If you are losing money in the markets or having a large drawdown in capital it could be a good idea to go back and return to first principles.
First principles are the core concepts or accepted foundation of beliefs that a theory, process, system, or methodology is based. Profitable trading comes from using the right principles and process over time, not opinions, predictions, and just being good at it.
Here are the core first principles of profitable trading.
- Creating good risk/reward ratios at entry. Your potential reward should be two or three times greater than your risk of loss.
- Using stop losses on each trade to limit a loss on a trade if you are wrong. This keeps losses small.
- Position sizing to consider the risk and volatility of each trade. Position size limits the size of your losses.
- Backtesting a price action strategy to see if it would have been profitable in the past. It doesn’t guarantee future success but it can show you what will not work.
- Understanding the potential drawdown in capital for your system from your equity peak. You must be able to handle your maximum drawdown mentally and emotionally.
- The return on capital you are trying to achieve during the time frame you are focused on. Your goal for returns will help you set your trading parameters.
- Your winning percentage expectations versus losing trades. Your expectancy of winning trades helps you accept that losing trades are just part of the process.
- Your losing streak probability based on your historical win rate for your worst case scenario of consecutive losses. You need to know the odds of a losing streak so when it happens you won’t think your system stopped working.
- Managing your risk of ruin by limiting your open risk and position sizing to eliminate the chance of eventually blowing up your account.
- Setting high probability profit targets to see if the maximum potential reward is worth the risk.