Ed Seykota’s Magic Trading System
 Ed Seykota’s Magic Trading System
By Dave McLachlan
Many traders and investors are looking for the holy grail in trading. That one magic bullet that, once learned, will set you up for life and make all your dreams come true. Well, I have good news and bad news. The good news is that there is a holy grail to trading and investing. The bad news is that it is still going to take a heck of a lot of work on your part to achieve. Hard work doesn’t phase you? Read on.
You see most traders and investors who make it through the beginner’s cycle with their equity still in tact have devised some sort of system for their trading or investing. Rules for entry and exit, money management and trade management will all be part of this system (you can see my trading rules in the trading and investment course here – it is well worth the time you spend on it).Â
Because everyone is different, each individual will usually have a slightly different trading style, using different rules on risk, entry / exit and so on. So where does the good news come in? Ed Seykota (prominently featured in Jack Schwagger’s “Market Wizards” book - a highly recommended read) has outlined 6 steps to creating a successful system. Follow these and you will have success. The bad news is the system is up to you – no one can create a system for you and make it work except in rare cicumstances (sometimes you can buy someone else’s system). We must create the rules that are right for us.
So, what are the rules to the magic trading system? Apart from watching this fantastic and entertaining video by Ed Seykota (try not to tap your foot during the banjo solo), I have outlined Ed’s rules below:
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1: Do not stress about whipsaws – one good trend pays for them all.
A whipsaw is when you enter a stock, but get stopped out quickly. In a period of whipsaws, this may happen many times. This can be frustrating to a trader or investor, and it may cause them to change their system. But the fact is that one good trend will pay for all of these whipsaws, and if you change your system you lose the benefit of that!
2: When you Catch a Trend, ride it to the end.
Your system must be able to jump on a trending stock (for instance, up if you are going long), but then also be able to ride that trend to the end. Many novice traders will jump out of stocks before they are finished trending because they are scared the market has gone too far. Let your system tell you when the trend is ending, and only exit once it does.
3: When you show a loss, give the loss a toss.
Every single successful money manager ever interviewed has said something along the lines of: “Cut your losses short”. Get rid of your losses. Keep your winners. And once you have your system don’t second guess it! Being stopped out is part of the process.
4: We know if our risk is right when we make a lot of money, but can still sleep at night.
Risk is the amount of risk per trade (the price between your entry and your stop loss), and how much your total risk is (regarding how many positions you have open at one time).
Both of these should be in your trading plan (I use 1 – 2% per trade, and up to 15 open positions, but everyone will be different). Basically the idea is that it is not so little that you don’t make any money, but not so large that you can’t sleep at night.
5: When price breaks through, or there is a shock news announcement – DO NOTHING. Your stops are already set.
Stop losses: If you aren’t setting them, get out of the game until you learn to set them with your buy order. They can be either metal stops (where you know you will get out) or stops set with your broker. They are the most important rule in trading bar none.
Once you are setting stop losses – stick to them! Don’t let the news, your broker, a friend, an analyst, or a newsletter scare your out of a trade when your rules say otherwise.
6: When you get a drawdown (or series of losses), stick to your plan and pull the trigger on your entry signals.
A drawdown will happen to you at some point in your life if you trade for any decent length of time. This is where you might encounter a long string of losses or a losing period. If you are averaging 60% wins in your trading, you can still mathematically expect to have a series of 12 losses in one period of your career.
What Ed is saying here is: Don’t change your plan just because you are having a drawdown. If you have tested your system and it works, stick to it and keep pulling the trigger according to your rules. Otherwise you will miss that one good trend that pays for all or most of the drawdown (There is one caveat here – sometimes your trading plan does need to be modified as market conditions have changed. Obviously it should be tested thoroughly if you do).
A Final Word
So there you have it – stick to these rules when devising your system for trading and you will be well on your way to success. It may seem simple, but all the best trading systems are. And remember – money is nothing if you aren’t happy, so find or create a system that works for you! You can start here!
Read More on Ed Seykota: “Everybody Gets What They Want From The Markets” and “The Single Most Important Part Of A Trading System” and Ed Seykota’s First Trading System.
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December 30, 2009
Tags: ed seykota, trading system Posted in: Articles On Building Wealth
2 Responses
Hi Dave, with “I use 2% per trade, and up to 20 open positions, ” am i correct in assuming that 2% risk is applied to one’s trading equity (stock plus cash), and the total risk of 20 open positions is 40% of one’s equity? If the 2% applies to cash only, then the size of the trades would diminish quickly if you have open trades.
Hi Angela,
That’s an excellent question, and yes you are correct! It is your stock and cash, equal to 40% of your total portfolio in this example. Everyone is different, and a trader or investor should be ready for a losing streak of at least 12 just in case.
Hope this helps – Dave
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