I've been a professional trader for more than 5 years, in front of multiple monitors looking at the price tick by tick and bar by bar on a chart. I've also read dozens of books on technical analysis, fundamental analysis and psychology.
I want to share the process of what's worked best for me from first principles. As a trader I'm still a continually evolving work in progress, I hope that by consolidating and sharing what I've learnt I can push myself to the next level. Please jump in and grill me with any questions you have, I'll be happy for any challenge.
The Traders Equation
The most important concept to be aware of as a trader is having an 'edge'. At a simple level an edge is 'making more money than you lose'. But how does that work? On a trade by trade basis?
That’s where the traders equation comes in. Something that should be in the mind of all traders, let's keep it simple to start. If after a series of trades, let's say 20..
Your average winner X number of winners > Your average loser X number of losers
Then you're making money, you have a positive expectancy.
So if you make 20 trades and on average you make $10 per winner for 10 trades and lose $5 for 10 trades then you have an edge. After 20 trades you'll make $50 overall. In this case you have 50% winning trades and your risk:reward ratio is 1:2 , i.e. you make 2x your risk on average.
Let's try and incorporate this information into a more complete equation that we can use on a trade by trade basis.
Reward x (probability of winner) > Risk x (probability of loser) = POSITIVE EDGE
Reward x (probability of winner) < Risk x (probability of loser) = NEGATIVE EDGE
Reward x (probability of winner) = Risk x (probability of loser) = BREAKEVEN
You can play with the probability of your winners to losers or the difference between the amount of your winners to losers… but it all comes down to whether you make more than you lose, whether you have an edge. You can make money with 10% winners as long as your winners are much larger than your losers or with 90% winners allowing for much larger losers on average.
Some people will say you need to have a certain % of winners or a certain risk reward ratio to be successful, It's only one piece of the puzzle. Look at the maths. You need to take into account both pieces of information and make sure you tip the equation in your favour.
You have the freedom to decide whether you like a higher winning % or you prefer larger winners with a lower winning %.
You generally can't have both, in order for markets to function someone else has to take the other side of the trade to you, if there were opportunities where you could make high rewards with a high probability of success then there will have to be someone else on the other side of that trade taking low rewards with a low probability of success. This does not happen in the long run in markets, the person taking the other side to you would eventually lose all of their trading capital.
So it comes down to a choice, do you want a high probability or do you want high rewards? You have the power, you have the option... craft something that fits with your personality...
In my next post I'll break down the markets into three 'states' - trending, ranging and reversing.
No fancy indicators, just the context of the market, what is it doing? How can you see the probabilities and how can you potentially have a positive edge.. and make more money than you lose?
Leave comments, let me know what you think. Leave ridiculously difficult questions! It'll be fun :P