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My Trading System

I am currently reading a book "Trading for a Living" by Dr. Alexander Elder. Dr. Elder is a psychiatrist who seems to be vary much interested in trading psychology and trading systems.

What sets this book apart from most others on stock analysis is the professional background of the author. Most investment or trading books usually talk about trading strategies or market analysis. This book however also focuses on often neglected component of a successful trading system and that is psychology or behavioral part of trading. I particularly enjoyed chapters on trading psychology and found them useful and practical. I would strongly recommend this book to those interested in trading. Click here for some notes or go to the bottom of this page, or best, go out and buy this book. You may also find it on Half.com or on eBay!

This book has made me aware of some of my weaknesses and has prompted to approach trading in a more systematic way. I want to formalize and document my trading system so here it is.

Dr. Elder emphasizes that a success of a trading system depends on three pillars:

  1. Trading Psychology
  2. Trading Strategy
  3. Money Management.

I have been investing (not trading) in stocks since I was in college. However in mid 90s, I founded a stock brokerage firm in India and got a seat on India's biggest stock exchange. This is when I got in close contact with functioning of a stock exchange, various trading strategies of traders and real time stock quotes and order executions in front of my eyes. I guess this continuous closeness to market fluctuations and interactions with many traders (most of them losers) attracted me and before I could realize, I was also hooked to trading like many others. During those 3 years, I traded a lot and lost most of the time. As Dr. Elder points out in his book, I was an addict to trading. Like an alcoholic, I was not able to control myself. I didn't have a formal trading system either. I wanted to get rich quickly, but I kept losing most of the time. This was frustrating. Many times I decided to quit the game but I could not quit either. I was no better than an alchoholic. This is the time I moved to USA and brought an end to my trading. (Not all was bad in those three years. During last few months before I left India, I came in contact with a trader. He explained me a unique trading strategy. I was impressed by its simplicity, logic and scientific approach. Initially I was keeping records on paper and then I learnt PowerBuilder from a friend and created a program. If you have visited Trading Lessons on my Website, probably you know what I am talking about.)

Though I have a pretty good trading strategy (item 2 in the list above), I lacked the other two pillars of a sound Trading System. Trading is a short term game (rather a war between buyers and sellers) where our emotions and money management skills play as crucial role as a trading strategy in our success or failure. When I was trading in India, I was a hybrid animal- some part investor and some part trader. I would enter into a trade many (not all) times as in investor. If the stock moves in favorable direction, like a trader, I would book my profit. However if it went contrary to my position, I would turn into an investor and hold on forever! So my profits were usually small and losses were devastating. Small profits in few trades would boost my confidence and make me feel like the smartest guy! Then I would take a much bigger position and lose all. I guess this is not only my story but is of most traders.

I don't want to waste your time in my history. Following is my proposed trading system with some inputs from above book.


Trading System

Money Management rules:

  • I want to approach trading with a capital of 20,000$. This is my risk capital and I would be comfortable even if I lose all of this money over the period.
  • In any trade, the maximum loss I would take is 400$ (approx. 2% of my initial risk capital). In no circumstance I should let my losses run beyond this limit.
  • I would usually take a position that requires investment of five to ten times the risk taken. This translates into 2,000$ to 4000$ position when risk taken is 400$. However exception to this rule is permitted as long as amount risked is within 400$.
  • This being my risk capital, I would let go any temptation of earning return on it. I may keep surplus money (out of this 20k or residual amount of it) in Money Market or in a brokerage account but would not want to invest in stocks just for the sake of making my money work for me! This is to make sure that I don't wear two hats at the same time- an investor's and a trader's.
  • If I start making profit, I would withdraw profit whenever it reaches 5,000$.
  • If I lose money, I would not bring in any new fund and add this risk capital of 20,000$.

 

Trading Psychology rules:

  • I would take a position when the expected payoffs are between two to three times the risk taken. This means for a 400$ risk, the position should have expected profit of around 800 to 1,200 dollars.
  • I would create a record keeping system or use a form to record every trade. I would write down details, reasons for the trade as well as expectations on a piece of paper before I trade. This is to make sure that I watch my emotions as they change. As a fact, after we enter into a trade, our attitudes and expectations often changes and most of the time we don't even happen to notice them. This is the biggest psycholigical trap for any investor/trader.
  • When facing a loss, I would take it before it gets bigger. I would strictly adhere to my stoploss.
  • When looking at a profit, I would not close the position too soon fearing that the profit may get wiped out. I would book profit in a position only when target is reached (think about this: try using a trailing protective stop if you still find scope for additional gains.) or my trading strategy has flashed a counter signal in the stock.
  • I would not let my loss in a position run beyond my initial stoploss(400$ loss). If I found myself in a position(s) with more loss than 400$, I would quit the game with an acknowledgment that I am not psychologically and emotionally mature(fit) for trading stocks at this time.
  • If I lose in three consecutive positions, I would do a formal analysis of situations in a written form before I take next position. (What went wrong? Which were the factors behind it? What is the lesson? What will change in trading strategy?)
  • If I lose in a position, I would not keep looking at the same stock just for an opportunity to recover my past loss from it. Once we lose in a stock, our emotions are likely to blur our rationality and drag us into another wrong position in the same stock. (In behavioral finance, this is mental accounting. Somehow we tend to recover/repeat money in the same mental account!! We don't have to do it.)
  • Similarly, if I succeed with a stock position, I would not keep looking at it just to duplicate my success.
  • I will not avoid or postpone trading opportunities in order to minimize brokerage commissions. (Also always trade with low commission brokers to minimize brokerage and hence trading costs. However when a trading opportunity is there, don't let it pass by just to save commissions.)
  • I would continuously watch my emotions. If I found scared, greedy, day dreaming, too excited about a trade, position, loss or a profit, I am not a trader material. I got to behave neutrally all the time in order to make rational decisions. If I find emotions hard to control, I should quit trading.

 

Trading Strategy:

  • Never confuse investing with trading. Don't trade a stock just looking at its fundamentals, company reputation or the current price. (If this is the case, may be invest from your investment account or funds.)
  • There has to be a convincing reason behind a decision to create a position (trade): Why this stock, why at this price and why at this time.
  • Take a position when potential rewards outweigh potential risk. An ideal position is the one where expected payoffs are around three times the risk assumed. This means for a 400$ risk, the position should have expected profit of 1,200 dollars.
  • Look at the charts- last 5 days, 3 months and 6 months. Trade in a stock based on patterns, trend lines, gaps or break outs. Avoid trading on mechanical/stochastic indicators (Dr. Elder suggest a convincing strategy, Triple Screen Trading System, based on mechanical indicators. Please look at the bottom of this page for details.)
  • Enter into a trade based on the signals I use. Visit http://www.geocities.com/patel_jr/StockLessons.htm (Currently I have put 4 lessons but I intend to put them all when I get time.)
  • Whenever the trend you are riding approaches support or resistance, you have two choices: either to book profit or tighten the protective stop.
  • When a chart is strong, don't run after few pennies. Believe in yourself. A true upside breakout on a chart may not be followed by a pullback in the range. (Think of SUNW when I tried to buy at a lower price after a break out.)

(I am going to put all my trades on my TradingIdeas message board as soon as I make one. I guess if I make them public, it would work as a control on my psychology and behavior. Also such a message board is a good alternative to a paper based record keeping. Thank you all.)

Disclaimer: This page is not intended to encourage anyone to trade. This is a trading system for my personal use and it may not be appropriate or suitable to your financial conditions, financial objectives or circumstances. The trades I post on my message board are for record keeping purposes and not a recommendation nor an invitation to anyone to trade. However you may use any material on my Website or opinions and thought on my message board if you find them suitable and appropriate for you. You may also watch my experiments in my TradingLab (TradingIdeas). Please remember that trading stocks is very risky and needs a disciplined approach, self-control and significant experience. In short, I don't know a lawyer's language nor can I hire one for this purpose but I do want to adequately warn you. You are solely responsible for consequences of your trading decisions.


Some more notes from the book:

  • The best time to buy an upside breakout on a daily chart is when your analysis of the weekly chart suggests that a new uptrend is developing. True break outs are confirmed by heavy volume.
  • Stock prices spend more time in trading ranges than in trends.Trading in trading ranges calls for different tactics than trading in trends. When you go long in an uptrend or short in a downtrend, you have to give that trend a benefit of doubt and not be shaken out easily. It pays to buckly your seat-belt and hang on for as long as the trend continues. When you trade in a trading range, you have to be nimble and close out your position at the slightest sign of a reversal. In trends, follow strength and in trading rages, do opposite.
  • When you want to trade in a breakout, you have to decide whether to buy in anticipation, during a breakout or on a pullback after a valid breakout. If possible, buy one third in each of them.
  • When professionals are in doubt, they look at the big picture (weekly or monthly chart instead of a daily), but amatures focus on short term charts.
  • What number to use for an EMA (Exponential Moving Average)? See if you can find a cycle. If you find a 22 day cycle, use 11-day moving average. If the cycle is 34 days, use 17-day moving average. Trouble is, cycles keep changing their lengths.When EMA rises, trade from the long side. If it falls, trade from the short side. When the EMA goes flat and only wiggles a little, it identifies an aimless, trendless market.
  • ! MACD Historgram is one of the best tools. The slope of the Historgram is more important than its position above or below the centerine.They are more useful in weekly charts than in daily charts.
  • ! Divergences between MACD Histogram and prices occur only a few times a year but they give some of the most powerful messages- "extra-strength" buy or sell signals.
    " Sell short when MACD-Histogram ticks down from its second, lower top, while prices are at a new high. Place a protective stop above the latest high.Opposite for going long."
  • ! Oscillators (RSI, ROC, Momentum, %Williams, Stochastics) work spetacularly well in trading ranges but they give premature and dangerous signals when a new trend erupts from a trading range.
  • ! Divergences in Oscillators are best part of them.
  • Momentum is P-Pn while ROC is P/Pn P= Price today, Pn= Price on nth day.
  • A rule of thumb with all oscillators- when in doubt, make them shorter. This is opposite of trend following indicators like MA, EMA, MACD etc.
  • RSI= 100 - (100 /(1+RS))
    Where RS = (Average of net UP closing changes for a selected number of days)/(Average of net DOWN...)
    note: use n as denominator in both averages

Triple Screen Trading System

  1. Identify the weekly trend using a trend-following indicator and trade only in its direction. (EMA, MACD, MACD Histogram, Trendline etc.)
  2. Apply an oscillator to a daily chart. Use daily declines during weekly uptrends to find buying opportunities and daily rallies during weekly downtrends to find shorting opportunities.
  3. Use the trailing buy-stop* technique when the weekly trend is up and the daily oscillator is down. Use the trailing sell-stop technique when the weekly trend is down and the daily oscillator is up.
    * Place a buy order one tick above the high of the previous day.


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