consistency in their approach. Some are inconsistent in their life habits: waking up at the same time to start trading day, analyzing the market at the same time, following healthy sleep regimen to stay alert and concentrated during work hours, eating properly to have enough energy, etc. Others are inconsistent in their trading approach: jumping from one trading system to another, constantly modifying their trading rules, not following the rules in the first place. Finally, I think most traders are not consistent in doing proper accounting of their business: market analysis is not systematically recorded, the trades are not logged and analyzed for mistakes, studying the market may be done sporadically and so on.

Having the discipline in all these areas is extremely important. As I keep stressing, being a trader is, first of all, being a businessman. A business owner is completely accountable for everything he is doing. The problem, however, is that he is accountable only to himself which makes it easy to avoid in the short term, destroying all chances for success in the long term.

Accountability system

There are 2 elements of accountability system that I think most important to trading success: morning checklist and evening checklist. These simple lists will guide you throughout the day, always making sure that you are on the right track.

Next, I suggest setting up 2 separate journals: Market Diary and Trading Log. I use Market Diary to record any interesting trading pairs, trade setups, trading ideas, etc. The Trading Log is used to record each and every trade that was taken. First of all I write all data about the trade: trading pair, direction, size, time, price, etc. Then I describe the trade setup – the signal that I used to open this trade. Finally, the most important part of the trading log, is to record my psychological state upon entering the trade. I write if there was any hesitation to pull the trigger, what was my state of mind, any distracting thoughts, etc. I repeat all the same steps when the trade is closed. A screenshot of the chart is also added upon entering the trade and later showing how the trade has been closed.

Now that the basic setup is done, all is left is to make sure that the work is done properly every day:

  1. All market analysis and trade setups are recorded in Market Diary
  2. Trading Log keeps every single trade that was opened and closed along with psychological analysis

Next, we make sure that we advance in our understanding of the markets:

  1. We spend at least 10 minutes a day reading a market related book;
  2. Along with current market analysis, at least one historical setup is reviewed to ensure that we learn something new about the market.

We hold ourselves accountable to do this work consistently by following the checklists. In the morning we check:

  1. Wake up at the same hour, before everyone else, to create a productive and distraction-free start of the day;
  2. Re-read Market diary from the previous day to get into the right mindset first thing in the morning;
  3. Review any trades in Trading Log that were taken yesterday and document any trades that were closed since yesterday.

In my opinion getting into the habit of waking up at the same time every single day (including the weekend) is one of the most powerful things we can do to our success. By waking up before everyone else around, you create a distraction free environment that can become the most productive time of the day. When the day has been started with positive action advancing you in life, it will be much easier to keep going in the same fashion for the whole day.

Next, we follow through our market analysis checklist, which is created specifically for our trading system. The main goal is to look for all trading setups of our system on all trading instruments that we watch and record all this information in Market Diary as a clear trading plan.

Now we are ready to go through the Take Action checklist. This list is designed to help us pull the trigger and open the actual trades. Here we check:

  1. What trade setups we have available and clearly described in our Market Diary – if there is no plan put on paper, we don’t trade;
  2. Check our risk allocation for today (following the guidelines discussed in the previous issue);
  3. Place the trades according to plan, making sure that we use only allocated risk;
  4. Document the trade entry in the Trading Log.

Depending on trading timeframe and trading system, it is possible that market analysis will need to be done more than once daily. In this example we use swing trading on Daily charts, allowing us to analyze and place trades only once a day, thanks to the fact that there is only one new Daily candle available.

In the end of the work hours it is very beneficial to use Daily Summary checklist:

  1. Check once again that all analyzed signals were taken and everything was documented;
  2. Do all necessary paperwork preparations for the next trading day;
  3. Clean the workspace, ensuring that the next day can be started without any distractions.

Of course, we looked only through a very basic example here. It simply provides an idea how one can organize his working day. Every trader should prepare detailed checklists for his particular method of market analysis.

Trading is definitely not easy, but it can and should be made simpler. The checklists help to cut through all the guesswork and instead manage the work each day with absolute clarity, knowing that nothing important is missed.

Setting up the limits

Unrealistic expectations

As I mentioned many times before, it is my opinion that your expectations about the market is one of the most important aspects in defining you as a consistently profitable trader. Market is unlike any day job in that you do not have a clear certainty in your expectations, like the amount of your paycheck, possible promotions, vacations, health plan, etc. When you trade for living all these variables have to be defined by you. Alas, not all of them can be clearly defined at all.

In the previous article we discussed how you can build your expectations about the amount of work you have to do, how often you have to analyze the market, for how long you are going to hold the trades, etc. Today I would like to concentrate on another very important aspect, that of your profit expectations.

I think that many traders start with completely unrealistic expectations, which leads to a lot of frustration and emotional pain as they cannot get these fulfilled. When you see ads on TV with a truck driver owning his private island, implying that he bought it from the profits made in the market in his free time, it is not difficult to understand why so many traders are greatly misled.

Profit generation

First of all, let’s take a look at how the profit is generated on the market. At first sight it seems an obvious question – the profit is generated by the trades we close and open. I would like to argue that it is not as simple as that.

In my opinion it is much more beneficial to view the direct outcome of the trades as the return ratio between the risk in these trades and the reward they return in terms of price movement that was taken. In other words, if the trade returned 100 pips and we risked to be stopped out at -50, this trade generated the return ratio of 2 (100/50). I find such definition much more helpful because it emphasizes that our profit is always tied to our risk, to the potential loss we can have on that trade.

I keep emphasizing that on the market the goal number #1 is survival, i.e. account preservation. We have to play good defense before we can start applying offense.

With most investing even if you put all your money in just one company you are risking blowing up the whole account only if the company’s stock ends up trading completely worthless and there is no one who will take it from you even for free. When you distribute your money between 10 different companies in different sectors you chances of blowing up 100% of your original stake are getting pretty low. With options, futures or on Forex everyone is so used to huge leverage that they cannot even imagine trading without it.

When you trade on Forex, you normally get anywhere from 1:50 to 1:100 leverage. The leverage basically means that you can invest 50 or 100 times more money than you own. However, when you invest 100 times more than you own, the account will be wiped out with only 1% move against you instead of 100% when you trade with no leverage. At the same time you can double your money 100 times faster when the price goes in your favor.

Let’s take a look at a reasonably conservative example. Let’s say that we want to limit our potential losses to no more than 10% a month calculated from the initial capital at the start of the month. Given 20 trading days a month, we will have 0.5% risk available each day. To make sure we don’t lose all the money we already made, let’s say that we never open more than 0.5% worth of new positions on any given day.

Let’s say we lose 10% a month for the whole year and we started with $10 000. What is the size of our capital by the end of the year? No, we are not in debt of $2000 because we lost 120%. Our capital is still ~$2541. Because each month we recalculated our risks, when we lost the first 10% ($1000), the next month we only had $9000*10% = $900 available to risk. Essentially, it is not possible to blow up the whole account when using even such a simple money management technique.

However, let’s also consider how long it will take us to rebuild the account back to $10 000, giving the same trading rules and starting after 12 months of losses, i.e. at $2500. After 12 months stably making 10% and compounding our profits at the end of each month we will be at $7846. It will take another two and a half months before we arrived back to $10 000.

Even though it took us longer to rebuild back the losses, let’s consider it in a different way. During the first year, while we were consistently losing 10% a month, we ended up with approximately 75% loss – at $2500. The next year, when we started making 10% with the same consistency and reinvesting our money back at the end of the month, we arrived to ~$7850 after 12 month – more than 200% increase over the initial $2500 we had left.

Compound interest

In order to restore our $2500 account back in short amount of time, we used compound interest – any profits that we were making, were left in the account and we continued trading with them. The power of compound interest is well known, however in order to exercise it we need enough confidence in the system. It is OK if we just made 10%, invested it back into the market and the next month lost 10% – we are just 1% less than we were 2 months back. But what about a possibility of losing 20% or 30% the next month? Heck, without proper risk management, losing 50% or 80% the next month is just as easy!

Ultimately, the appeal of a trading method should be judged not as the extreme returns it promises the next month but as the consistency of these returns over the next 10 years and more.

Of course, the issue for starting traders is often a lack of capital. When you start with $1000, 10% a month does not seem to be that big of a deal at all. I would argue that the real issue for starting traders is lack of patience, followed closely by the lack of confidence in their trading method.

Here is another example: how much do you think the initial $1000 deposit will grow in 10 years using the basic 10% a month scheme we looked at, reinvesting the profits each month? The result will be an astonishing $92,709,068.82. Improve your edge by as little as 1% additional profit a month and you end up with $274,635,993.25 by the end of the same period.

So, the main question is not whether you find a way to make 20% a month instead of 10%. The main question is whether you are going to stick to your system and reinvestment plan after 5 years, when your $1000 has already become a respectable $304,481.64. After you increased your account 300 times starting with $1000, are you going to trust your system to do the same in the next 5 years, now starting with $300K?

There are two important points that were mentioned:

  • The most important parameter of a trading system is its stability in long term performance
  • The profitability is only relevant compared to the drawdown the system can experience

First of all, we need to realize that right now we are only discussing controlled drawdown – the amount of loss we will accept willingly when the market goes against us. Our ability to control that drawdown is also dependent on the market – we need a valid price in area of our stop loss in order to get out of the market. In situations of major crashes such control is not always achievable, as you are unable to exit the market at a desired price. Different risk control measures need to be used there, to be discussed in separate article.

Limiting monthly risk

Assuming normal market conditions when we can exit with our loss at a predefined price, let’s discuss how we increase the appeal of our trading method.

Any profit outcome is only relevant relative to the amount of risk we exposed ourselves on the market. Let’s differentiate between the loss we experienced and the risk we were exposed to. It is possible to finish the month in 10% profit with the highest draw down being 2%. That amount of draw down was our loss that we experienced in the course of making our 10%. However, it is not the risk we were exposed to. To me, the definition of the risk starts with the amount of money we could have possibly lost if all our trades would have closed in a loss – the worst case scenario, very rare, but possible. However, I would complete that definition by adding that the risk exposure is not only limited to the trades we actually took during the month but any trades we might have taken as well. Let me explain what I mean by that.

First, the drawdown that we experienced is simply the amount of money we were down during the month. We opened 20 trades and at some point a series of trades resulted in 2% consecutive draw down. It might have happened at any time during the month. We still closed the month with 10% profit.

The actual risk exposure during that month is defined as the amount of loss we would experience if all the trades would have failed. If we risked 1% a trade, our actual risk exposure was 20% – that is the amount we would have lost with same 20 trades failing one after another. Unless, of course, our system is limiting the potential of our risk exposure.

The potential risk exposure is defined as the amount of money we would have lost on all the trades we could have entered, limited by our system rules. What I mean by this is that our trading system may strictly forbid any trading past a certain loss threshold. In our example throughout this article the potential risk exposure was strictly limited at 10%, because all the trading stops, if such a loss is reached in any given month. Of course, it is still up to the trader to honor such limitation, but that is a matter of trading psychology and not system Money and Risk Management.

Limiting daily risk

Coming back to the example, there is another extremely important limitation we established in our trading system. Not only we limited the potential risk exposure at 10% a month, but we also limited the risk exposure during any given day at 0,5%, ensuring that we arrive at 10% loss only by consistently losing day in, day out. Let’s see why it is so important.

Imagine another system where potential monthly loss is also limited at 10%, but there is no such daily limit. The trader is using the system successfully, confident that he is well protected against any market surprises and will survive through the bad times.

Let’s say on a certain day the trades sees a great opportunity to buy USD against other currencies. He then opens EURUSD sell trade and GBPUSD trade with 0.5% risk each – very conservative approach. The next day he sees that the market retraced against him and stopped out the trades, but fails to go any further, therefore confirming his bias that the USD bears are very weak. This time even better entries are available on USDCAD, USDCHF and USDJPY, along with the same EURUSD and GBPUSD. Excited, he buys first 3 pairs and sells EUR and GBP again.

Alas, the market is still trading sideways and his stops are narrowly hit. Frustrated, our trader starts looking for explanation with further analysis and sees that the market was just reaching a round number. Now that the level of support was hit, he is even more confident in the reversal, because his original signals stays the same – buy USD against other currencies. Looking at his loss of 3.5% with quiet disgust, he decides to make the money back fast, with a near profit target and puts 1% risk into the same 7 pairs. Predictable as markets are in such situation, his stops are taken before the price finally moves in his direction. The trader, however, already hit his 10% limit and even exceeded it by 0.5%.

Did I mentioned that all of this happened in the first 5 days of the month?

There are many problems with his risk control:

  1. Because he didn’t limit his daily loss limit, he was susceptible to trading on emotions as well as overtrading.
  2. When the market was not presenting easy opportunities he managed to reach his loss limit in just a couple days and could not do anything for the reminder of the month.
  3. Because there is no daily limit, the trading can become very poorly diversified – the trader risked 0.5% in a couple USD pairs, knowing that when they move they usually do so together in the same direction.
  4. The trader is extremely frustrated with his performance and now the question is whether he will be able to honor his monthly limit or not – in his current mental state, when he already made a series of bad mistakes, he is risking to break other rules as well.

Now we can compare it to our original method, where the risk is not only limited to 10% a month but also to 0.5% a day.

  1. When the market is difficult to trade the trader will have to choose the best trading opportunities or spread his 0.5% risk in a couple trades. In other words, such limit ensures diversification, since when the signal is presenting itself in multiple related pairs at the same time, the chances are that the trades in these pairs will close in a loss or a profit together.
  2. If the trader has bad attitude today and is susceptible to making errors, he will be forced to stay out of market very quickly, losing no more than 0.5%. By the next day he has enough time to cool down and trade with proper attitude.
  3. Even the worst market conditions do not last very long and by giving himself freedom to lose money every single day and still be able to continue trading the next day, the trader is maximizing his opportunities.
  4. Because each day presents a new trading opportunity, the trader is truly distributing the signals provided by his edge in a wide array of market situations, ensuring that no single event can affect his bottom line greatly.
  5. The trader is better protected against force-major situations, since his risk exposure on the market is always limited. Even if the market trades through his stop loss, the damage will not be as devastating.

Summary

Besides protecting the account from being wiped up by a couple erroneous errors, such trading limitations are even more important psychologically.

When this risk management system is setup, the trader can work with more confidenc. The system allows him to know clearly what will happen not only if this trade loses, but also if every trade will lose until the end of the month. The trader can concentrate on finding his edges and acting on them. Each day he knows his limits, and he also knows that no matter what happens, he can continue trading for the whole month, looking at new opportunities each day, without the fear of hitting his loss limit.

In later issues we will be discussing different variations of managing the risk of trading. We will also look at profit expectations that we can realistically have when such risk limits are used.

Consistent analysis

Different trading terms

Depending on whether you trade intraday, swing trading or position trading your analysis goals will be very different. Let’s define these types of trading:

  1. Intraday, also called day trading, is when you are aiming to open and close your position inside the same day;
  2. Swing trading is when you are aiming to hold the trades for the length of daily timeframe swings, which generally results in holding the trades for 1 to 4 weeks;
  3. Position trading is usually defined as holding your trades for long term trends, such as weekly or monthly. The trades can be held from 1 month to a year or even more.

I believe that your trading style is a function of both your psychological preferences and the time you have available for active trading. Some people cannot sleep at night, worrying about their trades, if they know they didn’t close everything. Others lack extreme concentration required to watch the position nonstop from start to finish.

With day trading you need to develop a strict market analysis routine during the same hours each day and then watch the price according to your entry system for a couple hours while looking where to place the trades and where to close them. Usually you will want to schedule your trading hours according to main market sessions: Europe and US. Most day traders will close their trade in the end of the trading session if their profit target was not reached yet.

With Swing trading, you are mostly interested in daily charts and H4 to confirm the entry point further. The market can be analyzed one or two times a day, trades placed with SL and TP (ideally with 3 position system we discussed in issue 02, and automatic breakeven and trailing stop management). Each day during the same hours you reanalyze the market to see if there are new entry signals or if your current trades should be closed.

Position trading, in my opinion, allows to trade while doing analysis only once a week. You are looking for long term investments and any price action signals on H1, H4 or even Daily timeframes can easily distract you from the overall picture on weekly and monthly timeframes. Daily can still be used for price action confirmation along with the weekly trend.

Psychologically I prefer swing and position trading styles much more, but it certainly hasn’t been always like that. The allure of “easy” money made inside of just one trading day and desire to go to bed knowing that your net worth is greater than in the morning got me into day trading when I just started. As I mentioned before, it never worked out for me and I switched to trading midterm. It took a good deal of time and effort to change my mindset about trading and stop worrying about positions left overnight. In the end I am much more comfortable with this trading style.

Another important aspect to consider when choosing your style is the time you have available (or willing to spend). I do not know about you, but I see very little excitement in watching the market unfold on M1, bar after bar, hour after hour, looking for the entry point – only to continue watching all the same, now looking where to close the trade. Because of the amount of paper work (trading log, trading diary, system improvements diary, pictures with your trading patterns updated daily, etc.) necessary for any trading style, there is considerable amount of time to be invested in it. I consider such journaling to be the most essential step to success in trading business so if I have to choose whether to spend my time watching the trade unfold on M1 or finding more pairs to trade on higher timeframes, while having more time left for journaling, I will not hesitate to choose the later.

And yet another part of it, is the amount of rush you have to be in, possibly causing considerable stress as well. I love chess, but I never want a 30 second turn timer to be ticking beside me. Such skill of decision making under stress can be very important in life, but when you have a choice wouldn’t you rather allow yourself enough time to think and consider all options when making important business decisions? Every trade you take is a business decision and if you are willingly forcing yourself to make it under 30 seconds when trading M1 timeframe you might be adding unnecessary stress to your work.

All that said, every trader is free to choose any trading style they feel fits them best. However, one important point is that once you’ve chosen your trading timeframe, you’d better stick with it. It is one of the most common trading mistakes to constantly jump from one timeframe to another, hoping to see some signal you might have missed on your main trading timeframe. It is a particularly difficult issue to overcome for me personally so I can share a lot of experience actually making these mistakes again and again.

Greed driven inconsistency

Imagine that day trading is our preferred style and we decided to fade pullbacks along with the higher TF trend. We’ve chosen M5 as our trading timeframe and the goal is to take entries along with the H1 trend.

The following charts show exactly the kind of entry we are looking for.

M5_entry

 

Now, let’s say we entered the trade, it went our way and we moved SL into breakeven, as marked on the chart. We are analyzing the market in general and see that trend on Daily is really strong: the price just closed below the lowest of the previous 3 days and it seems that it will go on forever. We entered with 0.5% risk and SL was just 8 pips. At the lower prices shown on the chart we already had 20 pips profit, resulting in 1.25% paper profits. Now we project the daily trend further into the future and start thinking about holding the trade along with it: with the average range of daily candle in this trend being ~70 pips we make more than 4% every day while the trend continues! That’s a nice profit, and we don’t have to do anything to get it. Right now we have 1.25% in the market already, but it does not seem that much anymore. We decide to ride along with the daily trend.

Right at the moment of that decision not only have we broken the system rules (Daily timeframe is not even mentioned in our strategy) but we are also inconsistent in our analysis and in expectations. The next picture shows that the trade is stopped out in breakeven, but the Daily trend is far from reversed – it continues down for hundreds pips more. That’s a really frustrating moment in our trading: not only we gave up 1.5% profit already in the market, but also missed a move that seemed so obvious AND we were actually right about that move. How did it happen?

eurusd_daily_trend

 

One thing we failed to realize is that the whole move we were trading on M5 is nothing but noise on Daily. If we want to ride the Daily trend, the SL should be positioned in such a way that when it is triggered, your original premise is canceled and has to be reviewed. In this case a proper SL would have been at least above the previous day’s high – 70 pips away compared to our 7. As we can see on the charts the market could have hit our 7 pips SL day after day as we would keep on trying to enter using M5 timeframe, and the Daily trend would still remain intact.

The original premise was to take H1 trend, according to our system rules. We already took a good portion of it and because the trade seemed to be without risk (SL at breakeven) we decided to ride the Daily trend as well. But inside of that Daily trend there are countless bullish and bearish H1 trends starting and ending every single day. The market can easily reverse against our position, taking out the SL while not affecting the integrity of the Daily trend in the slightest.

Driven by greed, we broke our strategy rules trying to hold for the move that was never planned. In the end we failed to take the trend that was properly analyzed, executed and already in profit – it only remained to take the money according to our rules.

Fear driven inconsistency

I started with a very common example, a mistake I am guilty of making countless times when I was just starting trading intraday. However, there is a reverse situation that I would like to review as well. This time let’s use a higher TF perspective.

Let’s say our rules are very similar to that of the previous example. We want to take our entries on pullbacks along with the higher TF trend. The only difference this time is that our trading TF is H4 and we are aiming to take the Daily trend. The following picture shows our hypothetical entry where we fade the pullback, expecting the price to bounce from resistance. For simplicity, we use the same EURUSD pair, selling it on almost the same day, but this time with different goals in mind.

h4_entry

The entry worked out just fine, we have a protective stop order just above the Weekly pivot (marked on the chart) and now we get ready for a long ride, possibly 500-800 pips.

One psychological problem with longer term trading is that it is certainly not as “exciting” as intraday. Even on a relatively low timeframe, such as H4, you get no more than 6 candles a day – no matter how hard you try, there is not much to analyze the whole day. Swing traders rightly consider it to be a great benefit, freeing the trader from staring at the screen nonstop and allowing sufficient time to make proper trading decisions.

But there is also another side to this, a problem I experienced firsthand so many times. When your trading is going for days, even weeks, your brain really wants to “explore the market”, make sure nothing is wrong with the trade, that the market does not reverse against you and does not take your paper profits away. Given the lack of market information on your trading timeframes (6 candles a day on H4, 1 on Daily) such “exploration” is often done on lower timeframes that are really not part of your system.

There were times when I saw the price come to some level of support and bounce from it a couple pips – hardly visible on H4. Losing control of my brain and lacking proper discipline (in the beginning lacking proper strategy definition even) I would start looking for confirmation on H1 that the market is not reversing. Seeing that the bounce certainly looks bigger on H1, but still clearly not predominantly bullish, I would very soon find myself starring at a powerful bullish move on M15, breaking through all the levels of resistance and leaving no chances for the bears to counterattack. Closing my short entry then seemed only logical, common sense – the market is clearly reversing against me.

You know the rest of the story – after I took my position out it didn’t took much effort at all for Daily bears to push lower through that insignificant support (especially given the fact that M15 bulls were taking their 50 pip profits (i.e. selling their buys) by the end of the day).

Let’s take a look at the next chart, picturing the exact same scenario with our hypothetical EU sell entry.

eu_M15_false_reversal

Starting building a consistent approach

After we defined the problem of being inconsistent in our approach and analysis, it still remains necessary to find a way of dealing with this issue. We will go into this subject in more detail when we start discussing building and refinement of different strategy elements. Today, however, let’s start with a general outline to get us thinking in the right direction.

The starting point must be the clear definition of our trading strategy. Before we can do that, we have to think about the general psychological preferences by asking ourselves these questions:

  1. Do I prefer to watch the market on lower timeframes to find the entry and monitor through it to the exit point?
  2. Am I susceptible of jumping the gun, closing prematurely, making some technical mistake (buy instead of sell, wrong SL or TP, etc.) if I watch the market nonstop and have to make a trading decisions in a matter of minutes?
  3. Do I possess the level of concentration required to watch the market unfold, candle after candle, possibly for a couple hours?
  4. Can I imagine myself concerned about my position if I leave it over the night? What about leaving it over the weekend? Over the holidays, such as Christmas or New Year’s Eve?
  5. Am I likely to be tempted checking on my trades every couple hours if I leave them long term?

Here is an example of what simple psychological preferences might be (note: these are not my answers, nor will they be correct for you, but hopefully it can get you started putting your own on paper):

  1. I would not like to watch the market nonstop, many hours a day
  2. If the decision is required right this moment I believe I am susceptible to making trading mistakes
  3. Even though I believe I can concentrate on the market for an extended period of time, I cannot imagine doing it each day for many hours non stop
  4. There might be some concern about the positions left overnight, but it is something I can deal with and eliminate completely with experience. I am hesitant, however, leaving my positions over the weekend, since the market can gap greatly against me. The same goes for the holidays.
  5. Checking my positions 2-3 times a day should be sufficient.

Now that we defined our hypothetical psychological profile, we can see what strategy will suit better here. Clearly, this trader would be better off trading midterm strategy, aiming to get weekly trends and preferably not leaving any positions over the weekend. His goal would be to get the trend on H4, with H1 being his entry timeframe. Because the amount of time he can spend watching the market is limited, an acceptable strategy would be to watch the price action for breakouts during the open hours of UK and US sessions. His strategy might look something like this:

  1. Define the prevalent trend on Daily timeframe
  2. Find a pullback on H4 with slower price action
  3. Watch breakout entry points on H1 in the beginning of UK and US sessions

Given this definition, would it be helpful for his trading to go to M5 to look for a more precise entry? Similarly, would it be helpful to try and leave his positions along with the Weekly or Monthly trend (that he is not watching nor analyzing)?

Because he is not able to watch the price action nonstop, during the whole trading session, M5 is not likely to help him find better entry, as he can be easily stopped out and left without a position. His goal is to see a breakout pattern on H1, put his SL and let the market unfold.

At the same time, if he leaves the position along with the weekly trend after he set it in breakeven, he might easily find himself stopped out once again without the weekly trend being canceled. The distance of 100 points to his stop loss is nothing but a small correction on Weekly timeframe.

Summary

No matter how hard we try it is simply not possible to take every single move on the market. We cannot expect to take a bearish Weekly trend, while fading it on Daily, trying to catch every correction up, and also scalp up and down inside of each trading session. As was already mentioned in previous issues, trader’s expectations can be his worst enemy. When you start on the market with the premise of taking each move, never accepting a loss, finding the best price to enter in the market or any other common trader’s dreams, you are preparing yourself for a disaster. If your expectations are clearly unrealistic and you are not willing to accept that, each time the market proves you wrong will generate a lot of frustration and will fuel the desire to “get even” with the market.

At the end of the day it all comes down to our mindset and the amount of control we have over our brain – our desires, fears and expectations.

 

Being in control of your trading

The article is from Market Advance newsletter, issue 3

Three aspects of trading

In last article we explored three parts that in my opinion make up a successful trader. The most general assumption is that trading is about analyzing the market and predicting where the price will go. As we discussed, being an analyst is important – you do need a plan to execute in the market. However, that’s where most traders are stuck – finding a method they believe will make them rich, taking a couple trades that do not work out and then jumping to another method, assuming that they do not have sufficient knowledge about the market and therefore cannot open “the right” trades. The belief that I found to be groundbreaking in my own trading, however, is that there are NO “right” trades. There are simply trades offered by your method of market analysis and you have to take them all, before you make any judgments.

Therefore, the most essential addition to the set of skills of any trader, who desires to make profit consistently, is his ability to execute the trades with no hesitation, trade the plan exactly as his rigid rules are saying to trade it. The plan might as well be faulty and simply not provide the trading edge necessary to win, but without executing a sequence of flawless trades (not from the profit/loss perspective, but in terms of absolute discipline in following the system’s rules) you will never know that and very likely will switch to another Holy Grail only to find yourself with another set of potentially good rules that you cannot follow.

Five or even ten trades is not enough to judge any trading method. Your edge is not going to be visible and such a small set of data bears little to no statistical significance. Imagine a casino operating a slot machine with 4% advantage (meaning that they win 56 times out of 100 on average) calling a mechanic to repair the machine, or suing the gambler for somehow rigging it, just because after 10 customers the casino is in net loss.  Changing the machine after each 10 customers if their gambling produces a loss is just as absurd as changing your system after you have a couple losses in a row, especially if you “jumped the gun” on half the trades.

Mastering trade execution and getting a method of analyzing the market that provides you with some consistent edge are essential for any good trader. However, there is another aspect to trading we briefly discussed in the previous issue and arguably it can be even more important because unwillingness or inability of learning that aspect can help you decide pursuing a career elsewhere, long before you leave your life savings in the market.

Trading is a business

Like in any business, in trading it is most important to stay in control of what you do. First of all it implies having control over yourself, getting your mindset right and acting appropriately on each trading opportunity the market is offering. But when we see that opportunity and ready to enter in our direction, what do we really control in that trade?

I prefer to think of the trader as a small business owner. Anyone can open a small shop as a pursuit of having more freedom in one’s life, but interestingly enough 50% to 80% fail in the first 3 to 5 years. In trading I would argue that the failure rate is closer to 90%. My belief is that the reason for their failure (in business or trading) is defined primarily by the attitude they start with.

As we discussed before, the entrepreneurial freedom NEVER implies freedom from responsibility. In fact, starting out on your own increases the responsibility in almost all areas of your life:

  1. Your level of income
  2. Your medical insurance
  3. Your taxes and book keeping
  4. How you manage your time
  5. Your own development

It is my opinion that the understanding and full acceptance of this responsibility is what defines you as a success or a failure in business or indeed in trading.

In this issue we start our detailed discussion of managing your trading like a business. Being in business means being in control and yet I find that most traders have none –  often unknowingly giving up the only thing they have true control over in trading.

Being in control

If you are a small store owner and you are just starting out you can control quite a few things. First of all you control the stock in your store. You decide how you spend your initial investment. In trading that is your starting capital and in turn you control your Money Management and decide how many positions you can hold simultaneously.

In the store, when you spend $1000 to stock up, how do you know what your returns are going to be? Well, you know for a fact:

  1. The rent you are going to pay this month
  2. The salary to your employees
  3. You know the average bills you have to pay
  4. The advertising costs to attract the customers to your store

It is obviously an oversimplification, but it will do for our comparison. With that information on hand you add it to $1000 you just spent and now you know the amount of money you need to make in order to breakeven. Let’s say it is $1500. Everything above that is your profit (don’t forget the best part – the taxes!). Now, if you want to get $500, you have to sell your stock for $2000.

At that point you’ve already done your research and know that compared to your competition it is a reasonable price tag and given your location you should have no problem selling it at that price point. If (and it’s a big “if”) everything goes well, you just figured out your profit for the month.

Now, in trading you have some benefits, such as:

  1. No additional rent is needed (unless you like working in the office)
  2. There is no one to pay the salary to
  3. The bills are the same as if you would be living your normal lifestyle
  4. You have no product to advertise

In other words, you don’t have that extra $500 minimum you need to make this month just to get out in breakeven. In fact, the only thing you need to do in to order to stay breakeven is to do nothing!

The bad news though is that you have no expectancy for the amount of money you are going to make this month. On the one hand, you know your statistical results over the past months and if you are extremely consistent they can give a good average expectation for your profit (or loss). While the store owner can try to increase his sales in numerous ways by expending more money into advertising, introducing new services, etc., we can only do trades, and usually trying to trade more actively than our system allows will not increase the income by the end of the month – quite on the contrary, you stand a good chance to lose what you earned while following your system as it is.

When a customer enters into our hypothetical store, we don’t know what he is going to buy, if anything. He can go away empty handed or leave half his savings with us. We do know, however, that on this day we already invested ~$500/30 (our monthly expenses divided by the amount of days in this month) into our business in bills alone. We never know how this money is going to come back to us.

When you start your trade, similarly you have no idea what it produces. Yes, your edge provides you with statistics, saying that 12 trades out of 8 will make money, but you can never know the exact winners before they are closed and cashed in.

In reality, when you open your trade, there is one and one only variable that you have certain control over: how much money you are willing to pay the market in order to find out if the trade is going to work. In other words, your risk on that trade. You put your stop and you know where you get out if the trade doesn’t work. Everything else is only your expectation.

Giving up the control

Imagine that in our little store we decide to cut the costs on the salary by declining the medical insurance to our employees and instead paying the direct costs for any accidents they have. Yes, we are happy to know that we saved $100 extra every month but now we never know the costs of doing business. Another unfortunate day a fridge falls down and crashes our clerk’s leg, resulting in $100 000 hospitalization costs and ruining our business, all our savings – our car and the house taken away in addition.

Trading without a SL is exactly the same. If you give up control over the only variable you have in your hands in the market, you are going to do fine until one day you lose it all.

To emphasize the point, I offer this quote by Larry Hite in his interview in Market Wizards:

         I will tell you another story. I have a cousin who turned $5,000 into $100,000 in the option market. One day I asked him, “How did you do it?” He answered, “It is very easy. I buy an option and if it goes up, I stay in, but if it goes down, I don’t get out until I am at least even.” I told him, “Look, I trade for a living, and I can tell you that strategy is just not going to work in the long run.” He said, “Larry, don’t worry, it doesn’t have to work in the long run, just till I make a million. I know what I am doing. I just never take a loss.” I said, “OK…”

In his next trade he buys $90,000 worth of Merrill Lynch options, only this time, it goes down, and down, and down. I talk to him about one month later, and he tells me he is in debt for $10,000. I said, “Wait a minute. You had $100,000 and you bought $90,000 in options. That should still leave you with $10,000, even after they expired worthless. How could you have a deficit of $10,000?” He said, “I originally bought the options at $4k. When the price went down to $1k, I figured out that if I bought another 20,000, all it had to do was go back to $2k for me to break even. So I went to the bank and borrowed $10,000.”

Summary

The difference between any entrepreneur (traders included) and usual paid worker is in the acceptance of the risk and the responsibility. Most people prefer to live in the comfort of some assurance in life that they get a pay check every month as long as they follow the rules – and in the current economy that assurance is very tiny indeed. Any entrepreneur accepts and embraces the risk, giving up that assurance in exchange for control over his or her life.

As traders we can learn a lot in regular business. The costs of doing trading business must be defined as rigidly as possible.

We can:

  1. Set our monthly loss limit
  2. Set our daily loss limit
  3. Given the expected activity of our trading system, work out the amount of money we can risk in each trade, so that we do not exceed our daily loss limit after we fail a couple signals in a row

We cannot:

  1. Set a rigid profit expectation for every trade
  2. For every day
  3. Even for every month

Unfulfilled expectations will lead to frustration and mental disturbance, undermining our success in trading.

Being a Trader

The article is from Market Advance newsletter, Issue 2

Today we are going to look at the 3 main parts of trading profession, the essential treats of character for any successful trader.

Being a businessman

Trading is first of all a business. It is about embracing the risk, taking the action and accepting the full responsibility for the actions we take.

When I read about trading online, I always see that trading is about being home, waking up whenever you want to, and taking a couple trades with an easy to follow trading system that you can conveniently buy on the same website for $99.99. Even better, the system can be fully automated, a miniature variant of money printing machine at the convenience of your home office! Sure, I get the fine print required by the government about how risky it is (you can find it in the beginning of this newsletter as well), but the big letters right here say clearly “90% success rate on any timeframe, any trading pair, any account size!”

That was the general mental state I was in when starting to trade.  However, trading turned out to be one of the most difficult paths one can take in life. I was lucky enough to find an online community of professional traders where I learned not only all the basic and advanced technical analysis but more importantly the right attitude to trading. The rules for all newbies were the same: not only had you pay the monthly fee to be allowed in, but every day you had to be there in the discussion from 8am GMT+3 (start of the European session) to 6pm (after the start of US session) and had to create pictures for every single post that pros make. Only by going through that, following them word to word, typing in their comments in the pictures, could you understand what trading is about.

Of course, it was strictly intra-day short term trading – It is a little bit slower pace of action on higher timeframes. Either way, anyone expecting to have a relaxed time trading should seriously reconsider his goals.

Having said all that, it is not just hard work that make the trading difficult for most people. Being a businessman implies another important character trait – the ability to accept full responsibility for one’s life. Most people can never truly exchange the comfort of day job with an expected paycheck by the end of each month, employer provided benefits and a relative sense of stability for more freedom. Freedom of being self-employed implies the ability to make your own choices and decisions in life. It never implies freedom from responsibility. Only by embracing the risk, the unknown, being responsible for each moment in your life you can truly succeed as an entrepreneur.

Being a trader

What does it mean being a trader? If we had to define one core function a trader has to perform, what that would be?

Trading, like any other profession requires a particular set of skills. We teach economists, analysts, bankers, but I will argue that having all these skills, even at a very high level, does not guarantee any success in trading. In fact, I found that studying the market only made it more difficult for me to actually trade.

First of all, let’s define what trading is NOT about at its very core.

Trading is not about analysis of the market. It is not about forecasting the price, knowing where it will go. Trading is also not about understanding the underlying economic reasons why the price moved where it did. Sure, all these things can and will help in trading and I am not denying the great value in this additional knowledge, but at its core these skills are not definitional of trading.

Let’s take a look at an example. A musician, just like a trader, needs a certain set of skills to become successful. He can learn all he wants about the history of music, understand all different musical styles, become very knowledgeable in works of every major composer, learn all ins and outs about musical theory and harmony, etc. All these things are extremely important but in themselves they will only make a good historic of music, or (god forbid) a music critic.

What defines a musician, however, is first of all his ability to play, to perform. There are countless successful musicians, especially in modern popular music, that reached success with no knowledge of musical theory but simply by superb performance of their original or someone else’s work. The technique, the ability to make the sounds pleasant to our ears is the core of any musician.

Coming back to trading, let’s see if we can define a trader’s core skills in a similar fashion. Just like musician final creative output is the sound he produces, the trader’s final output is the money. There is nothing else a trader generates by the end of the day but a balance – negative or positive – in his account.

Musician’s ability to produce sounds pleasant to our ears is defined by his technique – his ability to execute every single note in just the right way. Similarly a trader can produce money by his technique – his ability to execute every single trade at the right time in just the right way.

I accept that one can be a high level composer, writing music for the orchestra or solo performers, without having the ability to perform his work himself to a high standard. You can also be a good market analyst, forecasting the price with high precision. You can plan your perfect trades all day long, and still be unable to trade your plan.

So, at the core, being a trader means executing the trades, pulling the trigger with no hesitation and great consistency. There may be bad trades indeed, but I never said that trading is only about taking the trades – I only shared my opinion that without that ability no one can be called a trader.

Being an analyst

This is where you plan your trades. We discussed trading the plan in the previous section, when in reality you have to plan the trades before you can trade them. However, I feel it is important to emphasize how much more crucial it is to execute the plan then to write it.

When I started my main goal was to analyze the market the best I can, try to forecast the price, predict every single move of the market. I read and learned everything I could find, starting with simple charting tools such as trend lines and channels, then trying every single indicator, hoping that I can find “the one” that works more often than it doesn’t, exploring the Fibonacci set in great detail (going as far as reading his original work), getting stuck with Elliot Wave theory for at least 5 years and then finally programming the most complex automated trading strategies I could imagine, powered with desire to have my own money-printing machine in the office. Naturally, none of that worked.

It was a very vicious cycle indeed, something many traders get stuck in for many years. You find something that seems to work on the history, start using it life, fail with the first couple of trades and quit before too long, swearing never to come back to the markets again. However, as frustration wore down with time I was ready for another try, another great idea to make me rich overnight.

Many traders are lucky to end that cycle either by becoming totally hopeless or losing enough money to quit for good. I did not have such luck on my side. Being careful enough to follow money management rules and never risking more than 1% in a trade I was going in circles for more than 7 years. When I was ready to quit after the first 4, I started programming for other traders and that was fueling my desire to come back to the markets all the time, nonstop.

I never actually did badly, I had many good trades and was considered a good analyst. The fact that I did not get at the time was that being a good analyst, predicting the price and winning consistently in trading have very little in common.

Until very recently I never even considered that my problems could be in trading execution. Any time I would miss a good signal that I planned to take, I blamed my analytical abilities – they are not good enough to provide the confidence to take the trades I plan. And so I searched for the next golden trading rule. When I took the trades that failed, guess what, I blamed my analytical abilities again. When I took the trades I never planned I once again reasoned that I do not have a trading system good enough to trust and not consider taking any trades that are not part of it. You see, our brain is extremely good at finding excuses.

Putting it all together

Just like any other profession or pursuit in life, trading is a journey. In this series of articles on trading mindset and psychology I am attempting to draw a map that we can rely. It is not going to be a perfect map that can change us from failure to consistent success overnight, to follow the map precisely we will need a key. That key is our understanding of ourselves – our own beliefs, fears, expectations, the excuses our brain makes. Developing such deep understanding that is necessary to succeed goes well beyond the scope of any writing – it is the pursuit of one’s whole life.