The Way to Trade. John Piper
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find trading a tough proposition.
In my own trading career I owe a great deal to Adrienne Toghraie for her help with my psychology, and to Adam Seccombe who is, even now, helping bring in further sums for me to manage.
Thank you to those who took the trouble to read the first draft of this book, especially Dr Alexander Elder who was kind enough to also write the Foreword.
Thank you, also, to the team at Financial Times Pitman Publishing who are responsible for the work you hold in your hands, particularly Richard Stagg, Iain Campbell, Elizabeth Truran and Heather Serjeant.
Thanks also to my family who bore the brunt of the difficult years before I learnt how to make money consistently.
Finally I must thank Karen for all her help with the book, not the least for soothing my troubled brow when I most needed it.
Chapter 1: AN INTRODUCTION TO THE TRADING PYRAMID
When we enter the trading arena we enter an environment unlike anywhere else. The rules we have lived by in the normal outside world no longer apply and, indeed, will cause us loss. Our very motivation can be our own worst enemy as we seek to extract money from the markets.
To succeed in the markets we need to put in place an entire structure, as we have put in place an entire structure (personality) in the outside world. The Trading Pyramid is just such a structure. But before I begin to explain how it works let me give you two examples of why our normal behavior and motivations are not going to help us in the markets.
Many people enter the markets because they have had a successful career or business life elsewhere. At this point they may feel a little bored with life and seek a new challenge. This is very normal, and the kind of stimulus all of us have felt at one time or another. But think about this for a minute. Such an individual, starting to trade, will probably, like many other traders, trade in a fairly haphazard manner to start with. I term such trading “emotional,” because whatever method traders may think they are using, the ultimate decision is more usually an emotional one. I will explain this in more detail later in this book. So the overall rationale can be described as “the person is bored and wants to trade.” So what happens the next time boredom sets in? Once able to trade, it is very likely that a person will make the emotional decision to do just that when bored. This timing is unlikely to correspond with a low risk trading opportunity; I will also be talking a lot about those later in this book.
So the first question traders must ask themselves is “Why do I trade?” The answer to that simple question may save you a fortune.
Now to the second example. In this modern world where we all seek gratification as and when we want it, what do we do when we are offered something nice? We take it. In the real world what do we do when something unpleasant comes along? We seek to defer it and hope that time may lessen its impact. What are these tendencies going to do in the market? They are going to mean you take profits too quickly and take losses too slowly. Yes, you will be cutting your profits and running your losses. What works in the real world does not work in the market. These are just two of the many reasons why all traders need the Trading Pyramid.
The Trading Pyramid
The Trading Pyramid is illustrated in Figure 1.1. Each level builds on the next and, indeed, is essential if the next level is going to be put in place. Each trader already has such a structure in place but if trading and losing then the pyramid needs to be re-built along the right lines – lines which are going to be fully explained in this book.
In this chapter my only aim is to introduce the overall concept and in succeeding chapters I will look at each level in detail. The first level is you. Obviously if you are not in place, do not exist, then it will not be possible to add further levels. But also you determine the overall structure, as you have to build something which suits your overall personality. As such, each individual trader will have a somewhat different structure, although I believe there will always be common features. Because of this, it is vital that traders each plough their own field. I often tell my consultancy clients that one of the major steps they must take is to learn to be disinterested in what I or anyone else says about the market. Because your trading structure is going to be different from mine or from anyone else’s you must learn to initiate and manage your own trades, nothing else is going to work. So already we can see how this model becomes useful – it gives us insights into the way trading works.
Fig 1.1 The Trading Pyramid
The next level is commitment. Trading is a tough business, in my view one of the toughest. And that is only right as it is also the highest paid in the world for the high flyers – so you would expect it to be tough. If you are going to battle your way through then you are going to need to be committed. But even if you get as far as reading this book then you are probably already committed. That means that you have already accepted that it is not going to be easy.
Next comes discipline, a key factor in trading markets. You have to learn about your own emotions and control them. This takes discipline. You need to develop a methodology that gives you an edge, and if you are going to use that you will need the discipline to do so. This brings in another point, because there are some things we can do and some we cannot. We do not need to make it unduly difficult for ourselves, so our methodology should be one to which we are suited, it should also be one in which we become expert. Once these two conditions are in place the ability to exercise discipline and to follow our systems becomes a lot easier, although the discipline itself remains essential. But this is an example of how the various levels of the pyramid inter-relate. Also this illustrates how the structure is organic and evolves as our trading skills and experience grows. Our methodology is, in part, a function of our experiences of different market strategies and our knowledge about ourselves and our own emotions. So as we (you) evolve, this creates a feedback loop to our system/methodology which also has an impact on the discipline level, and all other levels.
We have so far looked at the first three levels and these levels may be categorized as the “Personal” levels; they contain what we bring to the party. For the purposes of these three levels, we may never have looked at markets, may never have taken a trade. The next five levels have to do with developing our methodology. There are many books on trading which only deal with system design. Some only deal with analysis techniques – yet this is a tiny part of this game, forming merely part of one of the levels within the pyramid – that level being System Parameters.
Money Management (MM) is the first key feature of any methodology. Without appropriate MM policies nothing is going to work. A system with a 99 per cent success rate (which sadly does not exist other than in the physical sciences, an airplane with that success rate would not be very popular!) would still wipe you out if you risked 100 per cent of your capital on each trade. Similarly risking too little on such a system would produce much less than you might otherwise expect. Getting your risk parameters right is the first step, and this also has to be personalized. Most people fail because they put themselves under too much pressure, this produces excess emotion, and emotional trading is a losing occupation. There are two types of pressure of particular importance. The first is financial pressure; if you risk too much cash then you become “a fugitive from the law of averages”, and you will be wiped out, that is guaranteed. The second is psychological pressure, maybe as a subconscious realization of the financial pressure. Both of these must be avoided. Partly this has to do with experience, and partly with your risk parameters for each trade. I think that 1–2 per cent per trade is about right. You can still make lots of money but you need not feel pressurized. One of the “market wizards” said that almost all traders should immediately halve their trading size, that is good advice.
Next we have Risk Control (RC). MM and RC are interlinked. MM is essential, as set out above, but often MM policies include RC. For example using a stop loss point (mental or “in the market”) controls risk, but the amount of risk is an MM matter. To be a successful