A Critical Stat Most Traders Overlook

12/28/2011 3:00 pm EST


Michael Toma

Author, The Risk of Trading: Mastering the Most Important Element of Financial Speculati

Mike Toma says that plan compliance, not bottom-line profit and loss (P&L), is the best way to judge your success in the markets. Here, he explains how to monitor compliance.

Most traders judge success for themselves with money. Is their P&L growing and is their account size growing, but is that really the best way to do that? 

Our guest today is Mike Toma to talk about that. Mike, how should I judge my success as a trader? We’re all here to make money, but is that the goal?

You ask a great question in the intro. We always track it by P&L. Have you ever asked a trader “How did you do today?” or “How did you do this week?” They reference their P&L. It’s kind of a natural tendency.

I actually think it’s very deceiving in a sense, because if you have some really good trades from the week, but maybe you broke some plan rules, or you broke some risk management rules—really important—maybe you traded too much size and the trade happened to work out. Now all of a sudden you going around saying “I had a great week” or “The markets are great, I’m the best trader in the world!” 

See also: Why P&P Doesn’t Determine Success

I really prefer, from a risk standpoint, measuring your business and your trades by plan compliance. Did I trade and execute my trades according to my plan? Nothing more and nothing less.

So if you do that then the idea is that the money will follow. Because we’re here to make money, it’s not like we’re judging success only by that, but by making it not all about money, is it easier to do?

I think it is. True, you can’t pay the mortgage with plan compliance. You really need the P&L to do that, but as an example, you can have a winning trade but really have terrible execution in the sense of maybe you broke your plan rules. 

Conversely, make a mistake here and there—I’ve done it too—and the trade still works out. 

That could be a very bad path you’re taking there. Really, you want to focus on plan compliance: is your discipline in effect at all times, because eventually, that randomness in the markets is going to take hold, and it’s really not about P&L.

I’ve just seen too many…especially younger traders starting out, they get too excited about some of these runs, and two weeks later, we see that little curve just bring it right back down to earth.

When you say “trade compliance” or “trade plan compliance,” are we talking just about a stop-loss profit target, making sure I’ve only traded as much size as I should? What else should be included in that compliance?

I think risk/reward is huge on that, in addition to the components you just mentioned. 

Am I using trading my plan effectively and using proper risk reward? Maybe your risk reward is 2:1, 3:1. I have a 1:1 risk/reward; I’m not too fancy about it, and that’s really coming from a risk manager. 

Some think maybe I want 8:1 or 10:1; I’m fine with 1:1 if I can get 60%, 63%, 65% consistency and win an edge on my trades.

But really, if you can focus on that risk/reward and execute with precision, you should really be fine. Easier said than done, of course, but consistency really wins the game here. 

How do I keep myself honest with that? Is it a matter of checking things off in my trade plan or showing it to somebody else to make sure I’m honest about sticking to it? 

Yes, I think having the second person to check your work is fine. You can also do it yourself by monitoring your trade journal. 

You could check it every week. I have a monthly report that I do that assesses plan compliance. I try to be in the 97%, 95% range. I’m a little data driven, but it really works in the long run because you really want to make sure that you’re trading your plan consistently. 

If it isn’t working and it’s in your plan now, obviously, you have to change your plan. Again, that inconsistent sort of flying by the seat of your pants will eventually catch up to you.

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