The Core Principle of Successful Trading - effective forex trading system

The Core Principle of Successful Trading ~ effective forex trading system

Trading methods come and go. Some of them are software-based, programmed from purportedly top-secret algorithms that claim to make profits with little or no involvement from the trader whatsoever (simply plug n play and youre a millionaire!). Some would avoid the automation route in favor of chart patterns so extremely complex that by the time youve finally recognized them, the trading opportunity has come and gone.

There is one principle however, that is not only much more simple and easier to understand and to see on your charts, but which also stands the test of time as the highest probability route to success in trading. That principle - which you have surely heard before - is as follows:

Buy the Dips in an Uptrend, Sell the Rallies in a Downtrend

Simple, isnt it? And yet so many traders, even after hearing the advice, fail to apply it in their trading. Instead, they spend much of their time trying to find the latest indicator-driven strategy, or spending thousands of dollars on those fancy charting packages (only to learn later that they didnt measure up to the sales hype). Others would give in to the temptation of chasing a  non-trending market, for fear that they would end their trading session feeling they failed simply for not taking a trade.

If you want to make your trading endeavour a success and also a whole lot easier, then make it your mission to buy the dips in an uptrend, and sell the rallies in a downtrend. OK, so as simple as it sounds, what exactly do we mean with this principle and why is this so crucial?

Firstly, note that we are trading with the trend, not against it. We buy in an uptrend and we sell in a downtrend. However, it does depend on the degree of the trend: the higher up you go (for example, to a Weekly chart) the longer the duration and the more distance covered in the significant counter-trend moves, which may in fact represent decent trading opportunity. But as a general rule of thumb - especially for day trading styles - buying the dips and selling the rallies means aligning ourselves with the market flow, the direction it is heading on the timeframe were looking at, which is the path of least resistance.

If we do the opposite, for example, selling the rallies in an uptrend, we put ourselves in the direction of a corrective action, which can be a really bumpy ride. Corrective action tends to be unnatural, prone to whipsaws and market noise. Its price targets are often much more difficult to hit, and less reliable. A trending market, by contrast, tends to move more smoothly and effortlessly towards its objective, more linear than overlapping in appearance. Putting ourselves on the right side of the trend allows us to take advantage of those really big moves that can be very profitable. 

As shown in the chart below (showing green arrows for buys, red arrows for sells), the other advantage of buying the dips and selling the rallies, is that it minimizes risk. In a trending market, a correction should only go so far. Once its exhausted, the return to trend can be relatively quick - in other words, the market moves off the counter trend extreme with little hesitation. If we jump in at that point, then there is a much lower chance that the market will tum against us later, triggering a stop. This in turn allows precise entry points with limited risk to be set. 

In order to buy the dips and sell the rallies, we need an analytical approach that effectively comprises two  components. Firstly, we need a reliable method of identifying a market that is trending. It is going to be difficult to sell the rallies in a downtrend if we dont even know whether we are in a downtrend. Secondly, we need a reliable method of identifying the retracements (the dips in an uptrend or rallies in a downtrend): where they start, where they are likely to end, and some sense of certainty that they are merely a pullback. 

There is no point in selling a rally in a downtrend if that rally is expected to confirm a reversal. Therefore, we need to understand how to detect these important components of price action relatively unaided. This means that we need to start developing a general idea for what trending markets and retracements tend to look like on the chart with recourse only to price action itself.

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My interview stop loss and the Principle of Latest Information - forex trading strategies work

My interview stop loss and the Principle of Latest Information ~ forex trading strategies work

You can find an interview of me in the July 2009 issue of Technical Analysis of Stocks & Commodities magazine. I mentioned in that interview and also in my book that I believe stop loss should only be applied to momentum strategies but not to mean-reverting strategies. I explained my reasoning better in my book than in the interview, and so I will paraphrase the explanation here.

In algorithmic trading, it is reasonable and intuitive that we should always make use of the latest information in determining whether we should enter into a position, whether that information is price, news, or some analysis. Lets call this the Principle of Latest Information. (If someone can think of a better or sexier name, let me know!)

So lets say we have a stock model based on price momentum, and we entered into a long position based on a recent positive return on price. A few minutes later, the price went down instead of up, causing a big loss on our position. If we now ran this momentum model again, very likely it would tell us to short the stock instead because of the recent negative return on price. If we did that, we would be exiting the previously long position and became flat. This is in effect a stop loss, and it follows strictly from adhering to our model and our Principle of Latest Information.

In contrast, suppose we now have a stock model based on mean-reversion, and we entered into a long position based on a recent drop in price. A few minutes later, the price went down further instead of up, again causing a big loss on our position. If we now ran this mean-reversion model again, it would definitely tell us to buy the stock again because of the ever cheaper price. The model would not ask you to exit this position and take a loss. Hence, adhering to the model and the Principle of Latest Information will not lead to a stop loss for a mean-reverting model.

(Now, if we hold this losing long position long enough, the model will incorporate new historical prices into determining its long or short signals as it retrain itself, as the Principle of Latest Information says it should! At that time, it may indeed recommend that we exit the previously held long position at a loss. But this adjustment takes place at a much longer time scale, and therefore cannot really be considered a stop-loss in its usual sense.)

More generally, I find that at every turn, and not only in the realm of stock trading, applying the Principle of Latest Information always help me to be disciplined and not be afraid to enter into new positions, take loss or endure a drawdown as the case may be.
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