A big part of trading is a probability
game. The market can move any directions and many times against all logic and
fundamentals for a period of time. An edge in trading is the ability to have winning
probabilities on your side.
Most people cannot distinguish between luck
and skill when it comes to forecasting the market. At the best, I am
right 50% on the timing of the trade but I am making money on >80% of the
trades.
I acknowledge I do not know how to predict
the market timing with certainty. The process of trading is replete with errors
and thus one has to cater for it.
Apparent
randomness in the market is so complex that it cannot be managed with my finite
mind.
So here are some ways that
help me to handle the random behavior of the market:
1. The
first edge I have is to have the underlying fundamentals of the company.
Although the stock may move short term against me but longer term it will be in
my favour if the analysis of the fundamental is right. Thus, the probability is
on my side assuming that my fundamental analysis is correct at least 70% of the
time.
2. I use a
set of technical indicators to determine the short-term trend and sentiments of
the market. It is a relative simple system that I had used for probably more
than 10 years.
Technical
system does not need to be too complicated. Many technical systems will be
correct >60% correct of the time if you apply it consistently. Normally, I
use leading indicators ( price actions, patterns, and candlesticks ) and it is
confirmed by the lagging indicators which are stochastic and MACD. There are
some subjective judgments made when comes to trend lines, support and
resistance. If the system is too complicated, you will not be able to apply it
consistently.
The problem is that once you have the
indicators, many people tends to second guess the indicators again. Emotions of
greed and fear are at play. Once you deviated, the technical system with all
its winning probabilities is no longer valid.
If you have a sound system, it does not
matter whether any particular trade makes a profit or a loss. What matters is
that the probabilities over time are in your favor. You must remember that no
system is perfect, and prepare for losses along the way. You should measure
yourself on whether you followed your rules and executed your system, for both
winning and losing trades.
3. Use options to hedge. tame the
volatility, buy time and reduce the emotions to allow you to follow the
technical system. I found this to be very helpful and effective. Many people
use options to leverage to enhance the performance. I use options mostly to
hedge my trade to tame volatility and buy time to allow the fundamentals to
work.
4. Keep your position size equal in your
trade. For stock with higher volatility, the position size can be adjusted
lower and vice versa. Statistically, it will allow winning probability, as
fundamentals and technical analysis will be weighted to your favor. However,
if the position size is not balance, a losing trade with a high position size
will upset the portfolio performance although you may be >70% right on the
fundamentals and technical analysis.
5. Strictly apply risk control rules. It is
part of the whole trading plan. In a losing trade, many traders are like a deer
in a highway facing a crash. They freeze when they see the crash charging
towards them. Instead of stopping loss or readjust positions according to the
system, they hope that this time it will be different. Many pray to God to give
them a last chance. But “HOPE” is dirty four-letter word in trading. You need
to follow your rules for getting out. Even if you are wrong and got whipsawed
by the market, at least you will be preserving your capital.
6. Finally keep a
journal. It is tedious work but it will be a great help. It will help you to
know whether you are following the trading plan. One day, I will write in
details on how I record my trades. It is a customized system using Excel. The
journal should be customized to your style of trading. Keep it simple. Allow
critical information like reasons for entering the trade, profit /loss %,
number of days held, reasons for adjustments and getting out.
