Thursday, May 24, 2007

Method to Madness

"Though this be madness, yet there is method in it."
Polonius, Hamlet by William Shakespeare

Couple posts ago I promised to return to the idea of the setup's structure. In order to come to it, however, I need to start with more broad theme - one of the adjustment and re-adjustment to changing conditions. Here is where the importance of the topic stems from: for many trading presents enormous difficulties because market is an unstructured environment. We are not readily wired to act correctly under such conditions. Our comfort zone lies in having schedules, guides, instructions, manuals, road maps and signs. When we are not familiar with the structure of our surroundings, we overcome the difficulties by learning it - looking at the map, reading the manual... but what do you do when you need to act with certainty in uncertain environment? Environment that changes by minute, by day, presenting new challenges, obeying new rules, being influenced by new factors? You work out the method to your own actions. You create algorythm which governs not only your course of action but also your course of adjustment - the way you change your behavior when the surroundings change. Those who trade long enough know very well how often they had to adjust to constant change. Fractions to decimals, anyone? 25K rule? Order routing? Bull to bear to lull?

This kind of changes for an experienced trader is similar to finding a new route for his routine trip when city authorities close the road for renovation. Not a biggie, right? Inconvinient, sometimes time-consuming but not a big deal. However, for a newer trader starting out in this profession the analogy would be more dramatic. Moving from a ghost town in prairies to New York perhaps? Let's throw in different language, absence of any prior information of what the big city is about, unfamiliarity with the concept of municipal transport and apartment buildings... now we are talking. Total chaos, no structure to dictate your action, strange life seethes around... and you need to do something. Will your first steps be the right ones? Most likely not. They will be much better when you learn the structure of what's going on, what elements are there and how they interact. This is what a trader starts with as well - providing he or she realizes the need to learn instead of diving in headfirst (always amazes me how many do just that, what is it about this profession that makes it look like it can be mastered without learning??).

So, you start with attempting to learn more about markets... and wierd thing happes - it doesn't get you anywhere. You just mastered the concept of earning announcements, EPS, price to earnings, learned to read balance sheets, you feel like deep dark secrets known to few have been opened for you... yet price action doesn't match your expectations. Wait, but what happened to our analogy? Learning the layout of the streets in your new city and what transport is available and what its schedule is, wouldn't you become capable of getting around? You would - but the analogy has ended earlier. It described your lack of understanding of what was happening around you, and that's it. Major differencies started after that - city is STRUCTURED. Markets are NOT. Not in the way you expect them to be, anyway.

Next thing that is likely to happen to you is getting familiar with technical analysis. Ahhh, that's where the problem was - there is this voodoo that for some reason impacts the movement... or does it? Or does it just reflect the movement in a certain visual way providing some hints for a scholar? Those are questions you start encountering while studying MAs, BBs, dark clouds and hanging men hit by shooting stars, and all other dolls and pins also known as studies and indicators. Your knowledge grows by day... does your trading account? Ummm... most likely not.

By no means do I want to say that all I listed above is not needed. Why, all this learning is necessary, or at least some elements of it - I for one still wouldn't be able to tell the balance sheet of Microsoft from one of Bre-X. It's just that it's not enough - not until you create YOUR OWN METHOD. Remember our very first article in this blog? We talked about indicators not being able to create profit by themselves and serving only as a tool. This is where we return to this theme. All this learning provided you not with answers but with tools to get them. No hammer goes ahead and drives nails in the wood without you. It just provides you with means to do just that. Now it's time to create your trading approach utilizing those tools. What kind of hammer do you need for the job? How do you hold it? How do you swing it? What kind of nails? Answer these questions, practice a bit and your nails hold two wooden details together.

What kind of questions do you ask (and answer) in order to create your trading system? And finally, how do you form your setups and what is their structure? Next post.
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