Designing a Trading System That Survives Yourself
Second Level Thinking · Issue 23
How to build a personalised methodology and why discipline is the only thing standing between a small error and a total collapse.
First up, it’s been 12-months since our first issue of Second Level Thinking and I’d like to thank everyone for their support over the first year and 23 issues. We will continue to raise the bar, improve what we do and provide higher-level content. Your feedback is always welcome and be sure to share our content with others.
In our last issue we talked at-length on the U.S. economy and generated predictions for 2025, where we used mind mapping, storyboarding and other techniques to promote idea generation so you could start to define ways to express your ideas through a series of high-conviction positions.
In issues prior, we talked at length regarding position sizing strategies to optimise your risk-per-trade and ensure you continue to play the game. Not to rehash old ground but the Kelly Criterion and other models will far exceed the risk tolerance of many, especially when validating edge and building confidence in the markets. A good rule of thumb is to apply a 0.5% - 3% risk-per-trade allocation depending on experience to ensure you mitigate risk-of-ruin.
It is important to note that we typically trade our beliefs about the market, and once we’ve made up our minds about those beliefs, we rarely change them. Additionally, when we play the markets, we assume that we are considering all of the available information. Instead, our beliefs through selective perception, may have eliminated the most useful information.
Therefore, the more you understand the real nature of your edge, the better! Position sizing is the most important part of any system because it is through position sizing that you will meet your objectives or meet ruin. Your net results as a trader and investor over the very long run will be a function of the expectancy of your system less any mistakes that you make.
Based on feedback, many of you are starting to explore the correlation between your positions and define your entry and trade management through a series of rules, or defined strategies. So what is a trading system or strategy and how can you best build one? The late Dr. Van Tharp was a trading coach and psychologist and the author of a well regarded book titled: Trade Your Way to Financial Freedom, first published in 1998. Today we will use the framework from this book to start building out our own set of objectives and trading strategy, to further assist you along your way.
Starting Out
Most successful market professionals achieve success by controlling risk. Controlling risk goes against our natural tendencies and risk control requires tremendous internal control. We also know that successful speculators have success rates of 35% to 55%. They are not successful because they predict prices well but because the size of their profitable trades far exceeds the size of their losses, which again, requires tremendous internal control.
There are many behavioural fallacies that one may fall prey to, here are three that I deem critical when operating in financial markets:
Representation bias: People assume that when something is supposed to represent something, that it really is what it is supposed to represent. Thus, we assume that the daily bar chart is the market or that our favourite indicator is the market. Instead, we need to keep in mind that the representation is just a shortcut for presenting a lot of information, or even worse, a distortion of that information.
Reliability bias: People assume that something is accurate when it may not be. For example, market data that you use in your historical testing or in live trading is often filled with errors. Unless you assume that errors can and do exist, you may make a lot of mistakes in your trading and investing decisions.
Conservative-with-profits-and-risky-with-losses bias: People want to take profits quickly and give their losses some room. This gives them the illusion of being right, but what they are really doing is cutting their profits short and letting their losses run.
Self-Assessment
As always, we must start by defining what our objectives are and what we actually want to get out of the markets. Let's start with a series of questions to support this effort:
How much time during the day do you have to devote to trading?
When you are trading, how many distractions can you expect to have?
How much time do you expect to devote to developing your trading system, to doing your personal psychological work, and to develop your business plan?
What skills do you need before you begin this trading venture?
What do you know about statistics?
How would you rate your market knowledge?
What are your psychological strengths and weaknesses, especially in terms of trading system development?
How about your strengths and weaknesses in terms of personal discipline?
Do you tend to get compulsive (that is, do you get caught up in the excitement of trading), do you have personal conflicts (that is, do you have a history of conflicts in your family life, at your job, or during your past trading experience), or do you have any emotional issues that constantly crop up, such as fear and anger?
Based on your personal inventory, what do you need to learn, accomplish, or solve prior to beginning trading? How will you do that?
Spend time on this as your system needs to fit your objectives and broader beliefs. Most of you have jobs and are not looking to invest full-time, so don’t build a strategy that requires you to watch price action for 8 hours a day. That is simply unachievable.
Defining Your Objectives
Again, let's slowly work through a series of thought-provoking questions.
What is your advantage or edge in trading? What is the particular concept that you are trading that gives you an advantage?
How much money do you have personally? How much of that money could you afford to lose? For example, most funds stop trading at 50%. How about you? How much risk can you afford to take on a given trade?
How much money do you need to make each year? Do you need to live off that money?
What if you don’t make enough to live off it? Can you make more than you need to live off of so that your trading capital can grow? Can you stand regular withdrawals from your trading capital to pay your monthly bills?
Are you being realistic, or are you expecting to trade like the best trader in the world? For example, suppose you have a very good system that is right half the time and gives you profits that are twice as large as your losses. In that system, just by chance, you could still easily have 10 losses in a row. Your system is still working as expected, but you could easily have 10 losses in a row. Could you tolerate that?
Do you have the time to trade short term?
How much social contact do you need?
Can you work by yourself day after day? Do you need one or two other people around, or do you need a lot of other people around? How much do those other people influence you?
In summary, what do you expect to make each year as a percentage of your trading capital?
What risk level are you willing to tolerate in order to achieve that?
What is the largest peak-to-trough drawdown you are willing to tolerate?
How will you know your plan is working, and how will you know it’s not working? What do you expect from your system in various kinds of markets? Trending? Consolidating? Highly volatile?
This takes us into financial expectations, but more importantly, how you like to work which will differ for each of us. Spend time on this and jump ahead if you are stuck on a question - you can always revert back.
Trading Ideas
Now, when you observe the markets, what do you see and how do you see yourself operating within them:
What kind of markets do you want to trade? Is it appropriate to specialise? Do you want to trade only liquid markets, or are there some illiquid markets you’d like to trade?
Do you want any conditions to set up before you enter the market? If so, what are those conditions?
What beliefs do you have about entering the markets? How important do you believe entry to be?
Given your goals in terms of returns and drawdowns, what kind of initial risk stop do you want? If it’s close, will you be able to get right back into the market so that you will not miss a move?
How do you plan to take profits? Reversal stops? Trailing stops? Technical stops? Price objectives? Contrary to popular opinion, much of your emphasis should be in the area of stops and exits.
What do you do in terms of position sizing?
I just want to call out, this is probably getting beyond the reasonable expectation that many of you can answer all the above questions immediately - that’s the point! This is going to take time, as you will need to conduct an exploratory phase, where you seek to form responses to these questions before proceeding into executing a strategy with meaningful size.
Developing A System
Now we have established our broader objectives, understand the time allocation to meet those objectives, and have thought more deeply about what markets we are interested in trading, let’s explore our system development more specifically.
Take an inventory – spend a decent amount of time answering the questions listed above (set your objectives). In addition, ask yourself the question: who am I? Sit down with several sheets of paper and start writing free flowing notes about you – who am I really and what do I believe? 100 beliefs should give a reasonable idea.
Develop an open mind and gather market information – when something conflicts with what you know or believe, think to yourself, “is there any chance that this is a more useful belief?”
Determine the concept that you want to trade – trend following, band trading, value trading, etc. As an example, ask yourself questions like – trend following: how will I spot trends? How will I know a market is trending? Will I be trading trends on the upside and downside? What will I do when the market goes sideways? What will my entry criteria be? How will I handle corrections? How will I know when a trend is over? Band trading: how do I find range bound markets to buy? Will my bands work in a trending market? How do I define range – should I use fixed or static bands? What if my bands breakdown – how will I exit? Do I exit at the other end of the band and under what criteria?
Determine the big picture.
Determine your time frame for trading – advantage and disadvantages of both long-term and short-term trading.
Determine the essence of your trading and how you can objectively measure it.
Determine what your initial 1R risk will be. (We talked at length about this here).
Add your profit taking exits and determine the R-multiple distribution of your system and its expectancy. Determine the accuracy of your R-multiple distribution.
Evaluate your overall system.
Use position sizing to meet your objectives.
Determine how you can improve your system.
Mentally plan for the worst-case scenario.
Trading Strategies
I suggest you do some form of mental scenario thinking as the basis for trading – track your big picture and trade two or three systems that develop from the patterns that emerge and think about how you will monitor your big picture. At a minimum do a monthly review of the major factors influencing the markets and measure the potential impact to the way you trade. Some comments that will help:
Reliability or what percentage of time you make money. For example, do you make money 60% of your investments and lose money on 40% of them?
The relative size of your profits compared to your losses when traded at the smallest possible level (that is, one share of stock or one futures contract). For example, the relative size would be the same if you lost $1 per share on losing trades and made $1 per share on winning trades. However, the relative size would be quite different if you made $10 per share on winning trades and only lost $1 per share on losing trades.
Your cost of making an investment or trade. This is the destructive force on your account size whenever you trade – execution costs and brokerage commissions.
How often you get the opportunity to trade. Now imagine holding the first three values constant. Their combined effect would depend on how much you trade.
Your position sizing model or how many units you trade at one time (that is, 1 share of stock versus 10,000 shares of stock). Obviously, the amount you win or lose per share is multiplied by the number of shares you trade.
The size of your trading-investing capital. The effect of the first four variables on your account depends significantly on the size of your account.
The first four variables are part of expectancy. The last two variables are part of the “how much” factor or position sizing. One of the real secrets is to think in terms of reward-to-risk ratios. Your position size on any given trade must be low enough that you can realise the long-term expectancy of your system.
Expectancy & Protecting Capital
The best and most accurate way to calculate the expectancy of your trading system is if you know your R multiples for each trade. Your expectancy is simply the mean of your R multiples, it’s that simple. Lastly, you need to evaluate your opportunity to obtain your expectancy. How many trades does your system make in a year? Multiply that by your expectancy and you’ll have some idea what to expect per year from your system in terms of R.
Once you have a large enough sample to feel you have adequate representation of your trading system’s R multiple distribution, consider:
How much you’d risk on each trade.
The result of the trade on your equity.
Your psychological response to each trade.
Do this at least 100 times and remember expectancy and probability of winning are not the same thing and even with a high positive expectancy you can still lose money if you risk too much per trade.
Your protective stop has two main functions: (1) it sets the maximum loss that you’ll likely take in your position (R), and (2) it provides a benchmark against which to measure subsequent gains. Consider going beyond the noise when you set your stops. This can be done by setting stops that are several times the ATR, by using dev-stops, or by determining the MAE and going beyond that.
Tight stops have an advantage of creating large R multiple winners and minimising losses. However, they have the disadvantage of reducing reliability and greatly increasing your transaction costs. In my opinion, you do not have a trading system unless you know exactly when you will get out of a market position at the time you enter it.
Remember, R is the amount that you would expect to lose on a trade when you need to get out and preserve your capital. If you haven’t predetermined R for every position that you take in the market, then you are just gambling money away.
Based on initial belief, a trailing stop will form part of your exit strategy. Exits assist in determining if you profit or lose and control just how big that profit or loss will be. There are four general categories of exits – exits that make your initial loss smaller, exits that maximise your profits, exits that minimise how much profit you give back, and psychological exits. My recommendation is to use multiple exits as a strategy to assist in meeting the objectives of your trading system.
Woah, that was a lot, I know. Move up and down through the document and try and keep-up some momentum with it. For those that want to see example responses, or want further templates to support this effort, please DM me. And well done on continuing this journey - you are putting in the work.
Parting Shot
"Failure is rarely the result of some isolated event. Rather, it is a consequence of a long list of accumulated little failures which happen as a result of too little discipline. Failure occurs each time we fail to think ... today, act ... today, care, strive, climb, learn, or just keep going ... today. If your goal requires that today you write ten letters and you write only three, you are behind by seven letters ... today.
If you commit yourself to making five phone calls and you make only one, you are behind by four phone calls ... today. If your financial plan requires that you save ten dollars and you save none, you are behind ten dollars ... today. The danger comes when we look at a day squandered and conclude that no harm has been done.
After all, it was just one day. But add up these days to make a year and then add up these years to make a lifetime and perhaps you can now see how repeating today's small failures can easily turn your life into a major disaster."
— Jim Rohn
