Let's look at the differences between profitable and unprofitable traders. Is it a question of experience, or are some folks just born with the talent to play the markets successfully? How does risk tie in with profitability? Are profitable traders more willing to make riskier trades?
Author Mark Douglas talks about three stages in becoming a profitable trader. First you learn how to find promising trade setups. Second, you learn how to enter and exit those positions at the right time. Third, get to a point where you build equity on a consistent basis. The secret to this third step is really no secret at all. You master the discipline required to follow your methodology, plan or system.
Traders need to make an important choice early in their careers. They can decide to follow a specific method that forces them out of the market during unfavorable conditions. Or they can master a broad range of skills, and then apply the right one at the right time. Neither approach is right or wrong, but both require paying close attention to the profit-and-loss feedback.
Most unprofitable traders rely on a poorly matched execution style, or a good one they haven't mastered yet. Very often they fail to recognize critical errors in their methodology because it was learned in a book, or through inappropriate conditioning, i.e., making money on bad decisions. Realize that profitable traders know all the weak points in their strategies and exercise damage control at all times.
You can't understand your methodology until you analyze your profits and losses. Identify its weaknesses quickly, and then decide if it really works at all. You may discover that your whole approach to the market isn't right for your lifestyle, emotional nature or long-term goals. For example, you could be a scalper with the disposition of an investor, or a daytrader who hates risk. Bad things will happen when your system doesn't match your personality.
Traders hate to think about discipline. After all, it's not as sexy as just becoming a market gunslinger. But the bottom line is that most of us don't follow our own rules. This is ironic, because the folks who ignore the reasons they lose money are the same ones who spend thousands of dollars attending trading seminars. Personal discipline is the one thing you can't learn sitting in an audience.
Discipline and money management go a long way toward becoming a profitable trader. But let's be realistic. However you trade, you must be confident in the positive expectancy of your style or methodology. This poorly understood concept refers to how much profit you can reasonably expect to make vs. each dollar risked on a trade. Gamblers know this equation as the player's edge in a casino. The problem is that most of us don't understand our strategy well enough to determine whether or not it has a positive expectancy.
System traders use backtesting to gauge the positive expectancy of their systems. Retail traders choose entry and exit without this methodology, so they need to compensate through extensive record-keeping and analysis of each trade result. Even so, they could be fooling themselves into believing they have an edge in their pursuit of profitability.
The sell side of the positive expectancy equation is more important than where you buy. Research suggests that a very profitable system can be built using random trade entry. Yes, you heard that right. It's possible to make money in the same way as a chimp who throws darts at a dartboard. But the hairy primate still has the same problem as the losing trader: He doesn't know when to take money off the table.
Positive expectancy requires a robust exit strategy. But you already knew that, didn't you? Volumes have been written about money management techniques, such as cutting your losses, riding your winners and trading adequate reward/risk. But somehow, losing traders continue to outnumber profitable ones by a very wide margin.
One aspect of positive expectancy is more difficult to manage than any pure numbers game. All trading styles experience drawdowns, and profitable ones are no exception. Traders routinely abandon profitable methods because they hate to lose money. They stop following perfectly good rules because they aren't getting the instant gratification they want from the markets.
If this all sounds like a big loop from the top of our discussion, it's meant to be that way. Losing traders get stuck in a vicious cycle. They want to profit from the market so they come up with a strategy to make money. They trade the strategy until it frustrates them to the point they abandon it and go looking for another strategy. In the process, they never take the time to find out whether or not it had positive expectancy in the first place. In other words, they don't let their methodology mature enough to watch its real potency bear fruit.
Which brings us back to discipline. Sure, it's boring to plan the trade and trade the plan. But it's the only way to break this losing cycle and get on the road to consistent profitability.
