Over the past couple of years, making money in the market has been a challenge for both traders and investors. Money has flowed into hot sectors at the same time that no sustained general up or downtrends have occurred in the broad stock indices for some time.

When there is no rising tide to lift all boats, participants must make an effort to find the money instead of waiting for it to roll in. In this environment, participants need to be resourceful and ever mindful of the three cornerstones of market mastery.

The First Cornerstone: The Mind
A number of books have been written specifically about the inner psychology of trading. The popularity of these books indicates that traders and investors experience serious issues that affect their performance.

In my 20 years of trading, I have observed the main problem to be conviction. To enter a trade, one must pull the trigger. Yet, having too much confidence can affect the bottom line as much as not having enough.

I view confidence as a function of the other two cornerstones: Method and management. If a method has been tested rigorously, it is easy for a trader to use it with confidence and maintain the conviction to make the trades. With professional risk and money management in place (that is, trade size is appropriate for the instrument and account), the trader views losses simply as the cost of doing business.

When sound method and management are in place, we can focus on the more interesting and profitable aspects of trader psychology, namely the outward game of trading as it relates to the crowd, their sentiment and actions.

The Second Cornerstone: The Method
When each of us starts out, we typically began with a narrow focus on method (that is, what to buy). For stocks, there is the requisite fundamental research, but, in the end, it all boils down to two questions: When do we buy? When do we sell?

Newcomers expend a great deal of effort on entry and exit criteria, particularly on the technical side. This is why I created PowerTools, and, even though the PowerTrendSAR trading system issues buy and sell signals automatically, it must be used as part of a complete method.

The tools we have at our disposal can be levered to our utmost advantage if we know what to trade and which time frame is appropriate for current market conditions.

There are uptrends. There are downtrends. There are sideways markets. Some markets are simply dead. Traders look for dynamic price action. They flock to markets that are active -- not only in terms of volume -- but also in terms of trading range. In other words, they like to play markets when the game is on.

Trading is a full-contact team sport, and it is not much fun to be the only one on the field. Discretionary traders typically describe the movement of the markets as if it were a living being. In many ways, it is alive because trades are transacted by people. The good news is that technical indicators can objectively measure and quantify the motion for us.

While the majority of us concentrated on the “when” part of the equation at the beginning of our careers, as we observe the market, we become more particular and turn our attention to the “what” part of the equation. What markets do we want to trade? What time frame do we want to trade?

One phenomenon that has had a great impact on us over the past few years is range contraction. Back in 2000, it was “normal” to see a stock trade through a $20 range in a day. Now, it is more like 50 cents. At the same time, trading volume is lower, and we do not have the option of simply trading a larger size. If anything, we have to trade a smaller size, but smaller size and smaller range equal smaller profits for the same effort.

When we use a mechanical trading system, finding a dynamic market and time frame is the challenge. Yet, many people are not aware that this is the problem. Instead, they think that their system is no longer working. They think that the market has changed when it is perhaps more accurate to say that large portions of the market are static at this time.

I wrote an article on range contraction for the June 2005 issue of the Exchange. You may wish to review the information and download the EFS for yourself. Historical volatility is very useful for daily charts. For intraday trading, we can use Average True Range as a guide.

The bottom line is that we want to make sure there is adequate movement / range / volatility to ensure that the market and time frame we are interested in is suitable for trading. I can do this visually with an experienced eye when I’m discretionary trading, but it is even more important when it comes to trading with a system. Yes, stock and time frame selection is key to making money.

One factor few traders consider is the relative strength, comparing the performance of one symbol against a benchmark. For example, to help us choose between trading Stock ABC and Stock XYZ, we can use eSignal Advanced Charts to benchmark these against an index.

If both stocks are tech stocks, we want to use the NASDAQ 100 Index as the benchmark. We can plot a ratio chart of the stock against the index to determine if it is outperforming or underperforming the index. In general, we favor stocks that are outperforming as potential buy side candidates and consider underperforming stocks fair game for shorting.

If the stock is outperforming the benchmark (trading above the 20-day EMA and the 50-day MA), I could use PowerTrendSAR system sell signals (red bars) to identify pullbacks and use the SAR value (buy the blue dot) to set up a buy stop to catch a retracement. I find this very useful.

Traders technically proficient with Excel can use eSignal’s DDE Output. For example, I make worksheets every night that rank and sort an entire universe of stocks. Download my worksheet.

In short, timing the trade is only a part of the second cornerstone. A critical component of the method has to be the selection of the instrument. Another is measuring the volatility and range of the time frame to see if it is even moving enough to warrant our attention.

The Third Cornerstone: The Management
Risk and money management is all about “how much”. In addition to implementing stop losses, we also need to size our positions accordingly. We need to ensure that the bet size is in line with the size of our account and the volatility of the instrument we are playing. This way, when the trade goes our way, we maximize the profit. When the trade goes against us, we minimize the loss.

In my next article, I will focus on how to determine optimal position sizing.