Professional Trader Series: The Art of Enlightenment | DZHI - DZH International 
logo

Professional Trader Series: The Art of Enlightenment

  • Brent Penfold
  • 15 June 2016

Professional trader and author of The Universal Principles of Successful Trading (Wiley 2010) now translated into German, Polish, Japanese, Korean and Simplified Chinese.

The third step in the process of trading is enlightenment. Most people new to trading throw their energy and resources into searching for the perfect entry technique or magic indicator that will deliver immeasurable profits with minimal losses. Such pursuits are a waste of both time and money. I hope this brief "enlightenment" note will guide you to where you should focus your energy and resources. You'll gain enlightenment when you come to the realisation that your survival, and hence trading success, will become dependent upon your acceptance of the following important points.

Avoiding Risk of Ruin
Risk of ruin, in my opinion, is singularly the most important concept in trading. Yet most traders are ignorant of it. Very few trading authors write about it. Very few seminars mention it. Very few workshops teach it. Is it any wonder so many traders lose when they don't know their own personal risk of ruin given the way they trade?

Risk of ruin refers to the probability of you losing so much money that you'll stop trading. Your risk of ruin can be calculated and is a function of how much risk capital you are prepared to risk per trade (commonly referred to as money management) and how much you can expect to win per dollar risked (commonly referred to as expectancy). Risk of ruin distils down to a probability the likely hood of you going bust given how much you risk and how much you expect to win given your money management and trading methodology. Anyone who has a risk-of-ruin above 0% is guaranteed to go bust. Certainly someone with a 30% risk-of-ruin will be expected to go broke before a trader with a 5% risk-of-ruin. However anyone with a risk-of-ruin above 0% is inline for the poor house.

If you have traded before you should calculate what your risk-of-ruin was. If it was above 0% you'll start to understand why you failed. You'll have your "aha" moment. If you're new to trading you shouldn't risk money in the markets until you have a risk-of-ruin of 0%.

Get your risk-of-ruin to 0% and you'll not only start to think like a professional trader but you'll start winning like one.

Embracing Trading's Real Holy Grail
The real Holy Grail is not a super trading system that generates big profits with small losses. In my opinion the real Holy Grail is the pursuit of a methodology that yields a positive expectancy that can be traded across multiple opportunities. A methodology with an edge that you can trade regularly. First up you need a strategy with an edge, a positive expectancy. To calculate your expectancy you'll need to back test your strategy over historical data. While you design your strategy you'll need to avoid over optimising the variables and falling into the curve fitting trap. Once you have your edge you'll want to be able to trade it over multiple markets. It's no good having a positive expectancy strategy if you can only trade it once a year in one market. You need an edge that can be applied regularly across a number of markets.

Expectancy
I've already mentioned expectancy a number of times so you shouldn't be surprised to learn it's also part of a trader's enlightenment. Expectancy refers to what you can expect to earn on average for every dollar you risk in a trade. To calculate expectancy you simply multiple your strategy's percentage accuracy over your strategy's average win divided by it average loss. From this amount you remove your strategy's percentage of losing trades. If you hope to make money from your strategy then its expectancy has to be positive. If it's negative you'll be trading a losing methodology. Your enlightenment will continue when you realise that you need to pursue or design a positive expectancy trading methodology.

Pursuing Simplicity
Most traders fail to grasp this and yet most traders lose! The majority of traders mistrust the obvious and they mistrust simple trading solutions. They can't believe trading should be simple so they seek clues and advantages in complexity.

When creating your trading methodology remember to keep it simple. I can't stress enough how it is simple methodologies that both work and stand the test of time. If you don't believe me then you should listen to Tom DeMark, a well respected market participant who has worked with market wizard Paul Tudor Jones. He remarked in the Art Collins book Market Beaters:

... The bottom line was, after 17 programmers and 4 or 5 years of
testing, the basic 4 or 5 systems worked best ...

So take it from me, and from Tom DeMark, that when it comes to trading, simple is best and does work. Once you grasp this your enlightenment will be heightened.

Validation
Finally, your enlightenment will be complete, once you accept that you need to validate any methodology you wish to trade. This may sound self evident however you'd be surprised at how many people hear a new idea and commence trading it right away without validating it's expectancy. If you expect to become a long-term successful trader then you'll need to live the mantra of validate, validate and validate. Do that and accept the other points above and you'll become an enlightened trader.

Once enlightened you'll be well on your way to profitable trading.

http://www.indextrader.com.au/