What it Takes to Become a Successful Trader

There are three major assets that one must posses in order to become a successful trader:

1) A Strategy
2) Discipline
3) Capital

A Strategy:

Without a carefully planned route to profits, you likely will not beat the market averages on a risk-adjusted level. This begs the question: How do you come up with such a plan? As opposed to what many may tell you, this is by far the most difficult quest you will ever encounter during your time as an investor or a trader. There are here three primary types of analysis one may study in search of a profitable trading method:

  • Fundamental
  • Technical
  • Statistical

Fundamental Analysis Forms:

1) The most common form, simple valuation analysis, requires you to delve into the worth of the business that your stock represents by analyzing such factors as:

  • Book value
  • Earnings
  • Revenues
  • Historic growth rates
  • Projected growth rates
  • Market capitalization
  • Projected industry saturation size
  • The simple form of this analysis is often used in conjunction with factors such as management efficiency, competitive positioning (do they own proprietary technology?), and risk analysis (are projections dependable? Might they go bankrupt?).

2) The second form involves studying the relationships between fundamental events, or shifts, and the stock of a company. A few examples follow:

  • Debt issuance
  • Competitor expansion
  • Supply chain events
  • Demand chain events, including purchaser’s debt/cash levels, plans for growth, etc
  • Currency exchange rate changes
  • Production cost changes
  • Technological changes

Technical Analysis Forms:

Technical analysis attempts to quantify investor sentiment and knowledge through analyses of price, volume, historic volatility, and implied volatility. The three most common forms of technical analysis are:

1) Support and resistance
2) Candlestick
3) Technical Indicator

1) Support and Resistance trades are usually based on multi-bar patterns, including:

  • Symmetrical/ascending/descending triangles
  • Bull flags / pennants
  • Head and shoulders formations
  • Rising / falling wedges
  • Cup with handle formations
  • Double top / bottom formations

2) Candlestick patterns are numerous; they are short price bar patterns that suggestion the direction of an ensuing trend.

3) Technical Indicators are formula-based analysis tools. Generally, they reflect historic price averages, volatility envelopes, or derivatives of price. Additionally, they may be used in intermarket analyses.

Statistical Analysis:

You will use statistics to study primarily:

Price move distributions
System performance

In the analysis of price move distributions, the goal is to find a non-normal distribution in a market liquid enough to provide a significant profit opportunity. Keep in mind that the analysis need not be performed on all the price moves of a stock. Rather, you may study the performance distribution of stocks after an event (your indicators go positive, for instance).

Great care should be taken when analyzing markets in looking for non-normality; sample non-normality does not necessarily mean that there exists market inefficiency. Rather, your results may merely represent an sample that is outlier in the distribution of the life of the market. A direct result of outliers is the possibility for curve fitting in the building of systems , especially complex systems.

You should check system results to ensure:

1) System performance changes continuously as you shift variable values away from optimized levels. Optimized levels should not provide performance results that are vastly better than levels modified by a few percent, or if they do, the levels modified by a few percent should be seen as the more representative testing results.
2) The system is profitable as a result of many trades. A small number of very large winning trades may more easily be the result of curve fitting.
3) Performance is strong on a volatility-adjusted basis.
4) Performance is reasonably similar in all markets tested.

After creating, historically testing, and forward testing several systems, you will develop an intuitive understanding of what historical results are significant for what complexity of a system.

Beyond the basics of statistics in avoiding curve fitting, one should always also use logic—an extremely underrated tool; one should always check to see if the connection that a system purports to exist really might. It is clear that the number of grains of sugar that ends up in your coffee each morning has nothing to do with how the market will then behave. Make sure your system is not based on something equally silly. It is best if you are able to explain your system in terms of greed, fear, logical intermarket effects, or the dynamics of existing indicators that have been shown to have positive expectancy.

Whatever system (systems, hopefully—diversification works here as well as between stocks) you end up with, be sure to use conservative position sizes; optimized backtested results are usually unrealistically good, and similarly, volatility is often understated.

Discipline

Discipline comes in two very important forms:

The Discipline to Follow a System
The Discipline to Question Everything

Should a trader lack the discipline to follow a system , they will not properly benefit from the work they have invested themselves in. Worse yet, a lack of discipline in stops or position sizes may result in a quickly decimated account. Even Turtles taught one of the most profitable systems in history (by Richard Dennis) have failed due to a lack of discipline.

Traders who do not question everything will not realize their mistakes, will repeat the mistakes of their predecessors, and will not develop a system of exceptional quality. If something does not make sense, try to figure it out. If your system is not acting as it should, try to figure out why. It is important to note, however, that questioning everything is very different from being flippant. Be logical in your approach, and ensure that your transient emotions are not the driving factor in your decisions.
Capital

The repercussions of a lack of capital are profound. Without sufficient capital:

You will not be able to properly diversify, and this will hurt your reward/risk ratio.
Commissions will be a high percentage of your transactions, and this will destroy your performance.
Even the best of traders would be nothing if they did not have the capital to create their success.

If you lack sufficient capital, you may do best investing your time in systems development. Alternatively, you may join a prop firm, which will provide you with capital, trading software, a professional trading environment, and possibly training.

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The Bottom Line:

The majority of traders fail. To the unprepared, trading it NOT a zero-sum game. It is a gamble with negative risk-adjusted expectancy. Prepare yourself properly.

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