High Probability Trading: Take the Steps to Become a Successful TraderHardcover (2024)

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HIGH PROBABILITY TRADING

McGraw-Hill

Chapter One

How To Make Money Performing Vascular Surgery Using Household Tools and Kitchen Utensils. I don't think people would read such a book with the expectation of being able to do open-heart surgery out of their garages in their spare time, yet people go into trading with little or no experience and expect to succeed just after reading a book or two.

Doctors, lawyers, and engineers need to go to school for years before they are expected to be professionals and earn a living. A pro baseball player spends a few years in the minors before getting called up to play with the big boys. Football and basketball players start out by playing college ball for 4 years, and then only the best get drafted. Electricians, plumbers, and welders are apprentices first. These people do not just decide to work in their field and start doing so from day 1; they work up to it.

So why should traders think they are any different or better? After all, they are trying to enter what I believe is the hardest profession of all with hopes of being successful with little or no experience. The same way it takes years to become a surgeon, a trader needs to put in time before expecting to be capable of doing it successfully. Just as in every other profession, a trader needs the proper education. Unfortunately, Harvard doesn't offer any degrees in trading. The only "schooling" traders get in learning their profession is hands-on, and the money they lose can be considered their tuition. It is through these losses that they will, they hope, gain the experience needed to be a great trader.

THE LEARNING YEARS

The first few years of trading should be considered "the learning years." This is not the time to try to make a killing; instead, one should concentrate on preserving capital and educating oneself. This time should be treated as if one were in school to learn. Countless mistakes will be made when one is first starting to trade, simply because one doesn't know any better. It's okay to lose a little, and traders should be prepared for this when they are first beginning to trade. Your capital should not be considered trading capital; instead, think of it as "learning capital." At the beginning you should risk only a small portion of your money, just enough to get your feet wet and start the learning process. Too many traders are gung-ho from the start, concentrating only on making money, not on becoming better traders. Keep in mind that most successful traders began by losing quite a bit of money. Even most of Richard Dennis's turtles lost money their first year before becoming some of the world's most successful traders. Almost all the stories you read in Market Wizards are about traders who got blown out once or twice before learning from their mistakes. It doesn't matter whether one is investing in stocks or day trading bonds; it takes a lot of hard work and experience to be able to trade well. While many beginners may give up after a rough start, the ones who accept the learning curve, don't get discouraged, and are properly capitalized have a good chance of making it in the long run.

Trading is an ongoing learning process, not something that can be learned overnight by reading a book or going to a seminar. People can read five books on learning to play tennis and take a few lessons, but until they get out there and practice, practice, practice, they won't be competitive. Trading is not much different; it takes lots of practice to get good. The only difference between tennis and trading is that when you are bad at tennis, you still have fun and maybe lose a few pounds while getting in shape. With trading you may still lose a few pounds, but that's because you may not have money for food.

PAPER TRADING HELPS, BUT IT'S NOT THE REAL THING

No matter what one may have read in a book or how long one has paper traded, as soon as a person starts trading for real, everything changes. Mistakes one never even thought of start popping up left and right, and the best way to avoid making them is to make them, lose money, realize they were mistakes, and consciously be aware of them the next time the same situations arise. Losing real money will make you feel a pain that paper trading can't. Eventually, if you lose enough, you learn not to make the same mistakes over and over. Although paper trading is a good way to start and traders shouldn't risk money until they've done a fair amount of it, it is not the same as putting real money on the line. Losing $1000 on paper is quickly shaken off; when it's real money, it can be emotionally gut-wrenching and depressing, and when it happens on Friday, it ruins the whole weekend. These emotions aren't normally felt in paper trading, where there is no pain or grave sense of having made a mistake. No one gets a margin call when paper trading and has to liquidate positions, and everyone gets the best prices on every trade. With real money at risk, trading becomes a different ball game. Things that would not be done on paper are done when real money is on the line. Risk aversion levels change, profits are taken too quickly, losses are allowed to grow too big, and slippage and commissions become a major factor. These are just a few things that paper trading can't simulate, and though it's important to risk real money, it is wise to start on paper until one gets a feel for the markets. I also recommend voraciously reading everything one can get one's hands on. There is always room for improvement, and after 15 years in the business I'm constantly trying to learn more about trading.

THE TUITION OF TRADING

The Cost of Learning

From everything I've ever heard, read, and seen, a trader needs about 3 to 5 years to get through the learning period. During this time in which he is learning and honing his skills, a trader will be paying his "tuition of trading" the same way lawyers, chefs, and doctors pay $25,000 a year to learn their craft. Since there is no school where he can go, the beneficiaries of his tuition are other, more experienced traders for schooling him and teaching him a few lessons. In time he will get reimbursed by the newer starry-eyed "students" eager to get their education. Overall one should be prepared to spend at least $50,000 in tuition money. With every bad trade, one gains a little knowledge and hopefully does not repeat the same mistake. Trading is without a doubt one of the hardest professions; it requires lots of hands-on experience to be good at it. They say that experience is always the best teacher, so don't get discouraged by losses; look at them as part of the learning process.

Start-Up Capital

Unless you are as "lucky" as Hillary Clinton, who was able to make $1000 grow into $100,000 trading cattle futures in a year, you will need a bit more money than that to get started. In my opinion, to be realistic and have a fighting chance to succeed one should have a minimum of $25,000 to $50,000, a 3-year horizon, and a very understanding spouse. Many people go into trading with a $5000 account and think they are sufficiently funded to start trading. They figure they have enough money to cover the margin requirements or buy the stocks they want, and so that should be enough to start trading. They never consider that they can lose; instead, they expect to start making money from the get-go, but this is rarely the case. Most individuals end up losing money at first; 80 to 90 percent of first-time traders are losers within a year. The more money one has to start with, the more likely it is one will be around at the end of a year. If you try to start trading and have only a few thousand dollars to do it with, I'd recommend saving your money or putting it into mutual funds. There is little room for error with such a small account, and it takes only a few mistakes to be wiped out quickly.

Working Capital

Trading requires more capital than most traders think is necessary. Not only does one need to be able to get through the beginning stages, one needs to make sure he has enough ongoing capital to succeed once that period is over. There is nothing more frustrating than being short on funds when the right move comes along. This happened to me several times. The great rally I'd be waiting for would finally happen, but I wouldn't have enough money to trade it because I had already blown the little I had. It seems that the best moves always came when I was out of the market. I remember bitching several times from the sidelines how this was the move I had been waiting for and I had to miss it because of a lack of working capital. Now that I'm no longer trading with limited funds, I don't have to worry about this: I know I'll be around for the next move. This doesn't mean I can be less careful; I still need to worry about not losing too much because I don't want to put myself in a hole. But at least I've stopped worrying about blowing out and having to raise capital; now I can focus my attention on trading.

People can't be trading with scared money and must accept the fact that they probably won't make a living from their trading the first few years. They need to be able to finance their trading for several years, not just for the first few trades. If one starts trading with a sum of $25,000 to $50,000 and is conservative, one has a chance of succeeding, maybe not right away but in due time. A trader shouldn't be discouraged when he loses; he needs to accept it as a cost that's part of learning and use every dollar lost to his benefit. Except for an occasional good period, I'd say I lost over $75,000 over a 7-year stretch before I was able to trade consistently well. I was a slow learner.

Enjoying Life

Apart from trading capital, you need to be able to pay bills and enjoy life. It is extremely important to be well financed so that you can take your mind off other things when trading, foolish things such as how I will pay rent, eat, go to a movie, and so on. When one begins to worry about this, trading suffers. One of the worst things someone can do is to hope to live off trading profits. You need as much money in your account as possible; when you start taking some out to pay bills, it has the same effect on your account that losing does. I know a lot of guys who tried trading full-time and had to move back home with their parents or have a spouse support them for a few years. All these people were miserable compared to the trust fund babies who had enough money to support themselves and trade. Not being able to take a vacation or go out on the weekend can take a toll on a person.

You need to be able to enjoy life; if you are trading with money that you planned to use for a nice vacation or new car, you are not properly capitalized. You would not believe the difference it makes when trading is more relaxed because there are no monetary problems to worry about. When I first started trading on the floor, I borrowed money to get my seat. I needed to make money right away to start paying off my debt, and so I was in a bad financial position from the start. I had to work nights and weekends to support myself and was never able to give trading the attention it required. I wasn't able to hang out with friends on the weekends or just have fun, as I always had to work. That was a bit depressing, and it was reflected in my trading.

The Tools

Aside from having enough capital to learn, trade, and live off, if one plans on doing it right, one needs to make sure he has the proper tools to do it with. Just as a professional in every other field needs a bag full of tools, a trader does as well. This includes charts, quotes, trading software, live feeds, and a good computer. They may not be cheap, but they are worth their price to competitive traders. Money should be set aside to ensure that one will have all the tools needed for as long as one needs them. When I first started trading on my own, off the floor, I didn't invest in them as well as I should have. Later on, when I was spending over $1000 a month on various things, it helped my trading immensely. Chap. 3, "Leveling the Playing Field," will discuss some of the tools that can help someone become a better trader.

LEARNING FROM MISTAKES

Everybody makes mistakes and has losing trades. The difference between a successful trader and a losing trader is how those mistakes are dealt with. The good traders take note of what they did wrong and try to learn from their mistakes; bad traders make the same mistakes repeatedly and never learn. After losing money time after time buying a stock after it just ran $2 in 10 minutes, astute traders finally get the idea that it's not a high probability trading strategy to buy stocks as they are running up. The ones who keep chasing trades are similar to a fool repeatedly trying to knock down a door by using his head as a battering ram. They keep doing it because they never know which is the blow that may knock down the door. It doesn't matter to them that the odds of this trade's working are low, they figure they are due for a good trade, and they don't want to miss it when it happens. Every time you think you did something wrong, stop and think about it; ask yourself what it was you did wrong, how you can prevent it in the future, why you made the decision, and what you should have done. You should also do this when you did something right. Little mental drills like these will help you get the most out of trading.

A mistake doesn't mean being wrong on market direction; roughly half the time traders will be wrong. It's how one deals with a losing trade that is the difference between making a mistake and making a good trading decision even though it turns out to be a loser. Once someone knows he is wrong and gets out, this is a good trading decision; holding on while hoping to get bailed out is not. Mistakes can also happen on trades that turn out to be profitable. Chasing a market, whether you make money or not, is a mistake.

Making mistakes and learning from them are part of trading and its learning process. This is why traders who are well capitalized have a better chance of surviving; they have room to make and learn from mistakes without blowing out. A small trader can easily lose all his capital before fully understanding the lesson the market was trying to teach him.

DON'T REINFORCE BAD BEHAVIOR

Aside from learning from mistakes, a trader needs to recognize the things that work so that he can continue doing them. Unfortunately, sometimes one can make bad trading decisions and get bailed out by the market. For example, a trader can hold on to losing trades too long in hopes of a turnaround in the market and then actually get it. If a trader gets rewarded for this once, he may feel he can get paid for it in the future and may end up holding onto losers too long every time. It's not a good trading practice to hold a stock $3 against you and then get out with a 5-cent profit as it turns back in your favor. Not a good balance of risk and reward here, is there? It may look like a winning trade and people are always happier gaining a few cents than losing a few dollars, but even though this is a profitable trade, it's still a bad trade that may reinforce bad behavior. One should have been out of the trade down 80 cents and not have let it get so far against them; one should not be rewarded by it. The best that could happen to someone who does this is to lose 10 points in the trade; at least then that person will learn to use stops.

Every day I review my trades and take note of any bad trades I may have made and file them away in my mental Rolodex in the "do not repeat" folder. Reinforcing negative behavior is as bad for a trader as is not learning from mistakes. I'd rather have a losing trade on which I did the right thing than a winning trade on which I acted imprudently. I feel good when I exit a bad trade right away and then watch the market get worse. I consider that a good trade; losing is part of trading, and losing properly is what makes good traders better.

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Excerpted from HIGH PROBABILITY TRADING by MARCEL LINK Copyright © 2003 by Marcel Link. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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