Wednesday 9 December 2020

Evolution of a Trader

Introduction

Every Trader goes through the following stages of evolution - Basic market reading - is the market going up or down? Note, that at this stage, very few people think of the third possibility.....that the market could be going sideways. Setting targets for the envisaged move - During this stage the person is happy if the market moves in the envisaged direction and even if the market comes just close to the target but misses it. Getting to know Technical Indicators and Tools, thinking that knowing the tools is the secret of successful trading. During this period, the person is focused on "being right", the mentality is "me against the market", or even, "my forecast is better than yours". The person trades during this period, experiencing both profits and losses, but consistent profits elude him. He is happy every time there is a profit, no matter if it be small and tends to forget about the losses.

Slowly, the Trader moves onto the next plane of evolution, wherein - He starts to think about various possible scenarios....and starts to think in terms of "If-Then-Else". He starts to think in terms of Probability....what are the chances of the IF or the THEN or the ELSE happening. Starts to think in terms of Risk-Reward.

Having mastered this higher plane, the Trader can then move on to the next plane. Thinking in terms of strategy, Managing multiple positions.

There are distinct stages of trader evolution: discretionary trader, technical trader, strategy trader. All successful traders have gone through them. It is almost impossible to be a successful trader without going through all of these stages. Every trader usually starts out as a discretionary trader. The amount of money lost generally determines how long it takes the individual to start using technical indicators to make trading decisions. Eventually, as even employing technical indicators fails to move the trader into profitability, the trader moves into the third stage and starts to write strategies based on quantifiable data. It is at this stage that the trader ordinarily starts to make money. Finally, the strategies and money management approaches are refined and the individual becomes successful as a strategy trader.

THE DISCRETIONARY TRADER

A discretionary trader uses a combination of intuition, advice and non-quantifiable data to determine when to enter and exit the market. Discretionary traders are not restricted by a concrete set of rules. If you are a discretionary trader, you can make buy and sell decisions using whatever criteria you deem to be important at the moment. For example, you can use both a combination of hot tips and relevant news stories from DalalStreet, and enter or exit the market based upon this information. If you begin to lose money, you can immediately exit the market and change your trading method. You don't have to use the same techniques day in and day out. It's a very flexible way to trade that you can customize based on what you think the market is going to do at any given moment. Fascinated by the markets, the discretionary trader is ready to put on a trade at a moment's notice. The most uncomfortable part of trading for the discretionary trader is when there is no action. So he will jump on any piece of information, anything that will permit him to take a stab at the market. Above all, he craves the action.

INTUITION & HOT TIPS

The discretionary trader uses several sources for his trading decisions. One is intuition, for example, I see a lot of people in stores, so I think the economy is good, and earning will increase, so the stock market should go up, and I should buy Retail stocks.He usually spends a lot of time talking to his broker. Hot tips are a common way that a discretionary trader gets ideas. A call from his broker or good friend, or a tip from a discussion at a cocktail party are all places the discretionary trader gets his trading ideas.

CRAVES EXCITEMENT

What a discretionary trader loves is the excitement. He loves being in the markets, playing with the big guys. He craves the risk, the excitement of trading, and the gambling rush that he gets from calling his broker and putting in the order to buy. Discretionary traders retain the flexibility of changing their buy and sell criteria from moment to moment, and change they way they trade from minute to minute and day by day. They don't have any discipline, nor do they think they need any. They use their intuition and their gut instinct, and feel justified in doing so. They think, Making money is easy, you just have to be smarter and quicker than the next guy.

It is after enough money has been lost that the discretionary trader in some way stumbles across technical indicators. It may be from the chart book he just looked at where there was a Stochastic Indicator underneath the chart. Or he may have gone to the latest Make a Million Dollars Trading the Stock Market seminar and found out that using the Relative Strength Indicator is the sure way to stock market profits. He thinks, So this is how they do it! These indicators look like magic. They add some rationality to an otherwise irrational trading style. He thinks, This must be how the big money players make the big money they use technical indicators!

DISCOVERS TECHNICAL INDICATORS


Once the discretionary trader discovers technical indicators, he or she incorporates some rudimentary ones into trading, usually as additional justification for making the trade. These newfound technical indicators give the discretionary trader a new lease on trading. Now our trader has a whole new world in front of him the world of technical trading. For a while, this newfound world combines with intuition and the discretionary trader views himself as a strategy trader. He says, I trade a strategy using moving averages and Stochastics with a dash of daily news and tips from my broker. I am now a real objective strategy trader. While the trader may view himself as a strategy trader, this could not be farther from the truth. The discretionary trader's style is still undisciplined, based on newly educated guesses, and he is probably still losing money. For a moment, these technical tools were thought to be the answer, and while they add a little more rationale to his trades, the losses continue to pile up. Despite his continuing angst, our discretionary trader is now on the way to becoming a technical trader.

THE TECHNICAL TRADER


A technical trader uses technical indicators, hotlines, newsletters and perhaps some personally defined objective rules to enter and exit the market. As a technical trader, you are beginning to realize that rules are important and that it is appropriate to use some objective criteria such as confirmation before making a trade. You have developed rules, but sometimes you follow them and sometimes you don't. It depends how confident you feel today and how much money you are making or losing. If an indicator gives you a buy signal, you may override it because your broker told you the earnings report was going to be negative. Or maybe the bonds are up, which means interest rates are rising, and you better see how high rates go before you commit more money to this already overpriced market. You may think, I have a profit, hmm, I just may take it now. Even though the Stochastic is not overbought, the markets are tough. It's not easy to make money. Like my father said, 'you can't go broke taking profits.' At least now I have a winning trade. I'll sleep well tonight.

Our trader now begins to realize that using the intuitive and hot tip approach will not lead to profitability. He now begins to focus on the technical indicators themselves. There are so many! Moving Averages, Exponential and Weighted. The MACD, Momentum, P/E Ratio, Rate of Change, DMI, Advance/Decline Line, EPS, True Range, ADX, CCI, Candlesticks, MFI, Parabolic, Trendlines, RSI, Volatility Expansion and Volume and Open Interest, just to name a few. So much to learn and so little time! This whole new world of technical books, seminars, newsletters, and hot lines now begins to preoccupy our trader. He learns all he can about indicators. He wants to find the one indicator that will ensure profitability. He surrenders to Indicator Fascination.

INDICATOR FASCINATION

The first assumption that our trader makes is that someone out there must know how to do this. There must be an expert, someone who knows how to make money, that has created the magic indicator to do it. This is the Holy Grail syndrome and our trader now embarks on a search for the Holy Grail Indicator. He knows intuitively that there must be an indicator that will give him the information he needs to make profitable trades that there must be teachers out there that know how to make money trading. He thinks, all I need to do is find him and his indicators.

This is the indicator fascination phase. How are indicators calculated, what do they represent, and are they the secret to making money? All of these questions need to be answered so he becomes a seminar junkie, He watches the CNBC expert technicians and surfs the net looking for that magic indicator. Now he'll only buy when the ADX is moving up and the MACD is positive, and he'll sell only when the RSI gets overbought and turns down. His trading becomes more indicator-based and he listens less to his broker. It is at this stage that he learns the value of stop losses, known as stops. He learns the importance of managing the risk on each trade. He gets a hint that there is more to trading than just the indicator, and his ears perk up when people mention the concept of controlling risk and conserving capital. He thinks, I just want to stay in the game, to keep enough money to make the next trade. I don't want to quit a loser!

But even with the newly found indicators, and controlling his risk with stops, he continues to lose money, although he also consummates some winning trades that keep his capital from depleting too quickly. And here he has another major revelation markets can be trending or choppy. It is at this point that he realizes, If I could only predict the choppy markets, where I lose most of my money, I could simply stay out of the market and get back in when it starts to make the big move. So he starts another quest, that of leaning how to predict choppy markets.

PREDICTING THE MARKETS

Discontinuing the use of the old technical indicators, our technical trader now begins to flirt with the Elliot Wave theory, W.D. Gann techniques, and Fibonnacci Targets and Retracements. These techniques generally claim to help you predict when the market will be choppy and where and when it should be bought and sold. He does all of this studying so he can learn to stay out of choppy markets. It makes a lot of sense. Someone out there must know when the markets are going to go sideways and then step aside waiting for the next big trend. When the trend comes, they get on it and ride it for big profits. They then exit and wait for the next trend. He hears promises that he should be able to forecast all of this by using these predictive techniques. Unfortunately, our trader tries to predict a corrective stock market and ends up mistaking it for the next big wave up.

HISTORICAL PROBABILITIES

It finally occurs to him that he should back test some techniques and see how some of his indicators would have worked historically; he reasons that if he can do this, he would have more confidence and discipline in his trades. He begins to understand that no one (including himself) can predict the market. He starts to realize that he needs to have some confidence that the techniques he is going to use have worked in the past. He now knows that he can't predict the market. He thinks, All I really need to know is what the probabilities are when I put on a trade according to my rules, and I should make money. Our technical trader has now passed the second big initiation and begins to sense the need for trading a strategy. He realizes that there is immense value in historical strategy performance data. He purchases Trading Softwares and dives into learning how to design and trade strategies.

THE STRATEGY TRADER

A strategy trader trades a strategy a method of trading that uses objective entry and exit criteria that have been validated by historical testing on quantifiable data. Strategy traders are restricted by a set of rules. These rules make up what is known as the strategy. As a strategy trader, you will not deviate from your strategy's rules at all, unless you have decided to use a different strategy altogether. When your strategy tells you to buy, you buy. When your strategy tells you to sell, you sell. And you buy or sell exactly how much your strategy tells you to. You read Dalal Street and talk over the markets with your broker, but you don't make trading decisions to override your strategy because of something you read or heard from your broker.

The reason you are restricted by your rules is that your rules are sound. As a strategy trader, you've spent a lot of time and research in creating those rules. Your rules have been hand-designed by you and tested and re-tested on years of historical data. This testing has given you positive results and the conviction that lets you know it's time to take your strategy into the future. Your emotions might still fly as high and low as the market, but at least they are not causing you to make bad trading decisions.

Our strategy trader has now left behind the gurus, the hotlines, and the broker recommendations, and has stopped trying to predict which wave the market is in and how far it will go. He is becoming knowledgeable about computers, data and technology. He has realized the value of quantifiable data and back testing, and starts to put on trades with the confidence that comes with knowing the historical track record of the same strategy for the last 10 years. He is slowly learning the business of trading.

QUANTIFIABLE DATA

One of the first things a strategy trader needs to understand is quantifiable data. This is the data that he will correlate to the market and use to develop his trading strategy. Without quantifiable data, he would be unable to trade a strategy.

Quantifiable data is measurable data. Stock and commodity prices are quantifiable, as is volume. All technical indicators that are derived from price and/or volume are quantifiable and useable in designing a strategy. Are phases of the moon quantifiable? Yes, as are the location of the planets. They occur in a regular pattern, and each occurrence is measurable and predictable. What about earnings per share or the price earnings ratio of stocks? Yes. These are also quantifiable and can be used in strategy trading.

Once you understand what quantifiable data is, it is easier to spot non-quantifiable data. Non-quantifiable data usually consists of random events that cannot be reduced to a number and that cannot be predicted. For instance, speeches by politicians are not quantifiable, although we know that they can have a profound effect on stock prices. Opinions of our broker are not quantifiable. Are earnings surprises quantifiable? No, but quarterly earnings reports are, and they usually have a significant effect on stock prices. Are weather patterns, droughts, or freezes quantifiable? No, although we know they too have a considerable effect on commodity prices, it is not possible to quantify droughts and correlate them to Soybean or Corn prices.

A strategy trader thus moves into a mode of acquiring and testing quantifiable data as it relates to historical price activity. This is a marked difference from a technical trader, who tries to correlate data to price but usually through observation and intuition, and from the discretionary trader, who doesn't use quantifiable data at all or feels he needs to in order to make money. It is this acquisition and use of quantifiable data, along with the software to test it, that enables the strategy trader to investigate trading techniques historically and begin to put some rational and enlightened business practices to use in his trading. It is this process that enables him to start finally making money.

HISTORICAL ANALYSIS

Even though he knows that the market will never quite replicate that past, it is much more comfortable to trade a strategy that has been historically tested than to trade intuitively. He knows that the success of a strategy is not directly tied to the indicator, but to other factors: exits, money management stops, and cash flow management.

CASH MANAGEMENT & RISK CONTROL


Our strategy trader is now spending a lot of time on cash management. He'll tell you, I have finally realized that there is no Holy Grail. There is only so much money in the markets and most indicators can be rigged to catch most of the moves. The real task is to manage your money efficiently to take advantage of market moves. Our trader is now focused on refining techniques concerned with how to scale into a potential big move, and how to scale out as the market moves in his direction. He is focusing on the value of pyramiding a position to maximize the leverage of his open equity. He is using his accumulated net profit to be able to trade bigger positions without risking his own capital. Don't underestimate how critical the size of your trade is, and how important it is to add to a position at the right time. This may be more important than the strategy itself!

TRADES MULTIPLE MARKETS

Our strategy trader has observed that to maximize his return, he must trade multiple markets. At any given time there may be only one or two sectors moving. If you are only trading one market, you will have to wait for the next big move and fund the drawdown. The more markets you trade, the greater the chance that one will be in a big move. It is also likely that the profits in the markets that are moving will be greater than the drawdown in the markets that are not. That is the ideal situation because you can then reduce the fluctuation in equity and have a more predictable cash flow.

As you can see, our trader is now talking an entirely different language. He has become a sophisticated money manager, intent on maximizing the profits of his business. He manages his Trading as he would any other Business. He has truly evolved now!

Source: http://www.tradersplace.in

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