The Trading Journal

In order to succeed at trading, you must have an edge. Your edge begins with the knowledge you gain through your research and testing that a particular price pattern or market behavior offers a level of predictability and a risk to reward ratio that provides a consistently profitable outcome over time. Without it, one is just “playing” the market in order to have something to talk about on message boards. To get it, you have to know exactly what you’re looking for and what to do with it once you’ve found it. This process is what the journal is all about.

The journal goes through several stages depending on where you are. Once you’ve decided where you want to concentrate your efforts (at this level, the journal may resemble a diary), then you begin the process of developing a system (or method, strategy, procedure, whatever you want to call it). Here the journal takes on a different character. Once you’ve developed a tentative/preliminary system, you begin testing/trading it, and the journal adopts a still different character.

The first step is to decide what kind of trader you want to be.

* What do you want to accomplish with your trading? Is it recreational? Supplementary income? A part-time job? Do you want to make a living at it? Even the greenest of the green knows whether or not he wants to make a living at it, trade only part time, trade for recreation, trade for the action, trade to have something to talk about with other traders (for whatever reason), trade only long enough to earn money to do or buy X.

* Do you have any idea what sort of trading is most comfortable? Long or intermediate-term trading? Short-term trading? Day-trading? Trend-trading? Scalping? (Note here that a short-term trader, for example, does not become a long-term trader just because his stop was hit and he didn’t sell; a long-term trader doesn’t become a short-term trader because he chickened out and sold too soon. Each of these approaches are selected deliberately and for thoroughly-considered reasons.) How patient are you? How adventurous? Are you a leader or a follower (most people think they’re leaders)?

The second step is to decide what you’re going to trade and when you’re going to trade it.

* Have you found an instrument — futures, stocks, ETFs, bonds, options — that provides you with the range and volatility you require but also the safety that enables you to relax and trade in an objective and rational manner?

* Have you yet found a time (5m, hourly, weekly) or tick (1t, 200t) or volume (1K, 100K) interval that gives you enough trading opportunities but also gives you enough time to think about what you’re doing? If you want to limit your trading to the “morning”, are you physically and psychologically prepared to trade all day? If not, can you shrug off whatever opportunities you may miss by limiting the amount of time you spend trading?

The third step is to develop your system*.

A system consists of (a) a set of rules that you use to select profitable positions and (b) a set of rules that you use to manage the trade once you’re in it. (*Note: again, whether you call it a system, a method, a strategy, a plan, a scheme, an approach, a procedure, or a modus operandi is not as important as sitting down and doing it.)

* Developing a system begins with deciding just what it is you’re looking for. Therefore, begin by studying price movement in real time (or at the end of the day through “replay”, if your charting program offers it). By “study”, I mean to observe it with intent, not just read about it or listen to somebody talk about it. Note the conditions under which price rises, falls, drifts. Make every effort to avoid imposing your biases onto what you observe. You may see trading as a war, a competition, a game, or a puzzle. You may think you’re out to kill somebody, outwit somebody, or are out only to detect the flow and slip into it, riding the waves as if you were sailing. None of this should be allowed to affect what you observe.

* Develop a set of preliminary hypotheses which exploit the profit opportunities presented by these movements, e.g. price began trending “here”. Price broke out “there”. Price reversed “there”. What can I do to take advantage of that? What do I have to look for?

* Decide what strategy will best take advantage of what you think you’ve found. Are you looking to catch a reversal in the hopes that it will become a trend? Or are you looking to trade series of reversals within the day’s or week’s range? Or do you prefer to wait for a breakout and trade what may become a trend? Or would you rather wait for a retracement in what may be shaping up to be a trend? Limit yourself to only one strategy at the beginning.

* Carefully define the setup (the set of circumstances which you define which triggers an entry) which implements this strategy, preferably using old charts (attempting to define the setup by studying realtime charts is inefficient since you don’t yet know what it is that you’re looking for). This is called “backtesting”. All else flows from this. Unless you know what you’re looking for, you cannot test it, much less screen for it. If you have not tested it, you have no idea of the probability of its success. With no idea of the probability of success, any trades made are essentially guesses.

Therefore, focus on the setup. One setup. Determine its characteristics, find the markers of buying and selling interest, buying and selling pressure, buying and selling exhaustion. Define it so specifically and so thoroughly that you can recognize it without any doubt whatsoever in real time. Decide provisionally where best to enter, what the target ought to be, where the stop should be placed, and so on. Only after the setup is defined and tested (and it can’t, ipso facto, be tested until it’s been defined) can one even begin to think about trading it with real money, much less trading multiple setups. Attempting to shortcut this process merely expands the amount of time it will take to develop the necessary skills. Nothing is gained by painting the house before scraping it, cleaning it, and priming it since you’ll have to do it all over again sooner rather than later.

You are free to create your own based on whatever jingles your bells. You may, for example, focus on divergence. Or higher swing lows and lower swing highs. Or candlesticks of one sort or another. Or trendline breaks. Or base breakouts. Doesn’t really matter. What matters is that you keep four concepts in mind: demand/supply, support/resistance, price/volume, and trend. In this way, you can create your own setups which hundreds of thousands of other traders won’t be watching along with you. You must understand, however, that what determines the success of the trade is the trader, not the setup. If you’re looking for something that “works”, you may as well save yourself a lot of time and stop right here. What will “work” – or won’t, as the case may be – will be you.

* Forward-test what you have so far, again using old charts, preferably replaying them (if replay is not available to you, then scroll through them, bar by bar). In other words, “pre-test” the setup. Make whatever modifications are necessary to the setup, i.e., re-examine and re-define your strategy. Address risk management, trade management, money management in further detail. Determine the ratio of winning trades to losing trades (you will, of course, have to define “winner” and “loser”, which is where risk management and trade management come in). Determine the ratio of profit to loss. Determine the maximum loss. Determine the maximum number of consecutive losers.

Note that beginners often use “win/loss” to combine two separate considerations into one, and failing to keep them separate can create problems. One is win:lose. The other is profit:loss. Between the two, the “lose” and the “loss” have two distinct meanings. Win:lose refers to the ratio of winning trades to losing trades. Profit:loss means, expectedly, the ratio of profit to loss. You’ll read that the % of winners can be less than the % of losers as long as the winners are sufficiently profitable, one’s management is superior, etc. And, yes, theoretically, one can “win” less than 50% of the time if his profits sufficiently outweigh his losses. But if your real-time real-money test begins with a string of the losses anticipated by your backtest, you’ll be out of the game almost before it begins. In fact, one can be left high and dry even if his % of wins outnumber his % of losses, as mentioned above, if there is insufficient control of the amount of loss OR if the losses occur in sufficiently high numbers at the beginning of the trial.Then there are commissions and assorted trading costs to take into account, which is why traders who actually trade find that, without size, all the postulations about percentage don’t mean much in practice.

* Paper-trade this plan, in a simulated environment, as a semi-final test, until you are satisfied that it performs at least as well as it did during the previous testing phase. This may take several months or more depending on how many trials you perform. If your plan is not consistently profitable, go back however many steps are necessary to arrive at a potential solution.

* Trade the plan using real money in real time, spending only what is absolutely necessary on “tools” (currently — 2008 — this is SierraCharts with an IB feed) and trading the minimum number of shares, contracts, etc., allowable. If your plan is not consistently profitable, go back however many steps are necessary to arrive at a potential solution. Recalculate your win rate and profit:loss ratio on a continuing basis.

* If your plan is consistently profitable in practice, increase your size to what is a comfortable level, maintaining a continuous loop of re-appraisal and re-evaluation. When things come unglued, back up as far as necessary to regain your footing.

Novices rarely do any of this. They borrow something from somebody or somewhere and perhaps modify it somewhat, but they rarely go through the defining and testing process themselves. Some just try whatever seems like a good idea and hope for the best.

If one has absolutely no idea where to begin, there is nothing wrong with using a canned strategy IF it is used only as a point of departure. In other words, the canned strategy, regardless of what it is or what claims are made for it, still has to be tested, which often entails taking what is unexpectedly vague to begin with and defining it to a level of specificity that enables the testing to take place (it should come as no surprise that those who do go through the process succeed and those who don’t, struggle, often to the point of being driven out of the market). Examples of canned strategies that are reasonably well-defined include the Darvas Box, the Ross Hook, the Opening Range Breakout, O’Neil’s Cup With Handle, Dunnigan’s One-Way Formula. Some of these are more vague than others and will require considerable work on definition before they can be tested. But they serve as points of departure.

Wyckoff’s “hinge” is another setup, though not one which would be classified as “canned”, requiring as it does some sensitivity to trader behavior. The hinge is a type of “springboard”, in which price action firms, like Jello, another Wyckoff concept (the springboard, not the Jello), the idea being that something is getting ready to happen as a result of what bulls and bears have been doing to “discover” price. (The pattern people call it a coil or symmetrical triangle; the difference is that the hinge is the result of a particular dynamic between bulls and bears and can be expected to result in something; the coil is technically nothing more than a pattern, and can result in nothing at all but drift.)

This particular “setup” occurs when bulls and bears are struggling over price, and it can be seen everywhere from a tick chart to a monthly chart. There is first a wide discrepancy between what one side thinks is a fair price and what the other side thinks is a fair price. Since they disagree, the range narrows, the bars get shorter, trading activity becomes subdued, and eventually you close in on a point which is more or less a midpoint between the two extremes. From this, price will then move — often explosively — in one direction or the other IF the hinge is being formed in an important spot, such as a point just after the initiation of what promises to be an important trend.

The market always tells you what to do. It tells you: Get in. Get out. Move your stop. Close out. Stay neutral. Wait for a better chance. All these things the market is continually impressing upon you, and you must get into the frame of mind where you are in reality taking your orders from the action of the market itself – from the tape.

Your judgment will become poorer from the very time when you decide that you know more about the market than the market is telling you. From that moment your results will be unsatisfactory, for in this trading business the tape is the boss. You must learn to obey its orders, doing exactly what it tells you. When you can accomplish this, you are on the high road to success in your stock trading.

– Richard Wyckoff

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