Discipline and the Trading Pyramid
So, let us look at discipline within the context of the Trading Pyramid. We have already discussed how the various levels of the pyramid interact. Now I want to concentrate on how this interaction relates to discipline. There is a great deal of difference between applying discipline to doing something you like, as opposed to something you don’t like. For example if you like playing a particular sport, say tennis, then you may find it very easy to be disciplined when taking shots, keeping score, following court etiquette, and the rest. No problem, because you would enjoy the whole thing. But say you had to go fishing and you couldn’t stand it. Would you have the same discipline with baiting the hook, casting the line, sitting patiently waiting for a bite, etc.? No, you wouldn’t. You would probably be slapdash and sloppy, you would probably fidget, when you need to be still. It is the same with trading. If you find an approach that suits you, it will be much easier to follow. You will avoid trying to squeeze a square peg (yourself) into a round hole (your market approach). This applies to every level of the pyramid. Your Money Management (MM) system is designed to keep you safe so that you can relax. Much easier to apply discipline in such an environment. Risk Control has a similar function. It is all about making you comfortable and developing the skills to keep your losses under control. Again this makes the trader’s situation a lot more comfortable. Moving up to the next level we come to the three simple rules. The logic of these rules is unassailable. However, we have to learn how to use them and this takes time, especially learning to let profits run. After all the skills needed to cut losses are almost exactly the opposite of those required to let profits run. The first requires careful monitoring and quick action (maybe using a stop in the market to do it for you) whereas the latter requires a more relaxed approach to avoid getting out. So one is actively looking to get out, the other is passively not looking to get out. Once you have learnt actively to look to get out, how do you then totally adjust your view to achieve the other? It takes time.
It is easy to see how we can be a lot more relaxed, and therefore more disciplined once we have learnt how to operate these rules. Some readers may feel that linking the words “relaxed” and “disciplined” is something of an oxymoron, or two incompatible concepts. I disagree. In my view relaxation is the essence of “easy” discipline. You do not need to be tense and standing to attention to be disciplined. You just need to be able to do certain things in a certain way. The easier these things are, because you choose what they are, the more experience you have in doing them, clearly the easier they will be to do.
System parameters
This brings us to your system parameters. It is going to take time to discover these. This is not because there is any particular magic about the parameters themselves, but because you need to know yourself well before you will be able to judge what is going to suit you. There is a feedback loop involved in this process. Once you start to use a more precise methodology that feedback loop can start. Until that point most traders are just spinning their wheels. Once you start to use a methodology you begin to learn a lot about yourself. This is because you start to see when you have difficulties with the methodology. You are forced to stop and ask yourself. “Why did I not take that trade?” and, perhaps more importantly, “Why did I take this trade which has nothing to do with my methodology?” Often you find that you have certain preconceptions which are not useful, that you have impulses to trade that have nothing to do with making money, but have everything to do with various emotions you have not yet learnt to control. At least that was my experience.
It is the feedback from these things you learn about yourself that allows you to modify your methodology. This process, which takes you round the loop many times, eventually allows you to discover something that is truly useful to you. It will not necessarily be useful to anyone else. This is why I am always distrustful of those who claim to have market “secrets” they will not disclose. To my mind this shows a misunderstanding of the entire process, although I can see why someone would not want to disclose their entire methodology. The more people who trade “your way” the less likely that way is to be effective. But even this is debatable as any trader who looks at another’s methodology is liable to alter it and trade it in their own way. However there is no point in taking any chances in this respect, why take the risk?
SUMMARY
Discipline is necessary because without it you will not be able to follow your methodology, or to control your emotions and instincts.
Developing discipline is a process rather like exercising muscles, but is helped by developing an approach that suits us.
Random reinforcement is the way in which the market often rewards “bad” behaviour and punishes “good behaviour”. Rats go mad when treated like this.
Inter-reactions between discipline and other levels of the Pyramid show the importance of developing all levels of the Pyramid in line with our personalities.
Chapter 7: MONEY MANAGEMENT
I often say in my newsletter (TTT) that Money Management (MM) is far more important than analysis. But I have never given a practical example of how this should work. This chapter is designed to remedy this omission.
It is easy to demonstrate that MM is far more important than analysis. A total lack of MM would mean risking everything on any one trade. You might have the best analysis system in the world and get 99 straight trades right but that 100th trade would wipe you out. On the other hand you might have the worst analysis system in the world. If so a proper MM system will quickly reveal this fact which at the same time minimizing the risk to your capital. So if you get 10 straight trades wrong you still only lose 10 per cent of your capital! It is therefore immediately clear which is the more important. MM is what makes the analysis/system work not the other way around.
The conclusion from this is that it is not entry which is that important – it is exit. This is clearly so, because exit determines your overall risk, your overall profit and your overall control. Now this is quite a controversial statement. If entry is not so important why do all traders spend so much time on it. The answer is because they are misguided. Clearly entry is also important, but not as important as the other factors in trading, in particular MM and Risk Control (RC). To put this in a nutshell: your entry cannot wipe you out – but the way you exit can. Your entry does not make you a profit – the way you exit can.
Using Money Management
So how do you use MM practically? For this I will use an illustration concerning one of my trading services. This sets out the MM rules behind this. This is universally applicable to any trading approach not merely to this system. The essential factor behind any winning approach is that it gives you an “edge.” Without an edge it is impossible to win – if anybody doubts this please e-mail me to discuss it. I consider that my methodology gives me an edge of around 60–70 per cent. This has to be related to a random process which could be gauged at 50 per cent. The figure of 50 per cent is not totally accurate as it ignores the costs of trading, but we will over discount for this factor by assuming that my approach will yield a success rate of 55 per cent. It now comes to apply an MM system to this. Let us assume that a trader has £10,000 he is prepared to lose. As a general rule a 20 per cent loss is considered the time to get out – so we are assuming that the trader has capital of £50,000 of which he is prepared to lose £10,000. With £10,000 our MM rule is that we are not prepared to lose more than 10 per cent per trade (i.e. £1000) and this equates to 100 points on a single FTSE futures contract, or 50 points on two contracts. If we adopt this approach it means we would have to suffer 10 trades in a row to be wiped out of the market – i.e. we would lose our £10,000 (20 per cent of our total trading capital of £50,000). So we then take our expected success rate of 55 per cent and see what the odds are of making 10 successive losing trades. The odds on this are 45 per cent