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A Disciplined Trading Plan

August 8, 2007

The better performing traders above chose a good trading system and executed it perfectly. The only difference was their different use of leverage. The use of leverage must be tested and built into a disciplined trading plan. Obviously, leverage must be handled judiciously. It would be beneficial to one’s reward and risk performance to find a way to use leverage only when the probabilities of success are very strong.

Overly leveraged traders without a tested and precisely defined trading plan are merely gamblers who face an almost certain "risk of ruin" and have no chance of success in the long run. Sure they can win and win big for a little while, but no lucky streak lasts forever.

Generally, a long series of wins and wipeout losses leaves the undisciplined trader in the unenviable position of fanaticizing that someday he will enjoy a run of unusually good luck, and then somehow quit the game while still on top. But it is only human nature that when he feels luck is on his side he does not feel like quitting when he is ahead.

Traders quickly making and then just as quickly losing fortunes is a very old story repeated untold times. See the book, Reminiscences of a Stock Operator, by Edwin Lefèvre, describing the experiences of an actual famous trader, Jesse Livermore, who made and lost many fortunes using his instincts with extremely high leverage in the early decades of the 20th century.

To reduce the "risk of ruin", we must have a sound plan to limit our use of leverage and keep sufficient cash reserves to keep our place at the table. It also is very useful to diversify our risk across many trades and across low-correlated financial instruments. Seasoned money managers refuse to risk more than one percent of their capital on any one trade. They can’t do that unless they adhere to strict disciplines that are well tested and designed to insure that they can stay in the game when markets turn volatile.

To reduce such risks, there are many techniques that have stood the test of time. These ideas are so old that they have become cliches, but that does not mean that they can be ignored. The old masters have long recommended respecting the trends in multiple time frames, thus putting the odds in our favor and not fighting the tide.

A strict loss cutting discipline also comes highly recommended, including the use of actual stop-loss orders. Never meet margin calls or average down: never throw good money after bad. Systematically eliminate losing positions and close out the worst performing positions. With a series of losses, cut back size and total risk exposure. These ideas can be back tested and built into a sound trading system.


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