Saturday, December 05, 2009

Basics

As far as I am concerned, successful trading can be very simple, but, by that, I don't mean to suggest that it is easy. I am constantly amazed by the trading talks I've heard and the concepts avowed that involve endless complexities.

It is my opinion that far too many traders fail or at least fail to succeed because they try to make their trading too complex. I agree that it is important to have rules by which to trade because that introduces discipline to the trading, but I don't believe those rules need to be particularly complex. In fact, with the prior history of coaching students who later come to me I have frequently seen their previous trading go from pretty good to not so hot as they began to add layer upon layer of complexity. My advice in those situations often is to keep your trading simple but if you want more complexity go study nuclear physics.

Unfortunately keeping it simple can be very hard to do. I know of traders, for example, who have developed a very successful trading methodology, but they persist in day trading different strategies that break even or lose money because they feel they need to be doing something else. Someone once suggested that they followed that pattern because it seemed so easy just to make money with a simple strategy that worked and they felt some element of guilt so they expended more effort even though it was not financially productive. Logically, of course, that makes little sense, but psychologically there is probably something to it. When we step back and think about it, after all, the markets well may be more about the psychological than the logical.

I guess it would only be fair to ask me what I mean by making trading simple. In "Trade Your Way to Wealth" I've discussed in depth the creation of an individual's personal trading plan. It includes money management. One thing that each trader should do in my view is have some specific plan of how much to assign to each trade. There are several ways to do that as discussed in "Trade Your Way to Wealth" and the works of other authors. None is terribly complex, but it is important to pick one. After the method of money management is decided a trader might establish a minimum reward to risk that must appear before any trade will be entered. Finally, an exit and entry strategy should be chosen and, in my estimation, in that order. For example, a trader with a longer time horizon might decide that he will use a 50 day moving average as both initial entry and initial exit. If the share price crosses above the 50 day MA he might decide to buy the stock and will use a cross below the same 50 day as the exit. He might continue the trade for a short or very long time, but the method of exit is in place; a cross below the moving average.

Is such a strategy the best? No one can ever tell until a trade is finished, but it is simple and it can be effective. One problem with moving average entries and exits is that one can get whipsawed when a stock is trading in a relatively tight range. Another is that the exit becomes pretty far away if using a fairly long term moving average like the 50, but once there has been a move in the right direction the trader can then use Part B of his plan and move stops up to attempt to protect additional profit.

Anyway, there is an example of simplicity. 1. Money management plan 2. Reward to risk requirement 3. Initial exit/entry strategy 4. Method to move exit strategy in direction of move. Now, off to nuclear physics class.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved


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10 comments:

Anonymous said...

Bill, you have described a fairly simple strategy - - - easy to use and follow. The E-Zone System is one more tool that fits well into the program you outlined - - - it gives a forward daily projection for the entry and exit zone. Thus good for both swing and day trades, and far superior to channels, bands, trends because its algorithms look forward, not back.

Anonymous said...

I agree with the comment that the strategy is a fairly simple but powerful one. In fact, 3 of the 4 steps can be mathematically determined. Where I have difficulty is with the risk to reward ratio. We can easily determine the risk - the amount we invest, but the reward can only be known after we have completed both the buy and sell components of the transaction. To accurately calculate the risk to reward ratio, would we not have to know in advance the ultimate reward? In the end, are we not just making a guess as to the direction and future price of a stock. Perhaps you could elaborate in a future article on ways to increase the accuracy of the risk to reward calculation.
Thanks

Anonymous said...

Bill thanks for your insights and encouragement. I was a buy and holder-- and now understand the idea of trading. I'm buying etf's and getting off the mutual fund ride. I am using 50 and 200 d moving averages and they are giving me more comfort. The use of stops and determining when to sell or buy before the trade makes alot of sense. I'm a physician and I don't have much time to evaluate. Fortunately I have settled on Vanguard ETF's low cost, good cap, narrow bid/ask. Almost everything is trending up since march, how will we do when things go sideways?

Anonymous said...

I realize this is a bit of an oversimplification, but the adage 'Don't just do something, stand there' comes to mind. Not a true trading strategy but there are certainly times when doing nothing is the safest short-term approach.

Bill Kraft, MarketFN.com said...

Thanks for writing Anonymous. I certainly favor simplicity as I wrote. One problem with forward looking algorithms such as the one you suggested is that an algorithm can never account for tomorrow's news or the unexpected. Of course, no entry system ever can so establishing an exit strategy first makes the most sense to me in the event the algorithm fails as it almost certainly must at some time. While it is fine to use algorithms I have seen far too many traders fail because they believed a given algorithm was infallible and then something like 9/11 occurred or we had a financial crisis of historic proportions or the CEO of a chosen company was unexpectedly charged with a crime. As with almost everything, awareness is critically important.
Bill Kraft

Bill Kraft, MarketFN.com said...

Great point about determining reward/risk ratio, Anonymous. It is quite true that we can only know the reward once the trade has been closed so when analyzing the ratio we are using available information to "predict" the reward. For example, we may identify a target at a support or resistance in making our analysis. Thanks for writing.
Bill Kraft

Bill Kraft, MarketFN.com said...

Dr. Anonymous, thanks for writing. Your ETF strategy has a lot of positives. When the market goes sideways, as it often does, your choices are to stay in the holding pattern or simply close the trade and enter a new trade in a sector that is moving. Most often there are at least a sector or two that are going your way. Of course, I also advocate an exit strategy be determined before entry and one element of that strategy might be to exit in the event a predetermined movement does not occur within some specified time interval. Hope that gives you food for some additional thought.
Bill Kraft

Bill Kraft, MarketFN.com said...

Absolutely true, Anonymous. Doing nothing at times may be an excellent strategic choice. If the trader is inclined to only buy stock, for example, he may want to stand aside in a crashing market and await some indicia of an upturn. Thanks for your comments.
Bill Kraft

JohnB said...

Bill,

I read your book and since I have an MBA in Finance, I completely agree with your perspective that successful long term trading begins with a plan that ultimately manages your risk. The basic questions I have are what initial book did you read that got you started and interested in trading? A second question is what initial seminar then did you attend? Finally, how does one go about picking the stocks or ETFs for trading? You can study all you want about trading strategies and charting techniques, but at the very core, you have to develop a strategy for selecting your trading candidates in the first place. What's the best way to get started selecting the trading candidates?

Bill Kraft, MarketFN.com said...

Thanks for writing, JohnB. The book that originally captured my interest and is now out of print and the seminar company where I attended my first seminar is no longer in business. I later put on seminars myself and have a 5 DVD set of that seminar available. It covers a complete two day class and is available to subscribers for $199 (shipping included in the continental U.S.). As far as finding trading candidates, there are a wide variety of ways. For example, one might look for stocks whose price has just crossed above the 50 day (or 15 day or 25 day, or any other) moving average. Sometimes I use a crossover of two moving averages, or a cross of MACD above the zero line. In general, I am looking for a place to enter that, if wrong on direction, I have a nearby exit. Hope that helps a little at least.
Bill Kraft