Every successful trader has a winning system. (They wouldn’t be successful if they didn’t have a system that worked for them.)
There are as many systems out there as there are traders. That makes sense, because no two traders are alike. Some traders buy on strength and sell on weakness; others do the opposite. Investors like Warren Buffett have succeeded through a "buy and hold" strategy, seeking to purchase value to realize long-term gains. Some traders buy and sell constantly, seeking to make money off of short-term trends or momentum.
There are many ways to profit from the markets. There is however, one common element all successful traders have: they approach trading in a systematic way. By “systematic,” we mean they have developed a system that is effective for them, and they follow that system. The system may of course evolve and adapt over time, based on experience and lessons learned from past mistakes, but never due to emotion.
Your trading system must fit your personality in order for you to be successful. Good traders succeed because they develop a system they feel comfortable with and that provides proven results over the long-term. They develop a methodology that maximizes their strengths and minimizes their weaknesses.
How can you do that?
Define Your Objectives
Since every investor is different, the first thing you need to do is take into account your present situation. You’ll need to determine:
1)Do you need cash flow or capital growth? If you’re a part-time trader with other sources of income, you may simply wish to grow your capital. If you’re trading professionally, and your sole income is from trading, then cash flow is critical to you because you need the profits to live on.
2)Can you trade part time or full time? If you’re new to trading, or don’t have a lot of capital, part-time trading is a great way to learn, grow your skills, and develop a trading system. If you have sufficient capital to invest, and are confident in your abilities, full-time trading may be right for you. Only you can determine whether you’re ready to trade professionally or not.
3)How much capital can you invest? There are two parts to this question: one, how much capital do you have, and two, how much are you willing to risk? You should not risk more money than you’re comfortable with, or doing so will affect your trading and cause you to make mistakes. If you’re risking too much, nervousness and fear will affect your decision-making and cause you to make undisciplined errors. Only invest as much capital as you’re comfortable with – as your confidence grows, the amount of capital you’re willing to invest will grow, too.
4)What annual rate of return do you want? The higher the return, usually the higher the risk. If you want a 5 or 10% annual return, your investment style will be much more conservative than someone who seeks double or even triple-digit returns.
For example, if your goal is cash flow and low risk, buying or selling at extreme levels, like when you feel a position is overbought or oversold is not the right style to adopt. If your goal is to quickly grow your capital, and you can accept the high level of risk that can come with high returns, then buying distressed stocks, a contrarian approach, or gap trading may be a trading style you will adopt.
Trading systems can be as different as aggressive day traders looking to profit from small point gains, to value investors looking to capitalize on long-term economic trends.
In between, there are a wide range of combinations including swing traders, position traders, aggressive growth investors, value investors, contrarians….
Your style will depend on your level of commitment and on your personality. Here are a few examples of types of traders:
Day traders pursue an aggressive style with high activity levels, focusing on extremely short-term price movements. They make huge numbers of quick trades, tend to take small profits on each winning trade, and maintain tight stop-loss levels to protect their capital. Day traders are by default almost always professional traders, because they focus on minute-to-minute market changes. Most day traders make their money through a huge volume of profitable trades, so they need to be dedicated and focused. Day trading also requires a lot of energy and commitment, and is best-suited for people who like constant activity and change.
Position traders focus on short-term and intermediate-term price movements. They tend to trade positions they feel are likely to move over a one to six week period. Their level of commitment is still substantial, but it’s certainly less than the commitment required from a day trader. It’s possible to be a part-time position trader, but you’ll need to be willing to spend several hours a day studying the market in order to stay in close contact with trends.
Equity traders focus on longer-term price movements. Because of that, the goal of most equity traders is to increase their capital rather than increase cash flow, since oftentimes equity traders will hold a position for weeks and months – their profits can stay as paper profits for a long period of time.
Defining your trading objectives is critical, because unless your system matches your own criteria, you’ll never make big profits. If you’re interested in cash flow, but you choose a trading system that is focused on equity appreciation, you’ll never be successful because your goals don’t fit your system. You’ll grow impatient, make mistakes… and your system will fail. On the other hand, if you’re trading part-time, but you want short-term profits, you may struggle as a day trader because you won’t have the time available to make high-volume, extremely short-term trades.
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Evaluating a Trading System
Once you’ve decided your trading objective, and what market you’ll focus on, you’ll need to develop a system. Hundreds of different trading systems already exist, and you can certainly learn about or purchase one. Or you can develop your own. What’s important is that you can objectively evaluate the system to ensure it meets your needs and that it performs well. Here’s how you can objectively evaluate a trading system:
1. Does it preserve my capital? Capital preservation is absolutely critical. If you don’t have money to trade, you can’t make profits. It’s as simple as that. Your trading system must preserve your capital or you’ll fail.
What does that mean? It means you can’t risk everything. As a trader, you’re looking for small, repeated successes. Your focus should be on consistently making profitable trades and limiting your losses on bad trades. A trading strategy that does not preserve your capital will quickly put you out of business. That’s why we recommend the stop-loss strategy: effectively using stops will keep you from losing your capital. In short, any system that can put you out of business is a poor system.
2. Historical performance is critical. Why? Because your goal is to make profits over the long-term and evaluating past performance is the only way to determine if a system, or if your system, is successful. It’s not important how successful a system might be; what’s important is how successful it is.
3. Success is determined by real profits, not by percentages alone. Of course, your percentage of gain is important, but only if it measures your true profits or losses. Money in your pocket is the only real measurement of success. Here’s how you should calculate success: at the end of the day, week, month, or year, do you have more actual money than you started with? By “actual,” we mean money that is liquid and can be accessed immediately. And if you do have more, what is your percentage gain? That’s the only true measure of success. The only way to truly show profit or loss is if percentage gains (or losses) are based on the amount of money invested.
Let’s say you’re a day trader. You start the day with $10,000, and when you’re done trading for the day, after closing out all your positions, you have $10,400 in your trading account. You’ve made $400. Your percentage gain for the day is 4%. That’s real, measurable success. If you measure historical performance in any other way you might not get a true picture of your success.
4. The system should be mechanical in nature. What does that mean? A good trading system must be automatic in nature, and should allow you to make decisions based on rules and parameters, not on emotion. A mechanical system is not one that’s based on buying every IPO. A mechanical system could be to buy stocks with a maximum price-earnings ratio two weeks before the ex-dividend date, with a 5% stop-loss set ― if you’ve determined that historical performance makes that an overall winning strategy.
5. The trading should always take place in liquid markets. An effective trading system should be aimed at liquid markets where sufficient daily volume exists to easily and consistently execute orders. For example, the S&P 500 Index Futures Market is highly liquid, whereas the Orange Juice Futures market is far less liquid. You want to be able to make trades as quickly as possible, and as close to the intended price as possible.
6. A good trading system will work in up or down markets. (If it doesn’t, you may be sitting on the sidelines during market run-ups if your system only works during a bear market.) It should have the potential to generate successful trading performance in all market conditions; bull, bear, and sideways trading range.
7. The maximum drawdown should fit your personal requirements and situation. An inherent characteristic of investing in general ― and of trading systems in particular ― is the maximum drawdown potential in account value from the most recent peak. No trading system is perfect; you’ll make some trades that are great, and some that will be bad. If the potential loss on bad trades in your system exceeds your tolerance for risk, and puts your capital in jeopardy, then it’s not the right system for you.
8. The system fits the capital you have available to invest. You have to be able to feel comfortable with your system, and if most of your capital is at risk, or the risk levels are too high for your comfort, you’ll make emotional decisions instead of logical ones.
The key to a good trading system is that it allows you to make rational and logical decisions, not emotional ones. Most successful investors develop their own systems because they need a workable formula that suits their own individual temperaments and needs. What works for one person will not work for another. If you like the action of day trading, and are excited by the thought of making large numbers of trades every day in search of small profits on most of your transactions, then equity investing won’t work for you – you’ll become bored and will make trades based on emotions, not on logic. By the same token, if you like to carefully consider trades, and don’t like to feel rushed when making decisions, day trading is a poor investment style for you to adopt. You’ll quickly be overcome by the “action” and will make mistakes that will deplete your capital.
A good trading system also manages risk responsibly. There’s risk inherent in trading, and your system should allow you to ensure your risk to reward ratio is favorable on every trade – otherwise, you shouldn’t be making the trade. Remember: Your goal is long-term success, so try for consistent profits, limit your losses, and make decisions based on reason and logic, not on emotion. Any system that doesn’t allow you to operate that way is a poor system for you to use.
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HOME
Advertorial 1 - Introduction
Advertorial 2 - The Basics of Analusis and Rational Trading
Advertorial 3 - Basic Principles
Advertorial 4 - Characteristics of Successful Traders
Advertorial 5 - Playing to Your Strenghts, Overcoming Your Weaknesses
Advertorial 6 - Winning Psychology
Advertorial 7 - Avoiding Common Pitfalls
Advertorial 8 - Sound Money Management
Advertorial 9 - Trading Systems
Advertorial 10 - Final Words
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