What does it take to become a consistently successful trader? It takes having a clearly defined trading methodology and the discipline to follow it, money management rules, patience, and realistic expectations. Lacking even one of these elements will not only make it impossible to succeed at trading, but it will also hurt your bottom line.
Let me give one example to show why discipline is important. By discipline, I mean the ability to stay with your trading plan rather than to follow the crowd, which loses money by buying at high prices and selling at low prices. At the end of 2009, the Wall Street Journal did the research to find out which stock fund had been the most successful from 2000 through 2009. The article noted that the best performing mutual fund of the decade was CGM Focus fund, which rose 18.2 percent annually (“Best Stock Fund of the Decade: CGM Focus” by Eleanor Laise, December 31, 2009).
With this remarkable return, an investor could have seen $100,000 grow to more than $500,000 over the 10-year period. Unfortunately, the average CGM Focus investor lost 11 percent annually, according to MorningStar, Inc. In other words, an initial $100,000 investment dwindled on average to just over $30,000.
How could the average investor in the best performing mutual fund of the decade lose money? Chalk it up to the herding impulse of investors, wrote Robert Prechter in the April 2011 issue of The Elliott Wave Theorist. Each time the fund’s returns surged, investors would dump money into the CGM Focus fund hand over fist. But when the fund’s returns sank, investors could not take their money out fast enough. Astounding as it may seem for investors to lose money in a bull market, it is the all-too-familiar reality of trading.
That is why it is wise to follow basic risk management rules. Many successful individual traders limit their risk on each position to 1 to 3 percent of their portfolio. If we apply this rule to a $5,000 trading account, then the risk on any given trade is limited to between $50 and $150. The guideline that we recommend for risk is to keep your risk-reward ratio at a minimum of 3:1. That is, if your risk on a given trading opportunity is $500, then the profit objective for that trade should equal $1,500 or more. (Remember, even though it is called a risk-reward ratio, the ratio is conventionally stated with the reward figure first. This explains why a 3:1 risk-reward ratio is desirable. It is actually a reward-risk ratio.)
Even with a methodology, discipline, and money management techniques, impatience can destroy your trades. How do you overcome the tendency to be impatient? By understanding the two triggers that cause it: fear and boredom. The first step in overcoming impatience is to consciously define the minimum requirements of an acceptable trade setup and vow to accept nothing less. Next, feel comfortable in knowing that the markets will be around tomorrow, next week, next year, and many years after, so there is plenty of time to wait for the ideal opportunity. Remember, trading is not a race, and overtrading does little to improve your bottom line.
If there is one practice that will improve your trading skills, it is patience. Be patient, and focus on trading textbook wave patterns and high-confidence trade setups like the ones we have described in this book. When it comes to being a consistently successful trader, it’s all about quality—not quantity.
Consistently successful trading is not easy; it’s hard work. If anyone suggests otherwise to you, then run the other way—and fast. That hard work, though, can be rewarding. Above-average returns, the sense of satisfaction, and the feeling you get after hitting one out of the park is priceless. But you must be realistic about it. Remember what I wrote at the beginning of this book: An excellent example of a realistic expectation for a trader in his or her first year should be to avoid losing money. If you shoot for a 0 percent return and achieve it, then you are ahead of the crowd and well on your way to becoming a consistently successful trader. In year two, try simply for a 5 or 10 percent return.
Trading is personal. It’s all about you and how much anxiety (on bad days) or satisfaction and elation (on good days) you can handle. Knowing who you are as a trader, understanding your role in the trading equation, and learning how to control your emotions will ultimately determine your success or failure as a trader. Using Elliott wave analysis can help provide the structural template that may help keep your head clear once you have initiated a trade and the market is moving fast; however, it cannot protect you from your emotions. They will become powerful adversaries when your own money is involved. Just re-read some of the trading examples in this book to understand what I mean.
To learn more about the importance of methodology, discipline, money management, patience, and realistic expectations, I highly recommend The Disciplined Trader by Mark Douglas and Super Trader by Van K. Tharp, PhD.
Each trader has a trading style. For instance, I like to take a somewhat risky posture. I prefer to use Elliott wave patterns to set up my trades as early as possible in anticipation of a trend change rather than waiting for further confirmation. In other words, I look for the best level and the tightest protective stop possible in lieu of waiting for evidence that the trend has indeed changed.
In anticipating where the market is headed, I am willing to take the risk that sometimes I will be wrong. If I were going short, I would rather go short at a high level with my stop just above the recent high, even if I were not certain that the trend had actually turned down. I do not like waiting for confirmation and then going short at a lower level with a stop that incurs greater risk, even though I might be more certain that the trend has turned.
This approach depends on accumulating enough evidence to support the case for an imminent trend change. Others who have a different trading style will argue that it is best to wait for an impulse wave in the opposite direction that decisively breaks a trend channel or major trendline of the previous pattern. That is a valid strategy, too. In deciding between these two approaches, is it simply a matter of personal risk tolerance, or can one make an analytical determination which to use? The answer is “Yes” to both questions. Let’s look at an example.
In Figure 9.1, we have identified a Fibonacci cluster that satisfies three key Fibonacci relationships at the market’s current level. In this type of situation, I would go short with a stop one tick beyond the beginning of wave (1). Why does this seem risky despite the evidence? To use courtroom jargon, the evidence is only circumstantial. No smoking gun suggests that the trend has changed, although some strong evidence suggests that it will.
I could have made a mistake. If the trend has not changed, what might be the correct wave count? It is possible that the low on the chart (see Figure 9.2) completed wave (C) of an expanded flat, so the market is trending to the upside in wave 3 of wave (3). I have seen this scenario play out a number of times. For those who are somewhat risk-averse, Figure 9.3 offers an alternate strategy.
You could wait for an impulse wave to the downside that breaks the lower line of the trend channel formed by the wave (2) zigzag. Then go short in wave [i] of wave 3 of wave (3), when it breaks the trend channel formed by wave 2. Without strong evidence that a turning point is near, it would be prudent to wait for further confirmation, as illustrated in Figure 9.3. Using this same logic, you would wait for a break of the B-D trendline of a triangle and wait for a break of the 2-4 trendline of an ending diagonal.
When I traded for a living with my own capital, people used to ask me, “What tools do you use besides Elliott wave?” I always replied, “I use anything I can get my hands on, if it makes sense.”
Using other technical indicators can help reinforce your Elliott wave analysis or warn you that something is wrong with it (see Chapter 6). Technical indicators fall into three categories: sentiment (measures of investor psychology), momentum (changes in price, breadth, and volume), and patterns outside of Elliott wave (such as time cycles and head-and-shoulders formations). Just keep it simple and use what works best for you. Using a large array of indicators can be more of a hindrance than a help.
Finally, keep in mind that our knowledge about Elliott wave analysis is still growing. What we know about wave patterns is fascinating and useful, but there will always be more to discover. You do not have to wait for someone else to make a discovery. As you analyze and trade, see if you can add to our body of knowledge.
