I think it was around 2 years into writing this website that we started getting into some deeper discussions about how and when you pull the trigger on trades. One of the reasons I started this site was simply because it seemed unnatural to me that the general public is commonly spoon fed toxic information from unreliable sources, and that many of the methods discussed rarely work for most people. Alternative means are needed, and today’s post follows that same path.
Something I always wonder with this site is what percentage of material is getting skimmed vs fully read. For most people, skimmed is the answer. Bearing that in mind, I wanted to revisit something that was discussed, but probably not put in the spotlight it deserved.
One theme I always seem to encounter from other writers is the topic of what makes a “professional” trader different from an “amateur” trader. While I myself have discussed this topic on this site in the past, it really boils down to one thing: self-control in maintaining the basics. While knowledge or consistency is no doubt a major determining factor of one’s success, self-control, hands down, trumps all. I doubt I need to tell you that while many traders possess good, core knowledge, that knowledge is commonly put to waste through a lack of self-control. And this is one of the reasons that good traders are so highly coveted in this industry.
Why do you think automated trading is so popular? Aside from the prospect of future laziness, it is because automated strategies answer the rarely addressed problem of self control. And even then people start distrusting the system, despite empirical data, and want to fiddle with it once trades are open.
And so the reason self-control trumps any other factor is simply because, from my perspective and what I have seen over the years in the experience of other traders, it is a much more difficult skill to master. It doesn’t matter the size of the book of which the trader is in charge. You could give me a choice between a guy managing a $20mm book and a retail trader managing a $20k book and I’ll pick the one that possesses internal strength when it comes to maintaining common sense, because he will be the breadwinner at the end of the day.
Maybe for some people, simply telling them to “have discipline” or “have more self-control” or “be consistent” is enough to get them moving on the right track. But I have yet to meet anyone where this is the case. Today, I want to examine the decision-making process from a bird’s eye perspective, in order to offer an alternative means of doing so.
A Good Trade Needs….
…a few essential components. The first and foremost is favorable risk to reward. Everyone knows this but few people exercise it. It is not that they don’t want to, it’s that they don’t know how to. And beating someone over the head with these catchphrases listed above is borderline scamming them into false hope. A trader’s job is NOT to find the perfect point of entry (“wait, Steve, you been drinking?”). A trader’s job is to forecast a chunk of price that allows them to enter and exit with a favorable financial outcome. And there is no easier way to achieve that last part, a “favorable financial outcome” than to exercise good risk to reward in everything you do. In order to accomplish this, we need a decision making process that puts laser focus on it, and turns our attention to take profit and stop loss levels as opposed to entry points, which is what most people incorrectly do.
PREP for good decision-making.
Like anyone else, I like proof. I want to see things work well prior to taking action myself. Whether it be through hypothetical or real examples, I need something, anything, to solidify my decision-making.
That being said, I’ve seen this work. When I propose this method to other traders, and they listen, a transformation usually occurs. Humans are hard-wired with certain instinctual behavior. As we all know, many of these actions can be very detrimental when they are translated to an environment of trading. Our goal here is to break away from our initial instincts and instill new instincts which lead to better results. To help memorize it, I came up with a simple acronym: PREP. So here goes nothing:
P – PROFIT TARGET: prioritizing action.
We begin with the end in mind. Before anything is determined, specifically (and) especially entry, we want to know where we are getting out of the trade. We work backwards. Working backwards gives you a massive advantage in terms of the contextual value of what you are doing. It also allows you to focus on your primary job as a trader: forecasting a chunk of price action. Focusing too much on trade entry is a common and in my opinion, very detrimental mistake. Essentially your perspective has shifted from the here and now to the future. Regardless of the strategy you use for entry, the ultimate goal of any trader is to get from point A to B. When we work backwards, we start with the end in mind. I cannot emphasize this enough, and this is no doubt the most important part of this process.
Additionally, we often don’t find the “perfect” means of entering a trade, despite the fact that we have a very strong focus of where it is heading. Starting with the end in mind allows us to worry less about the here and now and focus more on what is to come. It will also put our minds at ease should we not “nail” the entry precisely.
Be realistic. Fantasy tends to trump common sense in this business, so ensure that your profit target is something you are able to handle. You can start small and work your way forward. There is nothing wrong with this. Just ensure that the next point is achievable:
R – RISK ASSESSMENT: no favorable risk, no trade.
Next, we want to know whether or not there is enough profit in this trade to justify a reasonable stop loss in relation to it. In other words, this is where you assess the current (or EXACT location of where you intend on entering) value of whatever you are trading in relation to the take profit value. Cut it in half, and add or subtract it from your entry point, away from your projected path of price. This will give you at least a 2:1 reward to risk scenario.
This step simply assesses where your hard stop will be. The more you stay away from positive reward to risk scenarios, the greater your chances of hurting yourself in the long run. I have mentioned so many times on this site how good many amateurs could really be if they just applied this very simple and often times overstated principle. Should you use the methods outlined on the site for take profit and entry methods, your reward to risk scenario should be higher than 2:1, typically floating in the range of 3.5 to 5:1. So this essentially boils down to just basic arithmetic. No positive reward to risk, no trade.
Your stop loss value is based on multitude of factors. Without getting into too much technical detail (there is much posted on the site in the form of other articles and too lengthy to explain here) this should be your absolute worst-case scenario. And it should still be very favorable to you in terms of your reward to risk ratio.
E – EXIT SCENARIOS: realization that your plan is defunct.
This point is the most heavily challenged, but surely wouldn’t be here if it wasn’t absolutely common and relevant. This is where you ask yourself: “what could happen that would get me out of this trade before my take profit or stop loss is hit?”. Very frequently, price will create new technical points after you have entered a trade. In such situations, these technical points may be used against your projected path. While it is always a fantastic feeling to have entered a trade at a very accurate reversal point, sometimes it of course simply does not happen. Regardless of your level of experience, this is going to occur at some point or another if not more frequently.
It simply does not matter whether your trade is in profit or not. Throughout the process of marking up your chart, you will come across obstacles which must be broken in order for your trade to be successful. Typically, these are just trendlines, vital support and resistance values, Fibonacci values, or any other slew of technical factors. It is a “soft” stop.
People tend to criticize the use of “soft” stops, but I argue: if you know what price is going to do, why would you bother staying in a trade, or simply work on a new setup? Years ago, a work buddy advocated the use of a fully diversified portfolio just as the housing market was taking a nosedive. Our conversation went something like this:
ME: “Why would you invest in the housing market now?”
HIM: “Because it’s a standard component of a truly diversified portfolio.”
ME: “So you believe that the housing market is going to increase in value?”
HIM: “No, I don’t”
ME: “And you’re still going to invest in it?”
HIM: “Well, yes, because of what I said before.”
ME: “That’s stupid.”
I didn’t say I was tactful. Staying in a trade that you have a strong conviction will go against you based on newly developed information follows the same basic, but not necessarily intelligent, logic as my friend above. But, if you don’t know what you’re doing, it is often times mathematically favorable to simply stick with your original plan. Your positive reward to risk ratio will take over your equity curve. That’s what it is there for. But as you become more skilled and gain greater control of your actions as a whole, this point becomes all that more relevant.
P -PATIENCE: visualization of potential scenarios.
Like the first point this one is extremely important. And once again, we turn to a another cliche catchphrase canned by this industry: “Have Patience”. “Oh really? I need to be more patient? Clearly that’s the reason I’m such a crappy trader. Now that you’ve told me though, everything will be okay.” No. We need more:
Patience does not simply consist of sitting in a chair and twiddling your thumbs. Patience means having confidence in your actions, thus not worrying about them, through visualization of potential future scenarios.
So how many times have we heard the term “patience” in relation to trading? And how many of those times has the person explaining it say to do anything other than just simply sit and wait for a trade to work out? If you have no awareness of potential future events, you are going to worry, plain and simple. Without any other information, “patience” will turn into a reoccurring exercise of pulling your hair out. When we think of the word patience, we see a level of calmness associated with it. In order to be calm you have to understand what is normal.
Very rarely will a trade immediately work in your favor. And as I have said before on this topic: when it does, it feels as though you have just won the lottery, because you realize it is that rare of an occurrence. Your goal is to visualize as many scenarios as possible of what could happen between your points of entry and exit.
For example: price could meander for quite a few hours, or spike back into a support or resistance level and then your favor, or create a new trendline and use that support, etc. There can be many, many of these scenarios. The better you become at understanding common price behaviors, the fewer scenarios you will conjure. And this is simply because you have a better understanding of what happens on a regular basis.
Visualization of future events, whether they be favorable or unfavorable, eases our minds by understanding that what we are going through is actually quite normal. How many times have you worried about something, only to hear some fact which made you worry no more? This step follows the same principle. We are simply catching ourselves before we even fall.
While there is undoubtedly so much more to say about this topic, I wanted to post this here today in order to provide a basic framework for good, logical decision-making. This is the basic formula that I follow, and while not for everybody, I strongly believe it helps to deter from the instinctual process that tends to deliver poor results. There are many examples on this website which inadvertently point back to this process, and the original post in which this was mentioned can be found here: http://www.nobrainertrades.com/2013/02/correctly-applied-knowledge-is-power-bridging-the-gap-between-learning-and-application.html (skip down to the section entitled “So here’s what you need to do:”).
As usual, if you have anything else to share, please feel free to post below. Thanks and see you soon,