Making sure your daytrading plan works
In our article "Define your Goals and Make a Plan" you learned: How to define your financial and trading goals. How to select the right market for your trading goals. What timeframe you should trade in. The difference between trading styles and how to find the right one for you. How to create a basic daytrading plan. Now that you defined your goals and created your daytrading plan, you need to make sure it really works.
Thus far everything might look great, but how can you be sure that the day trading system works when you start trading it with real money? Evaluating a trading system is easier than you think. Below you'll find 10 Principles of Successful Day Trading Systems that we developed and refined over the last couple of years. You should use these Power Principles to evaluate your trading system, whether you developed it on your own or think about purchasing one. By checking a system against these principles you can dramatically increase the chances of being successful. Here we go: Principle #1: Few rules - easy to understand It may surprise you that the best daytrading systems have less than 10 rules.
The more rules you have, the more likely you "curve-fitted" your trading system to the past, and such an over-optimized system is very unlikely to produce profits in real markets. It's important that your rules are easy to understand and execute. The markets can behave very wild and move fast, and you won't have the time to calculate complicated formulas in order to make a trading decision. Think about successful floor traders: The only tool they use is a calculator, and they make thousands of dollars every day. Principle #2: Trade electronic and liquid markets I strongly recommend that you trade electronic markets because commissions are lower and you receive instant fills. You need to know as fast as possible if your order was filled and at what price, because based on this information you plan your exit. You should never place an exit order before you know that your entry order is filled. When you trade open outcry markets (non-electronic) you might have to wait a while before you receive your fill. By that time, the market might have already turned and your profitable trade has turned into a loss! When trading electronic markets you receive your fills in less than one second and can immediately place your exit orders. Trading liquid markets you can avoid slippage, which will save you hundreds or even thousands of dollars.
Principle #3: Realistic expectations Losses are part of our business. A trading system that doesn't have losses is "too good to be true". Recently I ran into a trading system with a whopping winning percentage of 91% and a drawdown of less than $500. WOW! When looking at the details it turned out that the daytrading system was only tested on 87 trades and - of course - curve fitted. If you run across trading systems with numbers too good to be true, then it's probably exactly THAT: Too good to be true. Usually you can expect the following from a robust trading system: · A winning percentage of 60-80% · A profit factor of 1.3 - 2.5 · A maximum drawdown of 10-20% of the yearly profit. Use these numbers as a rough guideline, and you will easily identify curve fitted systems. Principle #4: Maintain a healthy balance between risk and reward Let me give you an example: If you go to a casino and bet everything you have on "red", then you have a 49% chance of doubling your money and a 51% chance of losing everything.
The same applies to trading: You can make a lot of money if you are risking a lot, but then risk of ruin is very high. You need to find a healthy balance between risk and reward. Let's say you define "ruin" as losing 20% of your account, and you define "success" as making 20% profits. Having a trading system with past performance results let you calculate the "risk of ruin" and "chance of success". Your risk of ruin should be always less than 5%, and your chance of success should be 5-10 times higher, e. if your risk of ruin is 4%, then your chance of success should be 40% or higher. Principle #5: Find a system that produces at least five trades per week The higher the trading frequency, the smaller is the chances of having a losing month. If you have a trading system that has a winning percentage of 70%, but only produces 1 trade per month, then 1 loser is enough to have a losing month. In this example, you could have several losing months in a row before you finally start making profits.
In the meantime, how do you pay for your bills? If your trading system produces five trades per week, then you have on average 20 trades per month. Having a winning percentage of 70% - your chances of a winning month are extremely high. And that's the goal of all traders: Having as many winning months as possible! Principle #6: Start small - grow big Your daytrading system should allow you to start small and grow big. A good trading system allows you to start with one or two contracts, and then increases your position as your trading account grows. This is in contrast to many "martingale" trading systems that require increasing position sizes when you are in a losing streak. You probably heard about this strategy: Double your contracts every time you lose, and one winner will win back all the money you previously lost. It's not unusual to have 4-5 losing trades in a row, and this would already require to trade 16 contracts after just 4 losses! Trading the e-mini S&P you would then need an account size of at least $63,200, just to meet the margin requirement. That's why martingale systems don't work. Principle #7: Automate your trading Emotions and human errors are the most common mistakes that traders make.
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