The focus should be on the process and not on profit and loss (P&L), ace trader Madan Kumar tells Moneycontrol's Shishir Asthana.
Dow Theory author Robert Rhea whose works form the basis of technical analysis once said: “No profession requires more hard work, intelligence, patience, and mental discipline than successful speculation.” Such personality traits apply to all successful traders, be it in India or elsewhere.
Full-time trader and a successful one at that, Madan Kumar has a rags-to-riches tale to tell. And he credits his success to his mother and wife for each of them had a large part to play. His mother because she instilled an inclination towards education and his wife as she supported his family financially when he returned to India from the US.
“I tell my friends who want to be traders that if they do not have a supportive spouse do not be a trader,” he says.
Born and brought up in a middle-class family in Chennai, Madan had more than a fair share of humiliation as he grew up. Being punished at school because his family could not pay the tuition fee in time was just one of the embarrassing moments in his life. A strong-willed mother who believed that education was the only way out of poverty encouraged him and his brother in studies.
The siblings became engineers from reputed colleges and moved to the US for further studies. It was here that Madan was exposed to markets. After the initial bout of mistakes that most traders make, Madan managed to break free. His eureka moment came from a line in a book that made him see the mistakes in his approach to trading.
When it comes to trading Madan is old school. Madan trades a trend following system, and any trend follower would know that it takes a lot of grit, determination, and conviction to become successful in this form of trading. It is here perhaps that Madan’s humble background of standing firm despite adversaries has helped him.
Coming back to trade the same system after 17 straight losses, especially in his early years of trading requires grit and self-belief. Which is why Madan believes in the mental or psychological aspect of trading. Blogging on money management and the psychology of trading on his site www.marketswithmadan.com, he touches on the topic that is rarely discussed or talked about in India – the mental aspect of trading.
Though a successful trader, Madan has his heart in the right place. He is currently actively raising money for victims of the Kerala flood via Twitter.
In this Moneycontrol interview series, Madan Kumar shares his views on what it takes to become a successful trader.
Q: Can you walk us through your background and your journey to becoming a successful trader?
A: It’s been a long and arduous journey. Especially, as I come from a lower-middle-class family where we struggled to pay for our education. However, my mother’s belief and commitment that the only way out of the middle-class drudgery is good education paid off. I completed my B.Tech in IT from the University of Madras and moved to Virginia Tech in the US for my post-graduation.
It was in the US that I got interested in the markets. While working there I got a job offer which allowed me to work from home. This gave me some time to dabble in the markets.
My initiation in the market was by listening to a friend’s market stories between tennis matches. He used to trade the earning seasons by predicting the quarterly results. He used to buy call or put options depending on his guesstimates of the results. What got me interested was by investing around $2,000 on a trade he made $3,000, which was nearly half my monthly salary back then. Though my friend would only tell me about his victories, I was intrigued by the markets.
During this time in the US, there was an inverse ETF instrument that was launched which went up every time the Chinese markets went down and vice-versa. This was the time when the Chinese markets had just started falling. I made money trading in this instrument and felt it was not too difficult making money this way, all one had to do was guess which way the market was going.
But then Greece happened and volatility increased and the entire dynamics changed. It is then that I realised there is more to the markets than pure guessing.
Q: What did you do next?
A: I explored every possible indicator, I took numerous trading courses in search of the Holy Grail. But I was not in the frame of mind to take 3-4 losses in a row and hence jumped strategies.
I took a three-day mentoring program with John Carter, the author of Mastering the Trade, who introduced me to one Mark Douglas.
Carter told me Douglas could be the person who can change my trading career. At the time I did not know who Douglas was and the books he had written. My meeting with Douglas was rather casual, if I may say so.
It was only after I came home and read the reviews of the books written by Douglas did I realise how big a personality he was. Though not in person, I think it was Douglas’ book ‘Trading in the zone’ that has been the turning point in my trading career.
In his book, Douglas talks about the fact that as a trader one need doesn’t have to know what will happen next. Until this point, I was predicting what will happen next. Even the pundits appearing on media in the US talked about predicting the future direction.
I realised that the systems and strategies account for only 20 percent of the success. Money management and trading psychology account for 40 percent each if one wants to become a successful trader.
Another important point that I learned from Douglas is one needs to take at least 25 trades with flawless execution before changing the strategy. Yet in my experience, I can tell you that out of 100 traders not more than 5-6 will be able to test a strategy for the complete 25 trades without changing any parameters. It requires a lot of discipline and conviction to complete the 25 trades without tweaking the parameters.
Q: How soon did you turn profitable?
A: This knowledge, however, did not bring me instant success. I was still losing money and winning it back. I was in the revolving door business till Carter told me to look for price action rather than indicators. Technical indicators are just a pictorial indication of price actions. Price action is the purest form of trading, he said.
Till this point, I was under the impression that I needed a set of rules to get in a trade and another to get out. But price action required some kind of discretion. But this was against what I had been doing till date.
I then came across a book by Bill Williams on fractal points based on Chaos Theory. It is like your hand, where the middle finger is the longest, the ring finger shorter and the rest even smaller. The market also displays a similar structure, where you have a lower low and lower high bar before and after a middle bar. This middle bar is called the anchor bar. That made sense and I thought that I can mark these things as structural pivots or swing pivots from where the market turns.
Q: How did you use this information to trade?
A: I trade using structural pivots on the Nifty on a 30-minute time frame. I am a positional trader who follows price actions. I use the futures chart but take a position in the options market. My trades typically lasts for 3 days to 1.5 months.
I buy at-the-money options, either calls or puts. I am okay with the impact of time decay on my options. Since I trade in at-the-money options my delta is 0.5 and as the trade moves in my direction, the delta of the option increases as my option is now in-the-money option.
I do not risk more than one percent on a trade. I prefer buying my entire position in one go and exiting them in a similar way. What I have found out is that the best risk-adjusted returns for my kind of strategy come from an all-in-all-out way of entries and exits.
Through price actions, I identify breakout trades and keep myself in position if a breakout happens. Unlike some traders, I do not wait for a breakout but jump in as soon as the breakout happens. In trading, it is important to know what kind of person you are.
There are people who like discounts in anything they buy, these are the people who are best suited for pullback trades. On the other hand, if I buy something on the net, I sort it on price and look to buy the costliest with the assumption that the costliest has the best quality.
I mechanically mark the pivots – large pivots and small pivots. I go long above the large pivots and use the small pivots as the stop loss. Post the breakout, when I am in the trade, my trading is more like trend following.
Now in case if there is a gap opening the next day against my trend, I wait for the first 30 min low to be formed, (if it is below my stop loss point) below which I keep my stop loss. Based on the statistics that I have worked out, if the market is in a strong trend 80-85 percent of the time market will not go below the 30 min low.
If I do not have a position in place I will use this gap down on a strong uptrend by entering above the 30 minute high.
Till such time that I am triggered, my order is sitting there for a couple of hours. That is where the boredom comes in and I end up watching a movie or playing online poker. I generally tell people that if you keep on watching the chart you will end up making mistakes, as the ticker goes up and down your emotions also go up and down. You need to get out and come back periodically depending on the time frame you are trading in.
Q: What about your trade’s vital statistics?
A: Like every trend follower my win-loss ratio is very less. I am right less than 30 percent of the time. But my risk-reward is about 6.5 times.
On a trade level basis, I have a 28 percent winning rate, but on a month level I have a 75 percent winning basis, on a quarterly basis I have a 94 percent winning system and on a yearly basis I have a 100 percent winning rate system.
Between July 4 and July 27, I could get 550 points on the Nifty. But this good trade hides the fact that I may also be subjected to 10 losing trades in a row. It is only because my stop losses are low that I am able to absorb these losses. But one has to be psychologically very strong to take the next trade after a series of losses.
Most trend followers in the world go through this phase. Take Paul Tudor Jones or Ed Seykota, they have a success ratio of 20-25 percent, but their risk to reward is around 7 times.
For me, the worst losing streak has been 17 trades in a row in the second half of 2012. But that is okay, I was mentally prepared for it. My stop losses were low. Nifty was around 5,500 levels back then and my stop losses were around 12-15 points. So in 17 trades, I lost around 250 points, but all it takes is one big trade to wipe out these loses. In my backtesting, I had seen a streak of 22 losing trades so that prepared me for this streak.
But still, it takes grit and conviction in your strategy to stand up and take the next trade. That is why trend following is extremely difficult.
Trend following strategies have two type of drawdowns, one is the price drawdown and the second is the time-drawdown that a trader has to overcome. But after you have gone through to some drawdowns and come out with a higher equity than before, these drawdowns will not matter. It will feel like a mosquito bite rather than an elephant trampling on you. Your mind has to recognize that these drawdowns are like breathing. Losses are part of the system. You have to develop the mindset to take losses and stop jumping strategies after a streak of losses.
Q: Why did you come back to India when you were trading in the most liquid market in the world with access to the best brains in the business?
A: My mother was unwell and she was alone, that’s when I decided to come back. My wife supported me in this decision and my pursuit of trading in India. She took up a job and supported the family so that I could trade.
It was a big decision because when we came back to India I had lost around $125,000 in the US markets. Though I recovered around $30,000, I was still down. I had confidence in my trading abilities. It was then that my wife said that she was willing to support me both financially and emotionally. And she did so for the next three years till my trading picked up and was enough to support the family.
That is why I tell my friends who want to be traders that if they do not have a supporting spouse do not be a trader. If you are from a middle-class family, it is nearly impossible to come out of it unless you have a supporting spouse.
Q: What was the main difference you felt when you traded in India as compared to the US?
A: I trade only on the indices. The main difference in trading in S&P and Nifty is the liquidity. Secondly, S&P generally reverses back to the mean, so you can do a lot of range trading strategies in S&P. So I needed to change and adjust a bit. But by then I was already a trader with a lot of scars so I could quickly adjust to the changing scenario.
Q: How did you adjust?
A: You need to understand the parameters of your system and then adjusting to the changing market is not an issue. Everyone talks of risking one-two percent of their capital on a trade. But that may be true for certain people it might not be true for say, me.
If I would have bet two percent of my capital on every trade, the 17 losses in a row would have taken one-third of my capital and more importantly it would have taken a bigger toll on my mental make-up.
That is why I stress on back-testing and setting your own parameters. But back-testing for my kind of discretionary strategy is not easy, it cannot be programmed, unlike an indicator based system.
I tell people in my seminars that back-testing has to be physically done on a bar-by-bar level. I generally get the reply that this will take months. But who says trading is easy if you cannot put the hours needed to back-test you are in the wrong profession.
In my case, I back-tested 10 years of 30 minutes timeframe data which took me six months of continuous 10-12 hours of work. It is a boring job and many people leave it after a few days, but this back-testing gives you the pulse of the market and the strategy you are trading.
If you see mutual funds advertisements, it says past results are not indicative of future results. But if your past results are not good what is the point of following the system. The only way to find the performance of a system and make it his own for a trader is to back-test.
There is another advantage that back-testing offers. See the difference between me and a trader with 20 years of experience can be shortened with the help of back-testing. You can fast forward the learning experience by going bar-by-bar into the past rather than gaining experience by actually trading for 20 years. Back-testing gives you the feel of the volatility and you relive the moment.
I generally recommend back-testing a strategy with around 1,000 to 1,500 trades.
Q: How can a newbie trader turn successful?
A: One of the biggest difference between a successful trader and a non-consistent trader is the way in which they handle losses. We do not like losses. People tag losses with being a loser. A trader who is on a losing streak thinks he is a loser.
Normally, if a newbie trader faces a streak of 5-6 losses and if he has back-tested his strategy superficially, or for a few years, he would look out for an indicator that would have avoided these losses. This process would go on till he drops the system.
The problem is we are in a microwave culture, everyone wants instant. As I have mentioned in my trade statistics, I have a 28 percent winning rate system on a trade level basis but a 100 percent winning rate system on a yearly basis.
So one should not get perturbed by one trade or a streak of losing trades. One trade is just a small dot in the whole perspective.
What I tell in seminars is to start with the minimum amount. If you are trading in the cash market just buy one stock. If you have a big capital just buy one lot. The amount should be small but not so small that it does not hurt.
I generally give this example, if you are driving a car and focus on a point in the windshield you are going to lose track of the road, but if you focus on the road you are going to lose track of the single point. To gain that mindset you have to go through the process and actually trade but with a small quantity so that a few streaks of losses don’t destroy you.
It is important for the trader to have a system which has an edge. This is the foundation on which money management and trading psychology will be built.
The trader has to have a plan. Coming in the morning, listening to other’s recommendations and trading is not a plan. One should know the instrument he is going to trade in, the setups where he will enter and exit.
A very important point is that the trader has to come out of the ideology of predicting the market or the urge of knowing beforehand what is going to happen next.
The trader has to acknowledge and learn from his losses. He should treat losses and gains in trading as breathing in and breathing out, it is inevitable.
Back-testing your system is an absolute must.
Finally do not look at you P&L while you are in your trade. It is said in Blackjack and Poker that one should not count his money till he is on the table. Similarly, counting your profits while in a trade is not advisable.
The focus should be on the process and not on P&L. Have a process goal rather than a P&L goal.There is only one Holy Grail in trading and that is execution. If you are right 95 percent of the time in execution, you are way ahead of the crowd.