Before heading into the trading world, there are some basics you should know. This article is going to touch on several basic variables that you will have to consider before you jump into trading either as a career or a part time hobby.
First, what will be your trading approach?
There are generally two types of traders and they are categorized as using a technical analysis type of trading approach or a more fundamental analysis type. Of course there is an approach that employs a combination of the two
Those that focus on the fundamental side of the equation focus on the cause of price movements while technical traders focus on the charts and the price movement. Fundamentalists look at the macroeconomic indicators such as interest rates, employment rate and the general health of the economies. They take a macro view of everything related to the instruments they are trading.
Trading systems that rely on technical analysis use historical price data from the charts and attempt to forecast the future behavior or direction of price. These traders believe that all current information about the market is already factored in on the current price.
Many Different Trading Approaches
Regardless of the trading system you look to use, remember that there is more than one way to take money from the market.
There are many indicators that are used in technical trading systems. Some of the more popular ones are trend lines, Fibonacci, Stochastic oscillator, MACD, various moving averages and the Relative strength index. This is not an exhaustive list of the trading indicators you can use and most charting packages come with more indicators than you will ever need.
Another approach relies on the patterns charts make as price unfolds. Dating back since the dawn of trading, price patterns have formed the basis of many successful trading careers.
There is no question that for the budding trader looking for a trading system, that a indicator based system is the easier way to go. Trying to decipher the various fundamental issues affecting price can sometimes be a test of your mental patience. Most traders, both new and experienced, tend to focus their trading system on a technical level. They either develop their own or go with a trading system that has been developed by someone else.
As you gain experience, you may, like many veteran traders do, develop your own trading system. Usually it is a combination of the various systems that have tried over the years. It can also be a mixture of the various technical indicators that they researched and tested.
It doesn’t matter which approach you use for your trading system as long as it suits you and has a positive expectancy over time.
Prove The Trading System Works
Once you have decided on the ways you will trade, many traders start to back test their trading system. They are looking to ensure that the system they are using makes money. Back testing is fine but you should keep in mind that the past does not equal the future and does not put your trading system (or you) to the test in live markets. When you back test, you have the luxury of looking at different scenarios and taking your time in deciding what you will do. Hindsight bias is a real risk when it comes to using past price to test the system of your choice.
A more popular way to test your trading system is to forward test. This simply means that you trade your system live “in the market”. Using a demo account or real money, you put your trading system to the test in the real world. It also gives you the chance to see how the trading system suits you.
There really is no excuse to not forward test. Almost every single broker will offer you a demo account. Many brokers also allow you to trade dimes in a micro account or trade e-mini micros. There is one broker out there that I personally use for Forex that caters to new and veteran traders alike. For the new trader, they are able to trade in “units” which can be a lot lower than the micro account.
Will Your System Make You Money Over Time
So you have your trading system and you want to know if over the long term it can be successful. This is where we look at opportunity and expectancy. Think of expectancy as what you can expect to win or lose for every dollar you risk.
The formula is quite simple: Expectancy = (Probability of winning × average win) – (Probability of losing × average loss).
You do not want your trading system to have a negative expectancy. You want it to be positive and obviously the higher the better.
What is opportunity?
Simply put, it means how many opportunities it will present so you can trade. When you multiply the expectancy of your trading system with the opportunity, you can see how much you can possibly make with your system over time.
Are You Fit To Trade?
So you have decided on your trading system and now comes the most important part. We know that psychology plays a huge part in your success. You can search this trading tips blog for articles on that topic.
All that is meaningless without having sound money management principles. Most traders fail and one of the biggest reasons is due to their poor money skills. Risking too much too often is the path to the poorhouse. Not even the best trading system can fix that.
Most people entering the trading world think trading is all about profit and that is where they should focus. Any trader that has survived the learning curve will tell you it is all about risk and preserving your capital. The general rule of thumb for traders is to risk between 1-3% with their trading system. This is rule of thumb only as traders differ in how conservative they want to be.
This article was a “food for thought” type of post. It touches on a few key things that people thinking of entering trading should understand. Obviously, much of this can be an entire course in itself.
If I was to sum it up over a coffee for you, I’d simply say:
- Pick your system,
- Test it and
- Don’t bet the house on one trade.
You’d run into issues like psychology quick enough if you trade for any length of time. That is one reason that new traders would be best to join up with a company that offers a solid trading strategy and covers all the other areas outside the system as well.