Last Updated on
Let me ask you a question:
Do you know how to run?
Of course, you do!
What a silly question!
Now since you know how to run, do you think you can complete a marathon?
Unlikely, unless you train yourself to meet the necessary requirements.
You’re probably thinking:
“What has running a marathon got to do with trading?”
Just because you’ve read some books on Technical Analysis, or know how to insert an indicator, doesn’t mean you can make money as a trader.
You can have the best Technical Analysis tools, charting platforms, extensive trading knowledge, etc. and still remain a losing trader.
You train yourself to meet the necessary requirements.
Want to know what they are?
Then read on…
Your Technical Analysis must have an edge in the markets
Any Tom, Dick and Harry can insert indicators on a chart, identify candlestick patterns, or calculate their risk to reward ratio.
But, it doesn’t mean they have an edge in the markets.
So what is an edge?
You can define it as…
(Average gain * winning rate) – (Average loss * losing rate) – Transaction cost
And if the number is positive, it means you have an edge (otherwise known as a positive expectancy).
You’re probably wondering:
“How do I get an edge in the markets?”
Well, there are 2 approaches you can consider…
#1: The DERR framework
Here’s how it works…
Develop your trading plan
First, you develop a trading plan using a fixed set of trading rules to guide your actions. This includes entries, stop loss, risk management, target profit, etc.
Execute your trades
Next, you execute your trades according to your trading plan. Ideally, you want to have a minimum sample size of 100 trades, so you don’t get fooled by randomness.
Record your trades
After your trade is over, you want to record down the metrics for each trade. This includes the entry price, stop loss, target profit, R gain/loss, etc.
Review your trades
Finally, you want to review your trades and find out how you can improve your trading results.
You want to identify “patterns” that lead to your winners and focus on trading more of it.
Also, you want to identify “patterns” which lead to your losses and avoid those trading setups.
If you want to learn more, check out How to become a profitable trader within the next 180 days
#2: The RETT framework
Here’s how it works…
Read trading books that share trading systems with backtest results
First, you want to find trading books that come with backtest results.
This way, the hard work has been done and you’ve got a “template” to work with.
It doesn’t have to be just books, it can be blog posts, research papers, anything!
Extract the trading concepts
Now, just because someone shares with you their trading system doesn’t mean you trade it immediately.
Instead, you must understand the logic and concepts behind it.
So ask yourself questions like…
- What’s the core principles behind this trading system?
- Why does it work?
- When does it underperform?
- Is this something that will suit me?
Test the trading system
Once you understand the concepts behind the trading system, then you want to test it out for yourself to make sure your findings are similar to the backtest results shown.
Now, it’s unlikely you’ll get identical results due to the difference in data feed.
But if you get close to 80% similarity, it’s good enough.
Tweak the trading system to your needs
After you’ve validated the trading system, then it’s time to tweak and adapt it to your own needs.
You might have tested a long-term Trend Following system that uses a 10 ATR trailing stop loss.
But if you don’t want to ride a long-term trend, you can tweak it to a medium-term Trend Following system by using 5 ATR trailing stop loss.
Then, test your “new” trading system and see how the numbers stack up and whether it’s within your expectations.
The most important thing in every trading strategy
Take a guess…
It’s not the winning rate.
It’s not the risk-reward ratio.
It’s not the percentage gains.
The logic of the trading system.
Yup, every trading system you trade must be backed by logic.
If not, it’ll be difficult to continue trading the system when you’re in a drawdown.
You’ll have thoughts like…
“Does this trading system still work?”
“Should I continue trading or stop trading altogether?”
See my point?
But, when you’re trading a system that has logic to it, you’ll be more confident and have the conviction to trade through your losing streak.
Here’s an example…
Trend Following makes money when the market is trending.
So, for Trend Following to stop working, it means markets have to stop trending.
Now, what are the odds of that happening?
If you agree the odds are slim, then it makes sense to continue trading a Trend Following system.
Do you agree?
You must have this ONE thing for your edge to play out (or you’ll fail)
There are 2 traders, John and Sally.
John is an aggressive trader and he risks 25% of his account on each trade.
Sally is a conservative trader and she risks 1% of her account on each trade.
Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward.
Over the next 8 trades, the outcomes are Lose Lose Lose Lose Win Win Win Win.
Here’s the outcome for John:
-25% -25% -25% -25% = BLOW UP
Here’s the outcome for Sally:
-1% -1% -1% -1% +2% +2% +2% +2% = +4%
So here’s the lesson…
If you don’t have proper risk management, you’ll still end up a losing trader even though your trading system has an edge in the markets.
Discipline: How to know if you have what it takes?
Have you ever seen the lifestyle of a professional bodybuilder?
If not, then check this out…
5:00 AM – Wake up
5:30 AM – Breakfast
7:00 AM – Lift weights
9:00 AM – Post workout meal
12:00 PM – Lunch
1:00 PM – Pre-workout meal
2:00 PM – Reflect and work on weaker body parts
4:00 PM – Post workout meal
6:00 PM – Dinner
8:00 PM – Cardio and stretching
9:00 PM – Supper
10:00 – Bedtime
This is what we call Discipline.
The ability to stick to a routine through high or low, every single day without missing a beat.
Of course, I’m not asking you to lift weights but, the discipline required is the same.
Look at the results of this trading system below…
Yes, in the long-run it makes money and even beats the markets.
But that’s not the only thing that matters.
Because if you look at the “red boxes” above, you’ll notice multiple losing months in a row.
So here’s the thing…
- Do you have what it takes to ride out the drawdown?
- Do you have what it takes to follow your trading system?
- Do you have what it takes to continuously execute your trades even after a series of losses?
For most traders, it’s a resounding no.
You’ll likely abandon your trading system after a few losing trades and look for the next “holy grail”.
But guess what? It doesn’t exist.
So, instead of hopping from one trading system to another, you should ask yourself…
How can I develop the discipline to stick to my trading system?
One way is to surround yourself with a community of like-minded traders, who trade in a similar manner as you.
If you want to be a systems trader, then join a community of systems trader.
This way, you can develop the winning mindset of other systems trader and get influenced by them.
You’ll be influenced by their positivity and actions which makes you more inclined to follow the rules of your trading system.
“You’re the average of the five people you spend the most time with.” — Jim Rohn
So here’s what you’ve learned in this post:
- Technical Analysis is a tool to give you an edge in the markets — it doesn’t guarantee it
- Your trading system must have a logic to it or you won’t have the conviction to trade through a drawdown
- A trading system is useless without proper risk management
- Surround yourself in a community of like-minded traders so you get influenced by their positivity and actions
Now here’s what I’d like to know…
What’s the #1 thing you’ve learned about Technical Analysis?
Leave a comment below and share your thoughts with me.