Surprise earnings, unexpected news events and unmet expectations of company performance create an element of uncertainty that cause many sleepless nights for most traders. Like an alligator lurking under the water, there are many unexpected dangers of stock market trading that lie just beneath the surface.
Risk of ruin is the elephant in the room that most traders avoid talking about, yet it remains a nagging concern; just one unexpected price move and your ability to keep trading evaporates.
Yet, building a reliable strategy around the right trading edges can help you avoid risk of ruin while increasing your chance of greater returns.
The Realities of Trading
In trading, your goal is to catch large moves in an underlying security while controlling your risk. To achieve that, there are three things that you have to accept:
Huge moves happen, but they happen infrequently.
The majority of your trades are going to break even or lose.
Your focus should be to minimize the second point and increase your odds of success on the first point.
To help get around this, your strategy has to be built around a series of edges that put the odds of success on your side.
The Three-sided Chair
Imagine a three-sided chair designed to evenly distribute its weight on each leg. Each leg is critical for the chair to remain upright and support the weight of the person sitting on it. However, if one of the legs isn’t designed right then it increases the probability that it will fall apart. Remove one of the legs entirely and the chair will fail immediately.
Like the three-legged chair, a sound trading method has to be built around three distinct edges to have a better than normal chance of succeeding in the market.
This sound trading method will consist of instrument selection, solid repeatable entry signals and exit signals that balances maximizing profits while retaining gains. Each of these has its own unique contributions to the overall strategy, and lacking one or more of these legs will lead to failure.
The Most Reliable Method
Among all trading methods, trend trading has proven itself the most reliable. The reason for that is that there are underlying market behaviors in play that help sustain its price movement.
First is “herding bias,” which means that if the market is trending up then most of the traders will just assume it will continue and they will keep buying into it. If it’s trading downward then the majority of traders are likely to keep selling into it.
As this goes on, it develops another bias called “confirmation bias.” As the market continues in one direction, traders who assume it will continue will have their assumptions validated by the price trend. The longer it goes on, the greater the traders will feel validated that it will continue.
It is a self-fulfilling prophecy that reinforces a trader’s belief about the current price action.
To customize this trading method to your own unique needs, you will need to tailor the edges that define it.
Selecting Your Market
To avoid volatility, it helps to seek out underlying markets that experience greater predictability.
The foreign exchange market has several currency pairs whose key advantage is their price movement. Unless there is a huge monetary or fiscal policy change that affects a nation’s currency, there is very little to knock its trend off course. And, as long as you’re prepared for that possibility, there also is the chance of catching the new price trend early on.
As for entries, smoother price movement allows for price to confirm an entry into the trend by simply riding its momentum in its direction.
For exits, you can allow the currency pair to reveal when the trend is over by trailing your stops according to its daily price range, allowing it stop you out. You also may test different moving parameters depending on your market or sector.