Wednesday, February 17, 2010

Formula For Trading Success

What is the key formula for trading success? There are so many lists of rules that traders should follow it can be hard to make sense of it all. But it really comes down to understanding just a few "fundamental" facts:

1. You must be willing to take losses.
2. You must keep losses small.
3. You must have a plan to take profits.
4. Your plan must allow for profits to grow into large gains.

Thus we arrive at the following formulas:

Loss Of Capital = Small Gains - Small Losses - Large Losses

Eliminate the large losses and we have:

Churning = Small Gains - Small Losses

Or add large gains and we have:

Roller Coaster = Large Gains + Small Gains - Small Losses - Large Losses

But if add large gains and eliminate large losses we have:

Success = Large Gains + Small Gains - Small Losses

We eliminate large losses by using an appropriate initial stop loss. We keep losses small by using a trailing stop or exit criteria that follows price. We also keep losses small by following the trend of the broader market. We allow small gains to grow into large gains by not taking profits at an arbitrary price.

Of all of the above, keeping losses small is by far the most important. Examples of trailing stops are fixed percentage and volatility stops. Examples of exit criteria that follow price are N bar lows and highs, moving averages and ratchet stops that move with prior swing lows or swing highs. Implementation of one of these trailing stop methods is a must in order to realize success.

The one thing that may trip up many traders is that a trailing stop may actually reduce the win rate for a trading system, but that is far less important than keeping losses small because small losses will boost the profit factor dramatically. Also, the trailing stop reduces the time in a trade and thus gives traders more opportunities to trade which can increase the total profit.

The profits will follow if we are willing to take losses. This is the most important thing.

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