First principles thinking inverts complex problems to look at each step in a process or system. It seeks to find errors as places for improvements by looking at the most basic principles that lead to success or failure.
You must remove opinions, beliefs, assumptions, traditions, and predictions to see the essential core principles of a model or system. This is an approach that can look over the skewed filter of experience and see what the real drivers of success are.
The first principles of trading is what can be done inside the context of the exchanges that are traded on, the behavior of buyers and sellers to move prices, and your own ability to buy and sell positions inside your account. The first principles of price action are that a stock chart can move in an uptrend, downtrend, sideways, or become higher volatile. Markets can be liquid with tight bid/ask spreads or illiquid with wide and expensive bid/ask spreads. Volume of trades can increase and decrease, market trends eventually top out or find a bottom in price.
Going deeper into first principle thinking a trader can be mechanical or discretionary or a mixture of the two. A trading system can be profitable from big wins and small losses or from a high winning percentage as long as losses are kept equal or smaller than wins.
A first principle thinking trader looks at how to connect and combine the math of the markets price action to create a profitable trading system through the use of historical price movement. Developing a quantified trading system with an edge is first principle thinking. The majority of trading based on predictions, opinions, emotions, and ego is based on few if any principles, especially when practiced by new traders.
First principle thinking can see outside the box of how things have always been done and create new systems and improve on existing systems. As new data and outcome becomes available it is integrated into the systematic thinking to adjust and improve on potential outcomes.
Anything that is not fact, science, or math is an opinion. One of the best examples of first principle thinking was the Money Ball system created for baseball that used analytics to cut through a century of dogma and see what actually lead to winning games with the least cost.
Here are questions that can lead to finding the first principles of trading success:
- What has really made successful traders profitable? What was their edge? System, psychology, risk management or a combination of them all?
- What do you know to be true about historical price action? How can you create a profitable system based on what you know?
- What does the backtesting of your trading system show? How can you manage your trades to create good risk/reward ratios on each trade? How does each trade fit into your trading system?
- What is the best method for you to trade based on your own risk tolerance, return goals, belief system, and available screen time?
- What is the danger of your trading system having a large drawdown or even blowing up based on your position sizing and overall risk exposure?
- Are all your beliefs about trading and the markets correct based on fact? What do you need to learn more about?
- What impact does stress have on traders and how can you manage it?
- What are the tax implications of your style of trading?
A profitable trader must start with first principles then build up to create a path to profitability step by step.
The recipe for a profitable trading system:
- A watchlist that gives diversified opportunities across different charts, sectors, and markets.
- Diversified trading signals for buying dips, and trading momentum, swings, and trends.
- Entry signals with a better probability of being a winning trade than a losing trade.
- A stop loss that will keep a losing trade small if it doesn’t work out.
- A trailing stop that will lock in a winner if it reverses.
- A profit target that will maximize a winning trade if it goes the fully planned distance.
- Position sizing that limits risk exposure on each trade and limits stress.
- A limit set for maximum risk exposure on multiple positions.
- The discipline to follow a trading system with perseverance.
- Always studying to improve and adjust your system based on new data.
First principles thinking seeks the core of what makes a system work and avoids the noise that doesn’t matter.