We need to take a few moments to look at each of these elements individually
1. Your idea or edge....
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Every trader needs to come up with an idea of how he can win more times than he loses. This is one area where many traders fail. They sell themselves short by accepting the premise that they cannot devise a specific plan or "formula" with which they can beat the market. It is important to recognize that some successful traders believe that arbitrary entries could be profitable, as long as a sound money management plan and exit strategy are adhered to properly. So though an "edge" is important, it is not the sole factor that makes or breaks your approach.
When searching for the "edge" that will work for you, should remember two things of importance. Your chance for developing the best idea increases exponentially as you increase your time observing the markets. (i.e. the more time you spend in front of your trading platform, the more likely you will begin to notice patterns that work for you). The other important idea is to keep your premise simple. Rely on an idea that is easy to understand and makes intuitive sense. Many traders rely on inidicators as a trigger such as moving averages, bollinger bands, MACD, etc. An example of an edge utilizing this approach might be that a trader plots short term (10 minute) moving averages and sells when his market trades below that average and buys when it trades above. Other traders may avoid indicators altogether and look at charting directly and develop theories based on when they believe a breakout (or breakdown) is most likely to happen. This often involves price movement in coordination with volume change. As an example a trader may plot horizontal "support" and "resistance" lines on his chart when he thinks that his product is in a trading range. He many then choose to buy when the market trades above the resistance or sell below the support. He may choose to combine volume analysis and thus decide to buy when his market trades above resistance, only if a certain volume occurs above the resistance line.
There are an infinite number of "ideas" that can be concocted though not all are good. It is therefore important that once you grasp an idea, you test it with both old and new market data. Successful testing will reinforce your theory and give you the confidence necessary to trade on this approach. Your idea is one of the most important of the trading essentials.
2. Your Trading Plan....
What exactly is a trading plan? What does it involve? How does one develop a specific plan?
Let's suppose that you have noticed in your particular market, that when charting prices against a moving average, your market tends to break above the average on the third attempt in a single day. You therefore "test" this theory preliminarily by reviewing months of historical price data and charting the moving average you intend to use against this data. Sure enough your idea is reinforced and seems work. In addition, you note that it is in fact quite a simple idea and it intuitively makes sense (the more attempts at resistance the more likely a break through). BUT HOW EXACTLY DO YOU PUT THIS PLAN INTO EFFECT?Specifically, you decide to trade using your theory so you buy on your maket's break through resistance on its third attempt. Now what? You own the product. What do you do now?
This is where your specific trading plan comes into play. You have decided when you will buy, but how much will you buy and when and under what circumstances will you sell? Of course sometimes plans don't work so how will you know when your plan has failed and you should take a loss? This is all part of your specific trading plan. You must know ahead of time how many contracts or shares you will buy. You must have a specific plan for selling (perhaps after a 10% gain or on a 5% pullback) and you must know how to recognize when you are wrong (perhaps if your product moves back below entry or maybe on a loss of 2%). Whatever your idea or edge, you must have a plan with which to utilize that idea. Once you have developed a clear, specific plan, you then can test this plan empirically using historical data, and hopefully test it on new data as well, prior to utilization.
3. Money Management....
What is Money Management and how can a trader know how to implement it is his plan?
Money Management is likely the most, or at least one of the most, important elements in developing your overall strategy. No methodology is going to be correct 100% of the time. With that in mind, you must be prepared for losing. You must also understand that statistical probability allows for multiple losses in a row. Yes.....multiple losses in a row. This means that if you trade with too large a percentage of your capital, you risk losing it all......known in the business as "blowing up".
At least one key to making it as a trader, is to give yourself a chance. Trading takes time to learn. It takes great effort. And once you learn, you need money. Don't lose it in the learning stage.
Another thing to consider is that each of us who trades, at least to some extent has dreams of making money in the markets. You may start off trading commodities and utilizing two contracts per trade, because you intend to be sure that you are not one of the unlucky (or "un"smart) traders who "blows up". You trade that one contract utilizing a very sound edge and trading plan that works well. You gain more and more money........but you continue to trade the one contract. You may get rich this way, but it will take much, much longer than it would have had you instituted a plan that increased your contract size as your trading balance increased. This too is part of a prudent money management plan. Of course the more likely scenario is a decreasing balance and a proper money management plan provides for that too, by decreasing the size of your investment as you lose money.
There are many formulas that may be utilized and we won't discuss them here. As stated elsewhere, Ralph Vince does an excellent job of describing various approaches in his writings, including "The New Money Management". Brent Penfold also devotes a full chapter to it in his book "The Universal Principles of Successful Trading." Whatever book you read, whatever approach you take, recognize the importance of this aspect of trading.
4. Self Discipline....
What in the world does self discipline have to do with trading?
Much of the allure of trading, at least for many, is the idea of a life free from interference by bosses, corporate mentality, set hours, and rules. How does self discipline fit into that picture?
Good trading is boring. It often requires hours of sitting in front of a computer and doing...........Absolutely Nothing! Being a successful trader requires adherence to your rules and your plan. If the trade setup is not there. Do Not Trade. Of all the mistakes in trading, this is my worst. I have never had a problem making money. I can make money. My problem is being able to avoid losing money. Sounds crazy I know, but it is quite true and I want you to understand the difference. I can sit in front of a computer and watch the markets I trade, and recognize when a setup is right. I can, with some degree of accuracy, estimate the probability of success, and maximum loss, and adjust my investment accordingly. And I do make money. But here is my problem........and it has always been one of my major problems. If I sit in front of that same computer, and carefully monitor the markets I trade and NO setup occurs......I DO NOT do nothing. I SHOULD do nothing, but that is often not what happens. Instead, I begin to make myself believe that I something that looks quite similar to a trade setup. The more the market does Nothing, and the more that I SHOULD do nothing, I begin to get ancy and itchy and start to see things that simply aren't there. Sometimes I consciously know that there is really no trade there and I tell myself that this time it will be ok. This time things will work out so it Ok to place a trade. Other times I am not sure that there is even a conscious recognition on my part. Instead I am like the deer hunter who sits on the stand too long and finally convinces himself that the bushes in the distance, right at dusk, are in fact are deer. Or I am like the sailor, on the sea for weeks, who longs for shore so badly that as he scans the horizon he sees what he so desperately wants to see.
If I am lucky, the trade I make under the above circumstances turns out to be a loser and I am quickly shocked back to reality, not unlike the child whose hands is slapped by the teacher when he misbehaves. If I am unlucky however, the trade becomes a winner and I make a small sum of money, but it comes with a inordinate price. The price is the reinforcement of poor discipline, bad behavior, and only leaves me so much farther from my destination than I was before I made it. In the long run the price of such a trade is untenable, and though I know all this, I have done it many times.
Being a trader means all those things we talked about earlier such as not having a boss, having no corporate mentality to adhere to, and setting your own hours. But it does not mean no rules. The best traders are the most boring traders. They all have rules. They adhere to those rules. They all have self discipline. Self discipline is one of the most important of the trading essentials.
Mark Cook is a very prominent S+P trader. He needs to prove nothing to anyone, having proven his abilities many times over and having been profiled by Jack Schwager in his Market Wizards books. Mark has proven he can make money.
Mark once invited me to come to a seminar that he was hosting. I could not make it. He then offered me a chance to come visit with him alone, at the farmhouse where he trades. He told me of the objectives that he set for himself on a daily basis and over three or four days I saw him make large sums of money trading his own account. On one of those days the market was slow. Mark actually fell asleep in his chair for a short time. That sounds crazy I know. Here is a guy who not only is trading, but is teaching, and he falls asleep. It happened. But what never happened was that I never saw Mark make a poor trade out of boredom. I saw him leave early. I saw him engage me in conversations about other things. And yes, I saw him fall asleep for a brief time. But I never saw him make a pathetic trade because he was bored. Mark's vast experience may allow him to recognize that a slow market gives him leeway for other things. It does not allow him to "trade anyway". Mark, like all other successful traders, has self discipline with his trading.
If you are striving to be a successful trader, you can either develop self discipline, or find another goal. All Traders Must Have Self-Discipline.
Near the end of the Gulf War a British Destroyer the HMS Gloucester, was patrolling in the Persian Gulf. The ship was twenty miles off the coast of Kuwait, near Kuwait City. Around 5:00 am Lieutenant Commander Michael Riley, the anti-air warfare officer, spotted a radar contact over the Gulf. The contact was in the location of the enemy silkworm missiles, the location of which was known by the allied forces. Unfortunately American A6 fighters were performing bombing runs in the exact same area, and though they had specific routes that they were supposed to follow, the American pilots were known to cut corners and travel the exact same route as this specific radar contact. In addition, the American A6 is about the same size as the silkworm, and the A6 traveled at about the same speed as the silkworm on return to the carriers. The Gloucester had recently moved closer to shore, and the American planes had not yet taken that position change into account and were routinely flying over the ship. Officer Riley had insisted that this practice be ended, but so far his demands had not caused the pilots to change course.
Add to all this uncertainty the fact that only a few years earlier the USS Vincennes had, in the same vicinity, fired two missiles which destroyed a commercial airliner , Iran Air flight 655. Clearly, Officer Riley had a lot to consider as he pondered the radar blip that he encountered that fateful morning.
Officers who reviewed the incident later, testified that there were four ways to distinguish an American A6 from a silkworm missile. The first is location and we have seen from the routes that the A6's were flying that location would not help. The second is identifiable radar, which the American planes were equipped with, but which most of the pilots were known to avoid using since it allowed for easier detection by the enemy. The third way is a special system IFF (identify friend or foe), but again the American pilots did not use this system in enemy territory because it could become a homing beacon for hostile missiles. The last way to distinguish the American planes from the Silkworm was by altitude. Unfortunately the Gloucester's 992 and 1022 radars had no altitude capability. Only after a possible target is noted, is the Gloucester able to use the 909 radar to give horizontal, or altitude data. This takes approximately 30 seconds to gain altitude information. As fate would have it, on this occasion, the weapons director failed on the first two attempts to get altitude information on the radar contact (Errors were made in typing in the track number), thus our lieutenant had no altitude data with which to make his decision........a decision that was made forty seconds after first contact was noted. (Think about that.....a maximum of forty seconds to process the information and decide what to do)
After watching the radar blip approach his ship for those forty seconds, Officer Riley fired two missiles. He was certain that the blip represented an enemy silkworm. When the radar blip is hit and destroyed, voice data reveals the captain of the Gloucester responded "Whose bird was it?" (The captain was inquiring as to who shot the missiles that destroyed this unknown track). Riley responds "it was ours sir".
It took four hours for the Gloucester to verify that the blip that was destroyed ..........was in fact a silkworm, and officer Riley's actions had saved the ship.
This event and the exact manner in which it occurred has been detailed by Klein in "Sources of Power...how people make decisions". Experts interviewed Officer Riley, and reviewed the data recordings in detail. None was able to understand how Riley could be sure that the blip he shot down was a silkworm. But, from the beginning, Riley had insisted he was sure. In fact he said that he knew it was a silkworm within the first five seconds of contact. But he did not know how he "knew". The specific actions of all involved were reviewed with meticulous detail both by the Royal Navy, and by outside agencies. For the longest time, most of those reviewers felt that Riley had been lucky. They were sure that he in fact could not know with certainty what he claimed to know, that the radar blip was a missile.
In the end a researcher named Rob Ellis was able to recognize that since the A6 generally flew at around 3000ft. and a silkworm would be more likely to be at around 1000 ft.; and since the radar on the Gloucester would recognize or "pick up" a contact coming off the coast at 3000ft more quickly than one at 1000ft.; he concluded that yes, Riley could have "known" what he said he "knew". It was this knowledge that saved his ship.
How was Riley able to know what he knew, without being able to elucidate how
he knew?
Intuition.
This is not intuition as in something that he was born with, but rather simply
an accumulation of knowledge that comes with extensive experience.
The actions of a trader undoubtedly do not carry the same implications as those of Lieutenant Riley. Nonetheless those actions must be made under quite similar time constraints, with extensive uncertainty. The only reasonable preparation for making decisions in such situations is extensive experience. The best traders have that experience.