"Creating Wealth Through Trading" Sample
Written by Ian Crawford and Shirley Bates
The Four Basic Rules
The Four Basic Rules are not quite as easily adhered to as you may think.
These four rules are:
Psychology is what some people call the holy grail of making money in shares. It’s all about having the conviction to follow through with what you have planned, the patience to wait, and giving the share a chance to perform through price corrections. The ability to detach from the shares and exit when necessary is an important factor with psychology. We tend to get caught up in the emotion, hoping the share will rise again thereby reducing our losses. The moment we let the emotions of hope, fear or greed override our decision making processes, we no longer have any control. This affects the performance of our overall plan. Take your losses when you have to. Remember, the only good share is one which keeps going up.
You now know how to put your plan together. All you have to do now is put it into action. You know when to enter a trade, you know when to exit a trade, and with filtering you will know what to buy. You will experience a range of emotions that will probably lead you to make mistakes, but making errors is all part of the learning process.
You should know by now that the emotions we all possess tend to work against us in the investment world. To succeed you will quite often have to do the opposite of what your emotions are telling you to do.
First and foremost, know the reasons why you are investing. Learn to keep your ego in check, or it will lead you to mistakes. It is all about doing what needs to be done to achieve the best investment result possible. Don’t forget, you are investing to make money. You should not be investing for any other reason than to increase your wealth.
If you do your research, you will be a lot more comfortable with your selection method. You may choose some of the factors we have mentioned. You may choose to add others, but once you have selected the criteria for your trading method, stick with it. Changing your selection method is not something you do lightly and, once decided upon, changing your entry and exit points is something you should rarely do. Even if you do not make any money for months, you must always bear in mind that you have a long-term plan and it sometimes takes a little longer than you anticipate to produce the desired result, especially during a bear market correction.
Remember, discipline, discipline, discipline! Wise investments are made using logical approaches that minimise risk and maximise opportunities to profit.
It is very unfortunate that often a person’s first exposure to the world of share trading is by way of options. Thousands of investors every year lose money with this approach, due to the lack of knowledge or understanding of the risk. Many never return to any form of share investing. They leave the market telling their friends and neighbours of their experience, which perpetuates the myth that the share market is only for losers and gamblers. This is compounded by the fact that there are salesmen who make cold calls every day in order to find someone who is uninformed, greedy or gullible. Their only objective is to make a profit or commission for themselves.
Day trading is also another form of investment that quite often leads the trader to ruin. The attraction of day trading is the excitement and the feeling of being more in control, and the fact that there is no risk exposure in their positions overnight. And as very few investors are successful at short-term trading, this also perpetuates the myth that you can not make money in the share market, or that it is too complicated and risky for you to venture into.
You should always keep in mind the risk factors involved and match them to your personal perception about risk.
Ask yourself the following questions now:
• What is your individual definition of risk?
• What type of risk?
• Is the risk immediate or long-term?
• What is the overall relative risk?
It is natural that when making an investment or trade, we often tend to focus on potential profits rather than dwell on possible losses. We often convince ourselves that a particular trade will be profitable. To be a successful trader, you must be able to deal with such thoughts. Losing trades are inevitable. It is only through our management and control that we determine our success in the market. Money management is the process that helps a trader minimise the risk of loss, while still enabling him/her to participate in major gains. The trader must fully understand this concept.
It cannot be overemphasised that money management is without a doubt the most crucial element in being a successful share trader, and yet this fact is constantly overlooked by most investors. This is because they are distracted by their efforts at trying to forecast the direction of an upcoming move. They imagine that they only have to find the right mix of fundamentals to be correct. Many traders can spend years in this mindset. Many people, also, cannot accept the fact that their decision may have been wrong. If their trade turns out to be a loser, they are decimated both psychologically and financially. We quite often come to the trading arena holding beliefs that are counter productive to successful trading.
To develop any form of denial, instead of closing out the position, often proves to be a fatal mistake. You must be able to rise above your invested emotional energy in any position and realise that it is only one decision in an overall strategy.
The object of this whole process is to learn to keep your losses small and avoid any real damage being done on any one trade. Money management is all about knowing when to take your losses and when to take your profits, and deciding how much to risk on each investment as part of your overall plan.
Money management is unique to every trading system. The more you trade, the shorter your stop loss will need to be. This leaves two questions to be answered. Firstly, where should you place your stop loss, and secondly, how much money should you invest in each trade?
We do not suggest the mechanically placed stop loss, as this can quite often exit you out of a share on an intra-day fluctuation. We suggest that your stop loss is placed manually at a price that suits your investment criteria. After trying stop losses at various percentages and taking into account that we are longer term traders, we have found that a 15 percent stop loss below our entry price to be extremely effective. For the trader who does not use a mechanical stop loss, you simply calculate how many percentage points you are prepared to lose on any one trade and if the market closes below this point, simply exit the following day. The hardest part is developing the discipline required to follow your plan on a day-to-day basis.
Your money management style can be thought of as an overlay to your entire investment approach. Its purpose is to limit the amount of capital that you risk on each trade, in order for your account to survive a series of set backs. This can be done by arriving at a percentage loss on each trade and as a percentage of your entire investment capital. For example, if you were to divide $10,000 by 25 trades, each trade would equal $400. With a stop loss of 15 percent, each trade has a potential loss of $60, equating to 0.6 percent of your entire investment of $10,000.
As an investor, you need to have a plan and develop an understanding of your own investment goals. Nearly all professional financial advisors would agree with this. So it will be up to you to apply the fundamental information first and to keep technical information in perspective. Practise goal setting. Ensure that you stay focused on these goals.
If you break the rules by failing to define your goals, your chances of success will be greatly diminished. You still cannot forget or ignore risk. When investing, it is so easy to become preoccupied with the abundance of information, and to forget your total strategy.
By reacting to short-term situations and information, it is easy to forget your long-term plan. It is only by keeping your vision on the long-term goal, and not being sidetracked by the promise of immediate gains, that you can beat the averages over the long-term.
If you choose to ignore your tolerance levels for risk and your long-term goals, and give into panic or greed – the two most common emotions during times of change – you will be far more likely to experience what is the most common cause of financial loss.
There are thousands of investors who can look back and identify a time when they would have been well ahead of where they are now, had they had just stuck with their original decisions and plan.
Having said that, there will be times when changing your goals will also become a necessary part of your overall investment strategy. An example of this would be when your own personal circumstances change. Your original financial plan may not last forever, for in life there will be occurrences that require a re-evaluation of risk, goals and plans. Some of these things include: starting a business, having children, divorce and retirement. Each change in circumstance is often accompanied by a change in investment requirements.
Last, but not least, is the requirement for patience. Success in the investment arena requires time. To expect to get rich overnight (this never happens, anyway) does not mean that your approach is wrong, but rather, your expectations may be unrealistic. It may only mean that you need a longer time frame. The very nature of growth itself requires patience.
The successful investor
The majority of losses result from easily identifiable mistakes that can be avoided. Whatever strategy you employ, successful or otherwise, will be mirrored in your profits or losses.
If you meet your goals, then you have succeeded as an investor. If you do not, then this may require that you review your strategy and actions, or revise your goals.
While fundamentalists can lose – just like anyone else taking a risk – most of the unexpected losses you hear about result from speculative activity. When you hear about investors who have lost in the market, it is worth examining what they did. Quite often you will find that they invested on rumour, someone else’s advice, panic, or employed strategies without really understanding them.
All of these mistakes are likely to expose you to short-term market risk but, as a serious investor, if you are intent on succeeding, you will not make these mistakes.
If you follow a sensible course and set rules for yourself, you will have a better than average chance of profiting from your investments. In the long run, the successful investor is one who is willing to put in the time for research and to become proficient at interpreting the financial information. This requires commitment and work, but it will translate to profits in the future. You will succeed as long as you use fundamental analysis as your primary focus for selecting shares. The search for quick profits just does not offer consistent and sustainable returns.
Due to the fact that we often feel the need to be doing something, it is very easy to enter and exit too many trades. You must remember that it is only by trading consistently to a proven plan that you can remain calm and unemotional.
b) Being influenced by others
Even professionals fall prey to being influenced, as it is only natural to believe what others are telling you. To be successful, you must act independently and learn to make all of your own decisions. If you must listen to the advice of others, make sure that they have a proven track record and you understand the basis of their advice. An increasing problem for investors is things that fall under the banner of ‘theft by fine print’; in other words, conditions that are buried in the fine print of documents.
c) Not having a simple set of procedures
The steps for your own trading system should be strictly adhered to. Once you have a trading system, try it out with small amounts of money. This will give you real experience and a feel for the whole process. If it works to your satisfaction, trade modestly and always remember if you change course midstream you will never know for sure whether your strategy was effective.
Along the way you will find that you can not always beat the market and you will incur some losses mixed in with your gains. It is by monitoring your portfolio continuously, after making decisions, that you can be successful.
The biggest difficulty traders have is in separating the reality of a losing trade from the sense of feeling like a loser. At some level, many traders equate losing trades with being a loser. This frustrates them and makes them anxious because of the way their minds have been trained to think about success in the past. Trading is simply about making money, and to do this, it is inevitable that there will be losing trades. The goal is to make trading automatic so that it is no longer consciously driven. Trading psychology is not to create favourable states of mind. The goal is to create winning habits. Traders who can get past this type of thinking and realise that trading is a risk reward ratio and should be controlled by rules are well on their way to success.
It is common for traders to suffer from a lack of confidence in their trading, but it can also be overconfidence that does them in. Overconfidence results from a lack of appreciation of the complexity of market products, and an underestimation of the challenges of trading them successfully. In a sense, overconfident traders lack respect for the markets. They think that reading about a few setups, or buying the newest software, will prepare them to make money. Because they are so eager to make money – and so sure they can make it – overconfident traders generally trade impulsively. They do not wait for the setup to form, and instead of being patient and waiting for short-term patterns to align with longer-term patterns, they become impulsive. They think they are going to make something happen in the market, instead of patiently waiting to take what the market gives. As a result, they often fight the market trend – and get run over in the process. They fear missing opportunities more than they fear losing money. The antidote to overconfidence is rule-based trading. By making entries, exits, stops, and position sizing automated, traders can greatly reduce their impulsive trading. By using an automated process, traders interpose rules between impulse and action, gaining greater control of their trading.
Uncertainty and human emotion explains why a small percentage of traders are quite successful while a large majority fail to beat the market averages. Whenever you buy a share, you are hoping to make a profit on it. If it happens to go down, you may think ‘this is just temporary, it will come back’. Sure it might go back up, but there’s also a good chance it will go down further, and when that happens ‘Well, maybe I should keep it’ and then the share goes down again. And every time it goes down you will find it harder to sell. Every time you will be hoping that you can get back just a little bit of your loss – after all, how far can it really fall? The answer is a lot. The problem is that if a share is really going into a downturn, it will keep going down.
Listen, think, then act
What you do with your money affects you – not the people handing out the advice. We’re not saying you shouldn’t listen to outside advice, but you need to consider: does it fit into your plan? There will also be negative input from other people about the share market, some of it is genuine concern, but most is just plain uninformed.
Part of being a trader is to understand ourselves and the reasons why we really want to be a trader. You may think you are just trading for money, but you must also have given some thought as to how this money will change your life or the lives of the people around you. There are many reasons for making money, but if they are not to improve your life physically or emotionally then self-sabotage often becomes the main reason for trading mistakes. The more you understand about yourself and the true reasons for your emotions, the better trader you will become.
Trading is, in a sense, a forever forward journey into our own minds. Serious consideration should be given to the reasons for all trading rules and the type of trading you decide on. Are you trading speculative capital trying to make a small or large fortune, or to earn steady returns for your retirement funds? Are you trading or investing in the right products to achieve your goals? Which strategies do you have the confidence and knowledge to employ? These are all emotional as well as logical decisions.
Failure doesn’t mean you are a failure,