TRADING MYTHS

Trading Myths

We found that separating the reality of trading, from the trading myths that exist regarding trading, is challenging.

The misconceptions are not born out of some “plot” to mislead traders, and it’s not about true or false.

They are beliefs that arose and “grew legs” over time.

The beliefs are based on events that fit a specific set of trading conditions or the way that markets were traded historically.

However, the markets are continually changing, and no two trading styles are the same.

Your trading style shapes your trading system.

Your ability to execute trades, your view of the markets and your approach to trading will influence your trading style.

We adapted the beliefs and myths to the changing markets and, more importantly, to our trading style and our understanding of the markets.

Our perspective on the three most common myths we encountered is outlined below.

Trading Myths Number 1

Trading myths number one is that you need to have at least a 1:2 or 1:3 risk to reward ratio before you make a trade.

In our experience, that is wrong. We think it’s the biggest myth ever told to traders.

On the surface, it seems to make sense. You want to earn more than you’re risking but have you ever tried to do it. We tried to do it and found out for ourselves that it doesn’t work.

Why doesn’t it work?

It’s because you don’t know the reward side of the equation.

It seems simple, but traders continue to ignore it. Why would you take or pass on a trade based on the part of the equation that you don’t know?

Nobody Knows Where The Market Is Going Next

For the most part, professional traders ignore the risk to reward ratios.

They’re not oblivious to the concept. Professional traders know they need to earn more than they lose; however, they don’t take or pass on a trade if the ratio doesn’t fit with the 1:2 or 1:3 criteria.

They are more interested in probabilities. What is the probability of this trade working out versus is it going to have enough reward relative to the risk?

The fact is nobody knows where the market is going next.

Yes, you can make your best guesses and sometimes the market will make you look like a superstar and other times it will make you look like a complete idiot… because nobody knows.

Some setups have higher probabilities, and we cover that in the Market Makers model.

So what should you do?

Quite simply, if you can afford the risk, you take the trade.

The risk side of the equation is all that you have control over.

That is the only part of the risk to reward equation that you have any control over.

Controlling your risk is what will make or break you as a trader.

So how do you manage your risk?

Based on our experience, there are two ways to manage your risk.

First off you need to expect the worst and second, you should never risk more than you can afford to lose.

In every position, you should assume you are wrong until the market proves you right.

Why? Because thinking you are wrong makes you more receptive to the possibility that you will lose and the ability to take a loss is a precious quality for a trader to have.

Paul Tudor Jones, one of the most successful traders of recent times, said: “If 99% of traders focused on their risk, rather than the pie in the sky reward, they would all be very successful traders”.

Does Paul Tudor Jones know more about where the price will go than you do?

No, of course not. But he does know how to manage risk.

So expect the worst don’t be afraid to take a loss. Losses are part of trading. It doesn’t make you a lousy trader if you take a loss.

Trading Myths Number 2

The second of the trading myths that traders are fed all the time is that you need to take a lot of trades to make the big money.

Human beings are always uncomfortable with risk…. We’re supposed to be.

It’s no surprise, therefore, that we link reducing risk, and being successful, with winning.

We assumed that winning required a high win rate and that a high win rate required a high trade rate.

We spent many hours analysing and dissecting our trading approach and results in the aimless pursuit of a high win rate.

Achieving a high win rate was almost an obsession.

What we learnt is that success as a trader is not dependant on having a high win rate performing strategy. The vast majority of strategies aren’t, and they never will be.

It’s a futile pursuit.

Some Days The Markets Offer More

That raises the question about how many trades you need to take per day to be a successful trader.

As a start point, you shouldn’t try to be a mouse trading market maker, competing against the machines, because you will go broke. You will never be able to compete at that level.

Most of the order flow in the markets is generated by the big institutions that have paid a lot of money to get speed efficiency and have a lot of risk capital to be able to occupy a lot of positions on the order book very early.

They can make rapid decisions on whether to keep or fold those positions faster than you can blink. It’s a different game.

It’s a very viable model but its not a realistic model for a mouse trader.

Not only is it unrealistic from the trade cost perspective, but it’s also unrealistic because you can’t be that quick and efficient and get the exit prices that you need.

In our experience, you only need to take 1 to 2 trades a day when trading the daily charts.

Some days the markets offer more, and other days the markets provide less. But if you’re only looking for two trades a day, you can afford to be choosy.

You don’t have to rush in and take a trade just because you’re afraid you won’t take enough trades to make money.

You can be on the alert for the better signals.

Don’t think that you have to have the courage to take more risk to make money. To push beyond fear and pump yourself up to take more trades.

You will lose money because you’re forcing yourself to take a less than desirable signal.

Trading successfully takes more brains and fewer guts. Don’t feel like you have to take a trade if your instinct is telling you not to. That’s not being brave that’s being naïve.

Chasing trades is like having a trading strategy that requires you to put square pegs in round holes. It’s your money and, as they say, nobody cares about your money more than you do.

The critical factor is how much can you make per contract.

If you can make £50 a day per contract, you can earn as much money as you ever wanted. It just becomes a numbers game.

It’s not a game of adding more trades and getting more signals but of adding as many contracts as you can afford to trade.

That is the secret.

Stop chasing the next signal.

Trading Myths Number 3

The last of the trading myths is that you should cut your losses short and let your profits run.

Great advice, too bad no one ever tells you how to do it correctly.

We assumed that meant keeping our stops as tight as possible.

So we would ‘manufacture’ an overly tight trade. A trade that we hoped would yield a 1:2 or 1:3 risk to reward.

What we learnt is that we were strangling trades and setting ourselves up for a loss in the process.

Have you ever had the market hit your stops and then turn sharply and go to your profit target or well past year profit target?

Have you ever wondered why?

It’s No Secret Where The Stops Are

It’s no secret where the support and resistance levels are in the market, and it’s no secret where traders have their stops.

Part of our problem, when we started trading, was that we had not thought through what the stop-loss is for.

We believed that it was to get us out of a trade. But the real purpose of a stop-loss order is to get you out of a trade that isn’t behaving as expected.

There’s a world of difference between the two.

The stop-loss order is the point where you should say ‘OK, I’ve seen enough, it’s time to cancel the trade.’

The stop-loss is not there to minimise risk. You control your risk before you ever take the trade.

Your risk amount should be based on what you can afford, not on how close or how loose your stops are.

Think of your stop-loss like the ante in a card game. The ante is what you have to pay to play. The amount that you’re willing to pay to trade.

Once you place your trade, you should give it a chance of success.

If the market retreats to your stop-loss order and takes you out… well, then that’s fine. That’s simply what it cost you to play.

You can see that you were wrong about the trade. You can try to figure out why and go onto the next trade.

Making your stops overly tight will not help you avoid a losing trade. In fact, in most cases, it will only make it worse.

It would help if you had a concrete plan on how you’re going to manage an open trade.

Don’t wing it.

Average True Range – A Simple Approach

Your approach to stop loss/take profit needs to be influenced by the number of opportunities that arise, by how frequently you trade, and how many events and occurrences there are over a month.

We take a simple but effective approach.

For each trade, we use the Average True Range indicator (for the last 10 periods) from the previous days close.

The Average True Range is an indicator available on most trading platforms.

For each trade, we open two positions. The position size for each trade is 50% of the total risk amount (money) that we can afford.

The two positions are, in effect, 1 contract.

For the first position opened, we currently set the stop loss at 25% of the Average True Range and the take profit at 75% of the Average True Range.

For the second position, we only set a stop loss (25% of the Average True Range).

Please note, the Average True Range % applied to the stop loss is reviewed every three months and adjusted to reflect changes in the market performance.

When we hit the take profit for the first position, we move the stop loss on the second position to break even (the point at which we entered the trade) plus x pips.

We determine the value of x by our assessment of potential profits still to be made based on the Market Makers model.

We may then trail the stop loss.

Our approach is simple. More importantly, it eliminates a lot of ‘guesstimating’.

We’re not suggesting that you ‘blindly’ adopt our approach.

There are a lot of good strategies for managing your stops. Google is your friend.

What we are suggesting is that you pick a strategy and you work with it.

That you have a plan and you don’t panic because the market goes against you.