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Build a Profitable Trading Model In 7 Easy Steps
A trading model is a clearly defined, step-by-step rule-based structure for governing trading activities. In this article, we introduce the basic concept of trading models, explain their benefits, and provide instructions on how to build your own trading model.
The Benefits of Building a Trading Model
Using a rule-based trading model offers many benefits:
- Models are based on a set of proven rules. This helps remove human emotions from decision making.
- Models can be easily backtested on historical data to check their worth before taking the dive with real money.
- Model-based backtesting allows verification of associated costs so the trader can see profit potential more realistically. A theoretical $2 profit may look attractive, but a brokerage charge of $2.50 changes the equation.
- Models can be automated to send mobile alerts, pop-up messages, and charts. This can eliminate the need for manual monitoring and action. With a model, a trader can easily track 10 stocks for 50-day moving average (DMA) crossing over 15‑day moving average. Without such automation, manually tracking even one stock DMA can be difficult.
How to Build Your Own Trading Model
To build a trading model, you do not need advanced-level trading knowledge. However, you do need an understanding of how and why prices move (for example, due to world events), where profit opportunities exist, and how to practically capitalize on opportunities. Novices and moderately experienced traders can start by becoming familiar with a few technical indicators. These offer meaningful insights to trading patterns. Understanding technical indicators will also help traders conceptualize trends and make customized strategies and alterations to their models. In this article, we will focus on trading based on technical indicators.
Example of a Simple Trading Model Strategy
Based on the principle of trend reversal, some traders act on the assumption that what goes down will comes back up (and vice versa). Using the assumption of trend reversal as a strategy, we will build a trading model. In the steps below, we will walk through a series of steps to create a trading model and test if it is profitable.
Flowchart for Building a Trading Model
1. Conceptualize the Trading Model
In this step, the trader studies historical stock movements to identify predictive trends and create a concept. The concept may be a result of extensive data analysis or it could be a hunch based on chance observations.
For this article, we are using trend reversal to build the strategy. The initial concept is: if a stock goes down x percent compared to the previous day’s closing price, expect the trend to reverse in next few days.
From here, look at past data and ask questions to refine the concept: Is the concept true? Will this concept apply to only a few selected high-volatility stocks or will it fit any and all stocks? What is the duration of expected trend reversal (1 day, 1 week, or 1 month)? What should be set as the down level to enter a trade? What is the goal profit level?
An initial concept usually contains many unknowns. A trader needs a few deciding points or numbers to begin. These may be based on certain assumptions. For example: this strategy may apply on moderately volatile stocks having a beta value between 2 and 3. Buy if stock goes down by 3 percent and wait for next 15 days for trend reversal and expect a 4 percent return. These numbers are based on a trader’s assumptions and experience. Again, a basic understanding of technical indicators is important.
2. Identify the Opportunities
In this step, identify the right opportunities or stocks to trade. This involves verifying the concept against historical data. In the example concept, we buy on a 3 percent dip. Start by choosing high‑volatility stocks for the assessment. You can download historical data of commonly traded stocks from exchange websites or financial portals like Yahoo! Finance. Using spreadsheet formulas, calculate the percentage change from the previous day’s closing price, filter out the results matching the criteria, and observe the pattern for following days. Below is an example spreadsheet.
In this example, the stock’s closing price is going down below 3 percent on 2 days (February 4 and February 7). Careful observation of the following days will reveal if the trend reversal is visible or not. The price on February 5 shoots up to 4.59 percent change. By February 8, the change is below expected at 1.96 percent.
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Are the results conclusive? No. One observation matches the expectation of the concept (4 percent and above change) while one observation does not.
Next, we need to further check our concept across more data points and more stocks. Run the test across multiple stocks with daily prices over at least 5 years. Observe which stocks give positive trend reversals within a defined duration. If the number of positive results is better than negative ones, then continue with the concept. If not, tweak the concept and retest or discard the concept completely and return to step 1.
3. Develop the Trading Model
In this stage, we fine tune the trading model and introduce necessary variations based on assessment results of the concept. We continue to verify across large datasets and observe for more variations. Does the strategy outcome improve if we consider specific weekdays? For example does the stock price dipping by 3 percent on a Friday result in a cumulative 5 percent or more increase within the next week? Does the outcome improve if we take high-volatility stocks with beta values above 4?
We can verify these customizations whether or not the original concept shows positive results. You can keep exploring multiple patterns. At this stage you can also use computer programming to identify profitable trends by letting algorithms and computer programs analyze the data. Overall, the aim is to improve the positive outcomes from our strategy leading to more profitability.
Some traders get stuck in this stage, analyzing large datasets endlessly with slight variations in parameters. There is no perfect trading model. Remember to draw a line on testing and make a decision.
4. Perform a Practicality Study
Our model is now looking great. It shows a positive profit for a majority of trades (for example, 70 percent wins of $2 and 30 percent losses of $1). We conclude that for every 10 trades, we can make a handsome profit of 7*$2 – 3*$1 = $11.
This stage requires a practicality study which can be based on following points:
- Is the brokerage cost-per-trade leaving sufficient room for profit?
- I may have to make up to 20 trades of $500 each to realize a profit, but my available capital is just $8000.Does my trading model account for capital limits?
- How frequently can I trade? Is the model showing too frequent trades above my capital available, or too few trades keeping profits very low?
- Does the theoretical outcome match with necessary regulations. Does it require short selling or long dated options trade which may be banned, or holding of simultaneous buy and sell positions which may also not be allowed?
5. Go Live or Abandon and Move to a New Model
Considering the results of the above testing, analysis, and adjustment, make a decision. Go live by investing real money using the trading model or abandon the model and start again from step 1.
Remember, once you go live with real money it is important to continue to track, analyze, and assess the result, especially in the beginning.
6. Be Prepared for Failures and Restarts
Trading requires constant attention and improvements to strategy. Even if your trading model has consistently made money for years, market developments can change at any time. Be prepared for failures and losses. Be open to further customizations and improvements. Be ready to trash the model and move on to a new one if you lose money and can find no more customizations.
7. Ensure Risk Management by Building in What-If Scenarios
It may not be possible to include risk management in selected trading model depending on chosen strategies, but it is wise to have a backup plan if things don’t appear to be as expected. What if you buy the stock that went down 3 percent, but it did not show trend reversal for the next month? Should you dump that stock at a limited loss or keep holding on to that position? What should you do in the case of a corporate action like a rights issue?
The Bottom Line
Hundreds of established trading concepts exist and are growing daily with the customizations of new traders. To successfully build a trading model, the trader must have discipline, knowledge, perseverance, and fair risk assessment. One of the major challenges comes from the trader’s emotional attachment to a self-developed trading strategy. Such blind faith in the model can lead to mounting losses. Model-based trading is about emotional detachment. Dump the model if it is failing and devise a new one, even if it comes at a limited loss and time delay. Trading is about profitability, and loss aversion is in-built in the rule‑based trading models.
20 Rules Followed by Professional Traders
Booking reliable profits in financial markets is harder than it looks at first glance. In fact, unofficial estimates suggest that more than 80% of would-be traders eventually fail, wash out, and turn to safer hobbies. But the brokerage industry rarely publishes client failure rates because they’re likely concerned the truth will scare off new accounts. In reality, the washout rate could be much higher than 80%.
Indeed, success in trading is difficult and the consistently profitable traders share specific rare characteristics. These 20 rules are tips that long-time pros use to stay in the winner’s circle.
The Road to Long-Term Profitability
Long-term profitability requires two related skill sets. The first is to identify a set of strategies that make more money than they lose and then to use the strategies as part of a trading plan. Second, the strategies must perform well while the market experiences both bull and bear impulses. In other words, while many traders know how to make money in specific markets, like a strong uptrend, they fail in the long run because their strategies don’t adapt to inevitable changes in market conditions.
- Profitable trading is difficult and successful traders share specific rare characteristics.
- It is estimated that more than 80% of traders fail and quit.
- One key to success is to identify strategies that win more money than they lose.
- Many traders fail because strategies fail to adapt to changing market conditions.
- Classic rules from pro traders can help keep a sharp focus on profitability.
Can you break away from the pack and join the professional minority with an approach that increases odds for long-term prosperity? Can you separate from the herd of wannabe traders and achieve trading success? Start with a clear and concise plan with proven strategies and then leverage the 20 rules that follow.
1. Stick to Your Discipline
Discipline can’t be taught in a seminar or found in expensive trading software. Traders spend thousands of dollars trying to compensate for their lack of self-control but few realize that a long look in the mirror accomplishes the same task at a much lower price. The important lesson is that, once a trader has confidence in their trading plan, they must have the discipline to stay the course, even when there are the inevitable losing streaks.
2. Lose the Crowd
Long-term profitability requires positioning ahead of or behind the crowd, but never in the crowd because that’s where predatory strategies target. Stay away from stock boards and chat rooms, where people are less than serious and many of them have ulterior motives.
3. Engage Your Trading Plan
Update your trading plan weekly or monthly to include new ideas and eliminate bad ones. Go back and read the plan whenever you fall in a hole and are looking for a way to get out.
4. Don’t Cut Corners
Your competition spends hundreds of hours perfecting strategies and you’re in for a rude awakening if you expect to throw a few darts and walk away with a profit. The only way to achieve long-term success is with hard work and discipline.
5. Avoid the Obvious
Profits rarely come from following the majority or the crowd. When you see a perfect trade setup, it’s likely that everyone else sees it as well, planting you in the crowd, and setting you up for failure.
6. Don’t Break Your Rules
You create trading rules to get you out of trouble when positions go badly. If you don’t allow them to do their job, you’ve lost your discipline and opened the door to even greater losses.
7. Avoid Market Gurus
It’s your money at stake, not theirs. Keep in mind that the guru might be talking up their own positions, hoping the excited chatter will increase their profits, not yours.
8. Use Your Intuition
Trading uses the mathematical and artistic sides of your brain so you need to cultivate both to succeed in the long run. Once you’re comfortable with math, you might want to try to enhance results with meditation, a few yoga postures, or a quiet walk in the park.
9. Don’t Fall in Love
If you’re too in love with your trading vehicle or investment, you give way to flawed decision-making. It’s your job to capitalize on inefficiency, making money while everyone else is leaning the wrong way.
10. Organize Your Personal Life
Whatever is wrong in your life will eventually carry over into your trading performance. This is especially dangerous if you haven’t made peace with money, wealth, and the magnetic polarity of abundance and scarcity. Keep your trading needs separate from your personal needs, and take care of both.
11. Don’t Try to Get Even
Drawdowns are a natural part of the trader’s life cycle. Accept them gracefully and stick to the time-tested strategies you know will eventually get your performance back on track. Don’t try to make up for a losing trade by trading more. Revenge trading is a recipe for disaster.
12. Watch for Warnings
Big losses rarely occur without multiple technical warnings. Traders routinely ignore those signals and allow hope to replace thoughtful discipline, setting themselves up for pain. In short, keep an eye out for early signs that market conditions are changing and creating risks to your positions.
13. Tools Don’t Think
Some traders try to make up for insufficient skills with expensive software, prepackaged with all sorts of proprietary buy and sell signals. These tools can interfere with valuable experience when you think the software is smarter than you are. Use tools that fit well with your trading plan, but remember that, ultimately, you are the one calling the shots.
14. Use Your Head
It’s natural for traders to emulate their financial heroes, but it’s also a perfect way to lose money. Learn what you can from others, then back off and establish your own market identity, based on your unique skills and risk tolerance.
15. Forget the Holy Grail
Losing traders fantasize about the secret formula that will magically improve their results. In reality, there are no secrets because the road to success always passes through careful choice, effective risk management, and skilled profit-taking.
16. Ditch the Paycheck Mentality
We’re taught to grind through the work week for a paycheck. This pay-for-effort reward mentality is at odds with the natural flow of trading wins and losses during the course of a year. In fact, statistics indicate that most annual profits are booked on just a handful of trading days.
The number of actual trading days during a typical calendar year, as most markets are closed for holidays and weekends.
17. Don’t Count Your Chickens
It is okay to feel good about a trade that’s going your way, but the money isn’t yours until you close out or cover the position. Lock in what you can as early as you can, with trailing stops or partial profits, so the hidden hands of the market can’t pickpocket your gains at the last minute.
18. Embrace Simplicity
Focus on price action, understanding that everything else is secondary. Go ahead and build complex technical indicators, while keeping in mind that their primary function is to confirm or refute what your eye already sees.
19. Make Peace With Losses
Trading is one of the few professions where losing money every day is a natural path to success. Every trading loss comes with an important market lesson if you’re open to the message. Also, know when to quit and take a break from trading. Accept the losses, take time to regroup, and then come back to the market with a new perspective.
20. Beware of Reinforcement
Active trading releases adrenaline and endorphins. These chemicals can produce feelings of euphoria even when you’re losing money. In turn, this encourages addictive personalities to take bad positions, just to get the rush. If you’re trading to achieve a rush and excitement, you are probably trading for the wrong reasons.
The Bottom Line
Most traders fail to tap their full potential, eventually cashing in their chips and finding more traditional ways to make money. Become a proud member of the professional minority by following classic rules designed to keep a razor-sharp focus on profitability.
5 Best Trading Journals and How to Journal Successfully
Posted by Blain Reinkensmeyer | Last updated on Mar 5th, 2020 | Published May 6th, 2020
Using a trading journal is one of the most under utilized tools by investors. Recapping trades to break down what went right or wrong will help prevent future mistakes and improve returns down the road.
In this guide, I will break down the five best trading journal available today for analyzing stocks, options, futures, forex, and cryptocurrency trades. After the summary, I will cover some tips for success with examples from my own personal trading for those who are new to journaling their trades.
Best Trading Journals for 2020
- Tradervue – Best overall trading journal
- Power E*TRADE – Best overall trading simulator
- StockTrader.com Free Trading Journal – Best for basic manual entry
- Edgewonk 2.0 – Best for software download
- Trademetria – Best for simple design and included quote data
- Build your own – Best for Microsoft Excel users
Supports: Stocks, options, futures, forex
Pricing: Free (100 stock trades/mo), Silver ($29/mo), Gold ($49/mo)
Tradervue was one of the very first trading journals to come online alongside ours and I’ve known Greg (the guy behind Tradervue) for years. Tradervue doesn’t have the most modern design, and it takes some time to get used to, but it has the best broker importing support out of all the trading journals I’ve ever tested and Greg is extremely dedicated to keeping the site in top shape. It is used by hedge funds and professional institutions because it is so reliable and includes a variety of features, including automatic trade marking on charts and community sharing.
2. Power E*TRADE
Supports: Stocks, options, futures
Pricing: Free ($0 trades)
As the head of research for StockBrokers.com, I have spent thousands of hours testing online trading platforms. Hands down, Power E*TRADE offers the best trade simulator I have ever used. With streaming data, a fully featured trading journal for notes, and seamless order entry, Power E*TRADE is terrific for both beginners and fully experienced traders looking to tune their trading strategies. Available only to US residents, E*TRADE requires no minimum deposit and the platform is immediately available to use. Naturally, E*TRADE wants to earn your business so you fund the account and use the brokerage for your $0 stocks and options trading. See also: best online stock brokers 2020.
3. StockTrader.com Free Trading Journal
Supports: Stock trades only
Ok. I’m biased! But really, our stock trading journal is easy to use and 100% free. We have over 26,000 users and as of March 2020 there have been 121,764 stock trades logged BY HAND. That’s right, we do not support importing trades from your broker on purpose. Instead, we believe in hand logging trades to make sure no trade analysis steps are missed (see further below). No broker importing functionality is offered and as of now we only support stock trades. That said, we do fully support Van Tharp “R” multiples if you are a Van Tharp fan. Bottom line, if you want a simple, free replacement for excel, give it a whirl.
Supports: Stocks, forex, futures, CFDs, spread betting
Edgewonk is downloadable trading journal software that offers pretty deep analysis of your trades. The upside is the customization possibilities pending you enter in detailed notes and tags for each trade. Also, since it is software, you only need to pay for it once; there is no monthly subscription. The downside is that the broker import tool support is nearly non-existent for US based stock traders and is instead focused primarily on a handful of popular forex brokers and platforms like MetaTrader4 (MT4).
Supports: Stocks, options (single-leg only), forex, futures, cryptocurrency
Pricing: Free (30 trades/mo), Basic ($9.90/mo), Pro ($19.90/mo)
Trademetria is very basic as far as what data is tracked and what you can analyze; however, it does include real-time quote data for paid subscriptions. This allows Trademetria to serve as effectively a watch list tool as well as a trading journal. Arguably, that’s what your online stock broker is for, but nonetheless it is a unique feature. It also supports cryptos, which I’m sure will make some traders very happy.
6. Build your own!
Supports: Anything and everything
Pricing: Free with Microsoft Excel
To get you started, here’s a free trading journal excel spreadsheet template to use, which includes all of the basics alongside a handful of advanced data points. If you have a great spreadsheet template that you’d like to share with readers of the site, please email me!
Trading Journals are for Post Trade Analysis
Reviewing the film is critical part of professional sports, and investing is no different. Taking a screenshot of the stock chart after the trade is completed, plotting buy and sell points, writing down your notes recapping the trade, and tweaking trade rules thereafter all fall under the post trade analysis.
Trading journals provide you an easy way to figure out what went right, what went wrong, and look back at your trade history. There is simply no better way to improve over time.
Steps to a Journaling a Trade
You can improve your success rate, and ultimately make more money from your investing if you put in the time to conduct post-trade analysis.
- Log the trade details – This includes the ticker symbol, trade date, buy price $, total shares, sell price $, return $, return % (at a minimum). Other great data points to track include stop price, risk, and commission spend.
- Download a stock chart and mark it up – Mark it up with your buy and sell points alongside any trendlines, support, resistance, etc. Then, mark this chart with the trade info and archive it.
- Write your trade notes – Either on the chart itself, in your excel journal, or on paper, write down what you did right, wrong, and overall recap the trade in your own words. I personally use Evernote.
- Reflect back on trade data, chart, notes – This is the true “reviewing the film” exercise; identify potential bad habits, make rule tweaks, identify areas for improvement, and overall set the focus for the next trade.
- Archive for later use – Once you have reviewed the trade start to finish and gone through the motions of a proper recap, save your trading journal and move the trade to a folder on your computer. I use Dropbox and organize trades by ticker and date, e.g. “AAPL 050619”.
Why You Should Tag All of your Trades
Tagging your trades means marking the strategy you used to make the trade. By tagging each trade, you can assess performance over time and identify whether or not the strategy you are using is successful.
Any good trading journal will allow you to filter performance by tag to view your biggest winners, losers. By looking back every so often, you can identify areas of improvement and tweak your trade rules for that strategy.
Here’s an example of a day trade I made a few years back for Tesla (TSLA). Notice how it is tagged with “Day Trading 3.1”. By tagging your trades, you can easily create a new strategy, take a few trades (with a smaller position size to start), and assess the results thereafter.
Why Day Trading isn’t for Me
As an example of how using a trade journal correctly can be effective, over a year and a half of day trading in my spare time I found that I wasn’t profitable.
To track my progress, I started each strategy as “1.0”, then updated the trade tag each time I made a new rule adjustment so I could see how I improved over time. More specifically, I started with “DayTrading 1.0”, then updated it to “DayTrading 2.0”, and so on and so forth.
In total, I made 444 trades and had a net return of +$4,662.56. I risked on average $93.38 per trade (the average spread between my buy point and my stop price). I had eight total iterations of the strategy over the course of 18 months.
At first glance, +$4,662.56 doesn’t sound so bad. However, one key metric was being left out of the equation. Commissions.
With commissions factored in, my net return was a whopping +$86.37. I had roughly $25,000 allocated to the strategy, so clearly I under performed the overall market averages and would have been better off passive indexing.
Despite the blow to my pride, without tagging my trades and using a trading journal, I never would have been able to determine day trading wasn’t right for me. And, even better, thanks to the tagging and strategy honing, I was able to learn A LOT about myself as a trader.
Trying day trading sprouted numerous other strategies that I use now. I also didn’t lose any money, only time.
In life and especially in the market, you can’t beat free education!
How to use your Trading Journal to Build Strategies
Here are a few tips for success that I’ve learned over the years:
- Have clear rules for each strategy – I use Evernote to journal all my market thoughts, ideas, research, etc. This allows me to organize each strategy with clear rules so I can be consistent with my trades. Consider having preset profit targets, objectives, position management rules, and make sure to tag each trade!
- Use numerical identifiers – Start your seed strategy with “1.0” and refresh the tags each time you adjust your rules so you can accurately track performance. You can progress to “1.1” or “2.0”, etc. You’ll be amazed when you compare the trades and performance of each iteration.
- Challenge yourself to improve across the board – Don’t just analyze the net return of each strategy iteration, look also at mistake %, time committed overall, trade frequency, and your overall emotions to assess true success. For example, day trading requires far more trades, time, and stress than buying and holding long.
In Van Tharp’s book, Trade Your Way to Financial Freedom, he advocates finding the right strategy for YOU. The more you test different strategies and learn about yourself, the more successful you will be over time. For me, day trading just isn’t the right fit.
Final Thoughts for Maintaining a Successful Trading Journal
What variables do successful traders use when logging trades in their trading journal? Here are 11 to always include:
- Stop Price $ – The Stop Loss price ($) which can be a physical stop loss order or a mental stop. Cutting your losses short is one of many crucial keys to successful investing.
- Strategy – Always tag each trade with the strategy used.
- Risk $ – This is the amount of capital being risked on the trade. So, if you buy 100 shares at $100, and your Stop is at $99, then you are effectively risking $100 on the trade. Risk can also be expressed as an “R” multiple (Van Tharp principal), and is a concept that has truly changed the way I approach trading.
- Risk % – The percent of capital risked on the trade. Referencing the previous example, the total risk would be 1% ($10,000 invested / $100 being risked).
- Target Price $ – Back to our example of buying long at $100, if we set our target price at $110, that means our goal is to hold the stock until it reaches at least $110. Once we reach out initial target price, we can check back in and consider trimming our position to take some profits, sell the entire position, or hold the position and set a new, higher price target.
- Return $ – The number everyone loves to see, which hopefully is a profit and not a loss. If our 100 shares of stock we bought at $100 reaches our $110 target price and we sell our full position to lock in profits, then we would realize a return of +$1,000 ($10 per share x 100 shares).
- Return % – The dollar return converted into a percentage. Sticking with our example example, selling at $110 would yield a +10% return ($1,000 / $10,000).
- Return “R” – Applying R multiples, we convert the Return $ into “R”. Using this same example, if we had risked $100 (1R), and made $1,000, then our return would be +10R.
- Mistake? – Did you make a mistake or break a rule with this trade? If yes, then you mark the trade as a mistake. Mistake tracking is one of the more underused, yet very powerful variables. By logging mistakes, you force yourself to replay the trade in your mind and reflect back on what went right and/or wrong.
- Notes – Not necessarily a variable, but writing notes when reflecting on the trade is important to learning from each trade. What went right, what went wrong, what you were thinking when buying, selling, etc. are all examples of what can be journaled.
- Risk / Reward Ratio – The risk-reward ratio measures how much your potential reward is for each dollar you risk on the trade. Using the same long 100 shares at $100 trade example, with $99 as our stop and $110 as our target, our risk / reward ratio would be 1:10. As long as the trade works out at least once every 10 tries, we will still make money (excluding trade costs).
Regardless if you build your own trading journal or use one of the services recommended above, there are endless ways you can go about conducting post trade analysis.
What matters most is that you take the time to use and maintain a trading journal. Without one, you are setting yourself up for failure.
Check out our free Trading Journal here on the site and join over 20,000 other investors!
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