Are You Ready to Trade Stocks? Part 2: Will You Be Able to Make It?

The second of a three part series about getting ready to trade stocks.

How will you know if you are profitable?
The next step on the trading journey.

Today's article is the second of three in a series by guest author Adrian Reid, private trader and founder of Trading System Life. You can also follow him on Twitter @TradingSysLife

How do know if my stock trading system is profitable?

Let's take a step back first and talk about trading strategy. If your trading systems are going to be profitable then they need to be based on sound trading strategies that actually work.

A trading strategy is simply an approach to the markets that is based on a sound understanding and hypothesis about stock market behavior. Here are some valid trading strategies with their associated hypothesis that you can consider:

  1. Fundamental analysis: Buying stocks that are undervalued and selling when they are above fair value provides an edge which is profitable over the long run.
  2. Trend Trading: Stocks tend to trend and these trends go on for longer than most people expect. It is profitable to identify trends early and hold until the trend turns around.
  3. Swing Trading: Nothing in the financial markets moves in a straight line. Most stocks swing above and below the primary trend with some consistency. These swings are profitable movements for nimble traders.
  4. Mean Reversion: When stocks are not in strong trending phases they tend to oscillate above and below some mean value. Positioning to profit from reversion to the mean is profitable for nimble traders.

    There are many other trading strategies, but you need to ensure your system is based on a sound trading strategy that really works, and not some mystical price forecasting technique derived from natural order, astrology, or hidden price time cycles that only special gurus can identify.

    Assuming your trading strategy is sound, you then need trading system rules which capture an edge in the market.

    What I find most commonly is that once people have figured out what their entry signal is, they see their signals coming up in the market and want to jump in - This is a mistake!

    The entry signal is just one small part of your trading system, and the trading system is just one small part of you trading plan.

    An entry signal does not a trader make!

    As a minimum, your trading system must have the 5 components listed below. Just like your trading strategy, each of these components needs to be based on a sound understanding and hypothesis about market behavior. The example provided is based on a stock trend trading system:

    • Trade Setup: Trade stocks which are trending smoothly and strongly over several months.
    • Entry Trigger: Enter after a small pull back in the primary trend to reduce entry risk.
    • Initial Stop Loss: Place initial stop just below the recent low to keep losses small.
    • Exit Rule(s): Exit when the stock clearly changes trend using a trailing stop as the indicator.
    • Risk Management Rules: Risk a very small fraction of the account on each trade so that each trade is insignificant and losses are emotionally easy to take.

    Whatever type of trading system you decide on, it must have a positive expectancy.

    Expectancy is the amount of profit you expect to make per dollar that you risk over the long run. You can measure expectancy with the following formula:

    Expectancy = Average of R over many trades where:

    R = (Exit Price - Entry Price) / (Entry Price - Initial Stop Loss)

    You can calculate your expectancy from your historical trades, from a back test using historical data, or from your paper trading results. Whichever method you use, calculate the value or R for each trade and then average it. The higher the expectancy the better. If it is negative you do not have a profitable trading system and you are not ready to trade stocks!

     Photo Credits:   Johner Images/Johner Images/Getty Images