In order to design a trading system, one has to take care not to add the wrong ingredient into the mix of components. What is good for one system may be bad for the other. Like oil is necessary for a motor, one drop of it pollutes tons of drinking water.
One of the worst mistakes in trading, if not the worst mistake, is trying to combine procyclical and anticyclical elements. There may be specific constellations that work, but generally this combination is a red flag. Sadly the average trader isn’t aware of this. The bull market produces many novice traders in its final stage and most of them end up as investors, meaning they have no concept of stopping the ongoing loss.
But also many experienced market operators enter a position having a plan in mind but are then unable to take the first small loss. Either they had only planned the sunny side of what could happen, or they were not able to execute their form of stop loss.
In a nutshell, a trader is someone who uses a stop loss, always of course, and an investor never uses it, at least not one with a price limit that gets broken. The investor may of course change his mind about the valuation of his investment and consider it a sell even after its price went far below the buying price.
Unfortunately for traders the human psychology interferes with what logic suggests. Real life educates us to be bargain hunters. It is natural for traders to look for cheapness and also try to hop on a trend or any other upmove. Essentially you can get only one of it and that decision determinates whether you are an investor or a trader.
While it is very important to understand this distinction before money is put at work, it is evenly important not to forget about it during the lifetime of the trade or investment. Moreover, it is probably best to be either an investor or trader. Mixing both trading styles will most likely end up in hybrid positions, and these are the big loss bringers.
So, how does this look in reality? What is a simple investment method and a basic trading system? For the investor timing is nothing. He simply could replace positions with higher valuations by others with lower valuations. Doing this on an ongoing basis is enough of a system. The difficulty is here of course more the judgment of the valuation, whereas the investment system in itself is rather simple.
Astonishingly, the trader has an even more simple system. He could just buy at random points and execute his stop loss system. Really? Yes, this could work. The markets are 15% of the time in a trending mode and if they are, this system will make money. Otherwise it will break even.
This idea has just one catch. There are not only two but three market phases with the third one being the problem. At times or depending on the traded medium the price moves largely controlled by negative feedback, investors who sell at higher prices and buy at lower ones. Entering a position in such a phase will yield a loss, because the chance for a trend was small beforehand while hitting the stop is almost preprogrammed.
Instead of choosing the entry completely by random, this trading system could be finetuned by preselecting entries where the action is, where the price is unexpectedly going up – or down.
Yes! It is possible to enter the market from the trend trader’s perspective in the wrong direction, as long as the stop loss system gets honored. As Benoit Mandelbrot, conducting his investigations about the stock market from a mathematician’s view, once said, after volatility comes volatility. You just don’t know about the direction.