Most new investors to the financial markets seem to think the market is a casino where you can make a quick fast buck. They think the market works on luck and there is no structure or skill needed on the trader’s end to extract money out of the market. They have no idea the trader actually needs to build and trust a plan, a system, a method to trade the markets. And until they have one, they will not progress as a trader.
So, what is a trading plan? What is a trading method, a trading system? And why is it so important to the consistently profitable trader to have one?
Let’s use fishing as an analogy for trading. The ocean is the stock market, the fish is the money.
Say you are marooned on a remote island and the only thing available for you to survive is fish from the ocean. You have no knowledge of fishing and you have no tools to catch the fish.
There are countless fish in the ocean, but how do you with no knowledge of fishing and no tools catch fish everyday to sustain yourself? You need to come up with some sort of a plan. You cannot wildly chase fish in the ocean & hope to catch a few. You need a method of sort, you need to come up with a system to catch one or two at a time. So you go about building something that will drive fish towards you. It will not be a good method in the beginning but over time you’ll tweak it & improve on it. Over time you’ll know what works and what doesn’t. And over the months & years you’ll learn much about the ocean & yourself.
Trading is the same way. You cannot wildly trade without a method. You need to observe the market and test what works & what doesn’t and over the years you’ll learn much about the market & yourself.
A trading system consists of 4 parts: An Edge, Rules, Money Management and Trading Psychology. You need all 4 parts to work equally well for you to become a consistently profitable trader. This is discipline in trading.
Edge: You need to develop a Statistical Edge in the market. An Edge is a high probability signal that you recognize that makes you put on a trade. Having a positive expectancy Edge is the first and most important aspect of your trading business. An Edge is a rifle for a hunter, a parachute for a person jumping out of an airplane, an oxygen tank for the deep sea diver. Without an Edge your task cannot be done and moreover can be fatal. Thus the novice trader must spend however long it takes – for most hundreds of hours to develop an Edge in the market. This is a process of testing what works in the market and building confidence around the signal one develops to enter the trade. This is an Edge. If you do not have a legitimate Edge that you developed yourself, that you completely trust before you start trading then you are doomed from the very beginning.
Rules: You need to develop rules to deploy that Edge in the market. Rules such as: how much capital will you expose on a trade? When will you exit the trade when the trade goes against you? Where will you take profits if the trade should go for you? These rules need to be adhered to with an iron will in a speculative environment like the financial markets. These rules are there to protect your account. Everyone has heard that you must be disciplined to be a trader – this is what they are referring to: the discipline to follow these rules.
Money Management: How much you wager on every trade you take will make you or break you. Most newbie traders have no clue that you can only expose a very small part of your total equity on any one trade. The amateur trader does not realize that trading is a long term business and any trade you put on could lose money, so it is paramount the trader only exposes less than 5% of their total equity on any given trade. That way, if the trade should lose money you only lose 5% of your account and you can come back and make it back on the next trade or the next one. Most professionals will not risk more than 2% of their total equity on a trade.
Psychology: Why does your mind start racing the moment you enter a trade? Why does your heart start palpitate rapidly? Why are you fixated on the dollar made or dollar lost on the screen in front of you? Why do you feel euphoric after a win and terrible after a loss? Amateur one, you have not worked on your psychology. You do not even know what it is. This is the most difficult aspect of trading to overcome, and it will take you years of full time trading to come to terms with your own mind. Your mind will be the greatest hurdle in you making it as a profitable trader. You see, the human mind cannot handle uncertainty, it cannot handle fear – the human mind evolved to keep us safe, to keep us secure, you will have to unlearn centuries of evolution of the human mind to come to terms with how your mind works in an unstructured environment like the financial markets. That is why developing and trusting your Edge and Rules is important so it overrides the emotional decisions your mind is screaming at you to make.
If you are relying on luck and putting on trades without an Edge or a system you are doing it wrong. Start working on a system, this is the only way you will make yourself a trading career and make money consistently from the markets.