There are some who think that trading is easy. We almost all did at some time. Then we learned better, did we not? Trading is not easy, but actually it is simple: we must sell at a price higher than we buy. That is pretty much it. But we know that there are many times that the market will just not cooperate, and we shall enter a trade, only for the market to go against us. What do we do then?
We stick to the plan; that is what we do. But what is the plan? The plan is the one that you setup beforehand, designed when you were sober, and there was no pressure on you to make a decision that would put your money at risk. You take the trades with discipline, and wait for the statistics to play out. It is a numbers game. Regardless all the nitty-gritty of the plan, all plans must follow these basic truths.
The first 2 conditions are requirements of the trader.
- The trader must have a maximum size of Stop Loss for any trade.
- The trader must have a minimum size of potential profit required before a trade will be placed.
The next 3 conditions are requirements of the trading method.
- The trading method must have a definitive, measurable, positive Expected Value, and a reasonable Expected Value Ratio, the ratio of “Expected Value of Reward” to “Expected Value of loss”. This is not the same as saying the you must always have a target to stop loss ratio of some specific size (such as the oft cited, vaunted 3:1 that is a favorite of so many gurus and would be traders). Expected Value does not look in isolation at the distance to a stop loss and the distance to a target: Expected Value takes into account both the size of the targets/stops and the probability of reaching them.
- The trading method should provide a definite, inviolate price to place a Stop Loss order. This Stop Loss order should be such that if hit, the loss will be no more than the predetermined maximum size of Stop Loss for any trade.
- The trading method should provide a target that is no smaller than the minimum size of potential profit required before a trade will be placed.
These requirements are to be evaluated in that exact order. If any of them is not meant, then the trade should probably be skipped. In other words,
- If the Expected Value Ratio (EVRatio) of the trade is less than the predetermined size, that ends consideration of the trade as a valid trade to enter. If the EVRatio is greater than the predetermined size, then the stop should be looked at.
- If the stop would cause a loss larger than the maximum allowed, then the trade would be skipped.
- Only if the trade is not skipped because of the first 2 conditions would one look at the potential profit. If the potential profit is less than acceptable, then the trade will be skipped.
One might ask: “How does one determine an acceptable maximum size of Stop Loss for any trade? That will be the subject of another post. Stay tuned.
It should be fairly obvious then that trading well actually involves finding a reason to not take the trade, and only if such a reason cannot be found, to then place money at risk.
So the issue then is to:
- Design a trading method that provides enough, but not too many valid entries.
- Take every trade that is validated.
- Wait for the statistics to play out.
Are you following such a plan? Do you have a plan? Let us know in the comments. Good trading to you; may all your trades be winners.