Bill's Trading Lessons

Throughout my years in the trading business, there are many lessons that I have learned. I would like to share some of them with you.

1. Control your emotions.
2. Diversify your risk.
3. Don’t be so certain.
4. Have staying power.
5. Always have a plan.
6. You will make mistakes.
7. Risk and reward cannot be separated.
8. Know why you’re trading.

1. Control Your Emotions

After many years of trading in the markets for myself, I learned the most important tenet of trading the hard way: you need to get your emotions in control. Becoming successful at trading means becoming somewhat of a stoic—not getting too excited when things are going good, not getting down when things are going bad. To be a successful trader will involve having some analytical skills but most of the long-term success comes from proper money management and solid emotional control. If money is put with a successful Commodity Trading Advisor (CTA), it does not necessarily mean that the investor investing with the CTA will be successful at making money. Many times during drawdown periods, investors will withdraw their money because of the pressure of the short-term results. One must be prepared and capable of going through the difficulty of drawdowns not only financially but also psychologically.

Every good trader has drawdowns. They are inevitable. The long-term results are what is important, not the short-term fluctuations. Anyone who tells you otherwise is clearly someone you do not want trading for you. A good system will deal with the probability of large numbers. Even though there is a series of losses, a good system should eventually win in the long run if it has some form of an edge built into it. At Midwest Futures, the system we believe in is a trend-following system, not a trend-anticipating system. We want to flow with the market, not try to guess where it is going. What we are interested in doing is trying to make money, not see how much fun we can have. If it is fun we are after, we need to go to a casino.

2. Diversify Your Risk

In large part, successful trading also depends on how much you have spread out your risk through diversifying markets, strategies and investment instruments. This is called proper money management. In the process of diversification, one needs to make an effort to make sure that positions are as uncorrelated as possible. If you were flipping coins, even though in the long run you should end up with 50% heads and 50% tails, in the short run it is not impossible to have a string of five heads or tails in a row. This kind of mentality needs to be used when trading with strict management rules. There are going to be times when there are a series of losses that will take place, with winners being few and far between. This is what causes significant drawdowns. Traders can have all the probabilities working in their favor but be emotionally affected by drawdowns to the extent that they pull out of their positions at the worst possible time: at the bottom.

A good system cannot be expected to out-perform a bad trader. There are not a lot of traders who can follow through with their plans. The main purpose of money management is to make sure we do not run out of money before good trades potentially come along. A good system tends to trade smaller during bad times and larger during good times. Reserving capital is of utmost importance. We must be able to stay in the game until we find a good trade. Risking too much may cause us to lose all of our capital.

There is no guarantee that any system will make money. However, a good system with a slight edge should win out in the long run. There are no guarantees that if you flip a coin one hundred times, you won’t get 100 heads in a row but the probabilities are that you will not.

3. Don’t Be So Certain

Having an opinion when trading in the markets can be extremely dangerous; especially if you are a trend follower. Don’t be so certain. Having an opinion has a tendency to lock a person into a trade. If you know that the market price is going to move higher, not only will it cause you to want to overtrade by having too large of a position, but it will also cause you to overstay your position whether right or wrong. When letting price dictate whether a person wants to be long or short in the market, there is a better chance of being less bogged down by indicators that are inadequate to good trading.

If you are long in a market and technical indicators are moving more positively but the price is moving lower, do you make any money? Absolutely not! All that matters is where the price goes; it does not matter where RSI’s, %R’s, or stochastic move. You cannot store these in your bank.

Because futures trading is a zero sum game, the only way to get money out of the market is to take it from someone else. The majority of futures traders lose money because they do not have the experience and resources of big players in the markets. The ones who consistently win typically have a plan that is designed to decrease the negative effects that their emotions can cause.

Not only does a good system tell you where to buy and where to sell, it should also tell you how much to buy and how much to sell. One of the problems with trading discretionarily is that it allows too much room for emotional breakdown. Discretion means choice and, with too many choices, the chances of a trading meltdown are greatly increased. Many times people want to get a jump on the market. If they think the market is going up, they want to buy before it goes up and if they think it is going down, they want to sell before it goes down. This type of an approach to trading is analytical and has to do with market prediction, not trend following.

4. Have Staying Power

In order to have proper money management, an account must be funded to such an extent that it can afford the drawdowns that will eventually come. In other words, you need to have staying power. There is going to be a lot more volatility in a trend following system that tries to let profits run. Suppose you risk 2% on a trade. The trade goes good and you are up 15%. If the protective stop is not moved, the whole 15% is at risk. This is part of what creates such a large drawdown in a trading strategy that shoots for high percentage returns. People can trade for decades and, even though they are more knowledgeable in the mechanics involved in trading, they may not have yet figured out what it takes to make money.

Many times people will say, “Just do the opposite of what I do and you will be able to make all kinds of money.” I believe that this mode of thinking is in reverse. We need to figure out what it is that the person who loses money is doing. It is not just poor analysis that causes such people to lose money; it is poor emotional control, lack of having a trading plan, and the inability to endure drawdowns that are inevitable to every trading strategy. Many people who lose money have a helter-skelter, shoot-from-the-hip style of trading. Sometimes they plan individual trades but, unfortunately, to their own detriment, they do not have a long-term consistent plan for all of their trading.

I believe this “trade from the hip” style of trading is not the right way to target success. Many people do not want to use stops to protect their positions because they do not want to lose their positions.

5. Always Have a Plan

At what point in time do we decide to get rid of the position that continually moves against us? Without a plan, we are going to let our emotions dictate when we get in and out of positions and that is often at the worst possible time. Many times when someone gets into a bad trade and does not have a plan on how to get out of that trade, they will try to manipulate the market by adding to a losing position. This only compounds the problem. Once we begin to try to manipulate the market, we are already heading down a very dangerous slope. Even though a person may bail themselves out of a position a time or two, the law of averages tells us that this type of trading will usually end up in financial ruin.

Human nature is such that we seek pleasure and avoid pain. In order to be successful in the long run, sometimes we need to go through painful experiences in the short run and put off until the long-term the pleasures we so desire. People often look at a chart and say, “Had I bought it here and sold it there, I would have made all kinds of money.” What they do not consider is the tremendous amount of patience it takes to wait for those profits. Because of their impatience, most people will either get out way before those profits materialize or they will completely overstay their trade and ride the market all the way up and all the way back down because they didn’t have an exit strategy.

We often think we are stronger than we are. We start a diet that we say we are going to be on for 3-6 months only to find out that, after a few days, the excitement that goes with the great expectations of success suddenly wears off. When that happens, we give up. There will always be news that comes along to shake our confidence in the current position we are carrying in the marketplace. You need to always have a plan so that your actions aren’t as fickle as the marketplace.

6. You Will Make Mistakes

Markets move up and down. As trend followers, we are taught to buy when the market is going up and to sell when it is going down. The problem is markets go up and down all day long. How much up or how much down does the market need to move to trigger buy and sell signals? That will vary with every trading strategy but, in developing a trading system; we need to have a point at which we say the market has moved up enough to trigger a buy signal or down enough to trigger a sell signal.

My favorite motto is: “I’m failing my way to success.” In other words, I am not afraid to make mistakes in my quest for success. Part of the learning process involves making mistakes. When it comes to trading, taking small losses is part of the process. Not all trades grow into great successes. But every now and then, some of those trades do turn out to be great profitable successes.

If a trade loses money, it does not mean that the trade should not have been taken. It is simply the cost of doing business. Any business, whether successful or not, will have expenses. Simply put, the small losses that are taken time and time again in the quest for finding big winners are simply the cost of doing business. It is like an oil exploration company. They do not just dig wells anywhere. They dig wells where they think there is a chance of striking oil. They know there will be times when they will not find oil. There are also times when they hit it big.

7. Risk and Reward Cannot Be Separated

Many times when people invest, they invest for safety, not returns. Risk and reward are like husband and wife. You cannot separate the two. Wouldn’t it be great if we could get both: have our cake and eat it too? Stock fund managers try to out-perform the general market, but their approach is to try to find the best performing stocks. How can one know what these stocks will be? What happens to these best-performing stocks when the market, as a whole, is going down? Do the good managers get short stocks? What is the edge that stock managers have?

No investment is risk free. Buy and hold has its own risks as well. Having some capital invested in a good trend-following managed futures account not only gives diversification, but also gives the advantage of trading something that can be non-correlated with stocks. Being able to do nothing when you are right can be a very difficult thing to do. Waiting is not easy. Patience truly is a virtue and it can pay off. Without it, successful trend-following will be impossible.

One thing that will cause large drawdowns is having patience with a winning trade. This, however, is the same thing that will create large returns. If one gets ahead by a substantial amount on a trade in a short period of time, protective stops can remain a long way off in order to let the trade breathe. Sometimes all of the profits are given back. Sometimes, all the profits materialize. Either way, you have to be willing to risk in order to gain reward.

8. Know Why You're Trading

There is no better place in the world to learn about oneself than in the world of trading. To be a successful trader, a person has to have very good self-control. It is amazing how many times we can make the same mistake in trading before we learn what it is we have to do to make money.

I believe one of the reasons many people fail to make money is because they are unaware that they are not trading for the purpose of making money. They may be playing for the fun and it’s the money that makes it fun. They may also be trading to boost their ego. Losing money, however, does not boost one’s ego. The people that want to strut their stuff to impress the world will usually commit the cardinal sins of trading that keep them from becoming successful. These include overtrading, being impatient with winners and riding losers. Egoists don’t want to look like a loser by taking a loss.

Everyone has heard we should ride our profits and limit our losses. But that statement just arbitrarily thrown out there does not do anyone any good. Many people try to employ stop losses into their trading to help them limit their losses. That’s great! The problem is that this also seems to be a license to gamble. If I have $1,000 to lose and I am going to take pot shots at the market without a plan, what do I do next if I lose my $1,000? What do I do next if I turn the $1,000 into $10,000?

Investors who invest with money managers who employ trend-following methods should have an advantage over trying to trade their own accounts in a helter-skelter approach. Money management used in an account gives one an edge. Emotions still can get in the way of the investor. Investors still have the option of closing their account when things are going badly. Many times this is exactly what happens only to watch the performance of the manager begin to turn the corner and begin to be positive again.