I have dedicated nearly two decades of my life to trading and I have learned many things along the way. One important thing I have learned is that keeping it simple is a good strategy as long as we do not inadvertently remove some key aspects of trading in our quest to simplify things. That will only serve to make success more difficult to achieve.
I have been able to identify five aspects of trading that I feel are essential to being successful. Think of them as the foundation of a building. Together, they are stable and strong, but remove even one, and the building will easily topple.
Here are the keys to success in trading:
1. Risk Management
Portfolio risk management is an essential part of trading success. You will need to learn how to manage risk so that no position can ever make or break you. A mistake that most traders make is that they take too many risks on ideas and leverage their account. This mistake can easily lead to catastrophe.
To avoid this, I recommend that traders view their portfolio in its entirety rather than focusing on individual positions. By only focusing on the individual position, the possibility of placing too much risk on that idea is high.
A high level of portfolio risk will ultimately result in position sizing risk. A famous trader Dr. Alexander Elder, subscribed to the 2% and 6% rule. In my opinion, even this is too high.
If you have a very small account (less than $10,000), you can most likely get away with this because of high brokerage costs and buying and selling positions less than the 2%. However, keep in mind that if you were to get 4-5 in a row wrong, 10% of your account would be gone. As a result, just to get back to where you started, you would have to make that back and then start all over again. This situation does occur and, in fact, I experienced this myself.
Based upon my experience and considering market risk, I do not risk any more than between 0.1% to 1.25%.
Some have commented that this percentage is too low. The reason they give is that with this percentage, you do not make much of a profit. However, what they fail to understand is that even at this rate, if you take advantage of the many opportunities that are out there and the majority trades are successful, the returns add up while you operate with low risk.
2. Psychology, Mindset and Personality
Mark Douglas, author of “Trading in the Zone” and Dr.Van Tharpe, author of “Trade Your Way to Financial Freedom”, have both been my mentors. I owe both of them credit when it comes to the trading mindset I currently hold. Many years ago, I had the honour of spending two weeks with Dr.Tharpe while visiting New Zealand. Now considered a friend, Dr.Tharpe taught me what a large role trading psychology plays when it comes to trading success.
There are differing statistics out there regarding how much of a role psychology has when it comes to trading success, but according to Dr.Tharpe, up to 90% of trading success is due to psychology and the remaining percentage is due to systems.
As with any theory, there will always be someone that disagrees. There are those that attribute only 10% to psychology when it comes to trading success. Regardless of the exact percentage, the important take away from this is that psychology does play a significant role.
Psychology has many aspects and one in particular is worth exploring. That is, personality. I cannot stress the importance of matching your personality to your trading style enough. It is my opinion that not fitting your personality to your trading style is the primary reason why over 90% of traders fail. Many new traders attend weekend seminars and walk away with a number of trading techniques and styles. They try to replicate what they were taught, but they find that after 3 months, 90% of their account is gone. Why would this be?
The seminar is taught by one guru and therefore, they are only receiving information from one perspective. Trading techniques are not one-size fits all. The guru teaching the seminar will not necessarily teach them what best suits their personality and therefore, they fail. Of course, there will be those that are successful right away and that is because they were lucky enough to have a guru whose personality matched their own.
Trust me when I sat that you are not alone. When I first started out many years ago, this happened to me.
My hero was Warren Buffett. His value based investing approach was so fascinating to me and I wanted to be just like him. I adopted his approach and was very confident that I was going to be just as successful as he was. While I admired his approach, it just did not fit my personality. Much to my disappointment, I had to accept the fact that I was not Warren Buffett.
As an example, Warren Buffett has a keen understanding of how a company works at every level and gathers every possible piece of information about their competitors. Not only does he analyse their financial reports, but industry journals and publications. He uses information from all of these sources when making investing decisions. I tried so hard to do this myself and after a while, I realized that this was not something I was interested in, nor did I enjoy it.
I then moved on to day trading. This meant that I needed to be in front of a trading screen all day buying and selling securities like stocks, options, forex and closing out all positions by the end of the day. This did not work for me either. I disliked staring at a screen all day and I did not have the hand-eye coordination and speed that is required as a day trader. I enjoy my freedom and this style of trading would not provide me with that.
3. Market Analysis
Many traders keep a narrow-minded perspective and focus on the trade while ignoring the current market environment. With this perspective, they cannot make a sound decision as to whether they should be participating.
You want to go with the flow when trading. By going against the grain, you will make very little progress because you will be taking a high amount of risk for very low returns.
It is sometimes in your best interest to wait out an unsafe market environment and trade only when it has become a safer one.
Take the GFC, for instance. If you ignored the state of the market, traded long, and at the same position size as you would during a period where the markets were safer, you would have faced devastating consequences.
The best thing you could have done in that situation would be to wait or reduce your position size so when the trades went wrong, your losses would have been minimised.
If you incorporate all four of the key elements I have described above into your investing and trading practices, you will see that your skills will be elevated from that of a newcomer to a professional hedge fund investor.
4. Trading System
If you have adopted or created your own trading system, psychology and risk management are not going to help you at all if our own system has a negative expectancy. In other words, even if the execution of every trade is perfect, when you are engaging in many trades regardless of the market conditions, your system will lose money.
Unless your system has a positive edge or positive expectancy over numerous trades, the only thing that matching your personality, managing your portfolio and optimistic thinking will do for you is to slow down the rate at which you lose money.
The key is to have a trading system that is a good fit with your personality and has a positive edge.
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