The following is a Guest Post by John Davies of SwingTradeSystems.com

Advice to New Traders: Know Your Terms!

The single greatest piece of advice I can give new traders is to get a firm grip on trader terminology.

I’m not talking about Sanku Patterns or STRIPEs, Box-Jenkins models or GMMAs. Not even the more familiar Bollinger Bands, MACDs, and ATRs that appear on many traders’ charts today. What such terms represent can all be learned in due course.

No, I’m referring to what comes before such details come into play. I’m thinking bigger picture, elementally and in abstract concepts. This is a great place to start and is perhaps my favorite topic to discuss with both novice and professional traders.

The Concept of Trading

Naturally enough, we call what traders do trading. Traders do this activity in different ways.

At one extreme, a surprising number enter the financial markets shooting from the hip. They’ll buy a stock based on rumor or because of gut feeling. As you can imagine, they don’t last very long. Unless you have a gambler’s disposition and wish to roll the dice with your money, this group shouldn’t be yours or anyone else’s model.

At the other extreme are a small number of successful traders who remain consistently profitable through the years. They each do this in different ways – really, there are as many ways to trade as there are traders. But there are certain things all professional traders share as well.

For the absolute beginner, the pertinent question to ask is not so much how professionals trade, but what to call it when they do.

A Lack of Standards

No, seriously. Think back to when you were just starting off and were researching into how traders trade. If it was within the internet age, you probably had the same experience many of my students complain to me about. What one trading site refers to as a trading technique, another calls a trading strategy. Where some say elements ABC go into a trading plan, others insist that you need XYZ in your trading system

Worse still, each self-professed expert combines these and other terms in their own unique way, which they then use to compartmentalize different aspects of their trading method. The novice is left scratching his head at the Google search box: what exactly should he type in to start his trading venture?

This lack of a terminological standard no doubt reflects the wild west of the markets. Most traders would say this is desirable, and I would agree. The more independent traders are – the less regulation they are subjected to regarding the way they conduct their trading – the better. These circumstances lend a greater efficiency to the markets overall.

Your Choice

My only argument is that you choose a way to express how you will conduct your trading early on and stick with it.

This is beneficial for a number of reasons. Not the least of which is that it makes you less anxious contemplating the enormous amount of information out there. It also puts you in the proper mindset right from the start, reminding you that you are in charge of your trading. As the professionals will tell you, taking ownership of your own actions is one of the keys to being successful. But so is remaining consistent in all that you do, which is what you begin to do when you consistently use trading terms.

My Choice

Here’s how I decided to think about the way I would trade, many moons ago. I opted for a simple conceptual architecture. It has an over-arching term that breaks down into five distinct, yet interrelated, terms.

Trading System Tree

I tell my students that since consistently successful traders all trade systematically, it’s reasonable to refer to their activity as a trading system. The specifics of that system, of course, vary from trader to trader. But I argue that any and all trading systems are built from the same five elemental components. I usually explain these five components to my students using a simple analogy.

I liken trading to traveling.

More specifically, I ask them to imagine going to a place they’ve never been. Mount Rushmore is always a safe bet. Once a popular destination, it’s not so much anymore.

The Trading Plan

Now, if I asked you how this trip would work out for you, you’d initially have only a general sense. But if you were really committed to taking this trip, each day that sense would become more and more detailed. Until one day it would be difficult to think of everything at once and you’d have to break your thoughts down into more manageable bits. That’s when you’d be forced to take more direct action.

A similar process occurs when someone decides to become a trader. The difference is that for the trader, it’s crucial to actively maintain these broad thoughts that span all else. Doing so gives you insight into how trading fits into the larger aspects of your life. Many professional traders will actually create a physical trading plan document that acts as an overview of the other components of their trading system. Here they record their motivations for trading, for instance, or their general attitude about risk and money. Even though much of this will be found in greater detail in the other components of their trading system, it is always beneficial to have a bird’s eye view of things.

The Trading Strategy

As the day of your trip approaches, you begin to sweat the details. If you decided to drive your car to keep costs down, what route will you take? Which CDs should you bring to help pass the time on the road? What happens if you get into an accident, or a highway is unexpectedly closed? You need to prepare for these and any number of contingencies that could arise.

The same with trading. You need to know the exact trading method you intend to use well in advance. When will you place a trade? Which ones? Once you’ve entered a position, how will you maintain it? When will you take your profits and cut your losses? Having a detailed trading strategy that lays out an actionable set of trading rules to strictly follow encourages you to maintain discipline and to trade emotionlessly. It also forces you to think through the curve balls that the financial markets inevitably throw at you.

Trading Resources

 Besides deciding to drive, you also need to decide on other necessities for the trip. You calculate the drive will take 3 days each way. That means selecting a route with affordable motels. You also need to consider what clothes, food and other items to pack. Obviously, there are many materials you’ll need to secure just to physically get there and back.

Likewise with setting out to trade stocks and other financial instruments. One thing all traders must decide on is the broker they will use. But you also need to consider where you’ll get your market data if what your broker offers is subpar. And how you’ll maintain your watch lists and log your trades for tax purposes. In short, you need to think through your trading resources – the physical means by which you’ll actually conduct your trades.

Backtesting/Paper Trading

As you are planning, strategizing, and procuring resources for your trip, you realize how it would be prudent to take your car out for an extended test drive. It’s an old car and you’re unsure it will make it. It’s a good thing you did, because you discover it’s in need of a major overhaul. During your trip, you also discover other things, like how the car seat gets uncomfortable after a few hour’s drive. So you purchase one of those wood-bead seat covers that taxi drivers use.

This is also the case with trading, where it’s crucial to test your trading system before you trade with it. You wouldn’t want to open an account with a broker the day you plan to begin trading, only to find it doesn’t provide the data feeds, charts, and screening utilities you want. Or that your computer network isn’t adequate to the type of trading you intend to do. Doing thorough backtesting and paper trading will reveal these problems and more.

Live Trading

The day of your trip finally arrives and you anxiously set out for Mount Rushmore. But you didn’t realize the highway you planned to take on day two is tolled. Having limited resources, you drive northward to take another highway. This means canceling your motel reservations and looking for new accommodations. This also means a longer trip, as it is no longer the shortest route. You learn an important lesson that day: for future trips, have backup plans for each leg of the trip, and understand how activating those backups will have a ripple effect on all the other legs.

This is much like what happens when you begin to trade with real money. You learn things here that you learn nowhere else. No matter how well you test, select your resources, strategize and plan, nothing quite prepares you for what the markets have in store. But regardless of whether these surprises fatten your trading account or draw it down, be sure to learn from them. Always use the unexpected as an opportunity to improve future iterations of your trading system. Live trading is not just the culminating point of a trading system. It is an important component in its own right.

In sum, this is the way I think of my trading activity: as a trading system composed of five components – a trading plan, a trading strategy, trading resources, backtesting/paper trading, and live trading. It is my conceptual roadmap and it works well for me. It brings me precisely where I want to go.

Happy journeys!

For a separate and in-depth discussion on each of these components and how they interact with each other, please visit www.SwingTradeSystems.com

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John Davies is a university professor living in western New York. He has been actively trading for the past 19 years. His recent focus: large cap stocks on the NYSE, NASDAQ, and TSX exchanges.