Psychology, Money Management, Method

Aspiring traders typically go through three phases in this order:

1. Methodology - The first phase is that all-too-familiar quest for the Holy Grail—a trading system that never fails. After spending thousands of dollars on books, seminars and trading systems, the aspiring trader eventually realizes that no such system exists.

2. Money Management - So, after getting frustrated with wasting time and money, the up-and-coming trader begins to understand the need for money management, risking only a small percentage of a portfolio on a given trade versus too large a bet.

3. Psychology - The third phase is realizing how important psychology is—not only personal psychology but also the psychology of crowds.

But it would be better to go through these phases in the opposite direction. We actually read of this idea in a magazine a few months ago but we can't find the article. Even so, with a lot of years of trading experience under our belt, we wholeheartedly agree - Aspiring traders should begin their journey at phase three and work backward.

We believe the first step in becoming a consistently successful trader is to understand how psychology plays out in your own make-up and in the way the crowd reacts to changes in the markets. The reason for this is that a trader must realize that once he or she makes a trade, logic no longer applies. This is because the emotions of fear and greed take precedence - fear of losing money and greed for more money. Once the aspiring trader understands this psychology, it's easier to understand why it's important to have a defined investment methodology and, more importantly, the discipline to follow it. New traders must realize that once they join a crowd, they lose their individuality. Worse yet, crowd psychology impairs their judgment, because crowds are wrong more often than not, typically selling at market bottoms and buying at market tops.

Moving onto phase two, after the aspiring trader understands a bit of psychology, he or she can focus on money management. Money management is an important subject and deserves much more than just a few sentences. Even so, there are two issues that I believe are critical to grasp: (1) risk in terms of individual trades and (2) risk as a percentage of account size.

When sizing up a trading opportunity, the rule-of-thumb we go by is 3:1. That is, if my risk on a given trading opportunity is $500, then the profit objective for that trade should equal $1,500, or more. With regard to risk as a percentage of account size, I'm more than comfortable utilizing the same guidelines that many professional money managers use - 1%-3% of the account per position. If your trading account is $100,000, then you should risk no more than $3,000 on a single position. Following this guideline not only helps to contain losses if one’s trade decision is incorrect, but it also insures longevity. It's one thing to have a winning quarter; the real trick is to have a winning quarter next year and the year after.

When aspiring traders grasp the importance of psychology and money management, they should then move to phase three - determining their methodology, a defined and unwavering way of examining price action. One can choose candlestick charts, Dow Theory, cycles, etc. Our best advice in this realm is that whatever you choose to use, it should be simple. In fact, it should be simple enough to put on the back of a business card, because, like an appliance, the fewer parts it has, the less likely it is to break down.