The worst traders are those that have no system.
A trader I knew would make $40K in a month, then give it all back the next month. He was one hell of a trader but he had no method. He would have transformed his fortunes if he had simply stopped trading when his equity was trending down. Like so many traders, he was unable to separate his lizard brain from reality.
Reality, in trading, are the cold hard numbers that tell you what works and what doesn’t. It’s very easy to slip into bad habits when trading and to stop analyzing the facts. When you don’t see the growth that you want in your trading account, it’s your responsibility to figure out why.
Here are three simple ways to deal only with facts and improve your trading strategy.
1. Run A Backtest
The idea of backtesting makes some traders uncomfortable. Some people think you need to learn Python or become a coding wizard. However, backtesting trading strategies is much easier than you might think.
Getting to grips with a simple backtesting software like Amibroker can be achieved in less than a month. All you need to know are a few basics. You can then build some templates that will allow you to quickly run reliable backtests. To benefit from statistical analysis, you don’t need to know a complete programming language, like Python.
The most important thing is to be able to run backtests that are accurate and not biased. You need to be familiar with issues like survivorship-bias, look-ahead bias, start-date bias and curve fitting. Otherwise you will get biased results that will make things even worse.
Some traders think that backtesting leads to curve fitting. But that couldn’t be further from the truth. A good backtest will tell you not only what works, but also what does not work. By avoiding the wrong trades, you can save yourself time and money. Some things simply don’t work no matter how strongly you believe in them.
I always recommend that traders use backtesting as a tool to discover underlying market truths. Instead of looking for that one perfect system, run large scale tests to identify useful patterns. I like to see robust trends that are based on a large sample of historical trades.
Patterns based on large samples of historical trades can tell you a lot about how to trade a given market. These patterns can be further developed into a completely mechanical system or even a discretionary strategy. Use trading systems as a base to fine tune your own edge.
2. Keep A Trading Journal
A lot of quant traders believe they don’t need a trading journal. But I think this is a mistake. A good trading journal documents the obstacles and lessons you come across in real trading. It therefore includes all the things that are not present in a backtest.
In other words, a trading journal alerts you to the realities of trading. It helps you understand your emotions. Additionally, it shows you your true transaction costs, which might be different from what you expected. A good trading journal also helps you to identify edges that you may have missed during system development.
There are many trading journals on the market and it’s easy to create your own in Excel or Google Sheets. I like to use Tradervue. It’s reasonably priced and you can import trades from Interactive Brokers in just two clicks. I import my trades into Tradervue every couple of months and then analyze them using the in-built analytics.
It’s useful to see how time of day, day of week or type of stock can improve your trading strategy. Using this information, I discovered that certain priced stocks do not perform as well with my system. This helped me improve my edge by avoiding those stocks.
Tradervue also shows how your edge is developing over time. You can evaluate your win rate or profit to see if your edge is improving or deteriorating. This gives you an early warning if your strategy is losing its edge. In this way, you can either improve your strategy or start a new one before you lose a large amount of money. It also gives you targets to aim for.
3. Use A Trading Checklist
Checklists are vastly underrated among most traders.
In his book Thinking Fast and Slow, Nobel prize winner Danny Kahnemann said that checklists are often more effective than complex models. He said that a simple formula or checklist works best in low validity, uncertain environments. These include financial markets.
Checklists work because the human memory is severely biased. We remember things based on how recent they are or how they affected us emotionally. In other words, we view the past through a distorted lens. By using a checklist, you can get your mind back on track and focus on the things that really matter.
A trading checklist doesn’t have to be too sophisticated. It may be something simple like the pre-trade checklist shown below:
- Are you following your trading plan?
- Are there any biases or external factors affecting your decision?
- Do you have an exit strategy?
Alternatively, your checklist could be specific to the type of strategy you’re using. For example, an investing checklist might look like this:
- Is the company within your circle of competence?
- Does the company have a competitive advantage?
- Is the company undervalued compared to growth?
- Is the share price in an upward trend?
- Are insiders buying shares?
The main goal of the checklist is to refocus your lizard brain. The process forces you to remember the important things and eliminates your mistakes. It needs to be personal to you and doesn’t need to be too complex.
# Bonus Tip – Use A Daily Stop Out
I spoke earlier about the trader who used to make a lot of money one month only to give it back the following month. One final tip is to set a stop-out limit when you trade.
The idea is that when you are trading poorly you need to have a hard stop that takes you out of the game. This needs to be decided in advance and should be followed 100%. It doesn’t have to be daily. It could even be weekly or monthly but I would not recommend going any lower than daily. It’s impossible to decompress from a bad trading loss in just a couple of hours.
A good idea is to build your trading stop into your trading software or broker so that there are no ways around it. Another option is to enlist a friend to be your risk manager. This person will provide accountability and make sure you don’t override your stop.
There are two reasons for imposing a daily limit.
First, if you are trading poorly and losing money, you usually end up losing more money. That’s because your lizard brain goes into tilt overdrive and you make more mistakes. It’s sensible to stop trading and rest until you are mentally ready to trade again.
Secondly, if your profits aren’t coming in, it could be due to a change in market conditions. Due to the long tail nature of financial markets, these conditions could further derail your system. Risk could increase rather than decrease. Again, the sensible course of action is to stop trading for the day and reassess after the market closes.
Trading in the stock market is a personal journey. There are so many different paths to improve your trading strategy and many more roads to nowhere.
Beginning on one path, you meander through obstacle after obstacle until you find something that works for you. Most never make it onto the right path. Those that do, usually implement these three things.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information or entertainment purposes only. It is not a recommendation or personalised investment advice. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance, historical or simulated results are not a reliable indicator of future returns and may not account for real world settings. Financial trading is full of risk and margin trading can lead to financial losses totalling more than what is in your investment account. We take care to present accurate analysis but mistakes in backtesting and presenting of analysis regularly occur. Please read the Full disclaimer.
Thank you to everyone who takes the time to leave a comment. Your feedback, constructive criticism and identification of mistakes is welcome. In order to concentrate on work I may not have time to respond to all comments.