How do you become a profitable trader?

A trading system with a positive expectancy is the fastest path to profitable trading. A trader’s focus should not be on predictions, stock picking, opinions, or being right all the time. The best focus is creating a quantified system with a repeatable edge that creates small wins, big wins, and small losses that average out to profitability over time. Removing big losses from potential trading outcomes can be the best thing you do as a new trader to get on the right path to making money over time.

A positive expectancy means that you make money when you average out all the wins and losses. It means you divide your total profits by your total trades and have a positive outcome on average. You expect that if you place a certain amount of trades, you will be profitable at the end of a long sequence of entries and exits.

Positive expectancy could be the most important part of your trading. For every trader, no matter what trading method they use on any timeframe, they have no edge and likely have no long-term profits if they don’t have a positive expectancy trading model. Before traders start putting money at risk, they should know if the trading system they use has a positive expectancy. Without having a positive expectancy system to trade that fits your risk tolerance and return goals, your trading psychology and risk management don’t matter. You lose money slower if you use good position sizing and the right mindset on trading a system with a negative expectancy or high risk of ruin. There are no profits if you have no edge.

Knowing we have a positive expectancy means we have done enough homework, backtesting, and validation to show ourselves our trading system will create profits over the long term based on our signals, win rate, and risk/reward ratio. The first part of successful trading is the research to validate your system. This is a lot of work and effort and why most traders don’t make it as they want easy money, not to do hundreds of hours of work. The win rate is not what created a positive expectancy; the size of all the wins and losses combined creates the expectancy. You can have a profitable low-win rate system due to a few huge wins and many small losses. Big losses are the primary factor that creates a negative expectancy system. The first step to creating a positive expectancy system is removing big losses from your system, and the second most important is to let your winners run. This is the job of your entry signals, exit signals, position sizing, trailing stops, and profit targets to create small losses or big wins.

So how can you calculate a trading system’s positive expectancy?

E(R) = (PW x AW) – (PL x AL)

where;

E(R): Expectancy/ or Expected Return
PW: Probability of winning
AW: Average win
PL: Probability of losing
AL: Average loss

Positive Expectancy is a positive “E(R)”

This is the first step in a new trader’s journey, not something they do later. After a trade entry, many positive expectancies emerge from trade management, with stops to minimize losses and trailing stops to maximize gains.

How do you build a trading system?

The second step in a new trader’s journey is creating a quantified system with an edge that fits their beliefs about the market, risk tolerance, and available screen time. A good trading system allows the opportunity to reach realistic profit goals.

A trading system is a set of rules that quantifies buy and sell signals, as demonstrated by successful testing on price history or chart studies. A trading system is the specific data or knowledge used to execute a trading method based on price action or fundamental valuations. These signals are triggered by charts’ measurable technical indicators or meaningful price levels. Trading systems have specific parameters relating to position sizing that manage risk and increase the probability of profitability over time. A trading system has at least eight quantifiable metrics:

Watchlist parameters
Entry signals
Exit signals
Win rate
Risk to reward ratio
Position sizing parameters
Maximum risk exposure
Volatility filters

A price action trading system uses new price data to make buy and sell decisions on a watch list of markets. A price action trading system uses entry and exit signals with an edge by creating good risk/reward ratios that lead to profitable trading. There are five primary components in a trading system.

You will need a watch list; depending on what markets you trade, this list could be futures, forex pairs, ETFs, cryptocurrencies, or stocks. The items on your watch list should have good liquidity that creates tight bid/ask spreads that limit slippage. Your watch list can be filtered using fundamentals but should only be traded using price action. It’s a good practice to trade markets that historically have had good trends in the past and consistent, repeatable price patterns over the long term.

You need to backtest your watch list and study the historical price action patterns to find signals that have created good risk/reward ratios in the past. When you enter a trade, your initial stop losses triggered will create a small loss if the trade doesn’t work out, but your trailing stop and profit target will create a big win if it does.

To manage the size of your drawdowns and eliminate your risk of ruin, you must set guidelines for position sizing based on the historical and implied volatility of the market you’re trading. Also, you must consider the correlation of your positions and set parameters of how many open positions you can have if they move together or are diversified.

A good trading system can have diversified trend-following strategies, swing trading entries, and dip-buying signals. This can help smooth the equity curve through different market environments.

The trading system you choose must fit your risk tolerance and have the potential to meet your return goals. You must understand your edge and believe in the trading principles that will make your system profitable over the long term. You must mentally and emotionally deal with the inevitable drawdown it will have when a market environment changes and have the perseverance and patience to trade it with discipline over the long term to achieve profitability.

10 Profitable Trading Metrics

Here are the ten metrics to focus on in your trading system. These will be understood through backtesting, chart studies and real-time results tracking.

Here are ten essential metrics I look for when I trade that give me a profitable edge. These are based on math, not belief or ego.

  1. The expected win versus loss percentage. Your winning percentage performance is the first step to profitability.
  2. Average win size. The higher your winning percentage, the smaller your wins can be. The smaller your winning percentage, the bigger your wins must be to make you profitable.
  3. Risk versus reward ratio. Risking little for a high probability chance to make a lot should be your focus.
  4. Historical performance of entry signals. You must have an understanding of how your entry signals did in your time frame in the past.
  5. We are exiting trades in a way to maximize gains. Using trailing stops and overbought/oversold oscillators for price targets helps maximize profits.
  6. Proper position sizing. This keeps losses from being over 1% of total trading capital. Not having significant losses is a big step toward profitability.
  7. Limiting total risk exposure at any one time of total trading capital. Eliminating large drawdowns and the risk of ruin is the first thing a trader must do.
  8. The frequency of your trade entries is essential. When you start trading, will there be enough trades to make your system work? Will there be too many signals that lead to lowering your win rate or over-trading due to a watchlist that is too big?
  9. Consider market volume. Does the volume in the markets you want to trade keep the bid/ask spreads tight to avoid considerable slippage? This is especially true for options markets, over-the-counter markets, altcoins, or trading systems that are not scalable.
  10. Hope for the best, but plan for the worst. What are your expectations for maximum drawdowns in your trading capital? Can you handle it emotionally and mentally?

Top Ten Metrics of Risk Management

The third thing to understand as a new trader is that risk management determines your profitability and risk or ruin. Regardless of its expectancy, the results of your trading system will have more to do with your risk management than anything else.

Here are the top ten metrics you must consider when creating your risk management strategy.

  • Your position sizing should be based on the projected worst-case scenario for a trade.
  • Let market volatility and the trading range determine your trade size.
  • Your stop loss has to be set at the price level that should not be reached if your trade is going to work out.
  • Every trade has to be considered for the risk/reward ratio. Your stop loss creates the risk for each trade, and your potential profit target creates your potential reward.
  • Never lose more than 1% of your total trading capital on any trade. This is the amount lost if your stop loss is triggered based on your position size. 1% doesn’t refer to the movement of price.
  • Holding positions that are diversified and not highly correlated can lower your total open risk as they don’t usually move together.
  • Trading liquid markets can lower your risk of being trapped in a trade you can’t get out of when you want to. Liquidity is the most important fundamental. Penny stocks and out-of-the-money options can present liquidity risks for retail traders due to large bid/ask spreads.
  • Never trade so big that your ego and emotions become so loud you can’t hear your trading plan. A trader’s loss of discipline can be the biggest monetary risk.
  • Trade smaller and smaller during losing streaks in both position sizing and amount of open positions until a winning streak begins.
  • Manage your drawdown in capital carefully; don’t let it lead to mental ruin as a trader. You can come back from lost capital, but you can’t come back from losing your nerve.

10 Trading Psychology Rules

Finally, it’s crucial to understand that the trader is the weakest point in any trading system. Managing your thoughts, emotions, and ego will determine your long-term success or failure in the market.

  • Never trade so big that you watch every price tick even though you are not a day trader.
  • Don’t trade so big you dramatically increase your pulse rate, your leg shakes, or you get the sweats.
  • Each trade should only be one of your next one hundred. Never risk more than 1% of your trading account on one trade based on your stop loss. This should allow you to keep the proper perspective on any trade outcome.
  • Don’t spend time obsessing over market hindsight. All you can focus on is following your system in real-time.
  • Forget about your last trade and focus on your next trade.
  • Losses should be lessons that you paid to learn. Look at drawdowns in the capital as tuition and not failure.
  • If you followed your trading strategy has an edge, your loss is just part of reaching profitability. Think long-term.
  • Position sizes can’t be so large that they compromise emotions and distract you from your trading plan.
  • Don’t revenge trade to attempt to recover your losses. Stick to your trading plan no matter what.
  • Your signals must be based on price action, not greed, fear, or ego.

Profitable trading

By Steve Burns

After a lifelong fascination with financial markets, Steve began investing in 1993 and trading his accounts in 1995. It was love at first trade. After more than 30 successful years in the markets, Steve now dedicates his time to helping traders improve their psychology and profitability. New Trader U offers an extensive blog resource with more than 4,000 original articles, online courses, and best-selling books covering various topics.