The 3 Critical Elements to Being a Successful Trader

Before I define the 3 Critical Elements to being a Successful Trader, it is prudent that a distinction is made between "investing" and "trading."

Investing, by its very nature, can be defined as the activity of accumulating financial instruments and assets (often shares) on the premise that their collective value will appreciate over time. Trading on the other hand is the practice of utilising information and resources (both fundamental and technical) to buy and sell financial instruments purely for the purpose of profit.

Trading is often shorter term in nature than investing, hence the commonly referred to terms of "day trading" or "intraday trading."

In a nutshell, the 3 Critical Elements to being a Successful Trader are:

1. Finding a System to Trade; 2. Using appropriate Risk and Money Management Controls and; 3. Having the correct mindset (Psychology).

One cannot be a successful trader in the long term if any of these elements are missing or weak.

Let's explore each of these items at a high level.

1. Finding a System to Trade.

In trading, to be successful you require a trading "edge". Simply put, this means you need to find a way to trade where you either have more winning trades than losing trades, or your winning trades are bigger than your losing trades, so even though you may have more losing than winning trades, you will still be profitable in the long term.

For any system to be successful, you must also consider the timeframe you wish (or are able) to trade on and the type of system that best fits your risk tolerance. Could you trade a trend following system where only 3 in 10 trades were successful, but the winners were so much bigger than the losers, that the system was profitable overall? You need to be able to address these types of questions honestly if you are to succeed in the long term.

Also, it is best to focus on a particular way of trading when looking at systems. Broadly speaking, the 3 type of Systems you can trade are Trending Systems, Counter Trend Systems and Breakout Systems, because the market (whichever market or instrument you choose to trade) is always in one of the above 3 states.

Finally, a simple trading system is often more powerful and easy to follow than something that is overly complex and difficult to understand.

2. Risk and Money Management

Risk and Money Management is often overlooked in trading, and most people consider the terms interchangeable. In reality, Money Management is a subset of Risk Management. Money Management in its simplest form covers the amount per trade (or basket of trades) we are prepared to risk. Money Management should reflect the characteristics of the system traded, for example, if you know through research and back testing that a system is likely to have 10 losers in a row, it would be foolish to risk 10% of you account per trade, as you are most likely to wipe your account out at some point.

Risk Management, in the context of finding a system to trade, should look at things like the performance of a system over time. What is a systems maximum drawdown? What is the average Maximum Favourable Excursion (MFE) for a system, in other word its best hypothetical profit, and conversely what is its Maximum Adverse Excursion (MAE), its worst hypothetical drawdown? What is the Winning percentage of the system over time? What is the typical risk to reward ratio, meaning, for every dollar you are prepared to risk on a trade, what is the average return (profit) versus that dollar risked? This is often expressed as a ratio such as 1.2:1 where for each dollar risked; your average return in profit is $1.20.

Understanding all facets of Risk Management will help you better prepare to trade a system, and will give you a more realistic perspective on what to expect.

3. Having the Correct Mindset (Psychology).

Until you have traded, this might not seem like a big deal, but I believe this could be the most crucial factor of all!

Your ability to push the button and trade your system after taking a string of losers comes down to having the right mindset, and having belief in your system.

As humans we are often counter intuitive when it comes to trading by cutting our winners short (because our fear wants us to get out now with some profit before the market takes it back), and by letting our losers run in the hope that they will turn around, or psychologically, if we don't crystallise a loss, it isn't a loss and we have the "hope" that it will turn around at some point! Inevitably, this is why most traders fail.

If you can find the right system, apply the right Risk and Money Management control, and trade with the right mindset, you will be successful in the long term.