In June I asked my friend Dean Whittingham from Traders Universe who wrote a GREAT post that got me, and our readers thinking. I asked Dean to see if he could write another piece that got us all thinking again...and I think the below article is exactly what we need!
Many considerations go into creating and running a successful trading entity. We'll look at the most popular which get the most attention, right through to the most important, which usually get the least attention.
Here is the list:
1. Entry signals
2. Risk management
3. Exit signals
5. Reward to Risk
7. Capital management
9. Familiarity with Markets
Most, and by most I mean probably close to 80-90% look at number 1 and that is it! That is a startling reality, but a reality nonetheless. But there is a reason this happens. Most new traders are unaware that such a large number of traders ultimately fail in this business, and more importantly, this fact is well known by the very people who market trading in this way.
But enough of that, let's look at some serious considerations you should make and the order in which you need to do it.
Objectives – Set a target, a goal, a reason. Without this, you can't create or find the right system for you. You won't know whether the system will work for you, or even if it is on track or not once you begin trading it.
Familiarity with the markets – Quite simply, markets move in similar patterns which is all good, but there are different costs, margins, hours of trade, laws etc associated with each market that need to be considered.
Resources – These are your physical and mental assets. Everything from your time, capital, computer, to your mental strengths forms your list of resources. Day traders need different resources to a long term trader, not only in hard assets but mentally too.
Mindset – This is part of your self-image. Your self-image influences your decision making process on a continual basis. It stands to reason a trader would only become successful if they were making the right decisions. You need to see yourself as a success first.
Style – This is something you'll need to work out way before you look at any system. Are you mechanical or discretionary, in other words, do you want a system to tell you what to do, or do you want to be analytical? Do you want to trade for growth or income (part of your objectives)? These sorts of styles all require different tools, and so it seems silly to purchase a system before you even know your preferred style.
Once you have these aspects thoroughly researched and sorted out, I can guarantee you that finding or creating the right system of entry and exit tools will become far easier and much more enjoyable too. You'll naturally be attracted to the type of market tools that suit you.
But even then, once you find the entry and exit tools that suit you, there is more work to do.
You need to back test and paper trade your entry and exit rules to determine the rest of the considerations mentioned above.
Reliability – How reliable is the system for producing winning trades compared to losing trades, and does this suit you? The latter part of this question is the most important part. The reliability of the system does not tell you its overall profitability. It tells you your ratio of winning trades to losing trades, and this is a psychological question. Do you need to be right more times than wrong? This is the simple question you need to answer.
Reward to Risk – What is the average profit per trade? This is your total net profits divided by your total number of trades (if your system has a net loss then it's no good - obviously). When you know the average profit per trade of your system over a decent sample, you can then determine the number of trades you need to make to reach your objectives.
Opportunity – Now that you know the number of trades you need to make over a time to reach your goals, you must determine whether or not your chosen markets will offer the opportunities you need. Will you need to trade in multiple markets, trade both long and short and so on?
Capital Management – If you do find that your chosen markets offer enough opportunities for you to reach your goals, you need to consider if your capital can handle it. Many systems will require multiple positions open at one time in order to reach goals in a specified time. This means your capital may be stretched, or may not even cope. The size of your positions in the market is a part of your capital management and is also determined by whether or not you have leverage and the margin required.
Risk Management – Risk is what you are willing to lose per trade. Your exit strategy aids in determining this factor, but it also needs to gel with you, because your risk per trade is a factor in your drawdown. The higher the risk, the higher the drawdowns and you need to know the maximum drawdown you're willing to tolerate.
Management – The final consideration we'll cover here is management. You are controlling an entity and so management of all key areas is important. If you log each trade, you can assess for human errors, bad habits, you can also assess costs associated with trading and whether or not they can be reduced. In fact management is the part of your trading that is always looking for ways to improve the running of the business.
If you look at the list above it can seem like a lot. If one was to think of what goes into creating the great business models like McDonald's, Starbucks and so on, then I don't think it even compares. But why should it be so daunting? Enjoy the process and it will be a lot easier than you think.