Creating a System for Effectively Trading the Stock Market

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Improve Your Trading Educational Series
"Every battle is won or lost before it's ever fought." -- The Art of War.

All traders should know this quote by the famous Chinese writer Sun Tzu. He might have been giving military advice, but it’s especially useful in financial markets because emotions can cloud our judgment. Like in war, decisions are final and losses are painful. It’s a serious endeavor, so you need a strategy and rules to survive.

All Businesses Have a Plan

Think of a business like a grocery store or software company. Grocers know which products shoppers in their area want and software makers know the functionality their clients need. Both focus on satisfying these demands to consistently make money. Their goal isn’t to rake in all the profit in the economy, but to consistently thrive in their specific market.

Effective traders view trading the same way. They find certain opportunities with favorable probabilities and focus on those. This requires a plan.

It also requires discipline because plans are only good if you follow them. And financial markets have a tricky way of making us abandon our plans at the worst possible times. We all need rules to stay on course.

Rules Keep You Out of Trouble

Saying we all need rules sounds simple enough. But what does that really mean? How do they really work?

First, remember that all trading consists of picking stocks, taking a position and then managing the position. Each stage needs separate rules.

For example, the “picking” stage may have rules like:

  • Only look to own stocks in outperforming industry groups.
  • Only trade symbols with good option liquidity.
  • Only look short stocks below their 200-day moving averages.

The “entry” stage may have rules like:

  • Always enter on a pullback or counter-trend move.
  • Never go against the direction of the eight-day exponential moving average.
  • Buy when a support level is tested, or short when a resistance level is tested.

The “management” stage may have rules like:

  • Always use trailing stop losses.
  • Never hold through earnings.
  • Never have more than five positions open at a time.

Don’t forget these examples are for educational purposes only and not recommendations. While everyone needs guidelines, circumstances vary.

Positive Expectancy Is a Big Deal

Inexperienced traders think about profiting on every transaction, but informed investors view their whole strategy as a single activity. Some positions will clearly lose money — just as a grocery store has a negative markup on some items. However the entirety of the business, day in and day out, makes money.

Traders can measure this with the concept of “expectancy:”

Expectancy = Average Winner - Average Loser
where:
Average Winner = Total Profits / Profitable Trades
Average Loser = Total Losses / Losing Trades

A winning strategy has a positive expectancy and a losing strategy has a negative one. Pretty simple.

The great thing about expectancy is that it includes probabilities and adjusts for the win-loss ratio in a single calculation. It’s a little bit like a slugging average in baseball.

It shows you don’t have to make money on most trades, which goes against our innate human desire to be proven “right.” That’s the emotion of pride, after all.

Applying Expectancy

Here’s a quick example to illustrate how positive expectancy works.

Say you have 100 trades:

  • 35 are winners, yielding total profit of $30,000.
  • 65 are losers, yielding total losses of $10,000.
  • Average winner = $857
  • Average loser = $154.
  • Expectancy = $857 – $154 or $703.

Now imagine your winners and losers were equal size — you’d lose money. Even worse, your average negative trades could be bigger than your average winners — you’d lose even more money.

This is why it’s so important to keep losses smaller than profits. And that means following your rules.

Follow Your Rules

After all, the best strategy in the world is meaningless if you don’t follow it. Athletes know practicing for the big game and playing it are different. It’s easy to succumb to emotions when real money is on the line, resulting in spur-of-the-moment decisions.

Positive expectancy helps in these cases because it lets you accept losses when they come. You know your system, so stick with it. Don’t freak out and change course just because of one losing position. Follow your rules.

Temptations to break your rules occur all the time. Some opportunities outside your strategy may look amazing. But you have to obey your rules and abstain if that’s what your system commands. Think long-term and keep your discipline by recalling past failures. Follow your rules.

Remember that only a few mistakes can knock you off course and get you in a bad place. You don’t want to be careening from mistake to mistake. Follow your rules!

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