BUILDING
CONFIDENCE
IN TRADING
ANALYTICAL METHODOLO GY WHICH FITS YOU
BUILDING CONFIDENCE IN TRADING
DailyFX Research Team
Table of Contents
Find an Analytical Methodology Which Fits You ........................................................................... 3
Have an analytical methodology & strategy which fits YOU ................................................................ 4
Risk management and understanding your tolerance for risk ............................................................. 7
Focus on the process, NOT the results ................................................................................................. 8
Have a plan for handling both the good and bad times ....................................................................... 9
Conclusion ............................................................................................................................................. 10
Disclaimer..................................................................................................................................11
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Find an Analytical Methodology Which Fits You
It’s no secret that having a firm grasp on the psychology of trading and understanding how you
respond to risk is one of the most important facets to successful trading. Confidence in the world of
trading is a big part of achieving success, as is the case with anything we do in life.
There are steps which a trader can take to not only build confidence, but maintain it as well. This guide
is designed with both the novice and seasoned trader in mind. New traders can use the concepts
outlined to help formulate a process and build a foundation, while those who have been actively
trading for a period of time can use these precepts to expand and refine an existing approach. Even
the most experienced traders need to have a routine for keeping themselves on the correct course.
At the end of the day, it all comes down to this – every trader must have a comprehensive game-plan
which covers the most important aspects of trading. You wouldn’t travel the world without a map,
why would you navigate the markets without a plan? Having a sound plan of attack will go a long way
towards providing you with confidence.
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Have an analytical methodology & strategy which fits YOU
What types of analysis and tools do you use to find trading opportunities? There is no one right or
wrong way to analyze and trade the markets. In our experience, there are countless ways to take
advantage of market fluctuations, and when you compare the methodologies of successful traders
to one another, no two are the same. There are certain ‘dos’ and ‘don’ts’, however, which have become
universally accepted rules. For example, buying a market into resistance or shorting it into support is
agreed upon by market veterans as a low probability approach. But in general, there are many ways
to find an edge, or advantage, and then trade it. Having an edge which resonates with you and
consistently applying it is the most important concept to understand here. If you can’t ‘own’ the
analysis you are using then it will be difficult to have the confidence needed to act on it.
Analysis generally falls under one of two categories – fundamental and technical. Some traders may
solely utilize one form, while others use a blended approach. Shorter-term to intermediate-term
traders (intra-day to several weeks) typically put more weight into technical analysis, while longerterm traders or investors may lean more towards fundamentals with lighter emphasis on the technical
aspects of the market.
Since the majority of short to intermediate-term traders place heavy emphasis on technical analysis
we’ll focus on that area of expertise. There are many forms of technical analysis and tools one can
use, which include simple price-based support and resistance, trend-lines/slope analysis, candlestick
formations, chart patterns (i.e. triangles, head-and-shoulders, flags, etc.), moving averages, Fibonacci
retracement levels, Ichimoku Clouds, sentiment metrics, Elliot-Wave Principle (EWP), Gann analysis,
as well as others. All viable tools or ways of looking at the market, but not all of them will be for you.
“Everything should be as simple as possible, but not simpler.” – Albert Einstein
A good rule of thumb to keep in mind when constructing your analytical methodology – keep it as
simple as possible. When it comes to market analysis more is not always better, more can just be
more. More noise. Using just a simple trend-line tool is not likely enough to find good trading
opportunities, but using ten different forms of analysis will be too much. The more forms of analysis
involved, the more complicated it gets, and the more complicated it gets the more likely you are to
suffer from paralysis by analysis; that is, you will find it difficult to make decisions due to information
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overload. A good rule of thumb is that every additional facet to an analysis approach should offer a
whole unique view of the market. If it is merely derivative of something already evaluated, its value is
marginal and may be so detriment as to give a false sense of diversification. Bottom line: You won’t
be able to act with confidence when you become overwhelmed by too much information.
What is your strategy(s) for taking advantage of the conclusions drawn from your analysis? The
strategies employed varies from trader to trader, and while one strategy may work for one person it
won’t work well for another. Two traders could draw the same conclusion, but have different ways in
which they use the information. For example, some traders are more comfortable trading breakouts,
while others are more at home when buying dips or shorting rallies within a trend. Other traders, yet,
prefer to trade range-bound markets by fading key levels of support and resistance. So, you have to
ask yourself what kind of trades do you trade best?
(Remember: There are lots of ways to make money in the markets, what is most important is that
whatever methods you choose are ones which give you the conviction (confidence) needed to make
good decisions.)
Every trade should have a plan behind it. Ask yourself – What is my reasoning for entering into the
trade, and does it fit my parameters? Where will I exit if wrong (stop-loss) and where will I exit when
right (target price)? The distance from your entry to your target should be sufficiently larger than the
distance to your planned stop. A risk/reward ratio of approximately 1:2 or better is a good rule of
thumb to operate off of (For more details, see the risk management section.)
Successful trading requires consistency. This can be especially challenging for the newer trader, as
you are still figuring out what works. It’s important to be consistent though in sticking with your
analysis and strategies, and not jump around from one approach to another at the first sign of trouble.
You can’t possibly build confidence if you are constantly changing your process. If after time you find
that you need to tweak an existing strategy or change to a different strategy because of poor
performance, then that is another story.
In addition to patience when trading a new strategy, it is important to trade it with reduced size until
fully confident. Losing as little as possible during the ‘test’ phase will help keep your objectivity, and
most importantly, keep you in the game by not losing too much trading capital. Capital preservation
should always be on your mind, and certainly have an impact on confidence.
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What time-frame(s) are you most comfortable trading? This is highly dependent on the individual,
but there are loose guidelines worth considering. Popular time-frames such as the 4-hr (hour) and
daily time-frame offer traders ample opportunity without all the noise that comes with shorter-term,
day-trading time-frames such as the 5 and 15-minute charts. Not that there is anything wrong with
day-trading, but keep in mind it is far more mentally taxing and time consuming. A majority of people
have a day job which puts a restraint on how much time can be spent in front of the screen. The 4-hr
and daily time-frame is very effective in this regard, and even professional traders tend to gravitate
towards these slower time-frames. These are not only good on time, but also ‘slow down’ the market
action, which allows you to better process information. Any time you can slow down the process you
will naturally feel more confident about what you are doing.
It’s also a good idea to stick with a limited number of time-frames, as it keeps your analysis simplified.
Looking at multiple time-frames for opportunities is a highly effective way to identify larger themes
which you can trade on short-term time-frames, but it’s still a good idea to keep it limited. For example,
you might identify a trend developing on the daily chart, but don’t want to hold a position for days to
weeks. In this case, you could dial in on the 4-hr chart to find short-term trading opportunities.
Know what markets you want to focus on. Focusing on finding the best opportunities in a narrowed
universe of markets will give you more confidence when it comes time to act. Not every market moves
the same, so knowing the nuances of how a market trades will help you act more decisively. By
reducing the number of markets in focus you will also help reduce the number of positions you hold
at once; too many positions can be a daunting task to handle mentally, even for the experienced
trader.
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Risk management and understanding your tolerance for risk
Having a game-plan for how you handle risk is more important than the analysis itself…you can’t
trade properly if you don’t know what your tolerance for risk is, and have a plan for managing it. The
amount of risk a person can tolerate is highly dependent on the individual. When a trader exceeds
their risk tolerance they lose objectivity and become far more prone to making mistakes.
Have a good understanding of the risk impacting the entire account. How much capital to trade with
varies from person to person and their personal financial situation. Know what you are comfortable
losing, first. This will help put your mind at ease and allow for focus to be placed on making good
decisions.
How much you will risk on each trade is a must know. When deciding this you have to assume there
will be times when you will have a string of losing trades, or a drawdown. If you have 5,6,7 or more
losing trades in a row, can you accept the accumulation of losses? Accepting the worst possible
outcome beforehand will help you keep your head in the game when faced with adversity.
“It's not whether you're right or wrong, but how much money you make when you're
right and how much you lose when you're wrong.” – George Soros
You should seek out opportunities which have good risk/reward ratios. A good rule of thumb is to
look for trades where you can profit twice as much if you are right than you will lose if wrong. Right
off the bat by striving for good risk/reward opportunities you reduce the percentage of the time you
need to be right. For example, excluding transaction costs, a trader who achieves a risk/reward ratio
of 2:1 only needs to be right ~34% of the time to achieve breakeven, whereas with a trader using a
low risk/reward ratio of say 1:1 has to be right 50% of the time just to achieve breakeven. By seeking
out more fruitful opportunities on a risk-adjusted basis, you alleviate the pressure of being right.
Here is a good question to ask yourself prior to entering any trade set-up: Can I accept the loss on
this trade if it doesn’t work, or will I be upset with myself for losing on a trade I should have never
been involved with in the first place? If you can confidently answer – “YES” – then it is likely you are
taking a trade which fits within your game-plan. You will be surprised by how many ‘bad’ trades you
will avoid by asking yourself that simple question. It’s worth noting at this time that a ‘good’ trade can
be unprofitable while a ‘bad’ trade can be profitable. Remember, this is a probabilities game, and over
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time you are far more likely to be successful if you take only ‘good’ trades and reduce the number of
‘bad’ trades.
How many positions can you carry at any one time without it impacting your judgement? As already
discussed in the previous section, limiting the number of positions will keep you focused. When
carrying multiple positions, it is important to know your total risk if all your positions were to reach
their stop-loss. You might be willing to take on one level of risk per trade, but realize with several
positions the risk is more than you are willing to accept. Understanding how the markets you trade
are correlated is very helpful. For example, if you are long or short three Yen-crosses, you effectively
have one larger position. The position size for each then needs to be adjusted accordingly to reflect
this.
Focus on the process, NOT the results
Easier said than done, right? The topics discussed in this guide are all about the process of trading
and having a game-plan in place which gives you the confidence to act decisively. One of hardest
aspects to trading is not thinking about the outcome, both the losses and profits. It takes patience,
but over time with a pointed effort you can build the discipline to only focus on the aspects of trading
which lead to the results, win or lose.
One method to help with staying focused on the process, is to use a checklist prior to entering a
trade.
What to include in your checklist:
•
What is my logic for entering the trade, and does it fit within my trading plan?
•
Where will I place my stop and target, does it allow for a good risk/reward?
•
Am I willing to accept a loss on this trade, and the risk associated with it?
•
Is this a trade I would take 10 out of 10 times?
You need to be able to answer “YES” to these questions. As we said in the last section, ‘good’ trades
can be losers while ‘bad’ trades can be winners. The success of a trade should not be solely defined
by what is in the profit and loss column.
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Keeping a journal is also a helpful way to stay focused on the process. It’s an effective way for
identifying what you are doing well (so you do more of those things) and what you are not doing well
(so you do less of those things). You don’t need to make an entry every day, but at least be consistent
in how often you journal.
Consistency
We have already mentioned how important consistency is, but it’s worth mentioning it again.
Inconsistency in your process will lead to inconsistent results. If you aren’t consistent with the types
of trades you take, how you enter and exit, position size, then you will find your results will have a high
level of variance; ultimately diminishing your confidence level.
Have a plan for handling both the good and bad times
Handling a drawdown: Drawdowns are a natural and unavoidable part of trading. As a trader, your job
is to make sure a ‘normal’ drawdown doesn’t become a ‘damaging’ one. It’s the damaging drawdowns
where not only does a trader lose significant trading capital, but also mental capital (confidence). The
faster you recognize you are not trading well or that your style of trading is not conducive for the
current market environment, the quicker you can limit the damage.
Get out of the fire! The first step is to stop the losses and take a break from trading, even if it is for
only a few days – and don’t worry, the market will be there when you come back. By stepping away
you are almost certain to feel better immediately. Once you have had time to clear your head, start
figuring out why you were performing poorly. Were you making a lot of silly mistakes by breaking your
rules? Are market conditions not conducive to your trading style? It often times is a little of both. For
example, some traders perform best during times when the market is trending strongly, but if the
market is range-bound they conversely struggle. Knowing this gives the trader a course of action, or
inaction. Not trading is a trade; it’s trading in taking on risk for capital preservation until market
conditions become more favorable.
It could even be a situation outside of trading which is affecting your ability to make good decisions.
You want to try and get to the bottom of that so you don’t compound your problems.
Once you have identified the cause of your drawdown and taken a proper course of action to fix the
problem, you can return to the market with a healthy mindset. You should do so gradually by trading
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with smaller size until you restore your confidence back to a level where you can properly execute
normal-sized trades again.
Handling periods of success: How a trader handles the good times can be just as important as how
the trader handles a drawdown. When you are doing well you are prone to becoming overconfident
and sloppy in your efforts. Keep this in mind – if you do not humble yourself, at some point the market
will do it for you.
If you are doing well, ask yourself – am I performing well because I am trading well or only because
the market environment is highly favorable? Profitability (results) can mask mistakes. Staying
focused on the process can help keep you on the correct course for longer periods of time, and delay
the inevitable drawdown. This is where the beforementioned ideas of journaling and the using a
checklist comes handy. Your journal will reveal what you have done well and not so well. The checklist
will help you stay on course to making ‘good’ trades and avoiding ‘bad’ trades.
Conclusion
Trading isn’t an easy business, but if you create a plan covering the most important aspects and have
certain measures in place for various circumstances which arrive as part of trading, you will
significantly increase your level of confidence; and ultimately this will increase the odds of achieving
success and enjoying markets.
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