the triforce of trading success [part i]

In the Legend of Zelda, the ultimate source of power is held within the triforce. The triforce consists of three forces: power, wisdom, and courage. After the gods created the realm, which came to be known as Hyrule, they leave the triforce behind to keep balance and protect the land. Destined to conquer Hyrule, Ganon attacks Hyrule, steals the triforce of power and escapes. The only person who can save the realm is Link who sets out on a quest to defend Hyrule and take back the triforce of power.

Now while our quest as traders is not nearly as difficult as Link’s was, we too are on a mission to obtain the pieces of the triforce of trading. See, I believe there are three necessary skills to successful trading. They are all interrelated and, in order to see long-term consistent results, you must develop and master all three forces.

Ready for it? Here they are:

• trading strategy
• self awareness
• risk management

Brand new cutting edge advice right? Not.

Listed in order from least important to most critical are the three skills, strategies, forces, whatever it is you choose to call them to successful trading. I am sure everyone who has studied what it takes to make it in this business has read something about each one of these topics. But throughout the rest of this article I want to detail why I believe these three skills are so important and why I believe they are all you need to first survive and then thrive in the markets based on my personal experience.

Trading Strategy

The trading strategy for most people is what gets the most attention when looking to improve their trading results, and why not? It tells you what to look for when you’re going to take trade. It tells you how much money you can make. It tells you when to enter. It tells you when to exit. It is the most exciting piece of trading; it tells you when you can push buttons. And while the trading strategy is one of the three forces to master for success, based on my experience it is the least important of the three for a discretionary trader. If you disagree to the idea that your strategy is the least important of the triforce I am glad to hear it, and even happier to explain why.

How often have you heard of people going broke in this business because they did not have the “best” trading strategy out there? How many times do people take large damaging losses as a result of following their trading system? Never. Traders do not go broke because of their trading strategy. They go broke because they don’t have self-control (self awareness) or because they take trades without any risk measurements in place. But more on those later, let’s first break down the trading strategy by looking at directional probability and how that relates to profitability.

The directional probability of an equidistant move higher or lower in the markets MOST of the time during the day will hover around 50 percent. This means that price has an equal chance of moving up X ticks as it does moving down those same X ticks so long as X is a reasonable distance on the given timeframe you’re watching. For example, if you were to just blindly buy Apple without even looking at any charts or recent data and put a target sell order 1 point higher and a sell stop order 1 point lower, during “normal market conditions” you will have about a 50/50 chance of hitting your profit target before your stop. I don’t want to jump into the details and math of why that’s true within this post so email or comment if you want to hear more about that.

The point here is that with no trading strategy you could be about a 50/50 trader as far as your win rate and win/loss ratio is concerned (you’re also losing on the spread/slippage and commission costs with every trade and those do add up). Assume you’re taking an appropriate amount of risk per trade for your account size, and honoring your stops and targets 100% of the time. We can all agree it’s going to take you a long time to go broke and, hell, the study of basic statistics tells us we can actually have sustained periods of profitability without knowing a thing about the markets.

And now that I have offended all current traders and inspired all those just starting out let me explain why I wanted to bring up that example. I feel like I see many people searching for the “best” trading strategy out there as if they do not stand a chance in the markets without it. I can’t say I blame them, I was the same way starting out. But the truth is you can survive as a trader without the best or even a profitable trading system. The key is to not go broke and continue to build market experience day in and day out so you can improve your market instincts. Review your results, understand why the market moves the way it does, and then begin to form rules to create your strategy. Start simple.

The goal for traders as it relates to our trading strategy is to have profitable long term consistent results. And we do this by developing a strategy that increases our win rate and/or win to loss ratio to overcome the loss from spreads/slippage and the cost of commissions. So how do we create a profitable strategy? We study charts, we keep journals, we learn from other traders, and most important, we take our own trades until we fully understand and feel confident in price patterns and or indicators. I define a strategy as profitable only when trades taken have a positive expected value. If you took statistics class in school this might sound familiar to you, and if not here’s a review. A system or setup is considered profitable (long term) when the probability of success multiplied by the profit target outweighs the probability of failure multiplied by the stop loss.

Expected Value = [P(success) X reward > P(failure) X failure]

Here are some examples to help demonstrate what kind of win rate and win to loss ratios you need to achieve in your trading strategy to be profitable. Let’s assume the risks to reward in the following examples are in points.

40% win ratio with 1:1 risk reward: -0.20
50% win ratio with 1:1 risk reward: 0.00
60% win ratio with 1:1 risk reward: 0.20

30% win ratio with 2:1 risk reward: -0.10
40% win ratio with 2:1 risk reward: 0.20
50% win ratio with 2:1 risk reward: 0.50

20% win ratio with 3:1 risk reward: -0.20
30% win ratio with 3:1 risk reward: 0.20
40% win ratio with 3:1 risk reward: 0.60

Because the risk to reward ratios are in points, IE 40% win ratio with 2:1 risk reward = 0.20 means with a trade size of 1 share and a profit target of $2 and a stop loss of $1 our expected value each time we take that trade is positive 20 cents. So in the long run this strategy will make money averaging us about 20 cents every time we put on the trade.  If we were trading 100 shares in this example the expected value per trade would be (0.20 * 100)  = $20.

An important observation to make about these numbers is that they do not factor in any slippage or commission costs, which is unrealistic in live trading. So you need to do better then marginally profit, you have to overcome the costs of doing business in the market.  But the takeaway should be that you do not need to make money some crazy 80%+ in the markets to be profitable. Far from it. Even a trader that aims to make the same as they risk only needs to win 60% of the time to be consistently profitable or 40% of the time if they are swinging for doubles.

Getting to the point of having a long-term profitable system can seem difficult, especially starting out. But a system will come. Over time if you continue in this business you will begin to figure out how you like to trade and most importantly what makes the most sense to you. You will create rules as you go along, you will determine what timeframe fits your style, and you will learn what type of setups you like trading. You will continue to tweak your rules, add more, remove others, and eventually have something that is complete. The most important takeaway about your trading strategy is to make sure you own it. And by that I mean completely understand why it works, how it works, and to have absolute confidence in it.

Once you have an approach to the markets that is profitable and makes sense to you it brings you one step closer to the complete triforce of trading. But be warned,  having a profitable trading strategy alone by no means guarantees success in the long term. In part II of this article I want to describe the concept of self-awareness and how it considerably affects performance in the markets. Think about the following. Give 100 traders the same strategy so they all have the same approach and rules to trade and let them trade for an entire month. How do you think their results would compare? Would they all net the same dollar amount? More on that in part II.