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Most important lessons learned early on in trading

Here are 5 Most important lessons I learned early on in trading that could help others just getting started or traders that are frustrated not being able to achieve profitability.

1. Trade small when you are starting out.

When you are starting out as a new trader: “Trade small because that’s when you are as bad as you are ever going to be. Learn from your mistakes.” – Richard Dennis

New traders should learn their early lessons with a small account on their daily trading. The impulse is to trade as big as possible with the dreams of making big money fast, this is almost always a path to failure even if you encounter early luck. Start small and grow as you develop a trading system with an edge that you can execute with discipline.

Here is why it is dangerous to trade to much of your capital in one trade.

The below image shows the destruction of capital, not only for a losing streak, but also for a string of 10 trades with a 50%-win rate; alternating between wins and losses.

Most important lessons I learned early on in trading

Many things cause new traders to fail. One of the main reasons that traders fail is because they don’t understand the math of capital destruction. The more capital you risk per trade, the quicker you will lose it in losing trades. Once your capital is depleted, it takes a larger return to get back to even than what you initially lost.

  • A 10% loss requires an 11% return to get back to even
  • A loss of 20% of your capital requires a 25% return to get back to even
  • A 50% loss of capital needs a 100% return just to get back to where you started
  • Risking 1% of your capital per trade puts you down 10% after 10 trades
  • Risking 5% per trade puts you down 50% after 10 trades

2. Risk management should be your #1 priority.

“The key to long-term survival and prosperity has a lot to do with the money management techniques incorporated into the technical system.” -Ed Seykota

Risk management is the specific parameters traders put in place when trading to limit the losses on positions that go against them. Stop losses, position sizing, and trailing stops are all ways to manage risk in trades.

Stop Loss Meaning

A stop loss is meant to do exactly what it says, stop your loss. A stop loss sets the predetermined risk for your trade in monetary terms at a specific price level. You know at what price level you are getting out when you get in. A stop loss is your quantified price risk level that will tell you that a trade is a loser if it goes that far against you.

The first step in figuring out your stop loss level in a trade is to quantify “If this trade is going to work out for me then price should not go to this specific price level, the trade is unlikely to work out and I will need to exit.” A stop loss has to be given enough room for you to not be shaken out prematurely with normal price action but at the actual level that is meaningfully against you and shows price action is not conducive to profitability with your initial entry signal.

One of the simple principles that a trader can follow to ensure long term success is to never risk more than 1% of your trading account on any one trade. This does not mean trading with 1% of your account capital as a position size, or a 1% movement of price action. What it means is adjusting your stops and position sizes based on the volatility of your stock, currency, commodity, option, or futures contract so that when a trade is a loss the consequences are the loss of 1% of total trading capital. This not only eliminates the risk of ruin for a string of losing trades but also lowers the volume of emotions and stress so that you can think and trade with a clear mind and not have your ego become stubborn in a losing trade and hold it due to huge losses that you are unable to take as it grows bigger.

Quick formula to calculate you potential account loss percentage: (Entry price – Stop price) x Shares / Total trading capital.

Risk/Reward Ratio

Potential loss is the risk in the risk/reward ratio while potential gain in the reward side, both must be managed for profitable trading.

Looking at your stop loss versus your profit target for any trade can tell you whether the risk is worth taking the trade. Most trades are only worth taking if you have at least a 1:2 or 1:3 risk to reward ratio based on your plans to manage the trade after entry.

The higher your reward versus your risk, the less your winning percentage has to be to make money.

Your profit target on entry for where you project that price could go if the trade is a winner is where your potential maximum profit is located and can be used to establish the reward in your ratio. You can maximize the potential for capturing a big trend by being flexible and leaving your upside uncapped by using a trailing stop loss to take you out of a winning trade. By only exiting when price reverses you can create bigger winning trades and maximum rewards.

To psychologically create a great risk to reward ratio you need to be very patient with winning trades and give them enough room and opportunity to play out for the most benefit but at the same time have no patience for losing trades and exit the moment the trade is proven wrong based on your stop loss.

Quick formula for risk/reward ratio: (Entry-Stop)/(Target-Entry).

Risk of Ruin Formula

The risk of ruin formula shows the probability a trader could lose enough of their trading capital that the return to even or being profitable is near zero for that account. The concept of the risk of ruin came from the world of gambling, but evolved to also show the risk to traders in the financial markets.

The risk of ruin formula calculation is ((1 – (W – L)) / (1 + (W – L)))U.

Answer key:

W = The probability of a winning trade.
L = The probability of a loss.
U = The maximum number of trading risks that can be taken before the trader reaches their threshold for being ruined.

The risk of ruin formula shows the probability of ruin, the odds that a trading account will blow up based on the size of wins and losses and what sequence of straight losses would bring the account down too low to recover the lost capital.

The goal of risk management is to keep individual losses small, limit total risk exposure at one time, and eliminate the risk of ruin.

3. Focus on your trading signals, ignore the noise.

Among the mistakes of the new traders that never make it to profitability is the fact that they never develop a filter to enable them to see what really matters in the financial markets. Much of what a new trader is exposed to is just pure noise. Noise does not lead to making money, it leads to confusion and frustration. What the new trader must be in search for is signals.

Signals tell you when to buy and when to sell for a profit. Noise tells you nothing but information… and if that information cannot be used to make money in the markets then it is not a signal. While watching television or while you are on social media we must have a keen eye for what matters.

“The instinctual shortcut that we take when we have “too much information” is to engage with it selectively, picking out the parts we like and ignoring the remainder, making allies with those who have made the same choices and enemies of the rest.” – Nate Silver

This is the noise:

  1. Talking heads on television. They could have no position in their picks, they could be pumping their portfolio holding, or talking down their shorts. Who really knows?
  2. Predictions by anyone are not trading signals. The farther out the predictions are for the more the odds are against the prediction. The complexity of the world and the markets and the randomness of so many moving parts and players make predicting a future that does not exist impossible.
  3. Known news events are not signals. If there are escalating geo-political risks and the same stories are on the news day after day with no major changes in the situation then that news is already priced in. Continual fear mongering from the media is just noise.
  4. The shorter the time frame the more random the prices. The farther you zoom out in time the more patterns and trend are identifiable. If you sit in front of your monitor all day the majority of what you see is noise you have to wait until the signal appears inside all that noise.
  5. Short term trading results tend to be random. Someone with a long bias that holds losing trades until they come back in a bull market looks like a profitable trader with skills. It is the long term results of a trader that signals whether they have skills in system development, discipline, and risk management.  Many new traders that get lucky at the beginning and seem to be profitable are shocked when they end up giving back their bull market gains in the next bear market. Their winning streak was just noise in the long term as the market changed.

These are signals:

  1. A breakout of a trading range to new highs or new lows in your time frame that holds the new price level.
  2. An oversold bounce off support or an overbought reversal against resistance in your time frame that is strong enough to convince you it is a high probability trade set up for a swing trade.
  3. When the market rallies on bad news or sells off on good news that is a signal of a possible end to the markets prevailing trend.
  4. When popular market sentiment is overwhelming bearish or bullish and there is a strong move against that prevailing sentiment it is a possible signal of a market top or bottom being put in.
  5. Many times a gap in the direction of the prevailing trend is a signal of a continuation of the trend in the direction of the gap over the long term.

The real point of system back testing and the study of historical price patterns are to find the principles that are present in the markets historical price action.  The principles of fear, greed, and ego along with supply and demand are the key underlying causes of trends and range bound markets. The profitable traders are able to search out and find the signals that give them the edge over the traders caught up in trading the noise off their own emotions.

“The signal is the truth. The noise is what distracts us from the truth.” – Nate Silver

The ability to filter out the noise of what does not matter is a skill just as important as finding the signals. The vast majority of traders and investors find themselves lost in the sea of noise. Find the robust signals and incorporate them into a trading plan and then profits will find your trading account.

4. Focus on only trading your own edge.

Many traders don’t understand what it means to have an edge in trading. It is simply an advantage in the markets that over time leads to your winning trades adding up to more than your losing trades. There are potential edges in every market and in each time frame from scalping to value investing.

What does it mean to have an edge?

If a trader or investor has an edge, they have an advantage that makes them more likely to be profitable than other market participants, Their profits come many times from the mistakes, emotions, egos or inexperience of other traders and investors. Backtesting trading signals or developing a discretionary rule-based strategy that creates big wins or small losses can give a trader an edge over those that are not prepared. An edge is any type of advantage that can lead one person or system to outperform others over time leading to profits.

What is an example of different types of trading edges?

There are many types of edges in the markets that a trader can have with discipline, focus, knowledge, information, backtesting, chart studies, patterns, or perseverance.  Anything that leads to profitability by outperforming others is considered an edge. A trading edge doesn’t mean that you win every trade it means that over time your edge plays out and you are profitable. One of the best examples of an edge is the casino versus the gambler. The casino is a business that operates based on a mathematical edge over the gamblers that ignore the odds of success. The casino also has table limits to manage their risk per bet and also will ask any gamblers that have developed their own edge over them in Black Jack by card counting to leave eventually, cutting the casino’s losses short.

Here are ten edges that a trader can develop in the markets:

  • A positive expectancy model.
  • A profitable mechanical trading system.
  • A discretionary rule-based strategy that creates more profits than losses.
  • A positive risk/reward ratio on entry.
  • Cutting losses short and letting winners run.
  • Backtested signals that has wins on average that are bigger than the losses.
  • Discipline to follow a good trading plan.
  • Risk management that allows survival during losing streaks.
  • A high win rate with small losses for losing trades.
  • Proper position sizing.

A trading edge is an approach that creates an advantage of any size or dynamic over the people you are trading against. It doesn’t have to be fancy or complex, just something that maximizes wins and minimizes losses to create profits when the edge is allowed to play out consistently over time. If you don’t know what your trading edge is, then you don’t have one. If you don’t have a edge in the markets then you are just a gambler. It is important not to confuse being a lucky gambler with being a great trader. Only trade when your edge is present.

5. Plan on long-term survival and success as a trader.

With somewhere between 80% to 90% of traders losing money consistently in the long-term and most new traders not even making it through their first year I thought ten tips on survival may help some of my new blog readers be in the markets this time next year.

I have seen many come and go over the years and a few things can keep you in the game long enough to win. Some new traders send one e-mail then when they realize it is work to trade they move on quickly to the next get rich quick scheme. Others want the magic formula to success and think that rich traders are all holding back that they have the Holy Grail of making money in their possession but won’t share it.

The truth is trading is like being an entrepreneur, taking risks, being rewarded when right, losing money when wrong. Profits come from the traders that lose money so you have to be on the right side at the right time to make money in the markets. The first steps are creating a quantified systematic process for profits, managing the size of your risk, and following your trading plan with discipline.

New Traders Survival Guide For The First Year:

You need enough capital to trade so you do not take outsized risk because your account is too small. Focus on building your initial capital first, not going for big risk home run plays, you will lose money fast, add to your capital as you go, and grow it while you learn.

Never lose more than 1% of your trading capital on any one trade. If this is not worth your trouble then you need to build your capital up before you continue. This refers to where to place stop losses so you minimize losses it does NOT refer  to total position size and to trade with only 1% of your capital. It refers to how to manage your position size based on the volatility of the underlying asset at the location of your stop loss at the price level that shows you that the trade is invalid.

Don’t attempt to trade futures or options unless you fully understand how they work. It is too easy to lose a lot of money if you do not fully understand how they move and act.

Don’t trade illiquid markets in penny stocks, options, or even some stocks or futures, the bid/ask spreads will devour your account only the market makers win in illiquid markets.

Only learn about trading from sources you trust.

Find experienced traders to learn from whether in real life or social media, just watch how they operate and ask the right questions, but don’t bother them too much. Do enough homework so you know what good questions to ask are. Don’t feel entitled to their time for free.

Don’t even attempt to trade until you have a trading plan with a method that has a systematic approach and an edge.

If you don’t understand the probability of your risk of ruin based on your amount of risk exposure per trade do not trade until you do.

Take all the time you need to get educated in trading before you ever place your first trade. If you have not put in some serious time reading good trading books, studying charts, backtesting, and using all the resources available online. You shouldn’t trade any real money until you are educated in trading. The market isn’t going anywhere and there is no rush to get into it until you are completely ready.

Set specific goals with a timeline so you know where you are in your trading journey. Be realistic but stretch yourself. It is not about making money at first it is about work, effort, and experience to get you to profitability. Once you get the right process, discipline, and risk management in place only time will separate you from profitable trading success over the long-term. The first step however, is surviving the learning curve and avoiding the risk of financial or mental ruin that knocks you out of the game for good.