The truth of trading 6---Methodology

Methodology represents day-to-day combat instructions. It articulates how you will trade for expectancy. It consists of two parts:

* setups

* trade plan

Setups identify of possible future support or resistance. They identify whether you should be looking to buy or sell.

Trade plan should tell you how to take advantage of setups. It should have clear and unambiguous instructions on how to enter. place stops, and exit.

Methodology should be simple and logical. It should be able to pass the McDonald's test. That could a teenager trade your methodology? If not , it's probably too complicated, too complex , and almost guaranteed tofall apart.

Once you have designed your methodology, your next step will be to validate its expectancy using TEST procedure. If the results are positive, with a relatively smooth equity curve in which the profits aren't reliant upon one or two extraordinary trades, you'll know you have designed a good methodology.

Your final step will be to calculate your risk of ruin. This will combine money management strategy with methodology. From TEST results, you'll know the methodology's validated accuracy and average win-to average loss payoff. Combining this with your chosen money management strategy, you'll be able to use risk-of-ruin simulator to simulate and than estimate statistical risk of tuin. If your estimated risk of ruin is 0 percent, you can be confident in your methodology. If not, it's back to the drowing board.

Setup

A setup should identify a potential support or resistance level. A good support level will not only exist in an uptrend; it should also confirm the uptrend.　A good resistance level will not only exist in a downtrend; it should also confirm the downtrend. Setups are found through market analysis.

Trade Plan

Your trade plan should tell you how to take advantage of your setups. It should have clear instructions on where to:

* enter a trade

* place a stop

* exit a profitable trade

An effective trade plan should support and confirm your setup.

If your setup has found a potential support level, your trade plan should expect the market to move higher before committing you to a trade. Similarly, if you have found a potential resistance level, your trade plan should wait for lower prices before committing you to the market. When trading, it's good practice to assume your setup is wrong until the market proves it right. 

Have a trade plan that confirms your setup gives the market the respect it deserves. This is such a simple and poewerful concept yet many traders fail to understand it. Setups can give you no more than an inclination of where the market may go, and they are not going to be correct all the time. A good trade plan will not follow your setup blindly. too many traders fail to separate their setups from their trade plan, confusing technical analysis with trading. Having a trade plan wait for the market to confirm your setup is no guarantee the market will continue moving in your direcation; however, it will save you from entering many marginal trades. In essence , a good trade plan should have you paying higher prices to go long and selling lower prices to go short.

Many points in market structure can be used to make your entry level confirm your setup. If your setup has identified a potential support level, your trade plan can confirm the market's trength before entering by checking whether:

* the day closed higher than its open

* the day closed higher than the previous day's close

* the day closed higher than the previous 2,3,4,5 days

There are some general principles you can follow when designing your setups and plans, including:

* strive for simplicity over complexity

* ensure logic supports the methodology -- don't rely on a random collection of ideas

* minimize the number of parameters with adjustable variables -- this will reduce the risk of curve fitting

* use a combination of initial, breakeven and trailing stops

* use time stops where appropriate

* favor dynamic stops over fixed dollor stops

* be wary of profit targets-- they generally reduce profitability

* use trailing stops as an effective way to exit profitable positions

Key ingredients in the successful execution of your trade plan are consistency and discipline and a mechanical approach provides excellent training inthis area.

Entries are terribly important. They directly define your stop placement initial risk, and potential loss. The size of your losses, compared to your wins, directly affects your expectancy! And remember, you trade for the opportunity to earn expectancy.

When you enter a trade, the point is to controlling risk and trading for the opportunity to earn expectancy.

In addition, since entries define your initial risk, they also directly affect your money management strategy for position sizing.

" Avoid the fatal Attraction of large stops

The easiest technique to make a methodology seem profitable is to use large stops. Large stops will give a methodology  plenty of room and time to reach its profit objective or exit point. However, in my opinion, large stops will catch up with you in time and they will hurt you.

Traders will generally keep increasing the size of their stops until their methodology produces an acceptable-looking hypothetical equity curve. They unwittingly curve fit their methodology to the historical datd. By increasing the size of their stop, They manage to avoid incurring a string or series of losing trades that would render their methodology poor. They believe they have discovered the optimal stop. But all they have done is to curve fit their methodology to their data.

And invariably, due to the market's maximum adversity, When they start trading, the market delieve a series of extraordinary losses they weren't expecting. The losses will be so large that they'll eather discourage them from trading or the losses will damage their accounts beyond repair forcing them to stop trading. They will have reached their point of ruin.

 In addition, large stops will hamper your money management strategy's ability to increase your position size. Stops directly define your initial risk. Your initial risk directly affects your money management strategy for position sizing. The smaller the initial stop,the larger a position size you can put on. The larger your stop, the  larger a position size you can put on. The larger your stop, the larger your initial risk and the smaller your position's size. Remember, money management is the secret to survival and big profits.

This is terribly important. Hypothetically, amethodology can look good on a single-contract basis, producing a good positive expectancy. However, when you apply your preferred money management strategy, you'll invariably find your methodology's performance is hampered. Large stops drag down a money management strategy's ability to accumulate contracts or increase position size.

A methodology using smaller stops with a lower expectancy will make much more money than a methodology that uses larger stops with a higher expectancy when money management is applied. Large stops kill money management performance. Larger stops kill big profits. If money management is the secret behind large profit, which is it, then small stops is the secret behind extraordinary profits. 

* Confilm Expectancy Through TEST

Once you have designed a setup to identify potential support and resistance levels, and developed a trade plan to confirm and take advantage of your setup, your next step is to validate your methodology's expectancy using the TEST procedure.

 If your expectancy is positive and the equity curve relatively smooth wituout relying on one or two extraordinary trades, you can be confident you have developed a good methodology.

 Your final step is to combine your preferred money management strategy with your validated methodology and caculate your risk of ruin, using the acuuracy rate and average win-to-average loss payoff ratio from your TEST results. Your objective is to approach the market with a statistical 0 percent risk of ruin.   

Good strategies will satisfy two simple requirements, they will:

* help traders avoid fatal mistakes and

* address the basic strategy elements of successful trading