Many traders are fixated on finding the Holy Grail, that is, a mechanical trading system or methodology which generates large and consistent profits with no discretionary judgment on the part of the trader. Most traders who read this will deny they are looking for the Holy Grail, stating that they'd be happy with a mechanical system offering only a 60% win to loss ratio as opposed to the 80% to 90% that is claimed in many ads--as long as the system makes them a millionaire within a year to two.
I would, without hesitation, say that anybody in search of an enduringly profitable trading system that makes all your trading decisions for you is in search of the Holy Grail. In other words, such a money making machine simply does not exist.
But wait, you may say--"aren't all the highly successful traders in the world using some kind of unique methodology or system? Why can't I simply use the same exact approach they are and become just as successful?"
The answer is this: The markets are always changing. All trading strategies go through seasons of winning and losing. The key to long-term success is to understand the markets well enough so that you know how to adjust or switch strategies or even develop new ones in response to changing market conditions. Focus on systems and you may make money for awhile, but eventually you'll give it all back (and more). Focus on true understanding and you will be well on the way to consistent trading success.
What "Understanding" Is
You may wonder what I mean by "understanding." "Understanding" is the pot of gold that comes through your skills as a trader and on your ability to consistently find ways to limit your risks while participating in opportunities that have much more reward than the risk you are taking. It is the ability to see a strategy as nothing more than a tool and see when it's applicable and when it's not.
In short, the pot of gold does not lie in some system outside of yourself; it lies in the set of skills and degree of understanding and insight that you build within.
A True Story to Illustrate My Point
The Master Trader strives for understanding. The Novice Trader searches in vain for magical systems.
In closing this section, let me share a true story with you that will graphically illustrate my point:
In the mid-eighties, I met two traders who had attended a seminar by a very well known and reputable trader. These two traders did not know each other, but coincidentally, they both learned and applied the same system.
The first trader was the Novice Trader.
He began to trade the system in 1986 and was shocked at how much money he made. He was anxious to commit more capital to it, but wanted my opinion first. I back-tested the system and found that it had an identical performance to what was claimed in the seminar. However, I explained to this trader that I had three serious reservations. First, there was no stop-loss protection. Secondly, even though the system showed phenomenal gains in its four years of testing, that was not a sufficient time frame in which to evaluate the system properly. Third, the system was tested during a bull market. I didn't think it would perform well during a bear market. To address these concerns, I suggested that the trader employ stop-losses and trend filters. This would have cut the total hypothetical profits during the four year testing period and hence, likely reduce future profits. The trader, however, did not heed my advice and left my office intending to continue trading the system "as is." This trader's confidence in the system continued to build over the next several months as he made a fortune by racking up steady and consistent profits month after month. On October 17, 1987, the day of the great market crash, this trader was completely wiped out.
A few months later after the crash, I was talking to another trader. This trader was one I'd call a
Master Trader.
I found out that he had attended the same seminar spoken about above and that he had been exploiting the same strategy as the Novice Trader, but in contrast, he'd been successful using it, despite the 1987 crash.
I noticed that this trader had not taken the system's signals on October 27, nor during the entire October-November 1987 period. He explained to me anyone with a true understanding of the markets would not be applying the system during that period. He thought the system was good at identifying opportunities, but he'd only exploit them if he could limit risk with a stop-loss and in an upward trending market. That was not the case during that period.
The Novice Trader focused on the "system" and not "understanding the markets." In so doing, he assumed that the system was infallible and he was not able to anticipate the market environment that would usher in the system's inevitable season of loss. The Novice Trader wanted to find a fishing hole where the fish were always biting.
The Master Trader was simply looking for ideas that help him increase his understanding.
He didn't consider what he learned at the seminar to be a "system", but rather, it was knowledge that he could use to find more low-risk, high reward opportunities. There was no way he would use it without fully understanding it so that he'd know the conditions under which it applied best and when it might not apply. The Master Trader was looking for another way to find a fishing hole where the fish might be biting for a while.
Winning traders seek to understand the markets and not to find magical systems.
Now let's move on to my more general money management rules.
