This is the 1st post in the How to Trade series.
New traders and investors tend to focus on the big profits that certain trading strategies can yield. For example, my medium-long term strategy yields an average of 45% per year!
But before you decide what trading strategy to use, you must first ask “what strategy suits me the best?” Do not be automatically attracted to large profits. Almost all trading strategies can be profitable, but different strategies suit different types of people.
- A highly profitable strategy + the wrong trader = losses.
- A small profitable strategy + the right trader = large profits.
Here are the questions you need to ask yourself before deciding what trading strategy to use.
Understand your skill set
We all have different skills and strengths. Some people – by nature or by their chosen profession – are better at certain things than others.
- Some people are better at math. Some are naturally more sensitive to numbers and data.
- Some people are better at reading and understanding history.
- Some people are better at art.
All of these skills can be applied to trading!
- People who are better at math are more suited to quantitative trading and building trading models.
- People who are better at understanding history can build long term trading models that don’t require PhD’s in mathematics (such as Our Medium-Long Term Model).
- People who have a natural affinity for art are more suited to pattern analysis. (I’m terrible at art, which is why I never really attempted trading via chart patterns).
- Or if you have a lot of contacts in corporate boardrooms, you might want to trade individual stocks instead of ETFs. Provided that you’re not trading on inside information of course.
So ask yourself this question.
What am I ALREADY good at? What are my skills, talents, etc? Almost all skills and talents can be applied to trading.
Does the strategy suit your personality?
This is something that many new traders forget to think about. The best trading strategy for you must also suit your personality.
Personality is hard to change, especially the older we get. Someone who’s impatient can learn to be more patient, but can never become very patient.
Certain strategies require certain types of personalities. You will not succeed at trading if your strategy conflicts with your personality. Here are some examples.
- Let’s assume that you are an impatient person. You just can’t sit and wait. You want to be doing something. Hence, a long term strategy does not suit you. If the market goes down, you will be jumping up and down yelling “what is going on” when in reality, all you need to do is sit and ride out the market’s temporary dip. If you’re impatient, you will probably cut your position at the bottom of the market. A short term strategy is more suitable to your personality.
- Let’s assume that you do not handle stress well. Hence, your strategy needs to diversify your portfolio. I only trade UPRO (3x S&P 500 ETF) because I can sleep well at night even if my portfolio is losing money. Can you do the same? If not, then you need to e.g. cap each position at 5%. That way a big loss in one position will not ruin your trading psychology. A ruined trading psychology will mess you up and result in larger losses.
- Are you open to different opinions? If not, then you need to shrink all of your position sizes. That way a single loss (because you were too stubborn to listen to different views) will not destroy your entire portfolio.
Understand your financial situation
My Medium-Long Term Model sounds great: an average return of 45% since 1950. However, not everyone can copy my trades!
Sometimes the portfolio will be under water by e.g. 30%. With large profits also come large temporary drawdowns.
- It’s one thing to be emotionally capable of withstanding large drawdowns.
- It’s another thing to be financially capable of withstanding large drawdowns.
I don’t mind bear markets. I can just go to cash, wait for 2 years, and buy at the bear market’s bottom. But that’s because I don’t have a family to feed and I have enough cash in reserve to live off of.
If you do not have a large safety cushion, then maybe a long term strategy isn’t the best for you. If you lose your job in a recession and don’t have enough savings, you’ll be forced to sell your stock holdings at the bottom of the market!
This is why many people start day trading instead of medium-long term trading. Day trading’s profits are steadier. And for people who need to make ends meet at home, they need that steady day-in, day-out income.
How much time can you dedicate to trading?
Most people aren’t full-time traders. Most people have their day-to-day jobs, and trading is just a side project. Hence, you have to be realistic. How much time a day can you dedicate to trading?
The more time you can dedicate to trading, the more options you have. The more time you have, the shorter your trading strategy’s timeframe can be.
If you can only spend e.g. 1 hour each day on the markets (due to personal or career-related commitments), DO NOT try to compete with day traders! If full-time day traders can only make 15% a year, it’s unrealistic to think that you can make 15% with the same strategy whie working only e.g. 2 hours a day! In addition, strategies such as day trading require you to be constantly glued to the screen.
Likewise, short term trading via quantitative models is also extremely time consuming. These short term models need to be updated every now and then. This not a “set and forget” strategy. The research that goes into these models is extremely time consuming, and is not suitable for the everyday part-time trader.
The next post will outline the basics to various trading strategies, and their respective pros/cons.