Throughout the past year diving into the world of trading, there is a problem I’ve been recurrently experiencing: derailing from the original rules I told myself I’d never break.
I’m not talking about a detailed blueprint, but more of a set of core guidelines to prevent critical mistakes.
They’re mostly a subset of the same principles I apply for creating businesses and products. I always think of fundamental rules I’m going to adhere to. Yet, when the time comes, more often than not, I get off track and do what I shouldn’t.
It’s pretty frustrating. In the end, I know I shouldn’t do it, but yet I do it.
Altering the plan wouldn’t be wrong if the change were intentional. That would be adaptation. Indeed, a crucial thing to survive —in the markets in this case.
After all, plans shouldn’t be set in stone. They’re just a compass to guide us through the terrain so, when the terrain shows us a different reality, we should adapt consequently. But, more often than not, that wasn’t my case.
And the fact is, I think this is a common problem for many.
So here is an excellent opportunity to consolidate and share that core set of principles that I believe are essential to succeed. Following them is not a guarantee of success. But not doing it is certainly a ticket for failure.
Of course, this is not a comprehensive list. It is a work in progress and, hence, it will grow and evolve as my understanding of the topic does.
To organize these guidelines, I’ve followed the same process stages that, inspired by Shape Up, I use for building businesses, products, articles, or any other kind of solution. In the end, that’s what we’re doing here, right?
Framing the Current Context.
Our goal at this stage is to understand the current situation of the market.
It’s usual, especially when we’re starting out, to believe our job is simply to choose a timeframe to operate in —no matter if that’s 5min, 1h, 1d, or 1w— and apply the set of technical patterns we’ve learned. But as usual, the reality is more challenging.
As in any other endeavor, in the beginning, we usually operate from a limited perspective. It’s easy to fall into reductionism and believe that learning and applying a standard set of patterns will be more than enough to succeed. And that might actually work in “kind environments.”
But trading, like creating businesses and products, presents an uncertain environment. There is too much complexity involved, so looking at the market from a single perspective will often lead you to lose your bets.
As we do when building a product, before designing a solution, we must first understand the environment we’re going to intervene in to make better predictions of the price action ahead.
So here we go with a guideline to do just that.
Level up and down.
- Whatever the time scale you operate in, beware of the situation at higher and lower-level time scales.
How does the pattern you’re considering fit within the broader picture? Are there potential support/resistance levels to the expected target which might cause a reversal before getting there? And what about the short-term? Does it show us it’s going to break out now? Or could it have a reversal and take a bit longer? Did it already break? If so, is it doing a pull-back and giving us a good entry point? The list goes on. But I hope you get the idea.
Answering these questions involves moving up-and-down between different scales to build a more whole image of what’s happening and, more importantly, what can happen.
Remember, our goal is stitching a more whole picture by moving up and down between the short, mid, and long-term. You’re building a model of reality. That model will always be flawed, but the closer you get to the essence, the closer you’ll be to succeed.
Shaping Candidate Bets.
At this stage, our aim is to shape potential interventions.
Up to this point, we’ve built a more or less close image of reality. Now the goal is to shape potential trades. How to set an entry? How to place stop losses? And how to take profits? That’s what we aim to answer here.
So here are just a few principles I’ve found so far to do just that —although for now, they do it just in part.
Look for low-risk / high-reward bets (1:1 at a minimum).
- This one’s a trivial one. Yet, it doesn’t hurt to remind it. You don’t want to risk too much to earn too little.
Stop inventing your stop losses.
- Set your stop-loss where the pattern demands it, not where you want it to be. It’s easy to fall for the latter to limit your risk and improve your risk/reward ratio.
Instead, to control your risk, adjust your position size. And to improve your risk/reward ratio, only operate trades with a natural, good enough ratio.
By artificially moving your stop-loss closer to your entry price, actually, you might be doing quite the opposite. You might turn a winning position into a losing one, thus decreasing your risk/reward ratio.
- Set your stop-loss under the previous relevant low in the price action for the time scale you’re operating in long trades. For shorts, do it above the last relevant high. When we open a position, we are testing a hypothesis. Yet, that will be questioned when the price action makes a lower low —in long trades— or a higher high —in short trades—. It’s all about market structure.
Picking the Right Bets.
This stage is about choosing the right interventions.
Reached this point, we should have some potential trades. Which ones should we bet on? Well, that’s what we’ll see here.
Expand your options.
- Make sure of having multiple, potential, good enough trades before betting. By sticking with the first option you see, you might be falling into the local maxima trap. Instead, try to come up with several opportunities so you can pick the most promising ones.
Limit your exposure.
- Don’t over-invest. You don’t want to risk what you can’t afford to lose.
In the same vein, even if you can afford it, do not risk money you won’t be comfortable losing. Here, when you go beyond your comfort zone, you do not only risk actually losing what you put onto the table. You risk entering a state of anxiety. I’ve been there, and it’s not pleasant at all. It will capture all your attention and make it hard for you to focus on other matters you’ll likely have to pay attention to as well.
This is equally applicable to business, life, and everything else.
- Adjust your risk exposure to your success rate. It’s frequent for us to assume too much risk for the success rate we have in our trades. We might be following the typical advice. For example, “risk only 1% per trade.” But even that may be stupid, depending on our context. Experience might tell us that we fail nine out of ten trades, so risking 1% of our capital still might be too much. So this brings me to a couple of sub-rules here.
Don’t risk too much when losing is the norm. Assuming a high risk when losing is the habitual result is definitely stupid.
And following the last one… don’t risk too much when you still don’t know what the norm is. When you start, you don’t have a historical background of trades to know your success rate. Still, it would be equally stupid to assume you’ll have a nice ratio. Instead, place yourself on the other side. Suppose you’re failing every trade. Once you prove otherwise, then you can elevate the stakes.
- Diversify. There is a typical problem: you put all your eggs in one basket. The issue with that is that when the basket falls, all the eggs get broken. Said another way, you lose everything you put inside. Instead, diversify your portfolio with very diverse, low-correlated assets.
Following the above, avoid betting on highly correlated assets simultaneously. You might believe you’re diversifying your portfolio but, counter-intuitively, you might not.
This is a common trap in crypto. You might believe you’re introducing variety by simultaneously trading multiple assets. I also thought that initially. But the reality is far from that. When the market is not clearly bullish, if BTC dumps, the rest of the market usually dumps deeper.
Under that scenario, opening ten trades will not differ from opening just one. Probably, all ten assets will do the same thing.
Falling into that trap is the perfect recipe for suffering.
There is only one exception when you could increase your stakes, and that’s when BTC is in a clearly bullish trend for the mid-long term. As long as you get out on time before the trend reverses, you’ll be fine.
Follow the wave.
- When evaluating the odds a trade has for succeeding, beware momentum in the price action carries a lot of weight. Like surfing a wave, you don’t want to go against it. You want to go with it. The trend is your friend.
Turn off your emotions.
- Let go of your losses. Sometimes you get an open position into losses. Yet, you choose to lower its associated stop loss or even remove it so you can recover what you lost. Otherwise, everything you invested will have been for nothing. In the end, the movement should be close to finishing and bouncing back, right? Well, not at all. You may not be seeing the whole picture.
We don’t like losses, but sometimes it’s better to lose a battle so we can win the war.
Don’t fall into the sunk-cost bias. What’s done, it’s done. What you have is what you currently have. Believing that waiting inside the market will make a better bet is foolish. That’s faith, not logic.
So instead of building sandcastles and faking an internal narrative to convince yourself your trade will recover, ask yourself, “What’s the best use of the money I currently have?” Would I invest in this asset if I was currently outside?”. Or even better, “Is there currently a better use of that money? If the answer is yes, well…you should already know what to do.
- Sometimes it’s better to wait outside. The world won’t fall down if you don’t open a position. And, if instead, you already have a position opened and decide to take profit only to see the trend continue, nothing will happen either. Learn to be patient and don’t be greedy.
- Never enter based on emotion and intuition. Trust your system, not yourself. Emotions are not great partners in the markets. As said above, we’re biased, emotional beings. FOMO, greed, frustration, resentment, or loss aversion are some of the many psychological factors that can make us fail. You better beware of that.
So that’s all for now, folks.
In any problem domain, there are essential, invariant properties common to every successful solution that succeeds in solving the problem. And trading is no different. There are core rules that every successful trader adheres to. Indeed, following them is not a guarantee of success. But not doing it is certainly a ticket for failure.
You’d better stick to them.
Say it out loud. Is there anything you disagree with? Anything missing that you’d like to add? If so, I’d love to hear your thoughts so, please, leave them in the comments.
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