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Trading theory into practice

A guide to separating the wheat from the chaff

New traders can generally be put into one of two camps – those who just start to trade without any prior knowledge and those who choose to arm themselves with as much learning as possible.

Generally those in the first camp will eventually concede and have some education in one form or another and almost everyone at some stage will learn a theoretical approach to trading that needs to be turned into a profitable trading strategy.

Which indicators do you keep and which do you discard? What else helps put the theoretical learning into practice?

Timeframes

Some indicators may lend themselves to longer term trading while others to shorter term trading. In my robot trading strategy article, I talk about how a robust system can be used in any market – but the same is not true of any timeframe.

While the general premise of a good strategy can be used across multiple timeframes it will eventually need so much tweaking that it may become unrecognisable and, ultimately, unusable. Moving up or down one timeframe should be no cause for alarm (e.g. weekly to daily, daily to 4 hourly, 4 hourly to one hourly) but jumping from, say, daily to 5 minutes is unlikely to work as smoothly. The indicators required need to be able to adapt to intraday noise.

So, first pick indicators that are suitable to your trading timeframe

Timeframe indicatorsAn example would be the 200 SMA (Simple Moving Average). This is an excellent indicator for Dynamic Traders to use on a daily chart – Consider long positions if price is above it and consider short positions if price is below it.

The 200 daily moving average is widely used in this way across the trading community – professional and retail traders alike. So to go against it is to go against the majority of traders. This may work for you if you are a contrarian trader but for most traders it’s best to go with the flow.

If you are trading on an intraday timeframe, such as the 4 hour, sticking to the 200 SMA rule may continue to benefit your trading. It will also help you filter your potential set-ups by setting a rule to ignore those stocks/currency pairs which do not apply. But once you get down to a 5 minute timescale, the 200 SMA has become all but redundant.

The 200 period moving average does not have the same cachet on most other timeframes as it does on the daily timeframe.

If you are learning to use an indicator, identify which timeframe the standard setting is most suited to. If it is claimed it can be used on any timeframe, test it. There should be an ideal timeframe with maybe one or two either side in which it can also be used to produce similar results.

Breakouts and reversals

Traders typically fall into two trading styles – they either trade breakouts or they trade reversals. Breakouts will often be with the trend, reversals can be with or against the trend. The indicators used to confirm a breakout will generally be different than those to identify and trade a reversal.

So, secondly, pick an indicator designed to match your trading style

Finding the right indicator for the timeframeIf you trade stocks a great breakout confirmation indicator is volume – you want volume to increase during the breakout phase. This information is not available if you trade forex so look to something else. A reliable chart continuation pattern, such as a flag with a decisive confirmation bar, works very well – it is in fact one of the most reliable chart patterns. Neat flags are easy to recognise – just look on your charts for one that looks textbook. They happen often in good trends.

If you trade reversals you may look for a candlestick pattern, such as a doji or an engulfing candle. The doji, in particular, should only be considered decisive if identified in conjunction with another independent indicator – this could be a trendline or channel.

There are many indicators you can use to confirm breakouts or reversals. I prefer to trade breakouts because it is clear when price has broken out of a range, or made a higher-high or lower-low. But the quality of the breakout still needs to be quantified.

Personally, I find reversals a little more tricky and time consuming. There are many indicators designed to help you: Stochastic, MACD, RSI are a few of the most popular.

Pick indicators that make sense to you. A black box indicator which only it’s creator can understand will not serve you well in a drawdown. I’m not saying give up if you don’t understand something – learning to trade involves a lot of new vocabulary and a new way of thinking. But if you think your trainer is trying to blind you with science, strategies and indicators that are “secret” and information not divulged, it maybe best to walk away and look elsewhere for your trading education.

Trade duration

Many new traders want to scalp or day trade – since online brokers have become a common place, this has been considered the fastest way to go from zero to hero in the shortest possible time.

Trading is a business and a business needs time to grow. Trading also takes time – months to years – to build up your account. There will be times when it goes up with a bang in just a few weeks and other times when you can go weeks or months without seeing a sizable difference to your account.

Longer term trading requires more patience in both waiting for a set-up and waiting for the trade to develop and accumulate. Shorter term trading gets you instant results and feedback on your success (or otherwise).

I would consider short term trading as a few days. Generally there is a monetary or tick target which, once reached, will close the trade off. Time can be a factor, so if the position does not perform as expected, it might be exited manually.

For me, long term trading expectancy is from weeks to months. There is no specific time or monetary target, you simply wait for the trade to develop, have a trailing stop in place, and will eventually get stopped out with a price reversal.

Medium term trading is probably something in between the two. You may close one position off at a set target, fairly quickly, while allowing a second position develop.

Third, pick your desired trade duration

Multiple timeframesAs with a trading timeframe, some indicators will be more suitable than others. If your intention is to be in a trade for several weeks, you do not want to be using an indicator which tells you that you are overbought/oversold every time there is a small pullback.

If you trade short term and simply have a target price, you may not need an indicator at all for your exit on a successful position. However, you are likely to need one as an early warning signal that lets you know the trade is not developing in the desired direction. This would allow you to get out with a small profit or minimise a loss.

Find out which indicators can be used for your typical trade duration and then use the ones that have the highest success rate. If you don’t have access to someone who actually uses it successfully on a regular basis, then you will need to test it yourself.

Strategy testing

Trading accountWhen new to trading, an obvious way to decide on the efficacy a new system is to test it.

Simply find a market, go back a few months, days, or hours (depending on the preferred timeframe of the strategy) and apply the rules. Once you have tested 30 or more different opportunities over various periods of time in the last 10-20 years, you should have a good idea of how to apply the strategy and how well it works.

While backtesting gives us a reasonable overview of how a system works and it’s potential, the next step many new traders take is to open a demo account.

The advantages of a demo account are that you can test the strategy in real time (your broker may delay the data by 20 minutes, but this is not of concern while practicing). Using a demo account may take longer than backtesting – as you have to let the positions play out live – but you get a good feel of being in multiple trades and making decisions as new data appears.

The disadvantages are that some brokers only allow much larger demo accounts than the average new trader will have at their disposal when they begin to trade their own money. This, again, does not allow the trader to understand the significance of margins and drawdowns. Even if the demo account can be set at a level close to your starting account size, there is still the problem of it not being your own money. If you make a mistake it may be annoying but it’s hasn’t affected your bottom line – as it’s not real money. If you trade the demo well you could be enthused with a false sense of your own success.

Demo accounts serve a purpose – to practice placing a trade.

So, fourth, use a demo account purely to learn how to use your brokers system

Summary

BrokerPutting theory into practice involves five steps:

  1. Picking indicators that are suitable to your trading timeframe
  2. Picking an indicator designed to match your trading style
  3. Picking your desired trade duration
  4. Using a demo account purely to learn how to use your broker’s system
  5. Always trade using your own money

And fifth, putting theory into practice includes practicing with your own money

No one else can do this for your, you have to make these decisions yourself. I hope they resonate with you as you progress with your continuing trading career.

I wish you all the success in your trading career and hope you achieve the rewards you are aiming for.

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Successful trading…

Anne Chapman

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