I call them the THREE M's. Why are they at the top of the Equity Systems page?
Before going any further, let me say that over the years I have lost money in every imaginable way as a trader - of options, stocks, and futures - especially futures.
Just when I thought I had figured everything out, the universe figured out a new way for me to lose money. I have also read many times, and in many places, that about 95% of all futures traders go broke their first year trading.
So, I gradually came to understand that the way to make money was to figure out why I was losing money. In other words, if you can figure out how NOT to lose money, you're going to be on the road to making money.
After reading many books and listening to countless tapes on trading, I have noticed that 99% of all material out there tells you how to make money trading, and NOT how to prevent yourself from losing it immediately thereafter.
This is probably because books on how to make money sell better than books on how NOT to lose money. It's also possible that some of the authors and system developers are not traders - that is, they have not experienced the joy of losing huge sums of their own money on their published systems.
I can assure you that I have made and lost plenty of money trading - and this wasn't money some uncle willed to me. It was hard earned, very much needed cash.
To the THREE M's.
The first is MONEY. What I mean by this is MONEY MANAGEMENT. Another way of looking at this is LEVERAGE. Futures and options present you with tantalizing leverage. Every day you are tempted with the possibility of making huge amounts of money in the markets with leverage. Both futures and options are leveraged 10-20:1. Sounds wonderful until the leverage works against you.
The only way to get good at trading is to be able to take a series of losses - your worst nightmares realized, and to have enough to continue trading without fear (or without much fear). In fact, I don't think it's possible to make money until you learn how to lose it gracefully and unemotionally. But, you MUST be able to come back again and again and keep trading, and keep learning, and keep working on your methods until you can finally lean how to make money.
So, conservative money management is the key. In Evaluating Trading System Profitability I talked about allowing 10x your worst drawdown (from backtesting) to trade 1 contract. If you are trading a small account you will probably be comfortable with only 5x worst drawdown. But, this means that you will frequently have drawdowns near 20% of your total equity. Yet, if you are trading with money you can afford to lose, this is still conservative enough to allow you to suffer some sharp drawdowns and continue trading.
The second M is METHOD. This means, you MUST have a system, or some method that allows you to make trading decisions on a day-in and day-out basis.
If you have a system, and trade it, you are called a System Trader. My broker tells me that the only clients he has that regularly make money are the system traders. Actually, from what I have read, most traders don't use a system. They use gut feelings, intuition, faith (defined as belief without proof), hope, tips, or "whatever". They "think" or "believe" wheat will be going up so they buy wheat. It goes down.
If you believe wheat is going up you won't sell when it goes down. You may even buy more. This is not going to make you money in the long run. I have another saying developed after years of trading, "If you can't test it, don't trade it!". This means, you must understand your RISK/REWARD. You MUST know if your system is profitable, and you must understand the maximum risk so you can use proper money management techniques.
Have you ever traded a system or method without a thorough backtest? Probably yes. I know what happened, you saw something that made money for weeks, or months. It looked great. You paper traded it. It worked on paper. You didn't have the software or the time to learn how to program in BASIC or TradeStation so you started trading your system with real money.
Then, your system started losing money. What to do? You probably gave it up after the first few losses. On to the next system.
The third M is MENTAL. This means the emotional discipline to trade your system, and the emotional "cool" to avoid making out-of-system trades during periods of FEAR and GREED. In other words, you must be able to control your hand from picking up the phone during trading hours and saying something regrettable to your broker - like "buy 5 S&P Sept. at the market". Then, you put down the phone, watch the market sink, and ask yourself, "Why did I just do that?". Then, you panic, pick up the phone again, and buy the contracts back. Down -2.50 x $500 and you just lost a nice chunk of change. Fun isn't it? The devil made me (you) do it.
Without getting too long here let's recap:
MONEY: use proper MONEY MANAGEMENT - you MUST be able come back and trade another day.
METHOD: use a system and backtest it. You MUST know it's potential for profit AND loss.
MENTAL: you must develop the discipline to trade your system, and the courage to trade it even during periods of fear and greed.
Essentially, these three categories outline the primary ways traders lose money, and the challenges you must meet before you can expect to earn a living by trading.
---Tom Loffman
Copyright, 1997
Tom Loffman, Equity Systems