Developing a Systematic Trading Strategy
The main reason most people fail at trading is that when their hard-earned money is on the line, they become too emotional. The market plays psychological tricks with our brain. When the market falls for a few consecutive days, traders project their trading equity going to zero; and when the market rises, they fantasize about how much money they will make. Traders constantly struggle with these emotions. The natural tendency is for traders to hold onto their losing trades too long and sell their winning trades too early. Unfortunately for traders, these are normal human emotions that are hardwired into our DNA and ensured our ancestors’ survival on the African savannah, but these emotions do not serve us well as a trader. The reason most traders fail is they have not developed a mechanism to over-ride these natural emotions.
Your goal is to develop a systematic, rules-based, trading strategy that removes emotions from the trading process. Through backtesting you will confirm that your strategy has a positive expectancy, or an edge; and, therefore, you must take all signals generated by your strategy. The trading rules must be very clear and straight forward. Your strategy must clearly identify the following:
- What markets to trade
- How to identify potential trade setups
- How to enter the trade
- How much to risk on the trade
- How to determine your initial stop loss exit
- How to determine your profit stop exit
The rules for your trading strategy must be clear enough that you could give them to your spouse or a friend, and with minimal training they would be able to follow the rules. If the rules are clear, it will help remove emotions from the trade. Clear rules also make it easier to backtest your strategy to confirm its reliability.
Most new traders assume there is a Holy Grail trading strategy that, once found, will guarantee fortunes. The truth is there is no Holy Grail trading system, but there are hundreds of ways to make money trading. Your goal is to develop a trading system that fits your personality and is easy to repeatedly execute. If you try and use someone else’s system, chances are you will fail as you will not fully understand why it works, and it will not fit your personality.
Although there are many ways to trade, one method used by many of the most successful traders, that has stood the test of time, is trend-following trading. The principle of trending following trading is very straightforward. You identify a trending stock, find a trigger to enter the trade, enter a stop loss to ensure you will minimize any potential losses; and if the price continues to increase, stay in the trade until the trend ends. The challenge is that in trend following, trading only between 30%-50% of your trades will be winners, and the majority will be losers. However, if you use proper money management techniques, the winners will be two to three times as profitable as the amount you risk on your losing trades. The other challenge with trend-following trading is that the winning and losing trades are not uniformly distributed. You will have times where you have 15-20 losing trades in a row. After a losing streak, you must trust your trading strategy, so that you will have the emotional strength to place the next trade that your system generates. That next trade has the potential to offset the previous 15-20 losses, but only if you have the confidence to place the trade. The backtesting of your trading strategy will give you that confidence.
Trend-following trading requires a basic knowledge of technical analysis. The key to successful trading is simplicity; therefore, you do not need to become an expert in technical analysis. In general, a trending stock will show the price rising from the bottom left to the top right of the chart at approximately a 45-degree angle. A basic understanding of price, volume, trends, moving averages, and support and resistances is all that is required. This information can be found in any basic book on technical analysis. You may want to also add some general knowledge of oscillators, average true range, and candlesticks. Stay away from including price patterns in your trading strategy, as the interpretation of patterns requires discretion which will make it harder to consistently pull the trigger on trades. Many successful trend-following strategies use price as their only trading criteria.
Figure 1.1 Typical Trend Following Trade
As a trader, you do not need to read the daily financial news or watch the financial news networks. If possible, you should avoid them, as much of the information you read or hear will conflict with the signals generated by your trading strategy making it harder to implement your strategy. Nobody can predict the future. All the information you require to implement your strategy is contained in the individual stock charts.
In our next lesson we will develop Trading Rule #1 - Market Trend
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