THE PROCESS
The challenges of becoming a trader are similar in many ways to those faced by doctors, lawyers, or engineers in that a period of education is followed by a grueling period of apprenticeship and on-the-job training. Many people give up and fail at some point in the process and move to other careers, but some make it through and become competent. Fewer still achieve real mastery and rise to the top of their profession—the elite in any discipline are rare.
Trading differs from those careers in that the path to mastery is not as clearly laid out, and there are no prizes for second best. In many professions, people can develop the skills to become competent but not exceptional and can make a good living. In trading, especially for the individual trader, only the superstars make substantial profits over a long period of time.
In the interest of moderating expectations, it might be useful to lay out a rough road map of the typical path of trader development. In some ways, this is an artificial exercise because individual traders will have dramatically different experiences at some points due to differences in environment, innate ability, mentoring, or pure luck. Traders’ development will also depend, to a large degree, on the specific market environment in which they begin their education—some years are more challenging than others. However, the following stages are a useful guide:
- Pretrader: Everything is new at this stage, and everything is difficult. This is the point where the trader is learning the very basics of charting and of market structure and is also just starting to explore the marketplace. A trader at this stage has no business actually placing trades, because the emotional charge will hinder the learning process, and losses are virtually assured. Most traders should probably spend three months or so in this stage. Papertrading (trading a simulated, not real money, account) has limited utility, but it can be useful at this stage to acclimate the trader to the process of making decisions under uncertainty and in response to market movements.
- Novice trader. This trader is still guaranteed to lose, so his maxim must be “Stay small.” At this stage, traders are not trading to make money; they are trading for experience and to begin to deal with the emotional challenges of trading. Introspection and constant journaling are critical in this stage of development, which may last six months to a full year. Mistakes are common in this stage, but they are also learning opportunities, so trade size must be kept small enough that they are not too destructive to trading capital or emotional balance. If the trader neglects the process of journaling and trade review, these mistakes simply become losses and fall short of being the learning experiences they should be. One of the main signs of progress in this stage is that the trader will start to lose money more slowly than before. The novice trader is still losing, but losing less often and less consistently.
- Early competent trader. The first step toward making money is to stop losing money. A trader whose wins and losses balance out (before commissions) has taken the first steps to competence. Reaching this stage may take a year or more of very hard work. At this stage, the trader is still losing money every month due to transaction costs and other fees.
- Competent trader. The first stage of real competence is achieved when the trader is able to cover transaction costs with trading profits. Most traders find that they begin to develop emotional balance and control at this stage, and that they are not too attached to results and can focus more on the process. The trader will have an established routine for market review, execution, and trade review. Journaling is still important, but many of the psychological hurdles have been conquered and attention can shift to understanding how probabilities change while a trade is in progress. Reaching this stage may take a year and a half to two years for some traders. Consider this carefully—two years into the journey, a realistic expectation is to finally have accomplished the goal of being able to pay for your transaction costs. This may not seem like much, but very few individual traders ever survive to this stage.
- Proficient trader. Here the trader starts making money. Errors and mistakes are far less frequent, but when they do happen, they are corrected and reviewed, and the lessons are quickly assimilated. The trader has been exposed to the stressors of trading so many times that they have now lost most of their emotional charge and the trader is able to approach the markets in an open, receptive state. Trading returns are still variable and there may be significant losing periods, but the trader is able to match or beat appropriate benchmarks for most periods. As competence grows, the trader can look to manage larger and larger pools of money; developing the skills of trading larger size and risk becomes a focus at this stage. Most individual traders will be able to depend on income from their trading operation at some point in this stage, provided that they have access to sufficient capital. Expect that getting here may well take three to five years for the average trader.
- Experienced trader. It is difficult to imagine a trader becoming a true veteran without living through a complete bull/bear market cycle—about a decade in most cases. This trader has finally seen it all and has also become cognizant of the unknown and unknowable risks that accompany all market activity. It is possible for developing traders to gain much of this veteran trader’s knowledge through study at earlier stages of development, but there is no substitute for experience and seeing events unfold in the market in real time. Even this experienced trader is not immune to losing periods. For instance, it is not uncommon for very proficient traders to stumble in the presence of an outside influence such as illness or family issues, but these traders usually have the control to know when to scale back their operations to limit the damage.
Requirements
With this rough road map in hand, we can next consider the prerequisites and necessities of trading. On one hand, the requirements seem to be minimal: anyone with a few thousand dollars and an Internet connection can open an account and place trades, but this does not mean that you can compete effectively, anymore than buying a football qualifies you to be in the NFL. Just because you have access to a market and can execute effectively does not mean that you can profit in an environment that immediately punishes any errors or inaccuracies. Many traders who fail do so because they have unrealistic expectations about what it takes to be a trader, and these misconceptions are reinforced by many authors and gurus. What follows is a brief but brutally realistic assessment of the basic requirements a beginning trader needs in order to have a chance of competing successfully in the marketplace.
Time
Time is important in at least two different meanings. First, you must be able to devote a sufficient amount of time on a regular schedule to building trading knowledge and skills. Within reason, the more time you can devote to the task, the quicker you will grow. It is important that you have a regular schedule for reviewing current market action and potential trades, and also important to have a time to review your own trades and your performance. It is better to have many repeated, regular work sessions than to work one marathon session infrequently. For instance, most developing traders will find that a half hour a day, every day, is more rewarding than a single 12-hour session on the weekend. Remember, part of the reason for the length of the learning curve is that you are physically restructuring your brain; this process works most efficiently in the presence of repeated and constant stimuli.
These physical changes in the brain also take time, and it is important to be realistic about the amount of time required for the entire learning curve. Most traders are unlikely to find any degree of enduring success in less than three years—a three- to four-year time horizon is consistent with what is required to achieve some degree of mastery in most other fields. It does sometimes happen that new traders start in exactly the right environments and have quick success, but this is probably the worst thing that can happen to a new trader. Many traders made quick and easy profits in the dot-com bubble in the late 1990s, as did those who began their trading adventures during the 2007 to 2008 financial crisis and crude oil bubble. Very few traders who begin in an easy environment like this have long and successful careers. When markets revert to more normal conditions, they are not able to adapt to the slower pace and to a trading environment that requires real skill and discipline.
You should be prepared to endure three years of trading with very limited success, especially if you are gauging success by the bottom-line profit and loss (P&L). It is entirely possible that the majority of your trading experiences in this period will consist of booking constant losses, but this is a normal part of the development process. You will have triumphs, breakthroughs, and successes, but do not expect to be profitable; no trader should make a call on his or her long-term ability in those first three years of trading. If you find you do not love trading as much as you expected, then consider it an important lesson learned and move on to something that does give you joy. On the other hand, if you find yourself captivated by the process but are frustrated by your lack of trading ability, persevere.
Capital
It certainly is possible to trade for a living or to trade as a career, but there are significant constraints that must be considered. Most people do not have realistic expectations about the returns that professional traders make, so many of these traders believe they will be able to support their lifestyle with $100,000 (or less) of risk capital. At the institutional level, traders who can consistently make a 25 percent return on capital each year are very rare; these are the rock stars in the industry. Many competent traders are able to, at best, beat their benchmarks by a few percentage points; if you can do so by even a few basis points consistently, you can have a very successful career as a money manager. It is unrealistic to expect to consistently return hundreds of percents a year on your capital; it may happen in some extraordinary years, but this is not a realistic long-term plan. Do not go into this business as an individual trader expecting to dramatically outperform the industry benchmarks. It is also necessary for the developing trader to have a sufficient amount of risk capital to fund the learning curve. You will lose money while you are learning to trade. Make no mistake about it—plan to lose money. Too many traders start off with very small (less than $25,000) accounts and plan not only to be profitable but to pay living expenses out of that account very quickly. This is unrealistic and is a formula that virtually assures failure. Plan for additional funds for educational expenses, books, and possibly even some graduate-level coursework, depending on your interests and educational background.
A Business Plan and Trading Plan
Always think of your trading as a business and treat it as such. No one would try to start a business with insufficient capital, with no plan for how to expand the business, and with no vision of where the business could be in one, five, or 10 years, but this is exactly how most people start trading. The challenge, of course, is that you do not know at the beginning if you will be able to develop the skills to trade successfully, or how long it will take. There are many more uncertainties than in most other areas of business, but there are parallels—imagine a company that is making a speculative bet on a new product that may or may not catch on, or a new industrial process that may or may not be able to take market share from existing competitors. In these cases, the companies would make very sure that they understood the competitive marketplace, that they had access to resources they need to succeed, and that they had sufficient capital to weather the start-up period, though their long-term success might be less than certain.
With this in mind, craft a business plan for your trading operations. This will be a plan that, hopefully, will mature as your trading abilities develop. In the beginning, perhaps this is a document that focuses on your development and provides a yardstick for measuring your commitment. As you actually start trading, the document can be modified to encompass risk parameters, markets traded, and new directions you are exploring. (Strike a balance between modifying this document often enough that it is relevant and having a good control document. If the plan is always changing, it is probably not very helpful.) Hopefully, at some point you will expand this plan and perhaps even use it to recruit partners or investors as your trading business grows. The sky truly is the limit, but you must approach this as an extremely competitive and difficult business.
While the business plan is the overarching control document, the trading plan is more dynamic and flexible. The trading plan defines exactly what you will and will not do in the market, and it will evolve as your trading abilities mature. It is not unusual to revise a trading plan at least slightly every month; each trader will adapt the concept of a trading plan slightly, but a good plan will include all of the following:
- Schedule for your daily or weekly research and trade review.
- List of patterns and ideas you will trade, similar to Chapter 6.
- Target activity and risk levels. How many trades a day/week/month will you allow? How many positions can you have on at the same time? What is the maximum percentage of your capital that can be at risk at any time? How and when will you use margin? Is there a loss level at which you will stop trading for the day/week/month?
- A clear plan for trade management. Will you enter all at once or scale in? Will you take partial profits? If so, where and how?
- How often will you make trading decisions? Are you able to make decisions in the middle of the day, or do you prefer to create a plan the night before and simply execute it as faithfully as possible during the trading day?
Commit to the Process
In many ways, the intellectual problems of trading are trivial. This may seem to be an ironic statement, given that it appears in a large book about trading, but the essential elements of market structure and trade management could fit on a single piece of paper. The elaborations, variations, and applications are much more extensive and will reward long study, but the core knowledge of trading is not complicated. Most traders rather quickly assimilate the foundation, but the gap between knowledge and execution must be bridged.
The core skills of competent trading—and be clear that skill is not the same as knowledge—are primarily emotional. If traders have not mastered discipline and emotional poise in the face of volatile market movements, their trading will be forever plagued by errors that will erode whatever edge they may have had. Though it is possible to accelerate the learning curve in many areas, the only way to master emotional control is through actual trading over an extended period of time. The process of trading can be summarized as doing analysis, making decisions, putting capital at risk, and dealing with the consequences. Only by living through that loop repeatedly can the trader make progress; regular, repeated exposure is the key.