Hi, this is your Trader of Stocks. In this article we look at the importance of each piece of the trading puzzle and provide a blueprint for building a solid systematic foundation first so that you can effectively dedicate yourself to the hard-to-learn skills as soon as possible.
When you start trading in stocks, it is important to build a solid foundation from the beginning. 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 really operates. The latter simply takes a lot of time and there is no difference here from learning and mastering other crafts. Chart reading certainly follows the 10k hour rule and only a fool would believe that there is a ‘magic’ shortcut here. 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 came to the conclusion that it I spend roughly 7 to 8k hours, spread over 8 years, before turning profitable myself.
However, I believe that beginners can reach the net profit zone much sooner if they first build a solid foundation by using proper money management and risk control techniques. Improved chart reading capabilities are then just the icing on the cake. Unfortunately I also got this wrong during my early years as only few trading mentors focus on proper, state of the art, portfolio management at all. My mentor (a great trader) was no exception to this and completely neglected all that back then. I had to become an autodidact in that field and teach myself all these things. I did read a couple books on the topic 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 a paramount role as they help you create conviction in your system. This is especially true when you are stuck in a drawdown.
To better illustrate this whole concept I want you to imagine a pyramid just like the nutrition pyramid or the physical workout pyramid but applied to stock trading.
The 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 an exciting but long journey, and you need to approach it with reasonable expectations in order to speed up the steep learning curve. You should focus on the basics first before even thinking about adding any complexity.
Right out of the gate you want to do some research in order to find a solid and established broker (I picked Interactive Brokers 10 years 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 or eSignal, anyway.
Aside from the broker, you shouldn’t have a lot of drama around you in the early stages and money shouldn’t be scarce.The latter two points are important as trading during the first years is emotionally taxing at best so you really won’t be able to handle too much outside pressure during that time.
Time itself is another factor. In order to accumulate the 7 to 8k hours of quality practice in chart reading you’ll need roughly 7 years if you spend 3 hours each day.
It also helps if you are not an ego driven person in the first place. As a trader you must keep the upper hand over your ego at all times and this will be much more easy if you are a humble human being without a dominant ego.
Another desired virtue is objectivity in the sense of being able to look at things from a different perspectiveand act upon facts and not upon hopes and wishful thinking.
True and genuine patience is another trait you must eventually acquire.
Floor 2: Protection rules
When you decide to put your hard earned money on the line in the stock market 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 in order to avoid deep portfolio drawdowns. It’s a real bummer 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 (150%). You see that it is a necessity to keep your drawdowns in check.
To cut 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 controlling your losses. Over time the frequency and magnitude of wins will increase and you will reach the net profit zone eventually. The stability you will achieve by having such a solid trading pyramid in place is truly priceless.
Floor 3: Portfolio or money management
Proper money management doesn’t require much time or efford. You simply need to know what to do. There is no real learning curve as this part of trading is more like engineering or science where you just apply rules and then analyze your data and act upon it. Knowing which methods work and which don’t is the crux. Proper information in this field 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 info from an actual trader who is applying the techniques with success.
Read more about my own, highly effective (at least for me), approach to money management for active stock traders.
With proper money management you can get rid of major obstacles to trading success right away. A big one will be your ability to trick your own mind via various psychological tweaks. In general you want to track your past trades and make sure that you hit your maximum risk per trade on average. Once you see a deviation you must not hesitate and take action. Another big part is to monitor your various setups. Each setup will likely have a different win rate and thus needs a different target profit/risk ratio (Risk multiple). 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 nowasays.
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*. eSignal in combination with an API broker connection is also a good solution but in practice nothing beats TradingView when it comes to charting. Finviz and Tradingview 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. *:Referral links!
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 chart pattern.
My observations over the years
- Most traders suffer and have problems to establish stability in their trading over longer timeframes as they focus mostly on floor 4 and 5 thus missing 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. Read more about the fragile construct that is the fantasy pyramid in the next chapter.
Do not construct a fantasy pyramid
Some aspiring traders surely flip this pyramid upside down for good as they construct their own FANTASY pyramid. They start by joining a noisy social trading mosh pit (Floor 6). Then they go on and spend some money on the stock research/screener bundles which they hope will hand them a condensed list of 6 stocks which are poised to go higher on a silver platter (Floor 5). Their next step towards market domination leads them to the search for the holy grail. After some time spend on Google, or any random trading forum, they find the one and only holy grail indicator (because google never lies), put it on their charts hence increasing noise even more (Floor 4). They never even think about proper portfolio management and statistics is a complete alien concept (Floor 3). In the end they are here to have fun and statistics doesn’t sound like it. When it comes to protection they just try to stick to stops. Once their stops are violated because a bad fund manager obviously manipulated the stock in his/her favor, they 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 another which makes them stuck in the loser cycle 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 stocks and fight the evil money managers who clearly manipulate every stock just to hurt them.
A clever sales person could create a gamified gambling app -disguised as a broker service- and make a fortune. Call it Hobin Rood if you like. When aimed at inexperienced traders you wouldn’t even need to meet the normal broker quality standards such as keeping your service up and running during hours of market turmoil.
Sad but true to the core. Just take some time, join StockTwits for a day and read the feed of the crowds favourite speculative fever pitch stock. It is beyond absurd.
Here’s how such a fantasy pyramid looks like:
Build a proper pyramid with a solid foundation and then add the levels on top as needed. 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 spend your time wisely by following the BIG THREE pinciples.
Pareto Principle, Law of dimishing returns and Occam’s razor.