Since Wednesday was PI day (3.14), I thought I might update my PI trade article, says Dave Landry, f...
4 Universal Principles of Successful Trading
05/13/2015 6:00 am EST
Bruce Bower, contributor to SMB Training Blog, outlines four principles every smart trader adheres to in order to make money consistently.
So you want to be a wealthy trader.
Maybe you're just starting out in the working world or maybe you're considering a career shift. Nonetheless, you know one thing will all of your being, you want to make it as a trader.
There could be a host of potential reasons, all of which make sense. You want to swing around huge positions and make tons of money. You want to compete with the best and vanquish them. You want the excitement that comes with the market constantly moving. You want the intellectual challenge of figuring out the global economy and wagering on macroeconomic trends.
The primary goal of being a trader is to be profitable. Obviously, no one ever says, "I want to be a trader so that I can lose tons of money." In fact, it is an absolute requirement if you want to have a career as a trader. After all, trading is about taking controlled financial risks with the goal of making money.
Ideally, you won't be just barely profitable and scraping by, you'll be making a large and satisfying sum of money. The prerequisites for this are the same for every trader. In this sense, the best preparation is to be familiar with these basics.
Beyond being profitable, the reasons that you give for becoming a trader actually have little to do trading. Words like "intellectual challenge" or "competition" are less about the markets themselves and more about what they do for you. You like them because they fulfill certain needs and desires that you have.
These statements speak volumes about what's important to you and find their reflections in the markets. The markets are a mirror into our own personalities. In order to prepare better to be a trader, you need to understand your own unique personality and what it gets out of the markets.
As we said before, trading is about taking controlled financial risks in the markets in order to generate a profit. The time frame can vary, it could be a five-minute scalp, or a one-year fundamentally driven position in a stock. That is the only difference between trading and investing.
The four most important things to prepare:
1. A Knowledge of Markets
In order to trade, you have to know something about the markets. Mostly basically, you have to know that markets exist and which are the big ones; stocks, bonds, commodities, futures, etc.
Since you’ll be trading some slice of these, you need to know which instruments there are and how they work. When is your market open and closed? What are the margin requirements? What is the smallest size you can trade?
For instance, if you want to trade the FX markets, then it's crucial to know that they operate 24 hours a day. This is a key difference from other major markets. Maybe it will be reassuring to know that margin requirements are small and that there is no centralized exchange. Knowing all of this mundane information is critical to becoming a successful trader.
Some parts of markets are universal and you also need to know these. They are basic concepts like bid and offer; order types like market and limit orders; commissions; clearing; margin. These are like the plumbing of the markets, not very glamorous but absolutely essentially to their proper functioning. Make sure to have a good understanding of how all of this works so that it doesn't trip you up.
Beyond that, you have to know what drives the different markets. In each market, there are a few key news items or data points that can make or break the market. The US government bond market cares about economic growth, inflation and the Federal Reserve. It is less interested in the weather and in corporate profitability.
The stock market, on the other hand, is moved dramatically by perceptions of corporate profits and business conditions. Smaller markets like agricultural futures have their own drivers and nuances. You need to be familiar with those if you intend to trade them, so that you will understand what is and what isn't important.
2. Numerical Literacy and Probability
Trading absolutely requires math skills. You need to be comfortable with numbers and able to do all of the basic operations (multiplication, subtraction, division, addition) quickly and correctly.
There is no way around this. Your life will forever consist of buying 1500 shares @ 16.54, selling them at @ 17.01, then subtracting a commission of $7.99 and trying to figure out your profit. Leaving orders, figuring out trade executions, calculating PL, every area needs math abilities. Be comfortable with math. Basic numerical literacy is a bare minimum requirement.
In trading, you also need to know probability. You are not trying to predict the future; you are trying to make smart probabilistic bets where the risk-reward is in your favor.
Trading well is really about continually making good risk-reward decisions, which is not the same as "trying to make money." The money comes as a function of good decision-making as the odds compound in your favor. As Phil Hellmuth says about poker, "[It's] 100% skill and 50% luck."
You need to understand probability well enough to reason probabilistically. You want to have a decent idea of what could happen in a market scenario and what the probability is of each outcome. Then you want to figure out what odds the market is giving you, i.e., how much you could make or lose according to those various outcomes. Then you compare those two and see if it is a positive expectation bet.
For instance, suppose that a position in gold futures has a 50% chance of winning or losing, but if it becomes a winner, can be expected to make $40 or lose $10. You are getting 4:1 payout structure on a 1:1 (or even money) bet, thus you have a hugely positive statistical expectation. In this one case, the trade may turn into a loser—but if you put on enough trades with these risk-reward characteristics, then the odds will work in your favor over the long run and you will become hugely profitable.
Let's look at how different trading styles fit into this logic. Scalping has a 90% rate of winning or breaking even, averaging less than half a tick on the winners and scratches. But because those 10% losers will only lose three ticks, you can end up being a massive winner.
On the flip side, a long-term trend follower may have eight out of ten trades as scratches or losers for a relatively small percentage loss, but those 2 winning trades will turn into big winners of 25% or more. Each winning style has its own characteristics, but what unites them is a probabilistic approach to risk-reward.
3. Following Financial News
Following the news demonstrates, at the very least, a strong interest in the markets. If you're interested in a topic, you will generally want to keep up on it and learn more. After all, people who are interested in Hollywood read celebrity gossip; actuaries will read trade journals for insurance professionals; and sports fans will watch SportsCenter.
The benefits are clear: you'll know what's going on, know who some of the big players are, and the main things moving the markets. There are things that everyone is paying attention to, like major political events and monetary policy, and you must at least be familiar with them. For the biggest markets, e.g. government bonds, crude oil, stock indices, etc, and also for the market(s) that you specifically are trading, you will also need to know what items and events move the market.
There are other silver linings to this. Sometimes, the public can become overly optimistic and pessimistic, and you will see this reflected in the press. Articles will appear with titles like "The End of the Stock Market" or "The New Era for Bonds: Why This Time Is Different" that reflect sentiment extremes amongst market players.
Oftentimes, some of the biggest moves happen when sentiment is one-way, because everyone is already in one side of the trade and there is no one left to drive it higher. As market players, it is very useful to observe this cycle as it plays out, as you will develop an intuitive feel for when things are overdone.
4. Personal Finance
If you're preparing to become a trader, you need to understand the basics of personal finance. Because trading involves risk and reward, you need to make sure that you're not risking too much, and have a cushion against any potential downside risks. There is a saying "Never risk what you can't afford to lose," which contains a great deal of wisdom.
If you are starting out trading your own money, either part time or full time, then the biggest concern is to make sure you're trading only with money that you can afford to lose. Taking a small chunk of your savings and putting it into a trading account is fine. At the minimum, make sure you have left over an emergency that can cover several months worth of living expenses.
Furthermore, as the odds are high that you will meet with difficulties when you first start out, this argues even more for taking smaller risks and using a small amount of capital to start. On the opposite end of the spectrum, borrowing massively against your house to trade is super risky and also stupid, because if trading doesn’t work out, then you will literally lose everything.
We've just covered the basics that are applicable to any budding trader. Now, the key is to figure out what preparation is unique to you. The easiest way to prepare is to figure out what trading means for you on a personal level and what you want to get out of it, beyond just profits.
In order to have a satisfying and fulfilling career, you need to have a motivation that goes beyond the financial, otherwise you’ll never sustain the effort needed to be successful. Furthermore, your specific interest in the markets must reflect what’s important to you.
For every trader, there is something that draws them to the markets. It’s not something about the market itself. Flashing quotes and fast-paced are features of the markets, but by themselves do not draw traders to the market. Rather, there is something about the whole feeling of trading that hooks them, causing them to get intrigued. In other words, they “get something” emotional out of the whole experience of being in the market.
For instance, a high-level college athlete may want to continue competing and views trading as a way to satisfy that urge. For someone else who is very academic, trading may be an enjoyable and very stimulating intellectual challenge. Lastly, a poker player may view trading as another way to play the odds and win. For each would-be trader, there is a unique angle about the market that captivates them.
You need to get to know yourself. In order to become successful at trading, a would-be trader needs to understand what their “hook” is and build their trading style and market choice around it. Ask yourself a few questions, all of which will determine the best market fit for you.
- Do you like adrenaline and the rush of competition? Or do you prefer more measured decision making?
- Are you very academic and research-driven? Or are you more comfortable betting on your intuition and instincts?
- Are you very mathematical and calculating, or do you prefer a more qualitative bent to your decision-making?
- Are you interested in international affairs? In the intricacies of individual companies? Or in theoretical economics?
- What do you want out of trading—to be the next George Soros? The freedom to work from home? An additional source of income?
Answering these questions will easily help you to determine what motivates you in the markets—what emotions and experiences you want out of your trading. But that is only the start—once you know what motivates you, you can start to figure out the kind of markets you should trade; what trading style you adopt; and which additional preparation for trading you do beyond the basics.
This is the best preparation for being a successful trader—understanding which markets, strategy and approach fit you best and will maximize your profitability. Once you get a handle on your motivations and what you’re good at, then you can connect with the approach that will maximize your motivation and the best style fit for you.
There are some personality traits and interests that obviously match up better with certain trading styles. Some examples would include:
- Desire for competitive, high-pressure decision-making: daytrading and short-term position trading
- Research-driven who wants intellectual challenge: Longer-term position taking based on intensive research, either systematic or qualitative
- Interested in the functioning of politics or macroeconomics: you should trade more macro products like FX, government bonds, etc. You would work best with a fundamental approach.
- Wanting to learn more about individual companies because of fascination: trade individual stocks with a fundamentally oriented approach. There is a wide spectrum of fundamentally oriented strategies, anywhere from Ben Graham’s deep value investing to William J. O’Neill’s CANSLIM, so there is plenty of flexibility within this framework.
- Compulsive, addictive gambler who just wants “action”: You have a problem and you should not be trading.
This list is not exhaustive, but it should give you a good idea of where this is going. Once you know yourself, you can identify your strengths and interests as a trader. Knowing those, you can prepare to trade the markets and strategy that will suit you the best.
Bruce Bower is a contributor to the SMB Training Blog.
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