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Cook`s Kitchen

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Are you missing the big stock moves?

How many times have you missed the surge in a hot growth or momentum stock like Apple (AAPL - Analyst Report), Netflix (NFLX - Analyst Report), or priceline.com (PCLN - Analyst Report)? Remember saying to yourself, "If I just had a system to scan and screen for these plays before they double and triple!"

Or, maybe you prefer a combination of value and cyclical growth but somehow missed the nice moves in Veeco (VECO - Snapshot Report), SanDisk (SNDK), or Caterpillar (CAT - Analyst Report) as they drifted in apparent neglect, under the radar, before they exploded for 25%+ gains once investors rediscovered their earnings stories.

But where do you find such a system that can detect these moves early? If it's all about the fundamentals, which method is consistent enough and easy to follow so that we can build a solid portfolio of winners over time?

And if it's all about the charts, there are dozens of indicators and software packages that all seem to have a couple of things in common -- either they try to predict future price based on subjective patterns, or they are trend followers that only get you in after a significant move.

The bottom line here is that you definitely need a simple and objective data-driven system that can quickly and easily organize stocks into buy, sell, or hold categories -- before the big moves happen. This is how the top trading firms and hedge funds on Wall Street produce such superior, market-beating returns year after year.

This first article in series will address the significance of using a proven and robust system to capture these moves and returns. If you are in the least bit of doubt about why you need a system to beat the market, you won't be after reading this guide.

And at the end, I'll introduce a superior system you can start using immediately to generate profits in any market environment.

What Happens If You Don't Have a Trading System

There are many ways to carve profits from markets. But all successful investors and traders use a coherent and consistent system.

Such a system will contain a set of methods with clearly defined buy and sell rules that allow them to find winners, ride out rough patches, and come out ahead over the long run.

Let’s explore the overwhelming evidence that proves investing and trading without a system is a loser's game.

The Proof from Trading "Statistics"

The failure rate of entrepreneurs in any business is surely north of 80% -- and it’s even worse for one of the toughest occupations on the planet, day trading. Retail brokerage accounts for equities, options, futures, and currencies are opened with an average of $15,000 and drained to zero at an alarming rate within a few months as amateurs try and play a professional’s game.

And the "pros" here -- the ones who do survive over time -- are not simply those with Wall Street connections, money, and access to the best information and the fastest computers.

Successful professional traders will tell you that they can duplicate the returns of the big hedge funds from their home office, and with no "connections," if they work hard and follow simple plans with clear rules and ruthless consistency.

Trading is difficult because it pits our emotional, reactive brains against rapid price movements and immediate threats of financial loss as players swing markets back and forth.

The emotional swings are exacerbated the greater the leverage involved, both for the individual speculator and the market as a whole. As they say in the Chicago trading pits, the secret to making a small fortune in commodities is to start with a large one.

Failure among the pros is even high. Many have gone for decades carving profits from a single type of "edge," only to watch their fortunes vanish as they are blindsided by changing market conditions.

It takes some simple, yet uncommon, skills to succeed in both short-term trading and long-term investing. A disciplined and adaptable mind set and the ability to make and follow detailed plans are tantamount.

The Natural Born Trader -- An Impossible Standard

The head of one New York proprietary trading firm, who has actually turned away former investment bank traders from his shop, says that 95% of the traders who apply to trade for him, or even to enter his training program, never make it past the second interview.

He has high standards because he knows how hard it is to succeed and how rare the qualities are of the person who can be systematic and disciplined in their approach.

Everyone marvels over the master of so-called "Market Wizards" and wants to be just like them. And we think there's something wrong with us if we are not.

But the truth is that few successful traders are born. And the greats who achieved massive wealth may be statistical outliers. The reality is that, for most, trading is very hard work. A difficult, unnatural skill-set must be internalized with repetition, dedication, and discipline.

The only alternative to pouring over charts, research, and news all day is to have a proven system that gives you clearly defined buy/sell and risk management rules. Still, to follow this system requires dedication and discipline. Let's move on and see how the professional risk-taking houses do it.

The Proof from Hedge Funds

If you read all the Market Wizard books by Jack Schwager (there are 3 in total, full of interviews with self-made millionaire and billionaire traders), you will soon start to see a picture of the qualities and practices that lead to their extraordinary success.

There are components of proper psychology and discipline, exacting risk management and use of probability-weighted position-sizing and portfolio monitoring, and systematic market analysis and execution.

All these concepts and habits, honed to precision weapons through much trial-and-error testing, combine to create trading machinery that consistently produces outsized wealth-building returns for many years, if not decades.

In the early days, as these Wizards developed their craft, there wasn't much computer programming, back-testing, or automation involved. But as these practical tools evolved, ever-complex global markets were harnessed and continued to hand them profits as the "quants" and "algos" took over.

Now, every day, hundreds of hedge funds and new "wizards" are pulling outsized returns from the market through systematic execution of precision trading plans fed by deep data-mining of markets and methods.

They leave nothing to chance because they understand chance and how to use it systematically to build an edge, making sure that their super-fast computers are always buying or selling at predetermined entry and exit points. And they craft new edges as needed to exploit changes and shifts in market behavior.

The point of this description of hedge funds and other proprietary trading firm wizards is to emphasize where their success comes from. It's not simply the computers and algos coded by quants. Those are only the tools and architects of the money-making machines. It's the instructions and their systematic consistency that counts.

Rules-based trading where the rules are solid, and they are followed ruthlessly, is an unbeatable formula for market mastery. Many of the masters learned long ago that they could not rely solely on their intuition about a chart or a stock -- and they learned the hard way that they had to remove their emotions from the decision-making apparatus.

To make annual returns of 25% and more as many do requires strict allegiance to systematic trading. They define an edge and a set of methods for particular markets and they set out to exploit it every chance the market gives them with unfailing dedication. This is how the top incomes are made in the trading world on prop trading desks and it will always be thus.

Still Want to Learn the Rules of Success?

If I haven't discouraged you from pursuing an active trading career, give me some more time. I'm kidding, of course, but I do have two more areas of "proof" I want to share with you about why you need a trading system.

One is from science, where we look at human risk-taking behavior and decision-making under uncertainty and stress. And the other is straight from the dens of professional gambling. Casinos know a lot about systematic risk-taking and have something very valuable to teach us about how to win in markets. Both of these areas of research are on the risk appetite menu in part two of this article.

Then my goal is actually to encourage you to approach trading and investing with informed confidence and long-run sustainability. Once you are convinced why you need a trading/investing system, you will be more motivated to learn and follow the rules of any winning system you come across.

And you will save yourself a small fortune in the "school of the markets," where the tuition is limited only by the size of your account.

Kevin Cook is a Senior Stock Strategist with Zacks.com

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