Everything you need to know about trading — the rest is up to you

The Three Major Pillars

Everything you need to know about trading — the rest is up to you

95% of all traders lose money long-term. Conversely that means only every twentieth person trades profitably. Why is that? Do most people simply have bad luck, are not intelligent enough or get advice from the wrong people? Hardly likely.

Essentially, all problems in trading emerge from three fundamental aspects: The risk and money management, the influence of our psychology and the actual trading strategy. Those are called the three pillars of trading, which are the bases for all challenges, decisions and most of all returns. Hereinafter we will take a rough look at each aspect.

Risk and Money Management

When most so-called experts talk about successful trading, everyone has a different opinion. Countercyclical entries, exorbitant limits, writings of a stock market guru, the number of hits for a certain Google search. All of that is not really important — the majority of our attention should go towards the protection of our capital. Of the three pillars, solid money management is the easiest to implement but also the most neglected one. That is true not only for beginners, but also more advanced traders. The problem does not lie in defining the risk parameters, rather the uncompromising implementation is often being neglected.

As a rule of thumb: Do not risk more than three percent of your total capital on any single trade! However, that does not mean that you can only use up to three percent of your total capital. An example: If you use 100% of your capital for a trade and set your stop-loss at three percent, you effectively risk three percent of your capital. If you use ten percent of your capital and set a stop-loss at 30%, you effectively risk the same amount, namely three percent. Using the leverage and your limits, you can precisely calculate your risk profile. More on that in another article.

Psychology

Trading decisions are mostly being influenced by two emotions: The fear of losing money and the greed of not making enough, which makes you risk too much money (FOMO — fear of missing out). In interaction they make you instinctively buy high and sell low, even though rationally it should be the other way around. Why do we make our lives as traders unnecessarily so difficult?

Unfortunately, our brain is not a computer. We succumb cognitive biases that unconsciously try to sabotage us. They trick our mind systematically and are responsible for often not making the best decisions. On an everyday basis we usually don’t recognize them even though they have a huge influence on our being — especially in trading. There are many examples, here are a few major ones:

• Bandwagon effect: A decision is being made because other members of the social group (friends, colleagues, market participants) have previously made that decision.
• Overconfidence: A tendency to systematically overvalue one’s own competences (dancing, driving, trading).
• Confirmation bias: The tendency to interpret new evidence as confirmation of one’s existing beliefs or theories.
• Loss aversion: Emotionally, loss weighs heavier than the equivalent gain (especially with money).

Even though emotions are an integral part of human motivation, they should not influence our trading decisions. It helps to try to quantify one’s strategy as precisely as possible and then sticking to a predetermined plan. Over time it will become a habit which makes following the plan easier and easier.

Trading Strategy

The third pillar is the most obvious one, making it so dangerous. Most traders almost exclusively focus on their trading strategy, unconsciously neglecting the other two aspects. Nonetheless, having a profitable strategy is imperative — the only question is how.

In short, there is no holy grail. On the one hand there are an infinite number of strategies, on the other hand, everyone has to find something that fits one’s lifestyle (for example a doctor working 80 hours a week should not be a daytrader). A strategy is good if it’s profitable long-term ‐ not more and not less. There are many different approaches, here is a selection:

• News trading, basing decisions on the media, news and events.
• Price Action trading on the basis of market observations and price movements.
• Technical Analysis, the valuation of the asset based on charting patterns and technical indicators.
• Daytrading, exploiting small price fluctuations with short holding periods.
• Swingtrading, the analysis of medium-term price movements (swings).

No matter which strategy you end up using, the most important characteristic is the reproducibility. Market situations should be judged based on predetermined parameters and not based on feelings. The strategy should equally be applicable to new situations. The fund manager John Marks Templeton expresses this advice in the following way: “The four most expensive words in the English language are ‘This time it’s different’”. That means: Even if it’s tempting to keep telling yourself extraordinary reasons for a certain trading decision — a reproducible strategy does not have any exceptions.

Summary

The three pillars are not uncorrelated or independent aspects, but rather in a dynamic relationship with each other. Even though trading is a complex topic with many different facets, it is recommended to follow this recipe:

1. Learn to assess the risk and follow your money management without compromises.
2. Find a trading strategy that fits you and that gives you an edge in the markets.
3. Make the implementation of your strategy a strict habit.