In the first chapter of Trader Construction Kit (which can be read here) I assert that succeeding as a professional trader is a two-part problem: personal evolution to become the best possible risk taker and developing, refining and deploying an efficient process for interacting with the market. Given the recent widespread popularity of Behavioral Finance, most aspiring traders are aware of the need to improve their decision making and avoid common biases in risk taking behaviors. There is significantly less material available on how to develop a robust trading methodology, which I describe in idealized form in the following excerpt from the chapter:
- The ideal trader has a clear sense of what she is trying to achieve at all times.
- The trader expects a particular market response when a base set of fundamental and technical conditions are disturbed by incremental change or the influence of external stimuli. This informed perspective on the future of price is called a view.
- The trader considers a variety of strategies to implement her view, selecting the one with the closest response to the underlying driver with the best potential reward, the lowest probable risk, and the best performance characteristics.
- The trader sets the position with a defined profit target and a stop-loss.
- The trader monitors the position for changes to the underlying thesis while maintaining an alert, intellectually engaged but emotionally detached state.
- If action is required, the trader executes with the maximum possible efficiency.
- The trader evaluates the results and adjusts the operational parameters (trade selection criteria, stops, targets, etc.) of the methodology as necessary.
Exploring each point in greater detail, we see that:
A trader must have a clear sense of their goals, as without a defined set of expectations it is impossible to calibrate their allocation of resources and relative level of aggression. A firm grasp on their capability to take risk is essential when formulating position sizes and evaluating resource-intensive trading strategies.
A trader must incorporate all of the available relevant information into their decision-making process, given their stylistic predilections. While I feel that it is logical to incorporate both fundamental facts and technical information, many traders prefer to start with a more curated set of purely fundamental or technical inputs. Whatever works for the individual. One universal constant is that the trader’s analysis and interpretation of the informational inputs must lead to their view on the future of prices, not be an after-the-fact justification for a pre-conceived notion that the market is going higher or lower.
Once the trader has developed a view of the market they must evaluate the options available for establishing an exposure to capitalize on the anticipated price fluctuation(s). Different traders will have different resource allocations and products approved for use, and their ability to employ them will be a function of their relative year-to-date performance. A trader must consider all potential implementation strategies, evaluating each alternative on how much capital it puts at risk, the potential reward, and the unique performance characteristics that will impact its response to market fluctuations. The ability to accurately assess the relationship between risk and potential reward is the key determinant of a trader’s long-run success. Typically, a trader will require a reward that is a multiple of the amount they have put at risk to justify a position.
Having evaluated a variety of options to arrive at the optimal strategy to express their view, the trader must develop a plan to implement it in the market. A good trading plan will include (among other considerations) a stop-loss level beyond which the trader will concede that the position is not working and exit and profit target where they will happily book their winnings. The stop-loss and profit target must be derived prior to establishing the exposure, as this allows for a more clinical, unbiased assessment.
A trade is an exposure designed to express a view on the future of prices, a perspective that was informed by pre-trade analysis of the market conditions. Market conditions are not constant. The trader will have to remain immersed in the market and alert for any changes to the underlying drivers of their view. If the evolution is unfavorable, they must exit the position immediately.
When entering and exiting the positon the trader will seek to execute as efficiently as possible to minimize slippage and other transactional costs, which act as a tax on the profitability of the exposure.
Once the position has been closed and the P&L realized, the trader will forensically re-examine their decision making across the entire process, regardless of positive or negative outcome. While this type of methodological tuning is valuable for experienced traders, it is absolutely critical for younger traders who are still developing their approach to the market.
When all is said and done, the trader will start over at the beginning: watching the market, taking in information, and using it to re-formulate a view of the future of price.
From this basic blueprint the trader will add, subtract or modify elements as needed to adapt it to the demands of their particular market, take maximum advantage of their unique strengths, and de-emphasize their inherent weaknesses. Every trader should seek to leverage their comparative advantages relative to their peers in the market, wherever and whatever they may be. If they are a talented fundamental analyst, their methodology should over-weight fundamental inputs when deriving a view of the market. A skilled option trader might be able to contemplate constructing complex non-linear positions that might not seem as attractive or viable to a directional or spread trader, etc.
Developing a trading methodology is a complicated topic, and it would not be a stretch to claim that the majority of the 624 pages of Trader Construction Kit are dedicated to a step-by-step explanation of the process. For readers interested in a deeper dive into the material, I will be publishing a series of excerpts from Trader Construction Kit starting with Chapter 3 – Fundamental Analysis and continuing through Chapter 14 – Managing Positions & Portfolios. Each excerpt will be available here for one week, and will be replaced by the next chapter the following Monday.
 Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.