The three basic principles of Trading/Trendfollowing

If you want to be successful in not knowing what the markets are going to do, i.e. trendfollowing, three aspects are of utmost importance. At this point it is already required that you understand that fundamental analysis of markets is extremely tiresome, time-consuming, hard to understand, exhausting and not accompanied by enough success for the average Joe to have a real shot at being successful. Trendfollowing, though, if applied correctly, can be the opposite of that and yield great financial freedom if you have put enough work into it and let it play out over a long period of time.

The three most important aspects of the craft, ranked by importance, are as follows:

  1. Trader’s Psychology/Emotions
  2. Risk Management
  3. Trading System

Tom Basso, as heard on Michael Covel’s podcast (Ep. 400), originally came up with the order of those three components.

Actually, Basso researched the importance of very optimized entry and exit points, later this was done by another group of traders with many more markets, too, to find out what difference the optimization of a trading system makes for the profits of a trader. As it turns out, even on a coin flip you could make money in the markets if your Risk Management works out. Assigning heads to Long and tails to Short, you would flip a coin and simply enter the market in that direction – regardless of any technical analysis conclusions, and manage the trade from there. You would be profitable – not too much of course – but you would be, if you were just betting money on flipping a coin with adequate Risk Management. That’s the reason why having a trading system is only the least important factor in becoming a successful trendfollower. You definitely need a trading system – there is no way of navigating in the markets without the right tools for you – but next to these tools, there are two more important components you need to grasp for yourself to be successful.

There is no way in the world of trading that you will make money on every trade. Every trader, no matter how good and experienced they are, have losing trades. In fact, trendfollowers experience many losing trades in a row. These accumulated losses of course must not destroy the entire account, in this case you would not be able to come back to the table and play the game again tomorrow. There needs to be some sort of adequate Risk Management to ensure the account grows steadily over a period of many decades. In order to achieve exactly that, trendfollowers apply different, but very simple Risk Control rules. Following the literature and current trendfollowing information it seems suggested that you do not risk more than 1-2%, depending on your tolerance, per trade. There should also be a maximum % of loss defined for the entire account you are willing to take. Again, drawing upon current information and best-experiences of seasoned trendfollowers, it seems that maximum risk can be somewhere around 20-30% of the entire account. Risk Management, however, is very individual and only each trader him/herself can define the maximum loss that can be tolerated. A drawdown too deep can immediately result in negative effects on the trader’s psychology and emotions.

Those aspects of trading seem the most wishi-washi. Everyone who had a little bit of contact with trading has heard about greed and fear and other emotions that seem to have the negative influence on a trader to ruin his/her trading account. It seems these states of mind/body and emotions do not let us see clearly what is going on in the markets/our lives and which action we should take to minimize our losses and increase our profits. Dozens of books have been written on the subject, authors such as Brett Steenbarger and Mark Douglas come to mind. However, the core issue when it comes to trading psychology always remains the same, even in dealing with different emotions: the subject who is the trader also needs to be his/her own objective mentor in order to improve on mistakes regarding the three most important components. Separating oneself from being the trader who executes trades and the mentor, who has to always be in an objective observing position, is the hardest part of the most important component of trading. Mastering yourself – so to speak – is a task that is never finished, but is a life-long process that you have to be pationate about in order for it to be fruitful.

If you are able to line up these three components and continually apply and observe them, you might just as well have understood what trading is all about: not the money, but the joy of maintaining a healthy process of trading, i.e. running the trading system, managing your risk and continually observing yourself. At this point, financial success is merely a way of keeping score and a matter of time.

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