It took me years to figure out how to build a successful strategy from the ground up. The truth is, a strategy built on sound trading concepts and your personal beliefs, with a relatively small Sharpe ratio (risk/reward measurement) of 1.5, is infinitely better than a strategy developed through rigorous back tests to find the “perfect” combinations. Sound beliefs and personalization matter more than anything, to ensure your strategy is sustainable and impervious to changing market conditions. A strategy based on beliefs is superior to any other, because when your trading setups are supported by your beliefs, you won’t have trouble trading them. You’ll actually follow your strategy.
Your one goal is to trade the strategy, but if your strategy isn’t based on your actual beliefs, you will override the strategy when times get tough. Don’t let that happen.
If you haven’t traded before, you need access to a proven strategy (like the ones in part 4). Then you can simply execute it and learn as you go. Most people start trading and think they can come up with their own, unique strategies. That would be like someone reading four books on brain surgery and then stepping into the operating room. For brain surgery, fortunately, no one would let you into the operating room. For trading, though, access is easy. Open a brokerage account, and you’ll get bonuses. That’s to encourage you to trade, so brokers can get their commissions. Once you’re in the game, it’s hard to quit. Beginners are allowed to play with the pros, but they’ll lose.
To start, write down everything you know about yourself, in terms of trading. Don’t make the common mistake of evaluating yourself half-heartedly. It will destroy your financial future.
I’m a big fan of the Myers-Briggs personality assessment; knowing your type is essential before creating your strategy. This isn’t so that you’re put in a box and classified as a certain type of trader; it’s so that you understand how your inborn personality will reflect in trading. Next, you’ll identify the steps you can take to improve on your weaknesses.
Myers-Briggs is based on four dichotomies—each person leans toward one of the two options in each category. It’s not all-or-nothing; it’s simply a side you veer toward more.
First there is extraversion versus introversion. Next, there is sensing versus intuition, thinking versus feeling, and judgment versus perception. There are sixteen different personality types, determined by whichever combination of those four dichotomies the test says you prefer.
I haven’t seen any difference between extroverts and introverts in terms of trading, but for the others, the differences are significant.
People who prefer intuition tend to see the big picture better than those who prefer sensing—the more detail-oriented bunch. For developing strategies, intuition is preferred.
As for thinking versus feeling—thinking has a huge edge. In trading, you can’t make decisions with your heart.
Finally, judging types are more disciplined and better planners than perceiving types, who are more open-ended and dislike routine, discipline, and deadlines.
It’s important to understand that these are simply preferences. You can work on your weaknesses, and you can win money trading even if you aren’t the “ideal” trader. Also, your weaknesses in trading may be your strengths in other areas of life.
I’m a perceiving type, but I’ve worked on and account for this weakness. Once you accept it, you can overcome it. I hate working with a planned, nine-to-five routine; I work when I’m inspired. For that reason, I’ve outsourced and automated my trading. My programmer is the one that needs to be disciplined, and I hired him with that in mind. It’s the perfect solution.
Thinking of the big picture comes easily to me, but I also have a slight tendency toward feeling rather than thinking. It’s inborn. But I know that trading requires rational, objective thinking, so I have worked to step into that proverbial “thinking person” when I’m working. I’ve worked hard on that, and it has paid off.
Work on yourself to improve your weaknesses, and outsource what you struggle with. Your weaknesses are other people’s strengths. They’ll be happy to get paid to do what they’re good at. If you’re a feeling type, that’s a weakness, but having 100 percent awareness of that fact is the most crucial thing you can do. Weaknesses can be overcome, but only once you admit them. Take a Myers-Briggs test. If it turns out you have a weakness, accept it, realize it’s a strength in other aspects of life, and put routines and rules in place so that it doesn’t impact your trading.
Also, realize these aren’t absolute. If you’re a feeling or perceiving type, that’s just a preference, an inclination. The first step to overcoming it is awareness. Next is looking for a solution: outsourcing, automation, transformation. It’s possible to get more disciplined, by training yourself with things like Neuro-Linguistic Programming (NLP).
When you’re trading in the markets, you’re trading your beliefs. Therefore, accessing, identifying, and understanding your beliefs is essential.
The best traders use a wide variety of strategies—mean reversion, scalping, long-term trend following, short-term trading. They all can work under the right circumstances, for the right person. That said, there are a few common beliefs that virtually all top traders share, and they’re essential to understand. Your strategies can vary, but you should pay close attention to these core beliefs.
Most importantly, top traders understand the importance of having beliefs. That sounds simple, but it’s crucial. The average trader never defines his beliefs, and it crushes him. You can’t have a clear strategy without clear beliefs. That leads into the next point: You must have a proven strategy that you believe in, and you must follow it to the letter.
Whether you’re Ray Dalio, Warren Buffett, or Paul Tudor Jones, if you want to make money, you need beliefs that inspire a strategy, and then you need to vow to follow that strategy completely. The strategies vary, but the commitment to having and following them doesn’t.
It took me years of failure and study to adopt these beliefs, but finally, they’ve become second nature. Pay close attention to the list below, and start to drill these beliefs into your head.
The Beliefs All Top Traders Share
Know your goals and objectives before you start trading, and before developing any strategy.
By knowing what outcome you’re seeking beforehand, your strategy will take about 80 percent less time to create. When you don’t have an objective or goal, you tend to tread water, because you can’t make a plan without an endpoint. Set your objective, then make a plan to get there. You need to take a bit of extra time beforehand to save 80 percent of your time later and guarantee success.
The clearer your objectives, the easier the development process, and the easier the execution. Don’t skimp on this.
Don’t trade at all on days in which there are no low-risk trades available.
It’s common to think you have to trade every day, but that leads to big losses on days when you shouldn’t have traded at all. Don’t be afraid to sit out a day. You should only be trading low-risk ideas that fit your strategy, and that has nothing to do with your calendar. A day without a trade isn’t a lost day; it’s a win, because you’ve avoided losses.
Good trading is boring.
The way to succeed in trading is to overcome all of your psychological weaknesses as a human. Those weaknesses can make life fun, but trading is about being rational, even robotic. The only reason I am so profitable is that I apply the rules of my trading strategy perfectly. That means following protocol 100 percent, which goes contrary to my earlier mistake of using trading as grounds for adventure. That was a recipe for disaster. Setting good rules and then following them to the letter is the only way to be profitable. To win the game, you have to follow all of the rules of the game, as boring as that may be. Break rules elsewhere.
That frustrated me at first, and I didn’t want to execute the boring parts of trading (order management, setting and following rules and protocol). I wrote a complete script, hired an employee who e
njoys executing rules to a tee, and trained him for two weeks. The process used to cost me many hours a week, but now it’s outsourced to an employee who enjoys it. He sends me a report three times a day, which costs me a couple of minutes, total, to monitor. That saves me from boredom, and it allows me lots of time to research for more noncorrelated strategies and ways to improve the big-picture trading operation. That’s my strength and what I enjoy.
When I finally mastered my psychological state, outsourced my weaknesses, and got disciplined, my accounts blossomed. I stopped thinking about the money as exciting money, but rather as boring transactions that I could measure objectively and precisely. I was finally able to trade comfortably at a risk profile that suited my needs. I stopped thinking about money gained and lost on a daily basis, because I knew that focusing on my proven rules would lead to long-term success, which is the true purpose of trading.
Daily results are irrelevant. All that matters are your long-term objectives. When that has been set correctly, your state of mind shouldn’t change based on daily results.
That means no elation on good days, but no misery on bad days. My wife can no longer tell the difference between winning and losing days, because I’ve defined my risk and long-term objectives correctly. I can’t fail, because short-term fluctuations are irrelevant. I don’t freak out or get stressed.
I have many losing days each year, but this no longer bothers me. I consider the day a win if I followed my rules with 100 percent perfection. On that scorecard, I never fail. The daily losses are part of the game of getting rich long term. As Ray Dalio said in the book The New Market Wizards, “I’m not paid when I’m right 80% of the time. I only get paid when I make money.” Daily wins and losses aren’t real money made; they’re just temporary, meaningless changes in the scorecard. Trading is a business, and the losses are expected business costs in a profitable endeavor. Would you question needing to pay rent for your jewelry store? Every business has necessary costs in order to achieve a profit at the end of the quarter, and trading is no different.
To be successful in trading, you need to lose to be able to win. Without risk, you can’t win.
Entry size matters more than entry price.
The first time I read this was in Jack Schwager’s book, Hedge Fund Market Wizards, and he is spot on. If you’ve sized your entrance correctly according to your risk tolerance, you’ll stay with the position. You won’t override it, because you’ve risked the proper amount of money, and you’re OK with losing an exact, predetermined amount based on said risk tolerance. You aren’t risking enough to affect your mental state so that you override your position.
On the other hand, when you’ve sized your entrance too high for your risk tolerance, you’ll look at things differently when you start to lose money. If you bought a stock at 40 and the price drops to 39.50, you shouldn’t be affected. However, if your entry was too big, you’ll think in terms of dollars lost, and want to get out. Your exit won’t be determined by price movement, as it should, but rather because of your dollar loss. Proper entry sizes will protect you from this.
Successful trading can be effortless, when you’re committed and have worked hard up front.
Trading is easy for me, but only because I put in the preparation and years of practicing and commitment. I know every aspect of my trading strategies, so implementation is easy. I don’t get tired or stressed anymore. You can do the same, if you work to get there.
Everyone has inborn personality weaknesses for trading, but as long as you account for yours, you’ll succeed.
There are certain personality aspects, like patience and discipline, that are ideal for successful trading. But everyone has weaknesses, and you’re only doomed to fail if you don’t admit and account for your weaknesses.
The key is having the willingness to work on your weaknesses, so that you can transform them. Also, acknowledge them, so that they can be leveraged.
I personally hate discipline and rules, but I’ve committed myself to working on that weakness. You can do the same; it’s your willingness to improve that matters most. I chose to work on myself, and now there is no doubt I will follow my rules, daily. That said, I’ve made my rules realistic, sacrificing some potential profits to ensure I follow my rules. Otherwise, I’d fail, and catastrophe would ensue.
It’s just money. Be humble in victory.
You will see huge, daily profits at times. But remember: All that matters are long-term results. If you get cocky or greedy, the market will teach you a lesson.
You must know your risk tolerance. It’s lower than you think.
If you try and guess your risk tolerance, you’ll be wrong. You can’t know until you’ve visualized losing money intensely, or ideally, actually lost money. That’s how I learned. Now, it’s a joy that I know my results can never affect my state of mind.
You won’t lose a minute of sleep, even on your worst day of the year, because you’ve defined your low limit precisely and have crafted your strategy so that you never exceed your risk tolerance. This means you sacrifice a small percentage in profits, long term, but it ensures you’re 100 percent comfortable at all times. You’ll never lose your cool and override the strategy, and you’ll still make more than enough money, long term. Of course, the upside has to be there, too, but we ensure that when creating our strategies. It’s not like you’ll liquidate all positions at the slightest scare.
Virtually everyone overestimates their drawdown tolerance. Think you can handle a 30 percent drawdown? You’ll almost certainly feel uncomfortable at 15 percent, losing sleep, wanting to override your strategy. That’s normal. Don’t set your risk tolerance until you’ve clearly visualized how such a change in your account balance will impact your psyche. And remember: The higher the drawdown, the harder it is to come back and break even. At a 30 percent drawdown, you need to make 43 percent to return to breakeven; but at a 50 percent drawdown, you’ll need to make 100 percent. Ouch.
Project your strategy’s results in all market types.
The main tenet of my strategies is that we don’t try to predict which type of market is about to occur, because it’s too difficult. We trade a set of noncorrelated strategies, so that we can make money in any type of market. You must know how your strategy works in each market type, so you’re set for all possible scenarios.
Each strategy has times when it loses some money. That’s common sense. A long-only strategy will struggle to make money during bear markets. As long as you knew this beforehand, you won’t worry. You are ready for this and have other noncorrelated strategies in play that are making money. You will often have individual strategies losing, but the others will make up for them.
There is no Holy Grail strategy that works at all times.
I spent years searching for the perfect strategy. It stressed me out, and I lost years of trading because when I couldn’t find the perfect strategy, I thought I was missing something. I beat myself up mentally and sat on the sidelines. Once I realized the perfect strategy doesn’t exist, I was free to trade a decent strategy that makes money. The truth is, this strategy I thought was decent was about as good as it gets. All that matters are long-term profits.
The Holy Grail is in yourself. The Holy Grail is about conditioning your psychology and discipline and finding a strategy that suits your personality and objectives. You won’t be right all of the time, but you will make more money than you need, long term. It’s freeing to know that perfection is impossible, and “good enough” is truly more than you need.
The Holy Grail of stock trading is in the perfect execution of an automated suite of noncorrelated strategies, traded simultaneously.
Your strategy’s back-tested success rate is not the same as its future success. Trust me, as all of my strategies are created through back testing. The best you can hope for is similar success, but you may have your worst drawdown ahead of you. Your strategies must not only back test well, but they must be conceptually correct, otherwise you simply foun
d something that was coincidentally lucky in the past and that is doomed to fail in the future.
Having the belief that you can’t predict the markets is valuable and freeing, because it gives you the confidence to close a trade that has gone against you. You understand that short-term losses are inevitable, and you’re OK with admitting you were “wrong,” because you’ll be right in the end.
Be wary of super-successful, back-tested strategies.
There might be a bug. You might have unconsciously overoptimized your strategy parameters. It might have been a coincidence. The key for all strategies, after development but before implementation, is to do everything possible to try and disprove your strategy. You must ensure that it’s conceptually correct.
This is uncomfortable, because it goes against human nature to try and break your impressive creation. But in the end, you’ll be grateful. I do this often with my business partner—when I’ve finished creating a new strategy, I send it to him and say, “Try and break it.” I tell him to ensure that the great results from back testing were real, that the parameters weren’t lucky, overoptimized, or due to huge data mining without conceptually correct ideas.
The future cannot be scripted perfectly from the past. Evaluate every parameter in your strategy. If you disprove a promising strategy, that can be frustrating, but it will save you a lot of money. Celebrate the fact that you avoided disaster.
A mistake isn’t a losing trade. A mistake is failing to follow your rules.
Losing trades are part of the game. Don’t consider them a failure. As long as you follow your rules 100 percent, you will succeed, because you have created the foundation for success beforehand. On the odd chance you overrode your strategy and it made you money short term, you should consider that a loss and a failure. You can get lucky short term, but the market will soon teach you a lesson.
The 30-Minute Stock Trader Page 6