The Trading Pyramid of Stock Market Success

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Brief article illustrating the order of importance of “boring” but paramount trading methodologies which are often overlooked or even straight out neglected. You are not supposed to put the pyramid upside down!

Introduction

When you first start out in the markets, make sure to have a strong foundation in place to improve the odds of reaching early profitability. This means to first focus on the methodologies which give you the most bang for your buck so to say. Once you have such a solid foundation in place you can then go on and focus all attention on accumulating experience in chart reading and grasping how the market operates. The latter simply takes a lot of time and there is no difference to studying and mastering any other craft in life. Chart reading certainly follows the 10k hour rule and only a fool would believe that trading is different and that you can find a shortcut in that regard. According to the rule you can’t become elite in any field without accumulating around 10k hours of quality practice. I did the math and I spent roughly 7-8k hours, spread over 8 years, before turning profitable myself.

However I believe that novice traders can reach net profitabilty much earlier if they follow proper money management and risk control techniques after putting a solid foundation in place. improved chart reading capabilities are then just the icing on the cake. Unfortunately I also did this wrong as only few trading mentors focus on proper, state of the art, portfolio management at all. My mentor was no exception and completely neglected all that back then. Due to this I had to become an autodidact in that field to get it right eventually. I did read a couple books but mostly it was my engineering and scientific education which helped me set up various portfolio management techniques and employ reasonable statistical methods to stack the odds of coming our ahead. Statistics play an paramount role as they help you create conviction in your system, especially when you are stuck in a drawdown. The same is true for risk control techniques.

To better illustrate this whole concept imagine a pyramid just like the nutrition pyramid of eating healthy or the physical workout pyramid of becoming strong but applied to stock trading.

The trading pyramid of stock market success.

Let’s go through the various levels or floors of the pyramid one by one.

Floor 1: A solid foundation

Learning to trade is a exciting but long journey and you must be ready for it in order to make “quick” work of the learning curve. In order to properly focus on the craft of trading your first need to pay some attention to the very basics. First do some research in order to find a solid and established broker (I picked Interactive Brokers 10years ago and they never let me down). Check if the deposit protection is high enough and if they have a history of system downtimes during phases of market turmoil. It helps when the trading workstation has some charting capabilities but you will likely end up with a modern cloud based charting tool, such as Tradingview, anyway. Beside the broker you should not have much drama around you and money shouldn’t be scarce. The latter two are very important as trading during the first years is emotionally taxing so you really won’t be able to handle too much outside drama during that time. Time is another factor. In order to accumulate the needed 7k hours of chart reading and trading experience you need roughly 7 years if you spend 3 hours each day. It also helps if you are not an ego driven person because you have to suppress your ego eventually and this will be much more easy if you are a reflected person without a dominant ego in the first place. Another desired trait is objectivity in a sense that you should be able to visualize things and situations from different perspectives. True and “brutal” patience is another one you have to aquire eventually.

Floor 2: Protection rules

When you decide to trade your hard earned money in the stockmarket you are in direct competition with the elite traders of the world. It’s like putting a high school freshman into the major league. Your first years are not about making money, they are about survival. You need to follow sound protection rules to minimize losses and thus deep portfolio drawdowns. The worst thing is when you always dig deep holes and then have to spend the entire ensuing market leg up just to make it back to prior equity highs. Recall that a 15% drawdown already requires a gain of 17.6% to recover. However, to dig your way out of a 60% hole you have to make a killing of 150% already. You see that it is a necessity to keep your drawdowns in check.

To make this short please go over to the dedicated article where you can read some more about my own set of proven protection rules.

It is all about focussing and controlling your losses. Over time the frequency and magnitude of wins will increase and you will reach profitability eventually. The stability you will have established by having a solid pyramid in place for a while will be truly priceless.

Floor 3: Portfolio or money management

Proper money management doesn’t require much time or efford. You simply need to know how to do it. There is no learning curve as this part of trading is more like engineering or science where you just apply rules and then analyze your data and acting upon it. Knowing what to do is the trick part as proper information about this is truly scarce. There are a couple solid books on the topic, such as Van Tharp’s, but you will have a hard time to get the information from a successful trader who is actually applying them with success. With proper money management you can very easily get rid of major obstacles to trading success by tricking your mind via various psychological tweaks. In general you want to track your past trades and make sure that you stick to your stop losses. Once you see that your average loss over a couple trades is larger than your desired maximum risk per trade you must take action. Another big part is monitoring of your various setups. Each setup will likely have a different win rate and thus needs a different target profit/risk ratio in order to trade it profitably. It also makes a lot of sense to drop setups or techniques which simply don’t perform well and only dilute your performance. Last but not least I trade a capped system and never have to actively see my account balance in real trading. I just check my balance a couple times per quarter and even try to reduce that number. Not having a monetary value associated with your trading is truly liberating. A trader should be driven by curiosity over monetary goals anyway. I will write more about this in a future blog article.

Floor 4: Trade selection & handling

This is the hard learned skill which differentiates the good from the bad. Learning to properly read and act upon the subtle clues hidden inside the price and volume signature of individual stocks is a process comparable to becoming elite in any other competitive field. You have to rewire and accumulate quality experience in order to get a good read on the market at any given time. Stocks will always tell you everything you need in advance, if you keep the communication with the market up. You will be easily, even effortlessly, able to step aside before severe market drops. Moreover stocks rarely (never happened to me) implode without prior warning shots in the form of faulty price and volume action. By only trading in quality stocks, which flashed some recent signs of accumulation, you already greatly decrease the odds of getting caught in a sudden over night gap down. You will find out that many of the protection rules covered on floor 2 are therefore chart based.

When you learn to trade you will have a hard time to single out good stock picks as you are pretty busy with a lot of other things early on. I followed the stock picking service of my mentor until I learned to fish myself. My own stock idea service will fullfill the same purpose. You can follow my ideas and make them your own until you manage to do it yourself and learned to follow your own conviction. Once you reach that stage where you are much more comfortable trading your very own stock ideas you are very close to making it. For me this was the moment when I realized that I did it right and that reaching true profitability in trading is only a matter of time now.

Floor 5: Tools

As a young trader a decade ago I was sure that I need unique data and tools which do the work for me. I spend roughly 300$ each month on tools during my initial years. I subscribed to two well known stock research bundles, the stock picking service of my mentor, a service which provided earnings estimates and a news service. All this stuff is totally useless. News will not improve your edge in any way, it’s quite the opposite according to my honest belief. Advanced and fancy stock screeners and chart overlays will also not even come close to replacing a well trained chart eye. And earnings estimates or other “better” fundamental data is a complete nothing burger. Today I spend roughly 80$/month on just two tools which proved to be very reliable and versatile over the years. I find stock ideas solely via www.finviz.com and do all my charting via www.tradingview.com. Both tools couldn’t be more different as the former is having an outdated format without a mobile friendly website while the latter is a state of the art html5 online app. But what both do have in common is pure speed and reliability. I can use them from pretty much any device and due to the speed I can go over many many charts in rapid fashion. This is day and night compared to the much more pricey packages I used a decade ago. Selling you trading tools is a own industry branch inside the financial world after all.

Floor 6: All the other things

All other stuff besides whats already covered in floor 1 to 5 is a complete waste of your time. Social trading, various complex indicators, Fibonacci and all that stuff. Indicators can work but will always be derived information from pure price and volume. Please don’t spent too much time trying to find the holy grail chart overlay, correct moon phase or universal golden ratio fractal patterns.

My observations over the years

  • Most traders suffer and have problems to establish stability in their trading over a longer timeframe as they focus only on floor 4 and 5 thus neglecting to put a solid foundation in place first (floor 1 to 3).
  • Floor 4 will provide you with a clear edge over other traders eventually. Very few are able to accumulate thousands of hours of quality practice in chart reading. If you did it, you are inevitably ahead and thus have an inherent edge which you can exploit. This can’t be forced, no matter how hard you try. It’s a function of time spent observing charts and the amount of market cycles you traded through.
  • Floor 2 and 3 are easy to apply and have the potential to turn you into a profitable trader much earlier. Maybe even without having reached mastery in chart reading (It’s up to you to prove this).
  • Floor 1 should be in place as it is hard to raise anything on a bad foundation.
  • Many argue that they don’t have the time anymore to properly learn all this. Well, the market doesn’t care about your life situation unfortunately. You could make it more easy by “outsourcing” the stock picking and handling for you for a while. Doing this could lead you to profitability. Once you managed to accumulate the experience (will take longer of course) yourself you can quite and start trading on your own eventually. There is no shortcut but only training wheels in the form of stock idea services.
  • Some traders surely flip this pyramid upside down for good as they construct their own FANTASY pyramid. They start with joining a noisy social trading mosh pit (Floor 6). Then spent some money on the stock research/screener bundles which ideally hand them a condensed list of 6 stocks which are poised to go higher (Floor 5). They go on and try to find the best holy grail indicator and put them on their charts increasing noise even more (Floor 4). They never think about proper portfolio management (Floor 3) and when it comes to protection they just try to stick to stops. Once their stops are violated because a bad MM obviously manipulated the stock those traders oftentimes switch into a investing mindest trying to justify holding the bag for the long run (Floor 2). Or they will simply hop from one system to the next forever. The broker they pick has to be cheap and commission free (Floor 1) and must provide a social trading feature so that THEY AND THE BOYS can together pump & dumb prices of assets fighting against the evil money managers who clearly manipulate every stock in a way to shake them out. Sad but true to the core. Just take the time and join StockTwits for a day reading the feed for the current speculative fever pitch stocks. It’s beyond absurd. DO NOT CONSTRUCT A FANTASY PYRAMID!

The FANTASY pyramid of trading FAILURE before and after crumbling and burying your goals and dreams.

Built a proper pyramid with a solid foundation and then add the blocks as you need them on top. For most traders or people in general this sounds obvious, yet many do it wrong. The twisted part is that all those who do it wrong indirectly improve the edge of those who do it right.

It helps a lot if you spent your time wisely by following the BIG THREE pinciples. Pareto Principle, Law of dimishing returns and Occam’s razor.

Read our journey to learn some more about those principles.

pyramid of stock trading success.
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Disclaimer

The content of this article is my opinion which stems from my own experience gathered trading real money in the stock market. It represents my style and it suits my personality and risk allowance and it may or may not suit yours. Please refer to my honest risk warning for further information regarding the risks associated with active stock trading.


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