25 May How to Trade Profitably?
I have always wanting to find out what does it take to trade profitably. After all these years of reading, trading, investing, learning and what not, I have crystallized my experience and knowledge about trading profitably. There are many school of thoughts when it comes to this and also a lot of empty promises. I have captured the the necessary points you need to consider in this post. No fluff.
Trade or Invest?
If you want to create an income from the financial markets, then you should trade. If you want to grow your wealth, invest for the long term. You can pursue both objectives too if your capital allows. Either way, you cannot run away from the need to master your emotions. Investing is not a way for you to seek profits when you fail in trading, and vice versa. Trading is a frequent activity and with more trades done, you are likely to have numerous losses. Investing on the other hand, does not require frequent entries and exits, but the market will encourage you to buy when prices are high and sell when prices are low. If you cannot accept these risks and overcome the greed and fear in you, it is unlikely you can fulfill your financial objective/s.
For those who do not wish to stomach these volatility in their wealth, or do not wish to learn to overcome these psychological pains, they should choose investments with low volatility. Products like bonds and endowments, or strategy like Permanent Portfolio would suit them.
If you want to trade profitably, read on.
Finding that Edge
There are many gurus touting their strategies. Strategy is important and we need to find out if it really work. Do not listen to anyone until you test it yourself. And test it with real money because the psychological demands when your money is on the line is different from paper trading. Treat this as research cost. If you treat this as an income generating business, you must be willing to do such testing at a cost. Like any other research programs, you may not be able to find the edge at the very first instance, and you have to test another strategy from scratch. This is not easy for most people to accept.
The market is random but over a period of time, the sample size should be large enough to tell you if the strategy gives you an edge. It is akin to the casino operator, who is willing to accept occasional losses but over the long run, her small edge over the gamblers will ensure she will profit more than her losses. Hence, you must be willing to try out a strategy over a period of time, say 6 months to 1 year, to see if that edge exists. You cannot give up after 2 or 3 consecutive losses and denounce the strategy useless without giving it enough time to work itself out.
Losses must be smaller than Profits Cumulatively
A strategy is considered an edge if it has a positive expectancy or in other words, losses must be smaller than profits cumulatively. If you risk $100 to make $50, your strategy must give you at least 67% winning trades in order to be profitable over the long run. If you risk $100 to make $100, your strategy must give you 51% winning trades. If you risk $100 to make $200, your strategy must give you at least 34% winning trades. Your job is to figure out, based on the risk-reward ratio your strategy prescribes, does the strategy have enough winning trades to prove it gives you an edge.
Evolve and Diversify in Strategies
The bad news is that the market is more complex than the casino. The casino creates a controlled environment which in other words, they set the rules and nothing can happen outside these rules. The financial market is not a controlled environment and uncertainties are rife and anything can happen. This means that while the casino operator’s edge will always be the same, your edge in the financial market may erode and become obsolete one day. In other words, your winning percentage may drop as market conditions change and it is no longer profitable to trade with this strategy. To counter this, you must be constantly finding new strategies while you continue to trade your edge currently. An even better way is to trade a few strategies at the same time. Diversifying in strategies will ensure you still make money even if one of your strategies stop working.
Overcoming your Psychological Barrier
As we mentioned earlier, trading and investing are activities which are emotionally difficult to carry out. Nobody can help you overcome it except yourself. Nobody likes losses. It is detrimental to your pocket, and even more so for your psychology. Once you have found an edge, the rest of the work is on your psychology. You must be able to focus on following the strategy regardless of the losses (as long as win percentages are maintained in the long run). Trust me, the market will make it very difficult for you to follow your strategy. It will encourage you to doubt your edge by giving you consecutive losses. If you can overcome that, you will make money over the long run.