How Do You Start Trading Without A Methodology?  

Starting out in trading and investing can be a daunting challenge. Surveying successful traders, they will give you advice like “You need a methodology that works”; “You need a style that’s all your own”; “you have to find your own way”. That’s great, but when you are just getting started, you’re probably wondering how you’re going to make any money.

You’d just like to find something, anything that works.

It’s essentially a chicken and egg problem—how do you know what plan to use? How do you know if it’s right for you? And if it’s untested, then how do you have sufficient confidence in it to stick to it? Where do you start?

The key to allaying your fears is to know that you don’t have to reinvent the wheel. You don’t need to spend years doing groundbreaking research to get off the ground. As a matter of fact, it’s actually quite easy to get started on the right foot. And the answer may surprise you.

There are several basic pre-requisites, which I covered extensively in my piece “What Is the Best Preparation to be a Trader?”. The big four were:

–       Knowledge of markets: you need to really study and become immersed in the markets that you are going to trade. You can’t just stick your toe in the water.

–       Numerical literacy and an understanding of probability: trading involves lots of basic math, and you need to be comfortable with that. The correct approach to the markets is probabilistic, based on statistical expectation, and thus you need to understand probability.

–       Following financial news: You need to be following the news to know what moves markets, what people are watching and how people are positioned

–       Personal finance: You need to have disciplined personal finances—only risking money that you can afford to lose; spending less than you make from your trading profits, in order to have your account balance grow over time; and making sure that your overhead costs are low relative to your account balance and profits.

Once you have these basics in place, then you need to lead off with a detailed self-inventory.  In order to find a system that suits you, you need to have a good understanding of yourself. You should have a balanced idea of your strengths and weaknesses, and of your major personality traits. You’ll want to know which trading styles build on your strengths and which ones would be out of character—for instance, if you have a master’s degree in macroeconomics, then you would want to put that to use and pursue more of a research-driven investing style; if you are a successful athlete, then you would want to have a style that makes use of your superior reflexes and focus, such as day trading.

Once you have some idea of what you bring to the table, then cast about looking for a trading methodology that would match your skillset. Luckily, finding a methodology is easy. There are hundreds of examples of successful trading methodologies, covering all markets and timeframes. Just go to the bookstore or look on the Internet—you can find many from famous, successful traders that cost only a few dozen dollars. Just within the world of investing in stocks you can find excellent books by Benjamin Graham; Warren Buffett; Joel Greenblatt; Nicolas Darvas; Mark Minvervini; and William J O’Neill.  Of course, you can also find plenty of excellent resources on the Internet, such as websites, e-books or trading seminars which will also instruct you in a methodology. Once you’ve found a well-crafted methodology that makes sense to you, the next step is simple: COPY IT.

Yes, I said to copy the whole thing. Take the resources that you have and turn them into a concise trading plan for how you will do things. By copying something that works from a famous trader, you are getting started on the right foot—you have a plan, one which is likely to work. By having the endorsement of a famous trader, you are more likely to trust it and be willing to try it. By being willing to borrow ideas, you can get started sooner and start learning what you really need to learn—trading skills.

One of the common pitfalls for beginners is “paralysis by analysis”—i.e. they can spend too much time researching or analyzing and never actually get started or get moving toward their goals. The goal of straight up copying someone else’s system is to be able to get started, without getting bogged down in researching and coming up with your own system from scratch. Furthermore, by having your methodology formulated in advance, you will stand a better chance of being able to execute it.

If you are a beginner, then you probably think that your primary challenge is not to fund a super-duper methodology that will generate 30% per year with no drawdowns. But most traders have a more basic problem—even if they are in possession of such a methodology, they can’t execute it properly. They will commit careless errors like ignoring entry and exit signals; overtrading; and putting on positions in the wrong size.

Thus, your goal should be to train up basic trading skills necessary to succeed with any methodology. These are the simple-but-not-easy tasks like performing the necessary preparation; putting on a trade when it’s the right time to do so; cutting losses and managing risk; and keeping good records. Remember, most basic, proven methodologies should breakeven or make money, provided that you have the necessary skills to execute and the discipline to stick to them properly. Your goal is to learn the methodology, trade it properly and to make some money. Starting out, your risk limits should be very small, so that you are only risking a very small amount of your money and not putting any of your long-term goals in jeopardy. This is not the time to take out a second mortgage on the house! At this stage, you could lose, thus you should not risk more than a minimal amount.

Longer term, trading skills are the most important thing to get out of this process, as they will be your ticket to success. If your methodology isn’t quite suited to you or optimized the way you would like, then you can change it. However, if you don’t have the necessary trading skills, then you will lose no matter what methodology you use.  The key is being able to execute well on any plan, no matter what. At this stage, planning the trade is less important. You need to work on trading the plan.

Over time, you will be able to see how the system or methodology performs and all of the different metrics involved. After some time and close review and examination, you can begin to dissect it and to think about changes to make.  In terms of improving ad grower as a trader long term, the key factor will be keen vigilance to reviewing and tweaking your results.

As Bella discusses in ThePlaybook, you should build a playbook of your best setups—which ones consistently make money for you, which ones work the best under different market conditions. This can be an outgrowth of your own learning and development as a trader. But as we discussed, when you are starting out, you’ll need to get your original Playbook from somewhere—so just borrow someone else’s. And then worry about developing the skill necessary to execute it.

Below, I will do a sample walkthrough with one of my friends, EL. He started out by borrowing a methodology. We made a few tweaks to his original plan, in order to firm up some of the basic points—like how much he would risk per position and the exact criteria for exiting traders, both winners and losers. Once we had the second draft in place, he had all the foundations in place to get started and to begin working on the most important—being able to execute his methodology flawlessly.

In Van Tharp’s SuperTrader, he advocates that traders have a written business plan for their methodology and that they be able to execute it flawlessly 95% of the time. While this may be overly prescriptive, I think that we should strive to execute our methodology as close to perfection as possible. At the beginning stage, you should make the goal of your trading “to follow your rules and plan perfectly”, rather than worrying about money—just focus on sticking to the gameplan that you’ve chosen and the money will follow.

A sample walkthrough

 

Let’s look at how a friend of mine started out trading. EL had been interested in the markets for a couple of years and looking at various markets and ways to start taking risk. He experimented with a couple of products but finally settled on trading US equities. He decided that he wanted to get started sooner, so he borrowed an existing methodology from a book about how to swing trade stocks using technical analysis. He is an analytical guy, so this methodology is fine for his personality. In spite of his various other commitments, he is definitely able to devote the time necessary for preparation and watching the market. In summary, his methodology works and it works for him.

The checklist that he settled on was quite simple, in that it didn’t have too many moving parts. He would focus on buying stocks that were finding support in overall uptrends and then buying them at low-risk entry points.

 

His methodology seems to strike the right balance by having very defined guidelines for parameters like the amount of risk that he takes, but being flexible about his entry points.

>>>>> 

Summary: I will enter positions when the price pulls back on a long-term trend and breaks out of a range or consolidation. The opportunities will be identified on weekly candlestick charts.

Entry Point:

  1. Breakout: I will enter when price closes above range/consolidation with a weekly candlestick.
  2. Pullback/Range: I will enter when price approaches/touches weekly trend line or horizontal support or resistance level.

Exit: Once price has closed over my exit price with a daily candlestick.

Position Size: I will risk less than 2% of my equity on each trade.

Risk/Reward: I will only enter into trades where initial my risk/reward ratio is at least 1:2 (to first opposing support or resistance level). Once price hits this target, I will take 1/2 profits and let the position run, while trailing my stop loss, always behind the next major resistance level.

Portfolio: I will have a maximum of 10 positions.

Earnings Releases: For all of my equity trades, I will be aware of earnings release dates. The goal is to trade around scheduled releases to avoid volatility and drawdowns.

Primary Tools:

  • Trend lines for support and resistance
  • Horizontal support and resistance levels

Secondary Tools:

  • Candlestick patterns for price confirmation
  • Simple moving averages (50, 100, 200) as support and resistance
  • Fibonacci retracement
  • Volume

>>

Overall, this is a great start. From the document, it’s clear that he’s trading medium- to long-term positions and not anything short-term, which suits his personality. He is trying to trade with the trend but to get in with low-risk entry points, where is buying on a reaction to the overall trend. Moreover, he has certain indicators that he looks at to get in to a position.

There are a few changes and additions that I would make. The first is that I would upgrade the level of detail—this reads like a bunch of guidelines, but I would suggest turning it into a fully fledged checklist, whereby someone could follow exactly what he’s doing and almost replicate his entries and exits. That would mean being more specific about when exactly he gets into positions—for instance, some more detail on what the various technical indicators need to look like before he gets into a position; how exactly he determines exit prices and in what size; and how he determines top losses and what risk he is taking.  By spelling out the under-detailed pieces of the puzzle, we could get a better idea of what exactly he intends to do and how he does it.

Building on his original work, we have augmented EL’s original list into the following functional checklist.

>>> 

Summary: I will be trading blue-chip stocks in the US. I will enter positions in individual stocks either on the reaction to a long-term trend and when it breaks out of a range or consolidation. The opportunities will be identified on weekly candlestick charts.

Filtering the Universe:  I screen for stocks that are in steady uptrends and downtrends identifiable on weekly candlestick charts. These can be simple trend channels or trends with a single trendline that offers support or resistance. At any given point, I will be tracking a list of up to 200 of those.

Similarly, I will compile a list of up to 200 stocks that are currently undergoing sideways movement or consolidations. I will be following these for signs of breakout and a potentially sharp upward move.

Watching for potential actions:

  • Draw trend lines and channels that detail support and resistance on all of the trending stocks. Look for stocks where the price is reacting against the major trend, and getting close to a key level and volume confirms that it’s a correction.
  • Identify major horizontal support and resistance levels in all of the consolidating stocks on the list. Look for situations where the stock is close to holding breaking out from an important level and where the volume is confirming that there’s potential for a big move after the breakout.

Secondary tools to confirm potential setups:

  • Candlestick patterns for price confirmation.
    • Steven Nison’s book Japanese Candlestick Charting Techniques offers up a plethora of bullish and bearish patterns; if one of these confirms the previous analysis for a single stock, then even better
    • Look at a stock’s trading history to see if it has historically respected moving averages or ignored them.
  • Simple moving averages (50, 100, 200) as support and resistance
    • In addition to the static price levels that we identified earlier, these three simple moving averages could also act as support and resistance. If they add additional support/resistance to enhance our initial view, then even better.
    • Look at a stock’s trading history to see if it has historically respected moving averages or ignored them.
  • Fibonacci retracement
    • Fibonacci retracements can be another way of determining support and resistance levels. By using these, we can either find other levels of support or resistance within the overall trend or we can have additional confirmation of the existing levels that we have identified.
    • Look at a stock’s trading history to see if it has historically respected Fibonacci retracements or ignored them.
  • Volume
    • Volume should ideally be confirming every level that we are looking at. The more volume dries up on reactions or holds at key levels, then the more confident we are in the validity of these levels
    • Price action and volume are two key indicators that could also indicate something, in the absence of identifiable levels. For instance, a messy consolidation with many overlapping support and resistance levels could look that much more attractive as an entry point if price and volume showed a massive accumulation/distribution.

Entry Point:

–          Breakout from range:

o    I will buy when the stock price closes takes out the resistance level(s) at the top of the range/consolidation pattern with a weekly candlestick.

o    I will short when the stock price takes out the support level(s) at the bottom of the range/consolidation pattern with a weekly candlestick.

–          Pullback/Range:

o    I will buy when the stock price approaches or touches the weekly trend line support or  horizontal support with a weekly candlestick.

o    I will short when the stock price approaches or touches the weekly trend line resistance level or horizontal resistance with a weekly candlestick.

 

Trade entry:

I will only enter into trades where initial my risk/reward ratio is at least 1:2. I set the initial take profit as the first opposing support or resistance level, or, in the absence of any, 15% in the money.  The stop loss is 7.5% from entry price or the first obvious level, as long as it’s not more than 10% away. If the take-profit doesn’t make sense, then I won’t put on the trade.

Position Size:

Risk per trademeans how much I lose on the position if my stop loss gets hit. If I risk 1% on a trade and my stop is 8% away, then my position size would conceivably be 12.5% of my overall equity.

An average risk per position is 1.25% of equity; I can risk up to 2% if there are more confirming factors such as moving averages or Fibonacci levels. I will always risk less than 2% of my equity on each trade.

Position Exit Plan:

Once price has closed over my pre-detemined exit price with a daily candlestick. Once the stock price hits this target, I will take off half of the position. I will let the remaining half run, using a trailing stop loss that I set with the same criteria as for an initial stop loss.

Portfolio:  I will have a maximum of 10 positions or 100% of my equity invested, whichever comes first. My portfolio will also be diversified by sector, with no sector occupying more than 25% of my portfolio. Lastly, I will have strict loss limits on my entire portfolio

–          8% peak-to-trough drawdown—tighten stops and close unprofitable positions

–          15% peak-to-trough drawdown—close all positions and go to cash

Other Factors:

Earnings Releases: For all of my equity trades, I will be aware of earnings release dates. The goal is to trade around scheduled releases to avoid volatility and drawdowns.

>>>>>>>>

My thoughts

As of now, this looks like a very solid write-up to start out with. He knows which markets he’ll be trading; he has a methodology that he’s borrowed from somewhere, but which is obviously solid. The basics of the methodology are consistent with the universal principles of trading—the risk:reward on every trade is skewed in his favor, he has a strategy for limiting losses; he has pre-defined criteria for entries and exits. While he’s just starting out, he’s definitely on the right path.

At this stage, the key for him is to develop the proper trading skills to implement his methodology. He has a pretty good understanding of what he wants to be doing in the market, in terms of entries, exits, and following markets. Thus, he has a pretty good plan in place. The key now is to trade the plan well, to execute properly. This means making sure that he monitors the markets properly and stays on top of all of the potential setups that he could take. It also means getting in at the right time—that means watching all of the trades that he is close to putting on and getting in at the right time, either upon a hold of key levels or on a breakout from a consolidation pattern. Then he’ll have to evaluate the risk/reward properly and judge if the position makes sense; size the position according to his overall conviction level; and then make sure to close it at his stop loss point or trade the take profit levels properly. Each stage involves making a decision and following a plan, which gives the trader a chance to grow in his skills.

This trader’s priority is to execute his methodology as it is written down. By learning how to execute it flawlessly at every step, he will have learned all of the skills that will serve him for a while: preparation; discipline; cutting losses. The ability to have a plan and carry it out flawlessly, even if the markets are difficult or volatile, is immensely valuable. He needs to build confidence in his ability to analyze the market and take risk profitably. He needs to learn trading and to trust his methodology. Right now, his goal should be to trade small size and to get comfortable with his system and his ability to do it.

Most importantly, if he follows the methodology as it is written, then he will succeed, or at least live to fight another day. The risk management guidelines at each level—both position and portfolio level—are there to protect his capital. They will get him out of individual positions before they become too large of a drag on performance and will protect his portfolio from truly destructive drawdowns. The emphasis on proper risk management means that he will live to fight another day in all market conditions and be able to continue learning, sharpening his skills and refining his methodology.

The review/tweak phase should mostly focus on making sure that he’s trading his methodology properly. That means keeping accurate records of his market views; of why he’s getting in and out of positions; of how he’s doing compared to his plan; of how his trading statistics look. Success should be measured by following the plan successfully. Only after he’s proven the ability to stick to his plan fully can he experiment a bit. Once he’s found something where he’s doing it according to the plan but it’s not working—i.e. a setup with a poor track record or an exit policy that leaves a lot of money on the table—then he should start to modify the  methodology. But this is much more for a more advanced student, where they have mastered the basic skills and can then work on their methodology to get even better.

No relevant positions

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading

 

Please follow and like us: