When building a trading system, one should consider both one’s own personal circumstances and psychology. There are a lot more things to consider too – but these are the most important. It goes without saying that someone in full-time employment should probably not be focusing on an intra-day breakout strategy – yet you would be surprised how many people in this position pay for Level 2 access and check share prices during the day to trade. You may not be surprised to hear that most of these traders lose money.
Traders should play to their strengths in their own circumstances. Someone who works evening shifts would be fine to trade the morning open should they be well rested and prepared. Trading when fatigued leads to sloppy errors and capital lost, and should be avoided. People assume that if they work full-time they can’t trade, but in today’s market that is not true.
Advances in charting packages mean filtering for trades has never been easier, and many online brokers now offer the option to place orders in advance of the market opening, that can be triggered automatically – meaning we can be away from the screen during the market hours and not have to worry. Nicolas Darvas did exactly this back in the 1960s, and wrote about how he traded much better away from the market noise while he was travelling the world as a dancer in his book: How I Made $2,000,000 in the Stock Market.
As well as our circumstances, we should consider our own psychology. It’s no good employing a strategy which relies on a risk/reward strategy of lots of losers and one big winner if we are not tough enough to withstand the effects that continuous losing brings. Do not underestimate psychological capital as part of your trading plan, because if one is not disciplined enough to follow the plan then ultimately that plan will fail.
In my last article we covered breakouts – I like trading these as well as breakdowns because I am more comfortable with the stock running into profit as soon as possible, and cutting my losses quickly if I am wrong. For me, the first cut is the cheapest, and I’m happy to be wrong quickly rather than running a loss. Big losers affect me physically; you should trade a system that you are comfortable with.
Backtesting is great, but demo accounts neglect one big part of trading: emotions. In theory, everybody knows that trading is about cutting losses and running winners, but when one is down a week’s wages in the profit-and-loss (P&L) account, we have a tendency to become a rabbit in the headlights and take on more risk in order to avoid loss.
There are five building blocks to a good trading system, and if we can answer these then we already have a solid base to build on. We need to ask ourselves five questions in order to work out what our trading system will consist of (see diagram below).
What exactly are we trading?
When it comes down to answering this question, we need to drill down into specifics. Many readers will be investors and traders of UK equities, although this can be through spread betting and contracts for difference (CFDs) too.
However, this is not specific enough. We need several patterns that not only occur frequently enough to trade (a pattern that only sets up a few times a year is not enough) but also offer the liquidity to be able to get in and out relatively unscathed. Trading a breakout is great – but not if the spread is 30 per cent.
When it comes to knowing what to trade, we need to know what exactly we want to see. The more specific, the better. We need to know where we want to see it, and why. Here is an example.
I want to see breakouts from all-time highs and 52-week highs in stocks above £100m market cap (narrower spread) that have traded in a range and broken out of that range on increasing volume, because that shows a potential change of trade.
Once we are specific on several patterns, we can then go and actively search for this in our charting package, and set filters and alerts.
How much are we risking?
How much we risk is entirely at our discretion, and this topic is one of the most important aspects of a trading system. Position sizing will make or break us, but we have to consider both the spread and volatility of a stock. The narrower the spread, the easier it is for us to get in and out without having an impact on the price. Typically, the narrower the spread, the less volatility there is too.
A good rule of thumb is to never put 20 per cent of our portfolio at risk in a single position. Even if there is only a 1 per cent chance of 100 per cent loss – eventually the 1 per cent will happen and only through position sizing can we defend against this.
Not all trades are created equal and therefore it seems silly to trade them equally. If one pattern is constantly delivering higher rates of success then it makes sense to allot more capital to these patterns and reduce capital in others. Why would you not reward success? Let the data tell you what to do. If the data tells you that you’re constantly losing money on a Friday – then take Friday off. As traders, we are risking our capital in unknown events in the belief that our edge will keep us in business over the long term. Only through our data do we get our edge.
Very few casinos will allow you to stake a cool £1m on a single bet. But they’ll happily allow you to put it through over an entire evening – and they’ll give you free drinks and food while you do so too. This is because it knows its edge will slowly grind punters down. A broke casino can’t make any money, but if it can stay in business it can keep punters playing long enough for them to lose their money. If we can think like a casino, and focus on risk management, this will be the right mindset when it comes to our position sizing.
When are we entering?
We should know when we are wanting to enter in our strategy specifically, and these entries can be automatic and set up with stop limit orders and/or alerts. For intra-day traders with Level 2 data, it can pay to watch the tape. If we are looking at going long on an intra-day breakout, tape reading can give us an edge in entering. If we are seeing an iceberg order continuously reloading the offer when hit then it can be a good idea to wait until this is clear, as we don’t know how much the seller is working. Alternatively, the seller can provide the liquidity depending on the size we need. Just be careful there is sufficient volume to unwind that position should volume begin to turn the other way.
Many traders like to wait for confirmation of a trade going their way before entering. Depending on the situation, this can be a good idea, for example if we are scalping long a failed oil drill or a large profit warning – buying a falling knife is never a good idea unless you have a proven strategy to trade these. But if we know where we want to enter and we wait for confirmation instead, then the risk/reward ratio is moving against us the longer we wait. As traders, risk/reward is everything and we should execute as planned as often as possible. As traders we are paid to execute, not wait.
When to exit a losing trade?
Trading is about managing risk; therefore we are not traders but risk managers. If we can’t manage our money properly then the market will take it away from us – a fool and their money are soon parted.
The best time to exit a losing trade is at our predetermined exit price that we set when the market was closed. If you’re entering intra-day on an opportunity spotted – then where you’re getting out if the trade goes wrong should always be the first consideration. Many a trader has spotted an intra-day opportunity, taken a position, then added to the position when it went against them because they were not thinking logically and trading on tilt, resulting in a big chunk of capital being blown.
When to exit a winning trade?
Exit points for winning trades should also be set in advance. It is common for us to want to bank our winners quickly and run losers. Humans are naturally risk averse in this sense, and snatching at profits means we are gratifying our ego rather than optimally maximising our P&L. We need to make a clear and conscious decision to decide that we would rather make money than be right, and once our focus is set on the former and not the latter this will put us in the right mentality for nurturing and growing our trading account.
Having sensible risk/reward ratios (risking 1 to make 100 clearly is unlikely) and looking at the chart to identify potential resistance points help us here. It’s no good having a risk of 1 to try to make 3 if our position is going to hit heavy resistance before it gets to 3. The likelihood is that resistance will act as a barrier to our trade. When picking our risk/reward ratios and determining our risk, we must consult the chart first to see if we have a clear runway for the trade and the risk/reward ratio we wish to employ.
Managing the trade
Most traders think that once the trade is set, the risk/reward ratio stays the same throughout. But money never sleeps, and neither should we. The risk/reward ratio evolves as the trade plays out, and there is a case for actively managing it. Let’s say we are long a retailer and the trade is not far from our stop, and the next morning a competitor announces a large profit warning.
In theory, that RNS statement is company-specific, but the sector is likely to take a hit as the market reads across to other companies in the industry fearing the sector is weak. If we think our stop is now likely to get hit, we can try to spin our stock off in the auction by putting it onto the exchange at our desired price. If we’re filled, then this may get us out of the trade sooner than we otherwise would’ve if we had allowed our stop to play out.
However, we must be careful not to overmanage our trades. It’s helpful to keep a record of our trades, but it can also be useful to keep a record of our trades as they would have played out if we hadn’t managed them. Only by recording both the managed and unmanaged trades can we see if we are damaging our P&L.
Improving our system
To improve our system, there are only three ways that will do this.
1) Making more money from our winners.
2) Losing less money from our losers.
3) Generating more ideas.
Making more money from our winners
If we can extract more money from our winners then this has the potential to improve our system’s expectancy significantly. Hypothetically, when long, the potential of a stock is unlimited – and instead of capturing just 20 per cent gains one can, over time, capture gains of 200 per cent. One of my biggest problems as I rely on trading to pay the bills is cutting winners too early, and I always take money off the table when my target is hit. I now actively focus on squeezing out more profit from my winning trades. If you have read The Art of Execution by Lee Freeman-Shor, then you will know the ‘connoisseur’, who regularly takes small profits like a sip of a fine wine that gets better as it matures. The connoisseur is able to handle the pain of the gain by satisfying the itch to take profits.
Losing less money from our losers
Figuring out how to be wrong quicker also has the potential to transform a trader’s strategy. We can do this by analysing our entries – we want to be entering the stock as close as we can to the point where we would be wrong. We want to find more profitable patterns to trade, and commit capital to the patterns that reward us. Only by taking an honest look at our losing trades is this possible. For example, are we getting slippage? If so – why? Are we holding too much volume above normal market size? Are we constantly getting stopped out only for the price to reverse? If we know what is happening, we are in a position to do something about it.
Generating more ideas
We can have the best patterns to trade in the world, but if they stop setting up because the market has changed then we will have a problem. In a bear market, long-only traders will begin to struggle, and in sideways markets trend followers will become frustrated. The market conditions are forever changing, and if we don’t adapt, we die. Trading is a constant strive for improvement and survival. Twenty years ago nobody thought we would see negative interest rates; now there are entire trading floors who have only ever known low interest rates. The market will continue to present new challenges and new environments and only by continuously generating more ideas can we take advantage of this.
But that is exactly what is so exciting about trading and the stock market. No day at the office is ever quite the same. There are always new and exciting companies to discover, and new patterns to trade. It’s a sport where those who put the hours in and work to refine their edge in the market can benefit fabulously, and those who don’t crash and burn. It’s not always easy (and I certainly would never say that it is) – but I guess that is why we love it.
