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CHAPTER 6:
HONING YOUR TRADING STRATEGY


Calculating Risk
Pivot Tables
Equity Curves
Managing Drawdown
Keeping Accurate Records!
Part 06 – Key Points To Remember

This part can’t happen until you’ve got some live trades under your belt, and you’ve had a chance to field-test your trading strategy. Once that happens, you’ll undoubtedly see areas where you could improve. At that point, it’s time to take your trading to the next level, and the ideas presented in this section will help you do just that!

There’s one aspect of this that stands heads and shoulders above everything else though, and that is your trading diary. If you take your time and build it right, starting from the first trade you make, you’ll find that it’s the most indispensable tool you’ve got at your disposal. A well-constructed trading diary will not only show you the things you’re getting right, but will also clearly illustrate where things are going wrong for you.

This includes not just weak points in your strategy from a technical standpoint, but also those times when you let your emotions cloud your judgement (because you should include emotional observations in your diary as well as the technical aspects of your decision-making process).

We’ll have more to say about all that later. For now, it’s important that we plant the seed in your mind that your trading diary is vitally important. Before we circle back to it though, let’s talk about some other ways you can improve your trading game, and that starts with understanding one simple truth:
Nobody is born with a deep understanding of successful trading. Like anything else, it’s a learned skill, and as the saying goes, “if you swing a hammer enough times, you’re bound to get better at it.”

That’s certainly true, but you don’t have to just randomly swing that hammer and hope for the best. You can study the strategies and observations of investors with a proven track record and learn from them. In fact, that’s been done before and proved to be wildly successful.
William Eckhardt and Richard Dennis took a group of completely untrained people (“The Turtles”), taught them a trading strategy, then gave them accounts to put the strategy they’d just learned to the test. The Turtles went on to make millions of dollars doing nothing more than faithfully executing the strategy they’d been taught, and remember, none of these people knew the first thing about investing when they started out!
Bear that in mind as you study the moves of successful traders. Learn from them, then apply the things you learn faithfully. Let their thinking guide yours, then, once you’re trading successfully by copying the moves of others, begin to experiment with your own personalized twists and tweaks to your increasingly robust system.
Having said that, let’s take a look at a few things that the pros use, do, and understand that you may not (yet):

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Calculating Risk

This is hardly the first time we’ve talked about risk. That’s because it’s vitally important that you understand it, not just conceptually, but as a tangible element that should bound and drive your thinking.
Among the most important aspects of risk is calculating your risk-reward and win percentages. Knowing these two numbers gives you powerful insights into how effective your trading strategy is, and can highlight areas where improvements need to be made.
The key here is in keeping detailed records, all of which should go into your trading diary.
The simplest way to keep track of your trades is probably in spreadsheet form, and if that’s what you’re doing, then be sure to include a column that shows your profits and losses on a trade-by-trade basis.
Details matter here! It’s very easy, especially if you’re making short trades, to accidentally record a profit as a loss, so be careful when entering your values!
It will probably also be instructive to have a column that lists the types of trades (Share CFD, Commodity, Index, etc.) and whether the position was short or long, so you can quickly and easily spot trends. For instance, if you observe that most of your short trades end badly, that’s important to know, and something you can work specifically to correct.
Here are some formulas you can copy directly into Excel, when putting your spreadsheet together. All you’ll have to do is change the cell id’s, and you’re all set (this assumes that you’re putting your data in column “C” on the spreadsheet. Obviously, if you’re putting it somewhere else, then you’ll want to adjust accordingly. Note that if you’ve made more than 30 trades, then you’ll also need to expand the boundary of the formula).

To calculate your win percentage:
=countif(C1:C30,”>0”)/count(C1:C30)
Be sure to format this data as a percentage, with no decimal places

To calculate your Risk-Reward:
=-averageif(C1:C30,”>0”)/averageif(C1:C30,”>0”)
Be sure to forma this data as a number, out to two decimal places

NOTE: if you’re using an older version of Excel, then the “averageif” function may not be available. If that’s the case, then use the following instead:
=-(sumif(C1:C30,”>0”)/countif(C1:C30,”>0”))/(sumif(C1:C30,”<0”)/countif(C1:C30,”<0”))


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Pivot Tables

You’ll find the Pivot Table Tool in Microsoft Excel, and the more trades you make/the more raw data you find yourself working with, you’ll find it increasingly useful. Pivot Tables allow you to view your trades in different ways (through different “lenses” so to speak) to help you spot trends and identify things that do and don’t work.
When applied to raw datasets, it allows you to conduct research on any type of market (forex, commodity, share, etc.) and identify potentially profitable trading opportunities. That’s a great thing, because these days, there are oceans of data available, but sifting through it takes time and work. Pivot tables help cut through the clutter, making the process of finding gems hiding in the data a much easier prospect.


Your Equity Curve

In an ideal world, your equity curve should smoothly and steadily rise over time. That means you’re consistently adding profits! Of course, we don’t live in a perfect world, and especially in the beginning, yours might not be so smooth.
If you’re not sure what an equity curve is simply a plot of your trading account balance, over time, tracked on a daily basis.
The technical term for account losses is “drawdown,” and drawdowns are measured as a percentage, so for instance, if your account balance gets to $5000, then drops to $4000, you’ve experienced a 20% drawdown.
This curve really matters, and not just because it is reflective of your overall profitability. It can also tell you a lot about how effective your trading strategy is, because you can match losses with specific trading days, use that to identify specific trades, and learn how and why those trades went wrong, then make corrections from there.


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Managing Drawdown

Managing drawdown is just another way of saying managing your losses, and that’s a lot harder than you might think, especially if you’re a new trader, because a few bad trades can completely wreck your confidence.
Here’s the thing though: If you manage your risk well, you won’t put your account in jeopardy, even when you lose money on trades. That all goes back to only risking a small percentage of your total account balance on each position, having firm limits and a good understanding of the amount of loss you’re willing to endure before exiting, and sticking with your strategy, even when your emotions are going haywire.
Bear in mind that some trading strategies have more drawdown than others. If you tend to hold positions over a fairly long term, you can experience significant drawdowns. On the other hand, traders that tend to adopt positions held for shorter periods of time don’t see as much of a drawdown, but their strategies tend to be more difficult to execute well and consistently.


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Keeping Accurate Records!

All of this brings us back to good record keeping, and the importance of your trading journal. It is critical that you record as much information as you can in your trading journal, and the best way to capture as many of the details as possible is to record log entries as you enter and exit positions, or at the very least, at the end of each trading day.

Simply recording your account balances from one day to the next isn’t good record keeping, because that doesn’t capture any significant detail, and those details matter if you want to work out what you’re doing right and wrong, so you can make improvements.

Depending on how frequently you trade, keeping an accurate accounting of not just the numbers, but the analysis that guided your thinking, and what you were feeling, both when you made the trade and when you exited.

Fortunately, the software offered by all Brokers tracks all your trades, although the data may not be in an especially useable or accessible format, which means that you’ll want to grab what details you can from your Broker, and input them in your own spreadsheet, so you can capture whatever level of detail makes the most sense for you.

When putting your trading journal together, structure is important, so spend some time thinking about it. Remember, you’ll be wanting to capture more than just buy and sell values, but also the type of analysis you used, how it shaped your thinking, and your emotional state during the life of the position.

That’s a lot of different types of information, and how it’s presented is important in terms of making it accessible and digestible so you can make sense of it later on. After all, the whole point of the exercise is to help you improve your trading strategy. If you can’t make heads or tails of your own journal, it’s not going to help you much!

One way to get into the habit of making journal entries is to start your journal before you make your first trade. Granted, you won’t have any specifics to include, since you’re not actually trading, but you can still include your observations and analysis, recording the direction you think the market will move, and comparing with how it actually moves.

As to the actual format, here’s a good general guideline to get you started. Break your journal into the following functional areas:

  • Daily Prep Work
    What are today’s trading goals? This doesn’t have to be about making X amount of money – it could be just about making some incremental improvement to your strategy
    Today’s opportunities (opportunities you have identified based on market conditions and your analysis – the more detail here, the better!)
  • Daily Activity
    - Market Situation
    - Your thoughts, feelings and actions related to the situation
    - Consequences or outcomes (what happened as a result of your actions)
  • Daily Review
    - Did you achieve your goal? How and why?
    - On a scale of 1-10, how would you rate your trading performance today?
  • Losing Trades
    - Description of company, and position
    - What went wrong?
    - What can you learn from the mistake?
    - What will you do differently tomorrow?

    This is the kind of detail you’re looking for where your journal is concerned. This is task and action oriented, and will allow you to make consistent, incremental improvements. Try it for a week and see for yourself! You’ll be hooked, and your journal will quickly become an invaluable tool.

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Part 06 – Key Points To Remember

  • Learn to know and love your equity curve. Your goal, and a clear picture that you’re on the road to success is a smoothly rising equity curve.
  • Linear thinking will get you killed in the market. Markets do not move in a linear fashion, they move in cycles. The more quickly you embrace this truth, the better you’ll do.
  • Don’t get cocky. If you find early success in trading, don’t assume that’s the way it’s always going to be. You should be continuously monitoring the performance of your portfolio because that’s the surest indicator of how effective your trading strategy is. Be prepared to make rapid, decisive changes if things suddenly go south.
  • The only way your trading system improves is if you build a feedback process into it, and the most critical pieces of that are the records you keep and your trading diary. Don’t neglect these things, or you’ll seriously limit your own success!
  • In addition to recording your trades, be sure to not your objectives, results and emotions in your trading diary. This is something you should be adding to and reviewing on a near-constant basis.
  • Set process-oriented trading goals that you can control. As a trader, you never want to be in the position of trying to dictate to the market, because simply put…you can’t.
  • You should always know the statistics for your own trades (wins versus losses) without even looking it up. It should be at the very forefront of your mind, always, as this is how you identify where your system needs improvement.
  • New traders should focus primarily on two things: analysis and minimizing losses. Intermediate traders should add developing strategies for profit taking and making adjustments to position size (scaling in and out of positions), while advanced traders should be constantly tweaking and refining all aspects of their strategy.

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CHAPTER 7: Beware - CFD Trading Mistakes to Avoid