The Second Key to Successful Trading: Preparation
The first article explained that “specialization” was the first step. The goal is to move towards applying a consistent method to trading to get consistent results. Next, in the list is the preparation phase.
During the preparation phase precise rules to a trade entry and a trade exit are developed. One result of using precise rules for entry and exit setups is it reduces the judgment factor in your trading. Removing judgment from your trading will alleviate trader’s remorse. The trading results will be about the trading method, not the trader, unless they cannot follow their own method, which is a different problem for traders.
Next, collect historical data of your favorite markets and determine the range of outcomes for each time the entry and exit occurs in the data. Some trades are winners, small and large, and some are losers, small and large.
Next, determine what the market did in each trade between the entry and exit. Calculate for each trade the largest open profit, which is called the maximum favorable excursion. Find the largest open loss for each trade, which is called the maximum adverse excursion (MAE). Tabulate all of these statistics: the MFEs, MAEs, and closed profits and losses. You need at least 30 samples. For more information on MFE and MAE analysis, see John Sweeney’s book, Maximum Adverse Excursion: Analyzing Price Fluctuations for Trading Management (John Wiley & Sons).
First, you should see that the trade statistics will fall into three categories: profitable from the start with very little open loss, some open loss but the trade is closed out with a profit, and then some are losses and were either never profitable, or the open profit was small. You may discover that your trading approach is not profitable, which is better to see now on paper then in the markets with real money.
Next, do what-if scenarios and form a strategy. Find stop loss points where you can keep the first and second groups of trades, and quickly get rid of trades that will ultimately be a part of the third group. Next, do what-if scenarios for targets. You may find that using a hard money target will raise your percentage of profitable trades and smooth out your equity line.
Convert these results to trading rules, or your trading plan. The next phase is the execution phase.