Nowadays, there is a tendency among trading coaches to diminish areas outside the province of their expertise: those who specialize in psychology will claim this is the most important; those that deal with money management stress its critical role; others focus on the having of a written plan with an edge.
One reason I like Dr. Brett Steenbarger’s material is he stresses that often traders fail because they lack a coherent plan or because they fail to keep metrics of their results (TraderFeed) – and his area of expertise is psychology.
It seems to me that newbies fail to appreciate the nuances of the relationship between psychology, money management and trading plan. In this post, I am seeking to approach the subject from a different angle to describe the essential connections between the three.
Figure 1 is the Paradigm of Success.
FIGURE 1 Paradigm of Success
Success starts with the centre and the centre gives birth to the rectangle and the circle. The more we radiate away from the centre, the greater importance the factor plays in our trading success; at the same time, the closer we get to the centre, the more primary a role the factor plays.
On this view, the written trading plan plays the foundational role to our success. Unless it has an edge and unless it provides us with robust (i.e. repeatable over instruments and market conditions) entry & exit signals, psychology and money management have no role to play.
The plan gives birth to Risk Management: money management and trade management. Money management decided such issues as risk per trade, position size, portfolio risk, when to make our profits available for trading and when to reduce our capital because of losses. Trade management protects our open profits while allowing room for the market to fluctuate as it moves in our favour. I have suggested that the primary tool of trade management is the initial risk.
Risk management depends on our analysing the metrics of our trading plan. For example, knowing the plan’s Maximum Adverse Excursion; knowing the plan’s Maximum Favourable Excursion; knowing the plan’s Expectancy Return. Once the plan produces the data, Risk Management takes over to balance the maximization of profitability with minimizing Risk of Ruin. You can have the best trading plan in the world but it takes one breach of our risk management to send us bankrupt.
The circle surrounding the Plan and Risk Management is Winning Psychology. In my view, the chief function of Winning Psychology is the consistent execution of our trading plan and our Risk Management. A secondary role is to learn from our successes and failures. No matter how much of an edge our trading plan has and no matter how effectively our risk management rules optimize profitability, unless we execute both consistently they will be unable to produce their promised results.