A Risk Factor Any Trader Can Eliminate

03/29/2012 9:30 am EST

Focus: TRADING

Steve Palmquist

Founder, DaisyDogger.com

Traders who enter the markets with an untested or unproven strategy are foolishly putting their capital—and their trading career—in the hands of the unknown, writes Steve Palmquist.

New traders are often focused on what happens after they sell, or what happened to positions they did not take, or what would have happened if they would have ignored their trading system’s rules. This sort of focus develops bad habits that eventually cause problems.

I want tools that are repeatable and that work more often than they fail, and then I just focus on using those tools in specific market environments where they have worked well.

There is no technique that leads to profits on every trade. I have seen the ads for systems that work “98% of the time,” but the guy selling them is the only one making the money. Trading is a statistical business, and traders must find tools that have a good percentage of success and then use them in appropriate market conditions.

Traders make their money by testing and analyzing tools and techniques in order to learn what actually works, and what just sounds good but does not lead to profits.

See related: How to Spot a Winning Trading System

A few examples can be very misleading; traders test their potential trading tools over many different trades in different types of market conditions. Trading an untested system means taking unknown risks and often just churns the account. Extensive testing has led to several practical trading techniques based on the Bollinger bands. 

I have found that in most cases, it’s better to avoid trading when the market is extended above the upper Bollinger band. As indicated by the testing data shared in How to Take Money from the Markets, it is generally best not to initiate new positions when the market is extended above the upper band.

You can also see from just glancing at a two-year chart of the Nasdaq that when the market becomes extended above the upper band, it most often pulls back or trades sideways for a few days in order to get back below the band.

Trading should be data-driven, not based on emotion, wishful thinking, or hot tips from TV hosts. To be data-driven, one needs to test and analyze trading tools and find out what really works, and when each tool should be used. Traders must understand which tool to use for a specific task and have a clear understanding of how the tool works, and what can and can’t be done with it. 

I have extensively tested several trading systems, and the results of this testing is outlined in the books, How to Take Money from the Markets and Money-Making Candlestick Patterns. The testing process helps us understand how stocks usually behave after forming a specific pattern such as being outside the Bollinger bands, showing strong distribution or accumulation, or pulling back or retracing during a trend.

Understanding what a stock is most likely to do forms the beginning of a trading strategy. Trading without this information means taking unknown risks, and taking unknown risks can lead to disaster.

By Steve Palmquist of DaisyDogger.com

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