The Trading Commandments
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THE
13 TRADING
COMMANDMENTS By Tradeciety.com Questions: [email protected]
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Trade entries The stockbroker Gordon Gekko said – quoted several times – in the US-American film “Wall Street”: "The decisive point is that greed – unfortunately there is no better word for it – is good. Greed is right, greed works."1 But what is greed and how does it influence us in our daily trading? FOMO (The Fear Of Missing Out) is a problem that every trader has experienced at least once. We have prepared our trading plan and now the chart looks almost as if our trade is about to start, but the last criterion has not yet been fully met. But what if the price suddenly moves sharply and we miss the trade? All the effort, planning and waiting would then be worthless and we also missed our possible profits. Should we risk it now and just start early, the trade is almost confirmed and it looks like it will happen soon anyway? Every trader regularly fights such or similar scenarios and his/her own greed-driven demons. It does not seem like a big mistake per Se, because most of the signals are almost confirmed. But the word almost makes all the decisive difference in this context – and as most traders would confirm, such trades almost always and rightly end in a loss. However, losing is not the biggest problem in this case because a trader regularly breaks his/her rules, quickly becomes inconsistent and the results can no longer be interpreted effectively. If a trader constantly changes his/her rules or enters a trade completely without observing any rules, the subsequent trade analysis is of no use. During the follow-up of trades, no conclusions can then be drawn as to where trading is already running satisfactorily and where some catching up still needs to be done. Inconsistent results must therefore be avoided since this does not allow for further development. If you want to become a professional trader, you must be able to control your greed for entry and the FOMO mechanisms. Unfortunately, there are no secret shortcuts or tricks for this. The only way to achieve the goal is to continue improving yourself.
1
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1. The candlestick closure filter A good tip to deal with the problems related to trade entries is the so-called candlestick closure filter. The rule says: do not look at the charts during the candlestick period. You are only allowed to analyse the trades and the price when the candlestick closes. Those who use the 1-hour chart for trading should only look at their charts every hour; those, who choose the 4-hour chart, should only open their trading platform every four hours, and the traders, who use the daily chart, should look at their charts only once a day. I have hardly met a trader for whom following this advice would not have led to an improvement. Although most are sceptical initially, the advantages speak for themselves. Many traders fall for unconfirmed breakout attempts, which then reverse and become traps. This is a common phenomenon that can cost inexperienced traders a lot of money. Most traps can be easily avoided by waiting until a candlestick is formed completely before making a trading decision. Naturally, you will miss a trade every now and then – but you can also avoid a lot of loss-making trades. Greed-driven traders are more likely to mourn the missed profit opportunities – but for a trader's development and emotional well-being, avoiding losing trades is much more important.
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2. Structure breaks – entry filter Chart patterns usually have a clearly defined entry point. For example, the Head-and-shoulders formation is triggered only when the neckline is broken; the Cup-and-handle formation signals a trade entry when the handle is broken, and a Wedge leads to a trade only when the price has completed the breakout. We can also see all these points – necklines, handles, highs and lows, wedges – as entry filters and, together with the candlestick closure filter, we can make our trading extremely robust. Thus, we should always wait until the price has completely broken through such a structure and also closed outside. Trade entries during the candlestick period should be completely avoided to establish a new level of consistency. Traders who react very impulsively and constantly jump in and out of trades will benefit from this method.
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During the trade: trade management In the case of a trade that is currently in profits, we face two problems: Firstly, the price could reverse any second and all our unrealised profits could vanish into thin air. Secondly, we could possibly get much more out of our trade if the price continues to develop favourably. This is an internal conflict that often tortures traders. Even a good trading plan usually fades into the background as soon as the trader becomes aware of this problem. However, the fear of relinquishing profits usually wins and the majority of traders always closes their trades too early. This naturally leads to immense problems, because the combination of large losses and small profits will ruin even the best trading system. Even if a trader manages to make more profit than loss trades, his/her account will still move into minus if he/she cannot maximize his/her profits. If you suffer from this problem and constantly close your trades too early, you can deal with it better using the following points:
3. No baby-sitting for trades It is a rumour that you become a better trader if you follow your charts carefully and are always in front of your computer. This screen-time myth is very misleading and counter-productive, because a trader who follows every price movement point by point tends to be more impulsive with his/her trades. Even the smallest movement in the opposite direction suddenly looks like a complete trend reversal when profits melt away. Many traders then exit the trade impulsively, then panic and try to chase after the price that develops favourably. This reactive behaviour must be avoided. The candlestick closure filter is the best and most powerful aid for this purpose. Less is more – this is applicable to screen-time as well. I can recommend trying this despite scepticism. You can also look at the price much more objectively if you know that the candlestick closure rule prohibits closing the trade at present.
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4. Objective exit rules It is said that the last objective moment is before you press the buy or sell button. Therefore, before entering a trade, every trader should be aware of what would signal an early trade exit: What does he/she expect from the price on facing the next resistance? How deep can the correction waves go? What happens when the price breaks the last high? What should happen if there is a divergence or rejection of the trade? These points also belong to a trading plan. Those who then start to wonder can refer to their trading plan and validate whether a premature exit is appropriate or whether individual fear mechanisms are trying to gain the upper hand.
5. Do not trade your account balance A trade should never become a function of the trading account. This means that you need to use your own objective exit rules for the trade management and trade exit. It is a big mistake to see how the trading account performs while being in a trade. It often happens that traders want to continue with their winning trades too long to make up for the last loss trade. Or they close the trade too quickly when in profit if they can already achieve their arbitrarily set daily or weekly profit target. When you make a trade, you should never monitor your account movements simultaneously. It makes sense to keep the section in the trading platform that displays the unrealised profits closed. This way, impulsive and purely money-driven decisions can be avoided. As a swing trader, it is also possible to separate chart analysis and trade execution completely. Thus, the trader should use his/her broker platform only to execute trades. Once he/she has done this, he/she should switch to his/her neutral chart analysis platform, where he/she only carries out chart analyses and does not have the constant opportunity to tamper with his/her trade.
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6. The 10-second rule In his biography, Magnus Carlsen, one of the best chess players in the entire world, said: “I usually know what I am going to do after 10 seconds; the rest is double-checking.”2 This beautifully describes what goes inside the mind of a chess player when he thinks about the next move for a long time. Probably a world-class player like this has already memorised many of the possible chess moves in some form, but he does not rely on his instincts and checks every possibility many more times. We often feel the same way when trading. We have a premonition of what the price could do next, because the pattern looks kind of familiar. Inexperienced traders then quickly make the mistake of blindly following their gut feeling and not thinking further. Leaning back for ten seconds and looking at the current chart scenario can make a big difference. The greedy inner demon can thus be controlled in a better manner and brought to rest. Therefore: Before making a trading decision, always take your finger off the mouse or put your smartphone away for a moment (depending on the technology you are using for trading) for ten seconds!
2
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Trade exits When it comes to dealing with profits and losses we must take a bit more time because such trade exit related situation can pose great challenges for a trader if managed incorrectly. On the other hand, a trader who knows how to effectively deal with such scenarios can often improve his/her edge significantly.
7. Losses Greed influences us not only in our entry decisions, but also often in how we handle of losses. We quickly start wondering whether we should really close the trade in a loss, because there is still the possibility that the price could reverse in the right direction. It might even be advantageous to re-buy at the current price, because if the price really turns around, we could make a profit more quickly. Those who catch themselves with such thoughts can be relatively sure that their inner demon is just about to drive the trading account against the wall. Anyone who thinks this way has lost objectivity and is now looking for excuses to avoid the imminent loss. This is one of the worst habits in trading, because losses are quite normal and occur regularly. Profitable trading becomes impossible for traders who always let their losses get out of hand and then also close their winners too early. Those who realise that although they are often right with their analysis and their trades would have been mostly successful but their account nevertheless moves in the minus, face emotional problems. This inevitably leads to a further deterioration in trading. Good traders are not those who do not make any loss trades, but those who realise their losses quickly and then move on to the next trade without accumulating emotional burden.
8. The trade as a hypothesis The actual trade should always be seen as a type of chart hypothesis, which makes the objective realisation of losses easier.
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For example, if you are analysing a Head-and-shoulders formation, you probably have the following hypothesis: When the price breaks the neckline downwards, the prevailing upward trend is not only over, but a new downward trend is initiated since the sellers are stronger and push the price down with lower highs and lows and falling price waves. The sell-trade hypothesis is active as long as the price forms new lows. If the price breaks the last high and closes above it, this trade idea is no longer valid. The trader would thus remain in his/her selling trade until the price breaks the last high and rises again. This approach helps in objectively determining when the trade should no longer be held and in avoiding panicking in the event of short-term price fluctuations.
9. Sample-size-thinking At this point, it is particularly important to be aware of the actual role of individual trades. If you are looking to become a professional trader and want to carry out this activity for the next 15 or 20 years, you will make thousands of trades. A single trade is therefore meaningless. You should never let it get to the point where a single losing trade gets out of hand, because this is not only harmful for the trading account, but also for your mental assets. Many traders manage to remain disciplined for three, four or five weeks and make good trades. But then comes this one trade where they were so sure it would end in a profit. But they somehow lose the overview, make some fatal mistakes and suddenly have to realize an excessively large loss which neutralises all profits of the last few weeks. This is frustrating and a strain on the nerves. If this happens repeatedly, their mental assets are attacked and they lose their mental capital. Sooner or later, traders will not be able to recover and fall into impulsive behaviour patterns. No matter how good they trade during a short period, they always come back to square one. At this point, it is important never to lose perspective. You must learn to realize losing trades quickly and without emotions. The next trade is already waiting and if you manage to close losses properly, the next winning trade will have a much bigger effect on the trading account.
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10. Five tips to deal with losses and challenges Those, who implement the following practical tips, will soon be able to cope better with losses and emotions:
Reduce trade size Most traders make the mistake of increasing their positions after losing trades because they hope to move their account back into positive range faster. Naturally, such an approach rarely ends as planned and traders often dig their own grave. The mixture of losses, emotional agitation and increased risk is counter-productive. Those, who become increasingly anxious and confused, should not exert additional pressure by entering larger trades. Patience is very important in trading! Each cycle of losses will end sooner or later; however, you should not try to speed it up by hook or by crook. Instead, it makes sense to reduce the position size and rebuild self-confidence. This way, you can slowly work your way forward again.
Become more selective Some traders tend to make indiscriminate trades in the hope of regaining positive results faster. This should be avoided at all costs. The worse your trades are, the more losses you will suffer and the variance of account movements will increase. This means that the account development fluctuates greatly, which in turn will affect emotions adversely. If you are feeling under the weather, you should make only the best trades in order to improve the quality of your trading and thus bring more consistency to your results. The more stable the account movements are, the better a trader will feel and the pressure during a loss cycle will decrease. Less is more – this is especially true for the number of trades.
Test your expectations Misplaced and excessively high expectations soon have a demotivating effect: they do not inspire us, but, if they are not met, quickly lead to negative consequences.
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Those, who believe that they can make a lot of money in a short time, but suddenly find themselves in a cycle of losses often tend to become impulsive and throw all good intentions overboard. It is therefore important to know your behavioural pattern and ask yourself whether and why you want to become a trader in the first place. Independence and freedom appear to be good goals, but if expectations are too high and unrealistic, they will rather prevent a trader from achieving his/her true potential. Those, who are then confronted with loss trades, panic quickly and their goals are still a long way off. They quickly lose the desire to trade when they realise that there is no chance of reaching the ambitious goals ever. Especially during the first year(s), it is important to realise that trading is not a way to get rich immediately, because you then quickly get on the wrong track. But that does not have to be the case! If you focus completely on yourself, learn as much as possible and constantly work on yourself without being tensed up and looking at the growth of your account, you can achieve a lot.
Objective loss analysis Not all profits are good and not all losses are bad. This is one of the most important findings in trading. Anyone who breaks his/her rules, enters a trade without following his/her rules and also uses an excessively large position size, should not be too proud if he/she gets off lightly again and realises a profit by chance. Such behaviour will take its revenge sooner or later. Furthermore, traders tend to adopt such negative behaviour patterns in the long run, and as long as they are not brutally punished, they see no reason to change their behaviour. Once you are accustomed to undisciplined trading, it will be difficult to change this habit. We therefore have to get used to process-oriented thinking, i.e. we should not judge the final result, but our planning and our behaviour. If you plan your trades, wait patiently until all your criteria are fulfilled, follow all your rules and avoid impulsive mistakes, you can be very satisfied – no matter how the trade ultimately goes. Every trader has control over these things. However, how the price reacts and how the market behaves is beyond their control. It is therefore fatal to judge yourself only based on results alone. Objective loss analysis always focuses only on the
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factors that a trader can control 100%; these factors do not include price movements or the result.
Traders should always focus on the factors they can influence actively. This gives them a feeling of control, power and selfassurance. You should not see yourself as a victim, which often happens when you use your energy to change the uncontrollable aspects.
When analysing your trades, you should ask yourself the following question and answer as objectively as possible: Have I done everything right? Has the trade worked out or not? Or have I made mistakes, am I the reason for the loss? In addition to these questions, the trading journal of www.edgewonk.com and its analysis tools are helpful in objectively assessing your trading results in a better manner.
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Not every profitable trade is good and not every loss means you have done something wrong. It is important to judge your performance based on decision-making and not just based on short-term results.
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Dealing with revenge trading Every trader knows these situations, where a normal loss trade leads to one more followed by another – and one wonders how it could have come all this way, because, under normal circumstances, one would never have made such follow-up trades. Revenge trading is a big problem and, at that moment, it usually does not seem like we are making a big mistake, but we quickly lose track and control when we try to make up for our losses in a hurry. There is only one way out for those who have problems with revenge trading: to move away from the charts. If you notice that your inner demon is about to gain the upper hand, you should immediately switch off your computer and go away from your charts as quickly as possible. Now, nothing is more important than getting an objective perspective again. After one, two or three hours, the world usually looks completely different and the desire to pursue revenge trading is often completely vanished. In exceptionally bad cases, you can also take the rest of the day or the whole week off and take a short break from trading. This is not an escape mechanism! Even if it perhaps appears so at first glance. If you give adequate time to yourself, you will realise that it is not so bad not to trade for a while after a loss. It is empowering to see that the world won't end if you do not “bring in” everything immediately after a losing trade. Such a change of perspective can be extremely liberating and change the entire trading approach.
11. Avoiding performance targets Traders like to make calculations in which they invent weekly or monthly returns, based on which they hope to grow their trading account quickly into the six or seven-digit range. However, these calculations are usually based on the arbitrary key figures and have nothing to do with their trading behaviour or actual historical results. Arbitrary calculations thus become goals that traders try to achieve by hook or crook. This inevitably leads to many problems, because nobody can control the number of trades, let alone the number of winning trades that can be realised per week or per month. If a trader is
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below the self-imposed target and runs out of time, he/she often tends to slide into over-trading and force trades or increase the risk – all this only because he/she wants to achieve the arbitrarily set target. This worsens the quality of trading – the opposite of what was hoped happens and bad trades push the self-imposed targets further and further away. On the other hand, a trader, who quickly achieves his/her goal due to favourable market conditions and then reduces his/her trading activity, can leave a lot of money on the table. Instead of setting the performance targets, a trader should strive for process-defined goals. As trading coach Dr. Alexander Elder said in his well-known book “Come into my trading room”, the only goal of a trader should be to make the best possible trades. Making money is then a byproduct of good trades.
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System metrics 12. Performance metrics To develop and design their own trading system, traders have a wide variety of options at their disposal. However, two key figures have proven to be the most important. Although most traders already use these key figures in one way or another, hardly anyone knows how to interpret them correctly. As a result, traders often develop their trading systems in the wrong direction and draw the wrong conclusions. A trader, who understands how to interpret these two key figures in the right context and integrate them into the development of his /her trading system, can stand out from the mass of failed traders. Profitable trading would then be within reach. The two key figures are the win rate and the reward/risk ratio (RRR). We will first explore the key figures individually and then see how they determine our entire trading and how we can use them to our advantage.
Win rate (WR) At first glance, the WR is a very simple key ratio. It tells us the probability of our trades ending up winning or losing. It is based on our historical trading behaviour and is not a constant number, but always changes. Furthermore, the WR depends on a variety of factors, and hence a trader usually receives not only a single WR, but different WRs for different areas, set-ups and timeframes in his/her trading. The WR is almost completely ineffective and has virtually no informative value if we consider it as a standalone factor. The biggest misunderstanding concerning the WR is the assumption that a trading system with a high WR is better and has a higher profit potential. This is not at all true. A trading system with a WR of 90% or 95% can also be a losing one. For example, this is the case when the trader always closes his/her profit trades too early and, on the other hand, the few losses completely get out of hand and erase all previous profits at once.
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The WR says nothing about the magnitude of profits and losses. This is a major weakness of the WR when it is viewed out of context. Therefore, traders should not make the mistake of getting too attached to the WR.
Myth: 50% WR and game of chance It is extremely important to understand that you can also trade profitably with a WR of 50% or less. Many traders mistakenly believe that a trading system with a WR of 50% or less can no longer be profitable and that such a system is no better than a coin toss. But this is incorrect and only shows that the trader has not dealt intensively enough with probability theory and risk management. As long as the winners are larger than the losers, a system with a WR of 50% or less can also be profitable. Many professional traders trade with the WR in the 50% range or below.
Reward/Risk Ratio (RRR) The RRR is a key ratio that allows us to assess the possible profit opportunities of a trade more precisely. For a buy trade with an entry price of $100, a stop loss at $95 and a possible take-profit target at $130, the potential loss per position is $5 ($100 minus $95). The potential profit is $30 ($130 minus $100) and the RRR is 30: 5 or 6: 1.
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The RRR measures the ratio between the entry ($100) in the trade and the potential target ($130), as well as the stop loss ($95). The potential profit is $30 and the potential risk is $5 in this case, giving us a RRR of 6:1.
The planned RRR helps traders in determining the potential expected value before entering the trades. If a trade offers too small a profit opportunity, the trader should consider whether the trade is worthwhile.
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This is comparable to professional poker or betting in sports. Even the best hand is not necessarily playable if the bet is too high when compared to the possible win. The best sports betting experts do not bet on every game and even if the outcome of a game seems very clear, it is still not a good bet if the possible win does not justify the bet. If we apply this context to trading, it means: The best set-up must be avoided now and then if the profit potential is not good enough. What exactly “not good” means in this context will become clear later. The realised RRR, often also called R multiple, is a key performance indicator that indicates the magnitude of the realised profit or loss as compared to the risk taken. An R multiple of +2 means that the profit trade has achieved a profit equal to double the initial risk. If the stop-loss distance was $5, an R-multiple of +2 means a profit of $10 per position. A loss, at which the price has reached the stop loss, is then equal to an R multiple of -1 and a loss of $-5.
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13. The Holy Grail in trading The WR and the RRR do not offer any benefit when considered in isolation. Problems and ruined trading can even occur when traders use the key figures in isolation and draw the wrong conclusions from them. However, if a trader knows how to combine the key figures correctly, he/she can reorganise and align his/her entire trading professionally.
RRR meets WR We first need to understand how the RRR and the WR are directly linked. We can calculate the required minimum WR from the average RRR. If the average RRR of a trader is 1: 1, this means that his/her profit and loss trades have the same size and that this trader needs a WR of over 50% to be profitable. An RRR of 2: 1 means that two out of three trades are winners. This trader only needs to successfully complete one of three trades to be profitable. This means that a WR of over 33% is required. For most traders, it is a revelation and a great relief to understand that they do not have to achieve either a high WR or a particularly high RRR. They only need to know the correct combination. The general formula for calculating the required WR is: Minimum WR Minimum WR = 1 / (1 + RRR) The following table compares the RRR and the required WR:
Historical WR
Minimum WR
25 %
3:1
33 %
2:1
40 %
1.5 : 1
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1:1
60 %
0.7 : 1
75 %
0.3 : 1
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The WR and the RRR are directly correlated. The curve shows the combination of the WR and the RRR that are required by a trader to avoid losses.
As already explained, most problems arise when traders try to avoid all losing trades and always chase after enormous winners. However, it should have become clear that even a lower WR can
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lead to profitable trading. A combination of a low WR and a moderate RRR is sufficient for this purpose. This brings profitable trading within reach for many traders.
Timeframes As we have already seen, the investment horizon and the choice of timeframes used to identify trading opportunities are extremely important. Trading usually distinguishes between low and high timeframes, which are divided into two classes. The low timeframes are the 1-hour, 30-minute, 15-minute and 5-minute charts. The high timeframes include the 4-hour, daily and weekly charts. Most traders choose one of the two categories and then restrict themselves to the respective timeframes. This has the advantage that the trader can make consistent decisions and his/her approach is clearly defined. They should always avoid jumping from one timeframe to the other. This is because the differences are serious. Especially the demands on the emotional profile of a trader differ fundamentally. In the low timeframes, you have more trading opportunities and the patience factor does not play such a big role. But if a trader is emotionally unstable and quickly loses his/her nerve after losing trades, he/she runs the risk of quickly sliding into revenge trading or over-trading. In the low timeframes, you must keep a cool head and shake off losing trades quickly so that you can perceive the next opportunity and remain objective. In case of trading higher timeframes, you may have to wait for hours or even days for a new trade. Traders who suffer from FOMO (the fear of missing out) or are generally bored quickly often have a hard time in the high timeframes. However, it is a huge advantage that you do not have to sit in front of the charts all the time and you can control your emotions better if you have more time to plan and execute trades. Furthermore, your holding time will also be much higher which has various implications and can pose challenges as we will see shortly.
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The selection of the timeframes influences the entire trading and different timeframes also have different requirements for traders. It is therefore very important to be aware of the choice of the timeframe and to adapt it as per your own strengths.
Thank you for your time and happy trading! Rolf & Moritz Tradeciety.com
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13 TRADING
COMMANDMENTS By Tradeciety.com Questions: [email protected]
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Trade entries The stockbroker Gordon Gekko said – quoted several times – in the US-American film “Wall Street”: "The decisive point is that greed – unfortunately there is no better word for it – is good. Greed is right, greed works."1 But what is greed and how does it influence us in our daily trading? FOMO (The Fear Of Missing Out) is a problem that every trader has experienced at least once. We have prepared our trading plan and now the chart looks almost as if our trade is about to start, but the last criterion has not yet been fully met. But what if the price suddenly moves sharply and we miss the trade? All the effort, planning and waiting would then be worthless and we also missed our possible profits. Should we risk it now and just start early, the trade is almost confirmed and it looks like it will happen soon anyway? Every trader regularly fights such or similar scenarios and his/her own greed-driven demons. It does not seem like a big mistake per Se, because most of the signals are almost confirmed. But the word almost makes all the decisive difference in this context – and as most traders would confirm, such trades almost always and rightly end in a loss. However, losing is not the biggest problem in this case because a trader regularly breaks his/her rules, quickly becomes inconsistent and the results can no longer be interpreted effectively. If a trader constantly changes his/her rules or enters a trade completely without observing any rules, the subsequent trade analysis is of no use. During the follow-up of trades, no conclusions can then be drawn as to where trading is already running satisfactorily and where some catching up still needs to be done. Inconsistent results must therefore be avoided since this does not allow for further development. If you want to become a professional trader, you must be able to control your greed for entry and the FOMO mechanisms. Unfortunately, there are no secret shortcuts or tricks for this. The only way to achieve the goal is to continue improving yourself.
1
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1. The candlestick closure filter A good tip to deal with the problems related to trade entries is the so-called candlestick closure filter. The rule says: do not look at the charts during the candlestick period. You are only allowed to analyse the trades and the price when the candlestick closes. Those who use the 1-hour chart for trading should only look at their charts every hour; those, who choose the 4-hour chart, should only open their trading platform every four hours, and the traders, who use the daily chart, should look at their charts only once a day. I have hardly met a trader for whom following this advice would not have led to an improvement. Although most are sceptical initially, the advantages speak for themselves. Many traders fall for unconfirmed breakout attempts, which then reverse and become traps. This is a common phenomenon that can cost inexperienced traders a lot of money. Most traps can be easily avoided by waiting until a candlestick is formed completely before making a trading decision. Naturally, you will miss a trade every now and then – but you can also avoid a lot of loss-making trades. Greed-driven traders are more likely to mourn the missed profit opportunities – but for a trader's development and emotional well-being, avoiding losing trades is much more important.
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2. Structure breaks – entry filter Chart patterns usually have a clearly defined entry point. For example, the Head-and-shoulders formation is triggered only when the neckline is broken; the Cup-and-handle formation signals a trade entry when the handle is broken, and a Wedge leads to a trade only when the price has completed the breakout. We can also see all these points – necklines, handles, highs and lows, wedges – as entry filters and, together with the candlestick closure filter, we can make our trading extremely robust. Thus, we should always wait until the price has completely broken through such a structure and also closed outside. Trade entries during the candlestick period should be completely avoided to establish a new level of consistency. Traders who react very impulsively and constantly jump in and out of trades will benefit from this method.
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During the trade: trade management In the case of a trade that is currently in profits, we face two problems: Firstly, the price could reverse any second and all our unrealised profits could vanish into thin air. Secondly, we could possibly get much more out of our trade if the price continues to develop favourably. This is an internal conflict that often tortures traders. Even a good trading plan usually fades into the background as soon as the trader becomes aware of this problem. However, the fear of relinquishing profits usually wins and the majority of traders always closes their trades too early. This naturally leads to immense problems, because the combination of large losses and small profits will ruin even the best trading system. Even if a trader manages to make more profit than loss trades, his/her account will still move into minus if he/she cannot maximize his/her profits. If you suffer from this problem and constantly close your trades too early, you can deal with it better using the following points:
3. No baby-sitting for trades It is a rumour that you become a better trader if you follow your charts carefully and are always in front of your computer. This screen-time myth is very misleading and counter-productive, because a trader who follows every price movement point by point tends to be more impulsive with his/her trades. Even the smallest movement in the opposite direction suddenly looks like a complete trend reversal when profits melt away. Many traders then exit the trade impulsively, then panic and try to chase after the price that develops favourably. This reactive behaviour must be avoided. The candlestick closure filter is the best and most powerful aid for this purpose. Less is more – this is applicable to screen-time as well. I can recommend trying this despite scepticism. You can also look at the price much more objectively if you know that the candlestick closure rule prohibits closing the trade at present.
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4. Objective exit rules It is said that the last objective moment is before you press the buy or sell button. Therefore, before entering a trade, every trader should be aware of what would signal an early trade exit: What does he/she expect from the price on facing the next resistance? How deep can the correction waves go? What happens when the price breaks the last high? What should happen if there is a divergence or rejection of the trade? These points also belong to a trading plan. Those who then start to wonder can refer to their trading plan and validate whether a premature exit is appropriate or whether individual fear mechanisms are trying to gain the upper hand.
5. Do not trade your account balance A trade should never become a function of the trading account. This means that you need to use your own objective exit rules for the trade management and trade exit. It is a big mistake to see how the trading account performs while being in a trade. It often happens that traders want to continue with their winning trades too long to make up for the last loss trade. Or they close the trade too quickly when in profit if they can already achieve their arbitrarily set daily or weekly profit target. When you make a trade, you should never monitor your account movements simultaneously. It makes sense to keep the section in the trading platform that displays the unrealised profits closed. This way, impulsive and purely money-driven decisions can be avoided. As a swing trader, it is also possible to separate chart analysis and trade execution completely. Thus, the trader should use his/her broker platform only to execute trades. Once he/she has done this, he/she should switch to his/her neutral chart analysis platform, where he/she only carries out chart analyses and does not have the constant opportunity to tamper with his/her trade.
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6. The 10-second rule In his biography, Magnus Carlsen, one of the best chess players in the entire world, said: “I usually know what I am going to do after 10 seconds; the rest is double-checking.”2 This beautifully describes what goes inside the mind of a chess player when he thinks about the next move for a long time. Probably a world-class player like this has already memorised many of the possible chess moves in some form, but he does not rely on his instincts and checks every possibility many more times. We often feel the same way when trading. We have a premonition of what the price could do next, because the pattern looks kind of familiar. Inexperienced traders then quickly make the mistake of blindly following their gut feeling and not thinking further. Leaning back for ten seconds and looking at the current chart scenario can make a big difference. The greedy inner demon can thus be controlled in a better manner and brought to rest. Therefore: Before making a trading decision, always take your finger off the mouse or put your smartphone away for a moment (depending on the technology you are using for trading) for ten seconds!
2
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Trade exits When it comes to dealing with profits and losses we must take a bit more time because such trade exit related situation can pose great challenges for a trader if managed incorrectly. On the other hand, a trader who knows how to effectively deal with such scenarios can often improve his/her edge significantly.
7. Losses Greed influences us not only in our entry decisions, but also often in how we handle of losses. We quickly start wondering whether we should really close the trade in a loss, because there is still the possibility that the price could reverse in the right direction. It might even be advantageous to re-buy at the current price, because if the price really turns around, we could make a profit more quickly. Those who catch themselves with such thoughts can be relatively sure that their inner demon is just about to drive the trading account against the wall. Anyone who thinks this way has lost objectivity and is now looking for excuses to avoid the imminent loss. This is one of the worst habits in trading, because losses are quite normal and occur regularly. Profitable trading becomes impossible for traders who always let their losses get out of hand and then also close their winners too early. Those who realise that although they are often right with their analysis and their trades would have been mostly successful but their account nevertheless moves in the minus, face emotional problems. This inevitably leads to a further deterioration in trading. Good traders are not those who do not make any loss trades, but those who realise their losses quickly and then move on to the next trade without accumulating emotional burden.
8. The trade as a hypothesis The actual trade should always be seen as a type of chart hypothesis, which makes the objective realisation of losses easier.
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For example, if you are analysing a Head-and-shoulders formation, you probably have the following hypothesis: When the price breaks the neckline downwards, the prevailing upward trend is not only over, but a new downward trend is initiated since the sellers are stronger and push the price down with lower highs and lows and falling price waves. The sell-trade hypothesis is active as long as the price forms new lows. If the price breaks the last high and closes above it, this trade idea is no longer valid. The trader would thus remain in his/her selling trade until the price breaks the last high and rises again. This approach helps in objectively determining when the trade should no longer be held and in avoiding panicking in the event of short-term price fluctuations.
9. Sample-size-thinking At this point, it is particularly important to be aware of the actual role of individual trades. If you are looking to become a professional trader and want to carry out this activity for the next 15 or 20 years, you will make thousands of trades. A single trade is therefore meaningless. You should never let it get to the point where a single losing trade gets out of hand, because this is not only harmful for the trading account, but also for your mental assets. Many traders manage to remain disciplined for three, four or five weeks and make good trades. But then comes this one trade where they were so sure it would end in a profit. But they somehow lose the overview, make some fatal mistakes and suddenly have to realize an excessively large loss which neutralises all profits of the last few weeks. This is frustrating and a strain on the nerves. If this happens repeatedly, their mental assets are attacked and they lose their mental capital. Sooner or later, traders will not be able to recover and fall into impulsive behaviour patterns. No matter how good they trade during a short period, they always come back to square one. At this point, it is important never to lose perspective. You must learn to realize losing trades quickly and without emotions. The next trade is already waiting and if you manage to close losses properly, the next winning trade will have a much bigger effect on the trading account.
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10. Five tips to deal with losses and challenges Those, who implement the following practical tips, will soon be able to cope better with losses and emotions:
Reduce trade size Most traders make the mistake of increasing their positions after losing trades because they hope to move their account back into positive range faster. Naturally, such an approach rarely ends as planned and traders often dig their own grave. The mixture of losses, emotional agitation and increased risk is counter-productive. Those, who become increasingly anxious and confused, should not exert additional pressure by entering larger trades. Patience is very important in trading! Each cycle of losses will end sooner or later; however, you should not try to speed it up by hook or by crook. Instead, it makes sense to reduce the position size and rebuild self-confidence. This way, you can slowly work your way forward again.
Become more selective Some traders tend to make indiscriminate trades in the hope of regaining positive results faster. This should be avoided at all costs. The worse your trades are, the more losses you will suffer and the variance of account movements will increase. This means that the account development fluctuates greatly, which in turn will affect emotions adversely. If you are feeling under the weather, you should make only the best trades in order to improve the quality of your trading and thus bring more consistency to your results. The more stable the account movements are, the better a trader will feel and the pressure during a loss cycle will decrease. Less is more – this is especially true for the number of trades.
Test your expectations Misplaced and excessively high expectations soon have a demotivating effect: they do not inspire us, but, if they are not met, quickly lead to negative consequences.
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Those, who believe that they can make a lot of money in a short time, but suddenly find themselves in a cycle of losses often tend to become impulsive and throw all good intentions overboard. It is therefore important to know your behavioural pattern and ask yourself whether and why you want to become a trader in the first place. Independence and freedom appear to be good goals, but if expectations are too high and unrealistic, they will rather prevent a trader from achieving his/her true potential. Those, who are then confronted with loss trades, panic quickly and their goals are still a long way off. They quickly lose the desire to trade when they realise that there is no chance of reaching the ambitious goals ever. Especially during the first year(s), it is important to realise that trading is not a way to get rich immediately, because you then quickly get on the wrong track. But that does not have to be the case! If you focus completely on yourself, learn as much as possible and constantly work on yourself without being tensed up and looking at the growth of your account, you can achieve a lot.
Objective loss analysis Not all profits are good and not all losses are bad. This is one of the most important findings in trading. Anyone who breaks his/her rules, enters a trade without following his/her rules and also uses an excessively large position size, should not be too proud if he/she gets off lightly again and realises a profit by chance. Such behaviour will take its revenge sooner or later. Furthermore, traders tend to adopt such negative behaviour patterns in the long run, and as long as they are not brutally punished, they see no reason to change their behaviour. Once you are accustomed to undisciplined trading, it will be difficult to change this habit. We therefore have to get used to process-oriented thinking, i.e. we should not judge the final result, but our planning and our behaviour. If you plan your trades, wait patiently until all your criteria are fulfilled, follow all your rules and avoid impulsive mistakes, you can be very satisfied – no matter how the trade ultimately goes. Every trader has control over these things. However, how the price reacts and how the market behaves is beyond their control. It is therefore fatal to judge yourself only based on results alone. Objective loss analysis always focuses only on the
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factors that a trader can control 100%; these factors do not include price movements or the result.
Traders should always focus on the factors they can influence actively. This gives them a feeling of control, power and selfassurance. You should not see yourself as a victim, which often happens when you use your energy to change the uncontrollable aspects.
When analysing your trades, you should ask yourself the following question and answer as objectively as possible: Have I done everything right? Has the trade worked out or not? Or have I made mistakes, am I the reason for the loss? In addition to these questions, the trading journal of www.edgewonk.com and its analysis tools are helpful in objectively assessing your trading results in a better manner.
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Not every profitable trade is good and not every loss means you have done something wrong. It is important to judge your performance based on decision-making and not just based on short-term results.
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Dealing with revenge trading Every trader knows these situations, where a normal loss trade leads to one more followed by another – and one wonders how it could have come all this way, because, under normal circumstances, one would never have made such follow-up trades. Revenge trading is a big problem and, at that moment, it usually does not seem like we are making a big mistake, but we quickly lose track and control when we try to make up for our losses in a hurry. There is only one way out for those who have problems with revenge trading: to move away from the charts. If you notice that your inner demon is about to gain the upper hand, you should immediately switch off your computer and go away from your charts as quickly as possible. Now, nothing is more important than getting an objective perspective again. After one, two or three hours, the world usually looks completely different and the desire to pursue revenge trading is often completely vanished. In exceptionally bad cases, you can also take the rest of the day or the whole week off and take a short break from trading. This is not an escape mechanism! Even if it perhaps appears so at first glance. If you give adequate time to yourself, you will realise that it is not so bad not to trade for a while after a loss. It is empowering to see that the world won't end if you do not “bring in” everything immediately after a losing trade. Such a change of perspective can be extremely liberating and change the entire trading approach.
11. Avoiding performance targets Traders like to make calculations in which they invent weekly or monthly returns, based on which they hope to grow their trading account quickly into the six or seven-digit range. However, these calculations are usually based on the arbitrary key figures and have nothing to do with their trading behaviour or actual historical results. Arbitrary calculations thus become goals that traders try to achieve by hook or crook. This inevitably leads to many problems, because nobody can control the number of trades, let alone the number of winning trades that can be realised per week or per month. If a trader is
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below the self-imposed target and runs out of time, he/she often tends to slide into over-trading and force trades or increase the risk – all this only because he/she wants to achieve the arbitrarily set target. This worsens the quality of trading – the opposite of what was hoped happens and bad trades push the self-imposed targets further and further away. On the other hand, a trader, who quickly achieves his/her goal due to favourable market conditions and then reduces his/her trading activity, can leave a lot of money on the table. Instead of setting the performance targets, a trader should strive for process-defined goals. As trading coach Dr. Alexander Elder said in his well-known book “Come into my trading room”, the only goal of a trader should be to make the best possible trades. Making money is then a byproduct of good trades.
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System metrics 12. Performance metrics To develop and design their own trading system, traders have a wide variety of options at their disposal. However, two key figures have proven to be the most important. Although most traders already use these key figures in one way or another, hardly anyone knows how to interpret them correctly. As a result, traders often develop their trading systems in the wrong direction and draw the wrong conclusions. A trader, who understands how to interpret these two key figures in the right context and integrate them into the development of his /her trading system, can stand out from the mass of failed traders. Profitable trading would then be within reach. The two key figures are the win rate and the reward/risk ratio (RRR). We will first explore the key figures individually and then see how they determine our entire trading and how we can use them to our advantage.
Win rate (WR) At first glance, the WR is a very simple key ratio. It tells us the probability of our trades ending up winning or losing. It is based on our historical trading behaviour and is not a constant number, but always changes. Furthermore, the WR depends on a variety of factors, and hence a trader usually receives not only a single WR, but different WRs for different areas, set-ups and timeframes in his/her trading. The WR is almost completely ineffective and has virtually no informative value if we consider it as a standalone factor. The biggest misunderstanding concerning the WR is the assumption that a trading system with a high WR is better and has a higher profit potential. This is not at all true. A trading system with a WR of 90% or 95% can also be a losing one. For example, this is the case when the trader always closes his/her profit trades too early and, on the other hand, the few losses completely get out of hand and erase all previous profits at once.
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The WR says nothing about the magnitude of profits and losses. This is a major weakness of the WR when it is viewed out of context. Therefore, traders should not make the mistake of getting too attached to the WR.
Myth: 50% WR and game of chance It is extremely important to understand that you can also trade profitably with a WR of 50% or less. Many traders mistakenly believe that a trading system with a WR of 50% or less can no longer be profitable and that such a system is no better than a coin toss. But this is incorrect and only shows that the trader has not dealt intensively enough with probability theory and risk management. As long as the winners are larger than the losers, a system with a WR of 50% or less can also be profitable. Many professional traders trade with the WR in the 50% range or below.
Reward/Risk Ratio (RRR) The RRR is a key ratio that allows us to assess the possible profit opportunities of a trade more precisely. For a buy trade with an entry price of $100, a stop loss at $95 and a possible take-profit target at $130, the potential loss per position is $5 ($100 minus $95). The potential profit is $30 ($130 minus $100) and the RRR is 30: 5 or 6: 1.
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The RRR measures the ratio between the entry ($100) in the trade and the potential target ($130), as well as the stop loss ($95). The potential profit is $30 and the potential risk is $5 in this case, giving us a RRR of 6:1.
The planned RRR helps traders in determining the potential expected value before entering the trades. If a trade offers too small a profit opportunity, the trader should consider whether the trade is worthwhile.
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This is comparable to professional poker or betting in sports. Even the best hand is not necessarily playable if the bet is too high when compared to the possible win. The best sports betting experts do not bet on every game and even if the outcome of a game seems very clear, it is still not a good bet if the possible win does not justify the bet. If we apply this context to trading, it means: The best set-up must be avoided now and then if the profit potential is not good enough. What exactly “not good” means in this context will become clear later. The realised RRR, often also called R multiple, is a key performance indicator that indicates the magnitude of the realised profit or loss as compared to the risk taken. An R multiple of +2 means that the profit trade has achieved a profit equal to double the initial risk. If the stop-loss distance was $5, an R-multiple of +2 means a profit of $10 per position. A loss, at which the price has reached the stop loss, is then equal to an R multiple of -1 and a loss of $-5.
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13. The Holy Grail in trading The WR and the RRR do not offer any benefit when considered in isolation. Problems and ruined trading can even occur when traders use the key figures in isolation and draw the wrong conclusions from them. However, if a trader knows how to combine the key figures correctly, he/she can reorganise and align his/her entire trading professionally.
RRR meets WR We first need to understand how the RRR and the WR are directly linked. We can calculate the required minimum WR from the average RRR. If the average RRR of a trader is 1: 1, this means that his/her profit and loss trades have the same size and that this trader needs a WR of over 50% to be profitable. An RRR of 2: 1 means that two out of three trades are winners. This trader only needs to successfully complete one of three trades to be profitable. This means that a WR of over 33% is required. For most traders, it is a revelation and a great relief to understand that they do not have to achieve either a high WR or a particularly high RRR. They only need to know the correct combination. The general formula for calculating the required WR is: Minimum WR Minimum WR = 1 / (1 + RRR) The following table compares the RRR and the required WR:
Historical WR
Minimum WR
25 %
3:1
33 %
2:1
40 %
1.5 : 1
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1:1
60 %
0.7 : 1
75 %
0.3 : 1
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The WR and the RRR are directly correlated. The curve shows the combination of the WR and the RRR that are required by a trader to avoid losses.
As already explained, most problems arise when traders try to avoid all losing trades and always chase after enormous winners. However, it should have become clear that even a lower WR can
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lead to profitable trading. A combination of a low WR and a moderate RRR is sufficient for this purpose. This brings profitable trading within reach for many traders.
Timeframes As we have already seen, the investment horizon and the choice of timeframes used to identify trading opportunities are extremely important. Trading usually distinguishes between low and high timeframes, which are divided into two classes. The low timeframes are the 1-hour, 30-minute, 15-minute and 5-minute charts. The high timeframes include the 4-hour, daily and weekly charts. Most traders choose one of the two categories and then restrict themselves to the respective timeframes. This has the advantage that the trader can make consistent decisions and his/her approach is clearly defined. They should always avoid jumping from one timeframe to the other. This is because the differences are serious. Especially the demands on the emotional profile of a trader differ fundamentally. In the low timeframes, you have more trading opportunities and the patience factor does not play such a big role. But if a trader is emotionally unstable and quickly loses his/her nerve after losing trades, he/she runs the risk of quickly sliding into revenge trading or over-trading. In the low timeframes, you must keep a cool head and shake off losing trades quickly so that you can perceive the next opportunity and remain objective. In case of trading higher timeframes, you may have to wait for hours or even days for a new trade. Traders who suffer from FOMO (the fear of missing out) or are generally bored quickly often have a hard time in the high timeframes. However, it is a huge advantage that you do not have to sit in front of the charts all the time and you can control your emotions better if you have more time to plan and execute trades. Furthermore, your holding time will also be much higher which has various implications and can pose challenges as we will see shortly.
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The selection of the timeframes influences the entire trading and different timeframes also have different requirements for traders. It is therefore very important to be aware of the choice of the timeframe and to adapt it as per your own strengths.
Thank you for your time and happy trading! Rolf & Moritz Tradeciety.com
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