Seven Habits of Successful Traders

Stephen Covey’s The Seven Habits of Highly Effective People has been on the national best-seller lists for years–first as a hardback and then as a paperback. I wondered how its list might relate to commodity futures trading and spread betting.

While there does not appear to be any direct relationship between my spread trading list and Covey’s overall life experience list, there are some definite similarities and differences. It is well known that normally successful approaches do not work in trading. Additionally, life in general requires involvement and interrelating with other people, while trading is a more solitary endeavor.

Here is my list of successful habits for traders.

  • Rule #1 – Understand the true realities of the markets.

Understand how money is made and what is possible. The markets are what is called chaotic systems. Chaos theory is the mathematics of analyzing such non-linear, dynamic systems. Among other things chaotic systems can produce results that look random, but are not.

A chaotic market is not efficient, and long-term forecasting is impossible. Market price movement is highly random with a trend component.

Unsuccessful and frustrated commodity traders want to believe there is an order to the markets. They think prices move in systematic ways that are highly disguised. They want to believe they can somehow acquire the “secret” to the price system that will give them an advantage.

They think successful trading will result from highly effective methods of predicting future price direction. They have been falling for crackpot methods and systems since the markets started trading.

The truth is that the markets are not predictable except in the most general way.

Luckily, successful trading does not require effective prediction mechanisms.

Successful trading involves following trends in whatever time frame you choose. The trend is your edge. If you follow trends with proper money management methods and good market selection, you will make money in the long run.

Good market selection refers to selecting good trending markets generally rather than selecting a particular situation likely to result in an immediate trend.

There are two related problems for traders. The first is following a good method with enough consistency to have a statistical edge. The second is following the method long enough for the edge to manifest itself.

  • Rule #2 – Be responsible for your own trading destiny.

Analyze your trading behavior. Understand your own motivations. Traders come into trading with a view to making money. After awhile they find the trading process to be fascinating, entertaining and intellectually challenging. Pretty soon the motivation to make money becomes subordinated to the desire to have fun and meet the challenge.

The more you trade to have fun and massage your ego, the more likely you are to lose. The kinds of trading behaviors that are the most entertaining are also the least effective. The more you can emphasize making money over having a good time, the more likely it is you will be successful.

Be wary of depending on others for your success. Most of the people you are likely to trust are probably not effective traders. For instance: brokers, gurus, advisors, system vendors, and friends. There are exceptions, but not many.

Depend on others only for clerical help or to support your own decision-making process. Don’t blame others for your failures.

This is an easy trap to fall into. No matter what happens, you put yourself into the situation. Therefore, you are responsible for the ultimate result. Until you accept responsibility for everything, you will not be able to change your incorrect behaviors.

  • Rule #3 – Trade only with proven methods..

Test before you trade. When applied consistently, most trading methods don’t work. The conventional wisdom that you read in books is mostly ineffective.
Notice that authors never demonstrate the effectiveness of their methods. The best you can hope for is a few, well-chosen examples.

The reasons for this are that they are lazy and their methods mostly do not work when tested rigorously.

Have a good approach.

Follow the five cardinal rules of trading -:

  1. Trade with the trend.
  2. Cut losses short.
  3. Let profits run.
  4. Diversify and balance your positions.
  5. Limit risk & manage costs

These are well known clich├ęs. Yet virtually all losing traders violate these rules consistently.

Trading with the trend means buying strength and selling weakness. Most traders are more comfortable buying weakness and selling strength, the essence of top and bottom picking.

Trade liquid markets. Trend is your only edge. You must emphasise those markets which trend the best. This will maximise your statistical edge over time.

  • Rule #4. Trade in correct proportion to your capital.

Have realistic expectations. Don’t overtrade your account. One of the most pernicious roadblocks to success is a manifestation of greed. Commodity trading is attractive precisely because it is possible to make big money in a short period of time.

Paradoxically, the more you try to fulfill that expectation, the less likely you are to achieve anything.

The pervasive hype that permeates the industry leads people to believe that they can achieve spectacular returns if only they try hard enough. However, risk is always commensurate with reward. The bigger the return you pursue, the bigger the risk you must take.

Even assuming you are using a method that gives you a statistical edge, which almost nobody is, you must still suffer through agonizing drawdowns on your way to eventual success.

The larger the return you attempt, the larger your drawdowns will be. A good rule of thumb is to expect an equity drawdown of about forty percent of your annual profit expectation. Thus, if you shoot for annual returns of 100 percent, you should be ready for drawdowns of 40 percent of your equity. This is typically the maximum limit even the most aggressive traders will tolerate for drawdowns. Almost no one can keep trading their method through 50 percent drawdowns.

It is better to shoot for smaller returns to begin with until you get the hang of staying with your system through the tough periods that everyone encounters.
An experienced money management executive has stated that professional money managers should be satisfied with consistent annual returns of 20 percent. If talented professionals should be satisfied with that, what should you be satisfied with?

Personally, I believe it is realistic for a good mechanical system diversified in good markets to expect annual returns in the 30-50 percent range. This kind of trading would still result in occasional drawdowns up to 25 percent of equity.

  • Rule #5. Manage risk.

Manage the risk of ruin when you create your trading plan or system. Manage the risk of trading when you select a market to trade. Manage the risk of unusual events. Manage the risk of each individual trade.

The risk of ruin is a statistical concept that expresses the probability that a bad run of luck will wipe you out. On average, if you flip a coin 1,024 times, you will have ten heads in a row at least once. Thus, if you are risking ten percent of your account on each trade, chances are you will be completely wiped out before long.

If your trading method is 55 percent accurate (and whose is?), you still have a 12 percent chance of being wiped out before doubling your capital if you risk 10 percent of capital per trade.

For the mathematicians out there, this assumes that you win or lose the same amount on each trade. That is unrealistic, but I’m just trying to explain the risk of ruin problem. The point is that in order to reduce the harm caused by unavoidable strings of losses, you must manage the amount you risk on each trade.

Another element of risk is the market you trade. Some markets are more volatile and more risky than others. Some markets are comparatively tame. Some markets, such as currencies, have a greater chance of overnight gaps that increase risks. Some markets have lower liquidity and poorer fills that also increases risk.

Emphasize risk control over achieving big profits.

The most important element of risk control is simply to keep the risk small on each trade. Always use stops. Always have your stop in the market. Never give in to fear or hope when it comes to keeping losses small. Preventing large individual losses is one of the easiest things a trade can do to maximise his chance of long-term success.

  • Rule #6. Stay long-term oriented.

Don’t adjust your approach based solely on short-term performance. Our entire society emphasises instant gratification. We are consuming are long-term capital.

Eventually, this will lead to a decline in our standard of living over what it could have been with more attention to the future.

Most traders have such an ego investment in their trading that they cannot handle losses. Several losses in a row are devastating. This causes them to evaluate trading methods and systems based on very-short-term performance.

Statisticians tell us that there is no statistical reliability to a test unless you have 30 events to measure. Short of a reasonable number of events, the outcome is wholly dependent on luck. As we saw in the risk of ruin discussion above, strings of losses are as certain as government inefficiency.

Thus, the trader who chucks his system after four losses in a row is doomed to spend his trading career changing from one system to another. Don’t start trading a system based on only a few trades, and don’t lose confidence in one after only a few losses. Evaluate your performance based on many trades and multi-year results.

  • Rule #7. Keep trading in correct perspective.

Trading is emotionally intensive no matter whether you are doing well or going in the tank. It is easy to let the emotions of the moment lead you into strategic and tactical blunders.

Don’t become too elated during successful periods. One of the biggest mistakes traders make is to increase their trading after an especially successful period.
This is the worst thing you can do because good periods are invariably followed by awful periods. If you increase your trading just before the awful periods, you will lose money twice as fast as you made it. Knowing how to increase trading in a growing account is perhaps the most difficult problem for successful traders.

Be cautious in adding to your trading. The best times to add are after losses or equity drawdowns. Don’t become too depressed during drawdowns. Trading is a lot like golf. All golfers, regardless of their ability, have cycles of good play and poor play. When a golfer is playing well, he assumes he has found some secret in his swing and will never play poorly again. When he is hitting it sideways, he despairs he will never coming out of his slump.

Trading is much the same. When you are making money, you are thinking about how wonderful trading is and how to expand your trading to achieve immense wealth. When you are losing, you often think about giving up trading completely.

With a little practice, you can control both emotional extremes. You’ll probably never control them completely, but at least don’t let elation and despair cause you to make unwarranted changes in your approach.

Since correct trading is boring, don’t depend on trading as your primary stimulation in life. Unfortunately, the exciting aspects of trading, such as easy analysis and trade selection, are counterproductive. Good trading is repetitive and pretty dull. Thus, if you depend on trading for the major excitement, pursuit of fun will probably cause you to lose. If you can afford it, fine. If not, seek your entertainment elsewhere.

Here’s a summary of my seven habits of successful traders.

  1. Understand the true realities of the markets.
  2. Be responsible for your own trading destiny.
  3. Trade only with proven methods.
  4. Trade in correct proportion to your capital.
  5. Manage risk.
  6. Stay long-term oriented.
  7. Keep trading in correct perspective and as part of a balanced life.

The common theme is self-control.

If you can master yourself, you can master the markets.