Success in day trading comes from three elements: (1) mastering one or a few proven trading strategies, such as what I have devoted Chapter 6 of this book to; (2) excellent risk management, knowing proper share size, and defining proper entry, exit and stop loss levels; and (3) as has been emphasized several times already in this book, controlling emotions and sound psychology. As Dr. Alexander Elder writes in his book, Trading for a Living, these three are equally important, like the three legs of a stool – remove one and the stool will fall. It is exceptionally important to learn how to manage your account risk. It may surprise you to know that even if you get everything wrong except your risk management, you can still make a profit. Van K. Tharp, a trading coach, once said that even a totally random entry system can be profitable if your risk management system is sound.
Often, when a new trader fails to make money in the market, they get frustrated and go out and try to learn even more about how the markets work, study new strategies, adopt additional technical indicators, follow some different traders, and join other chatrooms. They don’t realize that the main cause of their failure may not be their technical knowledge but often their own psychology and behavior: a lack of self-discipline, making of impulsive decisions and sloppy risk and money management. You are the only problem you will ever have for your trading career and, of course, you are the only solution to this problem.
A good trading strategy delivers positive expectancy; it generates greater profits than losses over a period of time. All of the strategies outlined in Chapter 6 have been demonstrated, if executed properly, to show positive expectancy. But even the most carefully executed and best strategy does not guarantee success in every single trade. The normal uncertainty of the market will result in you at times having a losing trade or even at times suffering a series of losing trades. This is why risk control must be an essential part of every trading strategy. As I discussed in the Introduction, it is a career based on probabilities and statistics. Remember the Monty Hall puzzle?
One of my favorite trading expressions is “live to play another day”. This simple saying says so much about the mindset of a professional trader. If you survive the learning curve, then the good times will come and you can become a consistently profitable trader. But you have to survive. And many just can’t.
A common reason for the failure of new day traders is that they cannot manage their losses. Accepting profits is easy to do, but it is much more difficult, especially for beginners, to overcome the temptation to wait for losing trades to return to the break-even point. They will often say, “I will just give this trade a bit more room.” Waiting for something that is not likely to happen can result in serious damage to their accounts.
To be a successful trader, not only must you learn excellent risk management rules, but you also need to firmly implement them. You must have a line in the sand that tells you when to get out of the trade. It’s going to be necessary from time to time to admit that a trade did not work as you planned and say, “I was wrong,” or “The setup isn’t ready yet,” or “I'm getting out of the way.”
I’m a consistently profitable trader, but I still lose frequently. That means I must have found a way to be a really good loser. Lose gracefully. Take the losses and walk away. If a trade goes against you, exit the trade. In day trading, the unexpected will occur, this is the name of the game. There is always another trade and another day. Holding a position that is trading against you because you are primarily interested in proving your prediction to be correct is bad trading. Your job is not to be correct. Your job is to make money. This career is called trading, not predicting.
I can’t emphasize enough how important it is to be a good loser. You have to be able to accept a loss. It’s an integral part of day trading. In all of the strategies that I explained in Chapter 6, I noted what is my entry point, my exit target, as well as my stop loss.
I will reiterate: being able to make quick decisions and being able to make and then follow your trading rules are critical for success. As you read and reread my books and books by other traders, you are going to read much about risk management. Everything that traders do comes back to risk management because ultimately it is the most important concept for a trader to understand. All day long, you are managing risk. Related to this is the ability to manage risk so that you will make good decisions - even in the heat of the moment.
As mentioned before, traders are in the business of trading. You need to define your risk as a business person - the maximum amount of money you’ll risk on any single trade. Unfortunately, there is no standard dollar amount that I can suggest. As explained earlier, an acceptable risk depends on the size of your trading account as well as on your trading method, personality and risk tolerance.
The 2% rule cannot be overemphasized. The absolute maximum traders may risk on any trade is 2% of their account equity (not including margin). For example, if you have a $30,000 account, you may not risk more than $600 per trade, and if you have a $15,000 account, you may not risk more than $300. Do not calculate the 2% based on your buying power, calculate it only based on the amount of capital you have in your account.
If your account is small, limit yourself to trading fewer shares. If you see an attractive trade, but a logical stop would have to be placed where more than 2% of your equity would be at risk, pass on that trade and look for another trade. You may risk less, but you may never risk more. You must avoid risking more than 2% on a trade. I personally limit my loss per trade to 1% of my account; 99% of my account is always protected.
As I mentioned not too many pages ago, traders should not expect to be right all of the time. It’s impossible to be. Trading is based on probabilities (Again, remember the Monty Hall puzzle?) and it requires a great deal of patience to identify setups with attractive risk/reward potential. I am consistently profitable even though 30% of my trades result in a loss. I don’t expect to be right every single trade. If you owned a small business, you wouldn’t expect it to be profitable every single day. There would be days when you wouldn’t have enough customers or sales even to support your staff or your lease, but these would be more than offset by days when your business prospered.
If you examine the work of most successful traders, you will see that they all take many small losses. Their results are littered with numerous small losses of 7c (cents), 5c, 3c, and even 1c per share. Most good day traders have few losses that are more than 30c per share. Most winning trades should work for you right away.
One of the fundamentals you must learn from this book is that every day trading strategy comes with a stop loss level and you must stop out from stocks that trade against your strategy. Imagine for a moment that you are shorting a stock below an important resistance level and you are waiting for the price to go lower. That is fine. But suddenly the price turns against you and breaks the resistance level and trades higher. Now your original trade plan is obsolete. You have no reason to stay in the trade. You cannot wait in the trade in the hope that the stock may trade lower again. That is wishful thinking. You can wipe out your trading account with ONE crazy move. The stock may or may not trade lower again, but above the resistance level you have no reason to be short in the stock. If the stock was weak and comes back below the level, you may enter the trade again. Commissions are cheap, so accept a small loss and get out. You can always get back into the trade when the setup is ready.
Those who never master this fundamental rule will fail. This is a common problem amongst new traders: they don’t accept a small loss. You must work at this while trading in a simulator. You should move to live trading only if you have mastered accepting and respecting your stop loss. If you don’t know where your stop loss is or where it should be, then perhaps you should not be in that trade in the first place. It means you have not planned it correctly. It also means you should step back to reading about and reviewing your strategies and return to trade again in the simulator.
Consistently profitable traders make sound and reasonable trades. They accept that they cannot control the market or results on every single trade, but they stick to their plan and control their capital. Professional traders often review their P&L quarterly, and then make a decision on their performance and adjust their trading strategies accordingly.
Many traders think a good trading day is a positive day. Wrong. A good trading day is a day when you were disciplined, traded sound strategies, and did not violate any trading rules. The normal uncertainty of the stock market will result in some of your days being negative, but that does not mean that a negative day was a bad trading day.
Education and practice give you a perspective on what matters most in trading, how you trade, and how you can grow and develop your skills. Once you have a perspective on what matters the most, you can proceed to identify the specific processes on which to focus. The key to success is knowing the trading process. Often you will learn them the hard way - by losing money.