The Universal Principles of Successful Trading by Brent Penfold

Contents  ˅

Preface Introduction 1) A Reality Check 2) The Process of Trading 3) Principle One: Preparation 4) Principle Two: Enlightenment 5) Principle Three: Trading Style 6) Principle Four: Markets 7) Principle Five: The Three Pillars 8) Money Management 9) Methodology 10) Psychology 11) Principle Six: Trading 12) Just One Piece of Advice 13) A Final Word Appendices A, B, C Risk-of-Ruin Simulator

The preface sets the tone for the rest of the book when it states, less than 10 percent of active traders are profitable. But if the 90 percent who lose follow the general rules of successful trading, they can be winners too.

The difference between winning and losing is not found with a secret system, but by using six basic principles for sound trading.

The Preface concludes with a few warnings. The book is not for those who want easy, no work, 100 percent winning trading. The trading principles the book offers are simple, but not always easy to apply.

Brent Penfold has been an active trader of index and currency futures since 1983. He has learned the key trading principles the hard way, by violating most of them.

As a 100 percent mechanical system trader, Penfold attributes his success to the use of these principles and not some innate ability. And because of his experience, he feels others can do the same.

Above all, Penfold wants traders to be open to all ideas. But at the same time, consider them critically, even those coming from him.

Most traders are "bad" losers. These traders find it hard to accept losses and so they hold onto bad trades. The solution is to be a "good" loser and understand that accepting losses is a necessary part of trading.

But good losers don't just lose, they rely on a tested method, sound money management, and a balanced psychological outlook.

There are multiple ways to go wrong in these three areas, especially in the first three years of trading. Such things as following tips, trading without a plan, and lacking money management are a recipe for disaster. And that's just the first year.

In their second year, traders may attempt to pick tops and bottoms, overtrade, and rationalize their losses.

If traders are still losing in year three, some problem remains in their money management, method, or psychology. The cause may include a complex or untested method, risking too much on each trade, or lacking discipline.

The suggested solution to avoid these problems is to imitate commodity trading advisors (CTAs) and make trading a process. CTAs know how difficult profitable trading is and verify every step of their plan. They create a solid structure which leads to confidence in their method and money management. Their process provides a disciplined profitable consistency. Ultimately pros know trading is simple, but not easy.

As mentioned in Chapter 1, successful trading is a process. The process has six steps:

1. Prepare a foundation (Chapter 3)
2. Understand market realities (Chapter 4)
3. Select a trading style (Chapter 5)
4. Select markets to trade (Chapter 6)
5. Follow the three pillars (Chapter 7)
6. Start trading

This chapter merely outlines the trading steps. The details for each step are covered in separate chapters.

Before a person can begin to trade, it's important to be aware of certain realities and how to cope with them.

Maximum Adversity
This term describes how market action and public market information cause most traders to lose. The potential for pain is always present. Even a winning trade can result in thoughts of missing out on a greater gain.

Emotional Orientation
A trader must have the right objective and reasonable expectations. The right trading objective is not how many trades you win or the money you make, it's how you manage your risk capital. Trading is a matter of survival. Lose your trading capital and the game is over.

Instead of believing the hype about high returns from system sellers, consider what is reasonable for the markets you trade. If a market averages a 10 percent yearly gain, then a 20 percent return could be a reasonable objective, given the assumed risk. Of course the higher the objective, the harder it is to consistently achieve it.

Losing Game
This sums up another market reality. "90 percent of traders will lose their risk capital in 90 days."

Random Markets
Overall, markets are essentially random. Winning traders don't try to predict where they will go. Instead, winners act on a market's current direction.

Best Loser Wins
If you can manage your losses, you can be a winning trader. Keep losses small and the wins are almost automatic.

Risk Management
Once you understand the trading risks you face, you can create a plan to deal with them.

Trading Partner
Having a trading partner helps enforce discipline and eliminate self-deception. The partner's role is to monitor your trade preparation and trades. Anyone you respect to act as a trading conscious, can be your partner.

Financial Boundaries
A trader needs to decide how much money it's acceptable to lose and walk away if the limit is hit.

Successful trading is not a one time event, but a process which covers years. This makes long-term survival a key focus. And in order to survive, you need to take the following actions:

Avoid Risk of Ruin
Risk of ruin refers to the probability of going broke using a considered trading method. And if you don't know what your risk is, you probably will be ruined. Ideally, the risk of ruin should be zero. Good money management and the positive expectancy of a tested profitable method, can make it happen.

Risk of Ruin = ([1 - (W - L)]/[1 + (W - L)])^U
W = Probability of winning
L = Probability of losing
U = Number of units of money in the account

Embrace Trading's Holy Grail
The Holy Grail of trading is not some perfect system, it's any method which has positive expectancy. This means the method has been shown on a consistent basis to win more than it loses. Positive expectancy shows, on average, how much can be made for each dollar risked. Along with positive expectancy, a winning method must have sufficient trade opportunities.

Expected Return = [WP x (AW/AL)] - [LP x (AW/AL)]
WP = Winning probability
AW = Average winning gain
AL = Average loss
LP = Losing probability

Pursue Simplicity
The trading method you use has the best chance to continue to work if it's kept simple. Every added rule or indicator is another source for future failure. Identify the market's support and resistance levels and you'll have a good foundation for a trade.

Tread Where Most Fear
Since only a minority of traders win, you can't follow the crowd. This is the essence of the whole book. Do the work necessary to follow what the winners do and what the losers don't.

Validate Your Expectancy with TEST
A riskless way to test your system in real time, is by using TEST. It's the acronym for Thirty Emailed Simulated Trades. TEST requires you to email 30 simulated trades to your trading partner before the market opens. The trades should be single lots and must include any necessary responses to market action. Once the 30 trades have been made, they provide a statistically significant sample to calculate expectancy.

Choosing a trading style requires picking a trading mode and time frame. The mode describes which trades are taken. Either they follow the market trend or the trades run counter to it. Countertrend trading is usually called swing trading and swing traders look to profit from the frequent short-term-price moves. Their per trade profits are smaller than those of trend traders, but their win rate is higher.

Trend traders usually win less than 50 percent of their trades, but they can capture large profits by holding a position during a major market move.

The time frame you choose depends partially on the mode you prefer. A swing trade period may last for a market day, several days, or possibly up to 2 or 3 weeks. Trend traders usually rely on catching larger market moves with a time frame of weeks or months. However, both the mode and time frame may be different for traders who follow more than one system.

It's a common idea you should pick a trading style which fits your personality. The advice is well intended, but the markets are not designed to make you feel comfortable. It's comfortable to be a part of the crowd and follow what they do. But following the crowd is the path to losing.

Compared to swing trading, trend trading usually requires a larger account to trade properly. This is due to account drawdowns and limited trade opportunities. The relatively low win rate of about 30 to 40 percent, means trend traders can expect large account drawdowns from a series of losing trades. And since major price moves happen infrequently, trend traders need to be in multiple markets at the same time.

In contrast, swing traders have both higher win rates and shorter losing streaks, which results in smaller account drawdowns. Since they only trade small market moves, swing traders can find all the opportunities they need in one or a few markets. Regardless of your personality, if your finances are limited, so are your options.

In the end, your trading style relies on a tested method which meets your objectives. And with luck, it will fit your personality.

Operation Risk
The first criteria for choosing a market to trade, is the market's operation risk. Operation risk refers to anything which adds to the basic risks of a trade. A low volume market or a market that's traded on more than one exchange, won't allow for dependable trade entries and exits.

The price and volume information should be reliable, as well as the marketplace itself. Trades need to be completed in an efficient and timely manner.

The cost of doing a trade, commissions and price slippage, should be similar to other markets. Ideally, the market is open 24 hours a day, to permit trade exits at any time.

Trading Attributes
Once you've determined the chosen market and exchange don't add to trade risk, qualify the market's trading characteristics.

A good market should have a history of consistent price movement. This allows for making enough profit per trades and enough opportunities for a trade. There should also be a source for reliable past price data for testing purposes.

If you want to sell short, you need to find out if there are possible restrictions for doing so. And when shorting stocks, is there enough supply? Good market volume ensures as your trade size grows, it can be easily handled, whether long or short.

The final quality of a good market is leverage. This gives the ability to control a high value asset for little cost. Futures are a good choice for achieving this.

The Three Pillars of trading in order of importance are:

Money Management
Managing risk capital is critical to trading survival. Seven strategies for money management are detailed in chapter 8.

Methodology
A methodology consists of a setup and a trade plan. It should have a simple logical structure and be validated with testing. Chapter 9 provides the needed details.

Psychology
Trading is mentally demanding and emotions get tested constantly. Learning to manage emotions when trading is the subject of chapter 10.

The first and most important objective of good money management, is to avoid risk of ruin and keep risk capital intact. If you do that, you can meet the second objective of making large profits.

Martingale vs. Anti-Martingale Money Management
There are two basic approaches to money management, Martingale and anti-Martingale. With Martingale money management, a larger amount is risked after a losing trade and a smaller amount following a winning trade. This strategy has an appeal for gamblers, but for traders, it only increases the risk of ruin.

Anti-Martingale takes the opposite approach. Position size is increased after a win and decreased after a loss. This method is more sound because the amount risked on a trade rises and falls in harmony with the account balance size. Over time, anti-Martingale loses less and makes more.

Seven types of popular money management strategies are:

• Fixed risk. This strategy sets a constant amount for each trade. Because the amount doesn't vary with account size, it doesn't follow the anti-Martingale strategy.
• Fixed capital. This method divides the account balance by a predetermined amount which sets how much is risked on each trade.
• Fixed ratio. With fixed ratio money management, a set level of achieved profit is required before the amount per trade is increased.
• Fixed units. To apply a fixed units strategy, divide the account balance by a constant number to determine how much can be risked on each trade.
• Williams fixed risk. The trader Larry Williams created this money management formula. The amount risked per trade is the account balance multiplied by the largest percentage of your account you're willing to lose.
• Fixed percentage. The most frequently used form of money management is fixed percentage. The risk per trade is a percentage of the account balance.
• Fixed volatility. Unlike the other strategies, fixed volatility uses market action as part of its formula. A fixed percentage of the account balance is divided by market volatility to set the per trade risk.

In a simulation, all but the fixed ratio strategy made substantial profits, but also large account drawdowns. There is no perfect system of money management. Which one you choose depends on what features of a method you value most.

One final aspect of money management is the use of a system stop. Just as a trade stop exits a position to limit loss, a system stop exits a system for the same reason. Like the basic money management choice, a system stop is a personal decision. The goal is to stop using a system when its equity curve loses upward momentum. When momentum returns, the method is traded.

Possible system stops include an account drawdown which exceeds a set limit, is greater than a previous drawdown, or hits a percentage of a previous drawdown. The system stop can even treat the equity curve like a stock. An exit could be made if the equity curve crosses a moving average, makes a new swing low, or breaks out of a channel.

The first step in creating a trading method is to decide if it will be completely mechanical, entirely discretionary, or a combination of the two.

A mechanical system trader relies on a method which is strictly followed without any changes. The discretionary trader has a strategy which allows for the flexible application of the basic rules. Combining the two approaches is the discretionary mechanical trader who applies judgment on when a system is used.

With no trading decisions to make, the mechanical trader has less stress than the discretionary trader. It's the best option of the three to start with. Mechanical system trading offers simplicity and structure, which is especially helpful for beginning traders. Whether discretionary or not, the focus should be on a simple methodology since that gives the best chance for long-term success.

In choosing between the two trading styles of trend trading or countertrend trading (swing trading), it's recommended to initially develop a trend-trading methodology. However, this requires dealing with the low win rate of trend trading. So you have to be prepared for that reality. With time and experience you can add a higher accuracy swing trading method for balance.

Creating a Trading Method
A trading method consists of two parts, a setup and a trade plan. A setup locates support and resistance levels to indicate whether to buy or sell. The plan is a set of clear, simple, logical rules for trade entry, exit, and placing stops. The method should be validated and shown to have 0 percent risk of ruin.

The situation for setups is how to identify the areas of support and resistance. There are many ways to do this, but whatever approach is used, its accuracy should be validated. Common trading techniques and advice are often inaccurate or ineffective and should be judged critically.

It's best not to follow methods which try to predict the market, such as Elliot wave theory or the teachings of W. D. Gann. Prediction methods make it very tempting to try to pick tops and bottoms. But these methods instill misplaced confidence and tend to blind you to the current market action. At the same time, it's acceptable to be pragmatic. If a tested prediction strategy works, then use it.

Fibonacci numbers are derived from a mathematical series with each number the sum of the previous two. 0, 1, 1, 2, 3, 5, 8, 13,...and so on. Ratios created by dividing one Fibonacci number by another are claimed to indicate important support and resistance levels. In order to test the ratios' validity, Penfold created swing charts with multiple markets in multiple time frames. If the Fibonacci ratios have predictive value, then they should stand out from all the other possible ratios.

With a total combination of 18 currencies and indexes over 20 years, the results showed the Fibonacci ratios occurred no more frequently and sometimes less, than ratios either above or below.

Traders are also discouraged from using any of the common indicators, such as Stochastics, the Relative Strength Index (RSI), or Moving Average Convergence Divergence (MACD). These are second-hand price representations and tend to show what has happened, but not what prices are currently doing. However, like other areas of market analysis, if an indicator reliably works, use it. There's an additional caution if you use multiple indicators. Most technical indicators rely on price movement, so make sure the ones you use don't measure the same thing.

Instead of subjective methods for determining trend, it's suggested you use price alone in the form of swing highs and lows. The trend is up if each new swing low is higher than the last. A downtrend is identified by a series of lower swing highs. The trend reverses when the string of new lows or new highs is broken.

In contrast to relying on indicators, Penfold calls most successful traders pragmatists. These traders rely on raw prices or volume without any indicators to interpret the changes.

Once you've determined the setup process, it's time to create the trade plan. The trade plan should align with the setup. If the setup identifies a support level, the trade plan should wait to see price move up off that level before a trade is entered. Conversely, a trade made from a resistance setup is entered only after price moves lower. Setups aren't right all the time and the trade plan should include an indication the setup is correct.

Confirmation of a buy setup can be as simple as a day's close which is higher than its open or higher than one or more daily closes, or if a rally takes out a prior high. The same holds in reverse for a sell setup.

The idea is to keep things simple. The well-known trader Tom DeMark is quoted as saying, "The bottom line was, after 17 programmers and 4 or 5 years of testing, the basic 4 or 5 systems worked best." After all that testing, it wasn't some complex formula which worked, but basic strategies which proved the most robust. Simple plans also work well for discretionary traders by making their decisions easier.

Basic Trade Plan Principles:

• Keep it simple.
• It should have a logical, unified structure.
• The fewer the parameters, the better.
• There should be a combination of initial, breakeven, and trailing stops.
• Time stops are also sometimes appropriate.
• Prefer dynamic stops over fixed dollar stops.
• Instead of profit targets, it's usually better to use trailing stops.
• Ignore the advice that entries aren't important.
• Avoid large stops in the attempt to increase the win rate.
• Confirm the plan's validity with TEST.

If the trades made in TEST show a positive expectancy and the equity curve is relatively consistent, the method is good. A winning trend-trading methodology has good accuracy, an average win-to-loss ratio of 3 to 1 or better, and is combined with sound money management. These are the elements which lead to a 0 percent risk of ruin and long-term survival.

In the 1980's a group of people were taught a system created by two very successful traders, Richard Dennis and Bill Eckhardt. The two men referred to their students as turtles and were able to train them to be winning traders.

The trading plan for the Turtles' system is an example of a simple yet profitable trend-trading methodology. The system buys on a breakout above the high of the last 20 bars and sells on a breakout of the last 20 bar low. Along with an initial and exit stop, that was the complete method.

A trader's psychology is important, but not as important as effective money management or a validated trading method. When those two pillars of trading are in place, the emotional hazards of trading are reduced.

To deal with the psychology of trading you need to manage the three emotions of hope, greed, and fear.

Hope
Hope occurs if you focus on the outcome of a single trade. You hope it's a winner and you hope you don't get prematurely stopped out. But if you have sound money management and a system with positive expectancy, you can ignore the outcome of an individual trade. IF you have 0 risk of ruin, you can replace hope with confidence of long-term success.

Greed
Greed is not just bad for your emotional state, it's also bad for your trading. The desire to increase how much money is made, can lead to more and riskier trades. Instead of a trader, you become a gambler trying to make up for the increasing losses. The antidote for greed is to set an achievable rate of return. The math is undeniable. Higher returns require higher risk which lowers the chance for long-term survival.

Fear
When you trade, you're dealing with an unknown future and the unknown can cause fear. There can be the fear of failure, loss of control, and financial ruin. Much like greed, fear can cause taking actions not in the trade plan.

To manage fear, you have to face it with action. It's suggested to simply expect the worst trade outcomes. Accepting the idea that the worst will happen reduces the unknown future fear. With a sound trading foundation, you can expect long-term success. But on a daily and intermediate term basis, set your expectations to lose.

How far should your expectations go? Penfold expects each day's trade will lose. He expects he's at the start of his longest losing streak. He expects the last losing trade is the first in a series for his largest account drawdown. When you expect maximum market adversity, you have faced your fears head on.

Pain
An overlooked subject in most discussions of trader psychology is the pain involved. If you can't handle the pain in trading, nothing else matters. In trading, pain is all around you.

There's pain when you lose on a trade. There's pain when you win, but see you could have and maybe should have, made more. There's pain from the hours and effort put into developing a trading methodology, only to have it not validate. There's pain from buying books and courses or going to expensive workshops only to get techniques which don't work.

To manage pain, accept it will happen. The pain won't go away, but its intensity will be less. With a proven trading method, it's easier to objectively deal with pain as just another part of the process.

Despite all your preparations there may be times when it's more than you can handle. If that happens, get away from trading and give yourself a chance to refresh your energy. The markets will still be there when you're ready to return.

To help you stay emotionally in control, Penfold gives an affirmation for managing greed.

My objective in trading is not to be right or wrong but to manage my risk capital with a modest expectation.

Similar affirmations are given to manage fear, hope, and pain.

After the preparation to begin trading is done, the actual trading can be a consistent routine.

1. Once a trade setup is identified, determine the entry, stop, and exit points. Using the entry and stop prices, calculate the trade risk.
2. After trading for some time, check your account balance to make sure you haven't exceeded your risk capital limit. If you have, stop trading. The second check is the system stop. If the equity curve is above the stop, continue to trade. If not, place simulated trades and wait for the equity curve to rise back above the stop.
3. If your account passes the two survival checks, the final task is to determine the position size for the trade setup.
4. To acknowledge your fear of a bad trade outcome, expect the trade you make will lose. Actually enter the loss in your trading spreadsheet.
5. Use the positive affirmations from chapter 10 to manage your hope, greed, fear, and pain.
6. Place the trade order and get confirmation of the order instructions. Then wait to find out if the order is filled.
7. Once the order is filled, follow your trade plan to manage the position.
8. After the trade conclusion, update your profit and loss spreadsheet and the equity curve.

For new traders, the range of possible orders can be confusing as to what they do and which should be used. This chapter includes a section describing how the various order types work.

Trading should be conducted like you would a business. This requires good record keeping practices. You should prepare a monthly single page report for your trading partner. The report consists of all the financial aspects of your account. This monthly obligation helps enforce the discipline to stick with the objectives of your trading plan.

To add balance to Penfold's opinions, he asked 15 successful traders for one piece of advice. Although Penfold believes the principles he writes about are true and universal, he encourages you to be critical of all trading information, even his. Be open to new ideas, but don't accept them without validation.

A background biography for each trader is given along with their advice. The fifteen traders are: Ramon Barros, Mark D. Cook, Michael Cook, Kevin Davey, Tom DeMark, Lee Gettess, Daryl Guppy, Richard Melki, Geoff Morgan, Greg Morris, Nick Radge, Brian Schad, Andrea Unger, Larry Williams, and Dar Wong.

The advice these traders gave did indeed provide balance. They had a variety of ideas on what was most important in becoming a winning trader.

This last chapter expresses the hope the reader gains important trading knowledge from learning the universal principles and hearing from the master traders.

With all the information and market access available, there's never been a better time to be a trader. But at the same time, much of the trading information is simply worthless or unrealistic. The lack of honest and practical information is one reason 90 percent of traders lose today, just as they did 50 years ago.

The reality of trading presents constant challenges and sources for pain. To be a winning trader you need to recognize these obstacles and overcome them. But if you heed the universal principles, be patient, and remember the winners are the best losers, you can achieve success.

The use of a risk-of-ruin simulator and how it was constructed is described in appendix A. The code for the simulator is in appendix B and the test output in appendix C. The code is Visual Basic for Applications (VBA) for Excel. The variables used for the test example and the simulation logic are explained.

PJ Nance

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