Commentaries by Bruce Babcock for New and Experienced Traders

The Seven Habits of Highly Effective Futures Traders

Stephen Covey's The Seven Habits of Highly Effective People has been on the national best-seller lists for years--first as a hardback and then as a paperback. I wondered how its list might relate to commodity futures trading.

My interpretation of Covey's agenda is as follows: 1) Take responsibility for yourself and your life, 2) Act in light of your vision of success in life, 3) Act with proper attention to the correct priorities, 4) Act in a way that maximizes benefits for everyone, 5) Try to understand the other person before putting your point of view across, 6) Exploit the potential for cooperation among the people in your life, 7) Pay attention to maintaining and refining your physical, mental, social and spiritual dimensions.

While there does not appear to be any direct relationship between my commodity trading list and Covey's overall life experience list, there are some definite similarities and differences. It is well known that normally successful approaches do not work in trading. Additionally, life in general requires involvement and interrelating with other people, while trading is a more solitary endeavor. Here is my list of successful habits for traders.

ONE. Understand the true realities of the markets. Understand how money is made and what is possible. The markets are what is called chaotic systems. Chaos theory is the mathematics of analyzing such non-linear, dynamic systems. According to Edgar Peters, author of Chaos and Order in The Capital Markets, mathematicians have conclusively shown the to be non-linear, dynamic systems. Among other things chaotic systems can produce results that look random, but are not. A chaotic market is not efficient, and long-term forecasting is impossible. Market price movement is highly random with a trend component.

Unsuccessful and frustrated commodity traders want to believe there is an order to the markets. They think prices move in systematic ways that are highly disguised. They want to believe they can somehow acquire the "secret" to the price system that will give them an advantage. They think successful trading will result from highly effective methods of predicting future price direction. They have been falling for crackpot methods and systems since the markets started trading.

The truth is that the markets are not predictable except in the most general way. Luckily, successful trading does not require effective prediction mechanisms. Successful trading involves following trends in whatever time frame you choose. The trend is your edge. If you follow trends with proper money management methods and good market selection, you will make money in the long run. Good market selection refers to selecting good trending markets generally rather than selecting a particular situation likely to result in an immediate trend.

There are two related problems for traders. The first is following a good method with enough consistency to have a statistical edge. The second is following the method long enough for the edge to manifest itself.

TWO. Be responsible for your own trading destiny. Analyze your trading behavior. Understand your own motivations. Traders come into commodity trading with a view to making money. After awhile they find the trading process to be fascinating, entertaining and intellectually challenging. Pretty soon the motivation to make money becomes subordinated to the desire to have fun and meet the challenge. The more you trade to have fun and massage your ego, the more likely you are to lose. The kinds of trading behaviors that are the most entertaining are also the least effective. The more you can emphasize making money over having a good time, the more likely it is you will be successful.

Be wary of depending on others for your success. Most of the people you are likely to trust are probably not effective traders. For instance: brokers, gurus, advisors, system vendors, friends. There are exceptions, but not many. Depend on others only for clerical help or to support your own decision-making process.

Don't blame others for your failures. This is an easy trap to fall into. No matter what happens, you put yourself into the situation. Therefore, you are responsible for the ultimate result. Until you accept responsibility for everything, you will not be able to change your incorrect behaviors.

THREE. Trade only with proven methods. Test before you trade. When applied consistently, most trading methods don't work. The conventional wisdom that you read in books is mostly ineffective.

Notice that commodity authors never demonstrate the effectiveness of their methods. The best you can hope for is a few, well-chosen examples. The reasons for this is that they are lazy and their methods mostly do not work when tested rigorously.

You must be skeptical of everything you read. You must somehow acquire the ability to test any trading method you intend to use. The reliability of non-computerized testing is highly suspect. You must, therefore, use software that tests a particular approach or a variety of approaches. You must learn the correct way to test and evaluate trading approaches.

Have a good approach. Follow the four cardinal rules of trading. 1) Trade with the trend. 2) Cut losses short. 3) Let profits run. 4) Manage risk. These are well known cliches. Yet virtually all losing traders violate these rules consistently. Trading with the trend means buying strength and selling weakness. Most traders are more comfortable buying weakness and selling strength, the essence of top and bottom picking.

Trade good markets. Trend is your only edge. You must emphasize those markets which trend the best. This will maximize your statistical edge over time. I wrote a huge book (which I update every year) ranking the markets in historical trendiness.

FOUR. Trade in correct proportion to your capital. Have realistic expectations. Don't overtrade your account. One of the most pernicious roadblocks to success is a manifestation of greed. Commodity trading is attractive precisely because it is possible to make big money in a short period of time. Paradoxically, the more you try to fulfill that expectation, the less likely you are to achieve anything.

The pervasive hype that permeates the industry leads people to believe that they can achieve spectacular returns if only they try hard enough. However, risk is always commensurate with reward. The bigger the return you pursue, the bigger the risk you must take. Even assuming you are using a method that gives you a statistical edge, which almost nobody is, you must still suffer through agonizing drawdowns on your way to eventual success.

The larger the return you attempt, the larger your drawdowns will be. A good rule of thumb is to expect an equity drawdown of about half the percentage of your annual profit expectation. Thus, if you shoot for annual returns of 100 percent, you should be ready for drawdowns of 50 percent of your equity. Almost no one can keep trading their method through 50 percent drawdowns. It is better to shoot for smaller returns to begin with until you get the hang of staying with your system through the tough periods that everyone encounters. An experienced money management executive has stated that professional money managers should be satisfied with consistent annual returns of 20 percent. If talented professionals should be satisfied with that, what should you be satisfied with? Personally, I believe it is realistic for a good mechanical system diversified in good markets to expect annual returns in the 30-50 percent range. This kind of trading would still result in occasional drawdowns up to 25 percent of equity.

FIVE. Manage risk. Manage the risk of ruin when you create your trading plan or system. Manage the risk of trading when you select a market to trade. Manage the risk of unusual events. Manage the risk of each individual trade.

The risk of ruin is a statistical concept that expresses the probability that a bad run of luck will wipe you out. On average, if you flip a coin 1,024 times, you will have ten heads in a row at least once. Thus, if you are risking ten percent of your account on each trade, chances are you will be completely wiped out before long. If your trading method is 55 percent accurate (and whose is?), you still have a 12 percent chance of being wiped out before doubling your capital if you risk 10 percent of capital per trade. For the mathematicians out there, this assumes that you win or lose the same amount on each trade. That is unrealistic, but I'm just trying to explain the risk of ruin problem. The point is that in order to reduce the harm caused by unavoidable strings of losses, you must keep the amount you risk on each trade to about one or two percent of capital. This makes trading with small accounts difficult. Two percent of $5,000 is only $100. That means with a $5,000, you should be trading with $100 stops. If you trade with $500 stops, your chances of avoiding meltdown from a bad series of trade are not good. Trading with small stops is usually ineffective because they are within the market's "random noise."

Another element of risk is the market you trade. Some markets are more volatile and more risky than others. Some markets are comparatively tame. Some markets, such as currencies, have a greater chance of overnight gaps which increases risk. Some markets have lower liquidity and poorer fills which increases risk. If you have a small account, don't trade big money, wild-swinging contracts like the S&P. Don't be above using the smaller-sized Mid-America contracts to keep risk in proportion to your capital. Don't feel you have to trade any market that might make a move. Emphasize risk control over achieving big profits.

The commodity markets are notorious for making locked-limit moves where the trader is stuck in his losing position. The market can go against him for days while he must helplessly watch his capital disappearing. This is certainly a reality, but the trader is not helpless to decrease the risk of it happening to him. Pay attention to the risk of surprise events such as crop reports, freezes, floods, currency interventions and wars. Most of the time there is some manifestation of the potential. Don't overtrade in markets where these kinds of events are possible.

The most important element of risk control is simply to keep the risk small on each trade. Always use stops. Always have your stop in the market. Never give in to fear or hope when it comes to keeping losses small. Never risk more than one or two percent of capital. Preventing large individual losses is one of the easiest things a trade can do to maximize his chance of long-term success.

SIX. Stay long-term oriented. Don't adjust your approach based solely on short-term performance. Our entire society emphasizes instant gratification. We are consuming are long-term capital. Eventually, this will lead to a decline in our standard of living over what it could have been with more attention to the future.

Most traders have such an ego investment in their trading that they cannot handle losses. Several losses in a row are devastating. This causes them to evaluate trading methods and systems based on very-short-term performance. Statisticians tell us that there is no statistical reliability to a test unless you have 30 events to measure. Short of a reasonable number of events, the outcome is wholly dependent on luck. As we saw in the risk of ruin discussion above, strings of losses are as certain as government inefficiency. Thus, the trader who chucks his system after four losses in a row is doomed to spend his trading career changing from one system to another. Don't start trading a system based on only a few trades, and don't lose confidence in one after only a few losses. Evaluate your performance based on many trades and multi-year results.

SEVEN. Keep trading in correct perspective and as part of a balanced life. Trading is emotionally intensive no matter whether you are doing well or going in the tank. It is easy to let the emotions of the moment lead you into strategic and tactical blunders.

Don't become too elated during successful periods. One of the biggest mistakes traders make is to increase their trading after an especially successful period. This is the worst thing you can do because good periods are invariably followed by awful periods. If you increase your trading just before the awful periods, you will lose money twice as fast as you made it. Knowing how to increase trading in a growing account is perhaps the most difficult problem for successful traders. Be cautious in adding to your trading. The best times to add are after losses or equity drawdowns. Don't become too depressed during drawdowns. Trading is a lot like golf. All golfers, regardless of their ability, have cycles of good play and poor play. When a golfer is playing well, he assumes he has found some secret in his swing and will never play poorly again. When he is hitting it sideways, he despairs he will never coming out of his slump.

Trading is much the same. When you are making money, you are thinking about how wonderful trading is and how to expand your trading to achieve immense wealth. When you are losing, you often think about giving up trading completely. With a little practice, you can control both emotional extremes. You'll probably never control them completely, but at least don't let elation and despair cause you to make unwarranted changes in your approach.

Since correct trading is boring, don't depend on trading as your primary stimulation in life. Unfortunately, the exciting aspects of trading, such as easy analysis and trade selection, are counterproductive. Good trading is repetitive and pretty dull. Thus, if you depend on trading for the major excitement, pursuit of fun will probably cause you to lose. If you can afford it, fine. If not, seek your entertainment elsewhere.

Here's a summary of my seven habits of successful traders. 1) Understand the true realities of the markets. 2) Be responsible for your own trading destiny. 3) Trade only with proven methods. 4) Trade in correct proportion to your capital. 5) Manage risk. 6) Stay long-term oriented. 7) Keep trading in correct perspective and as part of a balanced life. The common theme is self-control. As I've often said, if you can master yourself, you can master the markets.

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TRADING IN COMMODITY FUTURES OR OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS.
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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