Thursday, March 6, 2014

Classes of Knowledge

Anyone taking up trading for a living will eventually ask themselves if trading profitably is possible. This is natural and really is part of an assessment of the mechanics of price action.

The trader is faced with the following possibilities:

  1. A profitable trading system is impossible to construct
  2. A profitable trading system may be possible, but no known system exists
  3. I'm familiar with a profitable trading system, but my knowledge is incomplete.
  4. My knowledge is reasonably complete, but I'm unable to follow its rules.
  5. I'm reasonably knowledgable about my trading system and have the discipline to follow its rules.
#1 and #2 are practically the same, except that #1 has a formal proof. Since no such proof exists, we can easily cross it out. The presence of great traders and professional traders suggest that there are indeed systems that enable traders to trade profitably consistently, no matter how hard it may be.

If you accept the above premises then the only steps between you and success are #3 and #4. #3 is about knowledge and #4 is discipline.

Knowledge and discipline work hand-in-hand. The more knowledge you have, the less you need to do dangerous things and have a greater command over your impulses.

When you first starts trading, the initial waves of success fool you into thinking "I know it all, I have it made". The market schools you over and over and you learn new things. Along with the new knowledge comes the burden of breaking old habits, of dropping setups and patterns of behavior that no longer fit into your understanding of the markets. 

As your discipline holds and you break your old habits, you catapult to a newer level of knowledge and the process repeats. You have not quite mastered your knowledge till you have developed discipline to obey your own rules.

I believe there are four areas of learning and discipline. 
  1. Trend and Chop
  2. Location
  3. Pattern and Bar
  4. Execution
Trend and Chop is possibly the most important to master since without it, your reading is invalid more than half the time. Setups that work beautifully in a trend will fail miserably in a chop and vice-versa. This will confuse and frustrate you and until you master it, you have no line of sight to success. Trend and chop also includes adjustment for hard trends and soft trends.

Good location is easy using trendlines. There are some intricacies but for simplicity, you can simply stick to the trendlines from HOD and LOD, which should work in most cases.

Pattern and bar are a bit more involved and this is where most traders focus (including this blog). Patterns are important, but they are a small part of your overall success. New traders should focus on the other three aspects of trading first and simply take any multi-leg poke of the trendline and not worry too much about specific patterns. 

Execution is very important and includes proper stop placement, money management and trade management. Good money management is more important to your trading success than all the patterns in the world put together.

A good starting point for a trader is to work on trading at good location and executing trades flawlessly.  This is fairly straightforward and sets the trader on the path to discipline. You should be able to follow the simplest rules before you can follow rules on patterns. This is a good application for simulator trading. Once the trader is comfortable spotting location and by implication the general market direction, the trader should focus on determining when the market has started to trend and when it has stopped trending. Staying out of chop is the single best thing you can do after good money management.

The general behavior of patterns and bars come last and they complete your education. Each area has its burden of discipline, which cannot be overstated. Knowing you have to wait for the trendline, yet having to take this one exception will be a struggle till you are able to master your own rules.

In future posts, I will elaborate more on each of these areas.