The Path to Successful Trading

In the broad category of “trading the markets,” there are basically three types of
trading: discretionary, technical, and strategy-based. When I sat down to write this
book, my intent was to write only about strategy trading. But then I realized that
to fully describe strategy trading, it was also necessary to discuss discretionary and
technical trading. It’s important that you understand the difference between them,
which is not always clear. I’ve met many people who believe they are strategy
traders when they’re actually technical traders, and vice versa.
I have known and taught many traders, and have observed that there are four
distinct stages of trader education: discretionary trader, technical trader, strategy
trader, and complete strategy trader. All successful traders have gone through
them. It is almost impossible to be a successful strategy trader without going
through all of these stages. My goal with this book is to help you understand and
move through the stages at much less cost in both time and money.
Every trader usually starts out as a discretionary trader. The amount of money lost
generally determines how long it takes the individual to start using technical
indicators to make trading decisions. Eventually, as even employing technical
indicators fails to move the trader into profitability, the trader moves into the
third stage and starts to write strategies based on quantifiable data. It is at this
stage that the trader ordinarily starts to make money. Finally, the strategies and
money management approaches are refined and the individual becomes successful
as a strategy trader.

The Discretionary Trader

A discretionary trader uses a combination of intuition, advice and nonquantifiable
data to determine when to enter and exit the market.
Discretionary traders are not restricted by a concrete set of rules. If you are a
discretionary trader, you can make buy and sell decisions using whatever criteria
you deem to be important at the moment. For example, you can use both a
combination of hot tips and relevant news stories from The Wall Street Journal, and
enter or exit the market based upon this information. If you begin to lose money,
you can immediately exit the market and change your trading method. You don't
have to use the same techniques day in and day out. It's a very flexible way to
trade that you can customize based on what you think the market is going to do at
any given moment.
For the discretionary trader, trades are made using gut instinct and intuition.
Unless a computer is generating a buy or sell signal and you actually follow the
signal, your emotions will affect your trading. I explained in the introduction what
problems instinct and intuition could be in trading. Remember fear and greed? In
discretionary trading, technical tools such as indicators are sometimes used;
however, when they are put to use, they are utilized sporadically as opposed to
systematically.
Fascinated by the markets, the discretionary trader is ready to put on a trade at a
moment’s notice. The most uncomfortable part of trading for the discretionary
trader is when there is no action. So he will jump on any piece of information,
anything that will permit him to take a stab at the market. Above all, he craves
the action.

INTUITION & HOT TIPS

The discretionary trader uses several sources for his trading decisions. One is
intuition, for example, “I see a lot of people in stores, so I think the economy is
good, and earning will increase, so the stock market should go up, and I should
buy Sears.” He usually spends a lot of time talking to his broker. “What do you
think Joe, isn’t Woolworth’s going to turn around?” Another is reading and
watching the news, “Retail sales are looking strong and Woolworth’s is closing
stores to lower their overhead.”
Hot tips are a common way that a discretionary trader gets ideas. A call from his
broker or good friend, or a tip from a discussion at a cocktail party are all places
the discretionary trader gets his trading ideas. “Hey George, HTECH Corp. has a
hot new product in the works, here’s a stock you can pick up cheap.” If it gets dry
in the summer, our discretionary trader may decide to buy Corn, Beans or Wheat.
However, when he looks out the window and notices that it’s raining, he sells the
position immediately. A news story on the nightly news may cause a discretionary
trader to short the airline that has just had a crash.

CRAVES EXCITEMENT

What a discretionary trader loves is the excitement. He loves being “in the
markets,” playing with the big guys. He craves the risk, the excitement of trading,
and the gambling rush that he gets from calling his broker and putting in the
order to buy. He loves being able to sell Gyro Corp. based on the news story of
the health hazards of their top selling Gyrometer. He has a real obsession for
buying Cotton based on the hot tip from his broker that the upcoming crop
report was going to be bullish, and he covets the tip from his friend who called to
say that he just bought Techno Corp. because the latest quarterly earnings were
going to be a surprise on the upside.
Discretionary traders retain the flexibility of changing their buy and sell criteria
from moment to moment, and change they way they trade from minute to minute
and day by day. “Well, that last trade was a disaster, so tomorrow I will buy
McDonald’s only if it opens up from yesterday’s close.” They don’t have any
discipline, nor do they think they need any. They use their intuition and their gut
instinct, and feel justified in doing so. They think, “Making money is easy, you just
have to be smarter and quicker than the next guy.”
I personally don’t know anyone who has made money by discretionary trading.
They may have been lucky and won on a few trades, but overall, over time,
discretionary traders always lose money.
It is after enough money has been lost that the discretionary trader in some way
stumbles across technical indicators. It may be from the chart book he just looked
at where there was a Stochastic Indicator underneath the chart. Or he may have
gone to the latest Make a Million Dollars Trading the Stock Market seminar and found
out that using the Relative Strength Indicator is the sure way to stock market
profits. He thinks, “So this is how they do it!” These indicators look like magic.
They add some rationality to an otherwise irrational trading style. He thinks, “This
must be how the big money players make the big money—they use technical
indicators!”

DISCOVERS TECHNICAL INDICATORS

Once the discretionary trader discovers technical indicators, he or she
incorporates some rudimentary ones into trading, usually as additional
justification for making the trade. “Not only did Ralph (my broker) tell me to buy
Gizmo Corp. but Gizmo has great relative strength. Gizmo’s moving averages are
bullish, and the Stochastics are oversold and giving a buy signal as well.”
These newfound technical indicators give the discretionary trader a new lease on
trading. Now our trader has a whole new world in front of him—the world of
technical trading. For a while, this newfound world combines with intuition and
the discretionary trader views himself as a strategy trader. He says, “I trade a
strategy using moving averages and Stochastics with a dash of daily news and tips
from my broker. I am now a real objective strategy trader.” While the trader may
view himself as a strategy trader, this could not be farther from the truth. The
discretionary trader’s style is still undisciplined, based on newly educated guesses,
and he is probably still losing money.
For a moment, these technical tools were thought to be the answer, and while
they add a little more rationale to his trades, the losses continue to pile up.
Despite his continuing angst, our discretionary trader is now on the way to
becoming a technical trader.

The Technical Trader

A technical trader uses technical indicators, hotlines, newsletters and perhaps
some personally defined objective rules to enter and exit the market.
As a technical trader, you are beginning to realize that rules are important and that
it is appropriate to use some objective criteria such as confirmation before making
a trade. You have developed rules, but sometimes you follow them and
sometimes you don’t. It depends how confident you feel today and how much
money you are making or losing. If an indicator gives you a buy signal, you may
override it because your broker told you the earnings report was going to be
negative. Or maybe the bonds are up, which means interest rates are rising, and
you better see how high rates go before you commit more money to this already
overpriced market. You may think, “I have a profit, hmm, I just may take it now.
Even though the Stochastic is not overbought, the markets are tough. It’s not
easy to make money. Like my father said, ‘you can’t go broke taking profits.’ At
least now I have a winning trade. I’ll sleep well tonight.”
Our trader now begins to realize that using the intuitive and hot tip approach will
not lead to profitability. He now begins to focus on the technical indicators
themselves. There are so many! Moving Averages, Exponential and Weighted.
The MACD, Momentum, P/E Ratio, Rate of Change, DMI, Advance/Decline
Line, EPS, True Range, ADX, CCI, Candlesticks, MFI, Parabolic, Trendlines,
RSI, Volatility Expansion and Volume and Open Interest, just to name a few. So
much to learn and so little time!
This whole new world of technical books, seminars, newsletters, and hot lines
now begins to preoccupy our trader. He learns all he can about indicators. He
wants to find the one indicator that will ensure profitability. He surrenders to
what I call Indicator Fascination.

INDICATOR FASCINATION

The first assumption that our trader makes is that someone out there must know
how to do this. There must be an expert, someone who knows how to make
money, that has created the magic indicator to do it. This is the Holy Grail
syndrome and our trader now embarks on a search for the Holy Grail Indicator.
He knows intuitively that there must be an indicator that will give him the
information he needs to make profitable trades…that there must be teachers out
there that know how to make money trading. He thinks, “All I need to do is find
him and his indicators.”
This is the indicator fascination phase. How are indicators calculated, what do
they represent, and are they the “secret” to making money? All of these questions
need to be answered so he becomes a seminar junkie, travelling the country on
the quest for that great technique, the one that everyone uses to make the big
money. He visits Chicago one month…L.A. the next…followed by a visit to the
Chicago Mercantile Exchange. He watches the CNBC expert technicians and
surfs the net looking for that magic indicator.
Now he’ll only buy when the ADX is moving up and the MACD is positive, and
he’ll sell only when the RSI gets overbought and turns down. His trading becomes
more indicator-based and he listens less to his broker. For example, he may tell
his broker, “No, I won’t buy Apple Computer until the Earnings Momentum
Indicator is over 80!” Unfortunately, even with all of this information, and all the
assurances of his seminar leaders, he still is not making money. He even begins to
wonder if he will be able to continue trading with all of these losses. He thinks,
“If I could only control the losses, I will probably be able to trade a little longer
before my money runs out.”
It is at this stage that he learns the value of stop losses, known as stops. He learns
the importance of managing the risk on each trade. He gets a hint that there is
more to trading than just the indicator, and his ears perk up when people mention
the concept of controlling risk and conserving capital. He thinks, “I just want to
stay in the game, to keep enough money to make the next trade. I don’t want to
quit a loser!”
But even with the newly found indicators, and controlling his risk with stops, he
continues to lose money, although he also consummates some winning trades that
keep his capital from depleting too quickly. And here he has another major
revelation—markets can be trending or choppy. It is at this point that he realizes,
“If I could only predict the choppy markets, where I lose most of my money, I
could simply stay out of the market and get back in when it starts to make the big
move.” So he starts another quest, that of leaning how to predict choppy markets.