Last Updated on 2 January, 2023 by Samuelsson
First Principles Applied To Trading: For many traders, achieving success in trading is not easy. But it doesn’t have to be too hard if you know the right way to approach it. One good question you can ask yourself is whether you are taking the best possible route. Don’t be afraid to examine your trading journey so far; all of us had to do that at some point.
What we found out was that trading with the first principle approach works very well. This approach involves reducing a problem to its fundamental elements and building up from there, starting with a clean slate and questioning assumptions, using logic and reason to guide decision-making, focusing on the essential elements of a problem, searching for the underlying causes of a phenomenon, taking a holistic view of a problem, avoiding biases and preconceived notions, and using a systematic and methodical approach to problem-solving.
It’s no surprise that this approach works well, as it is based on common sense and has been applied successfully by successful individuals such as Elon Musk. In trading, the first principle approach can be used to understand how the market works, create a workable trading plan, and turn your trading journey around. So, if you are struggling in the markets or experiencing a large drawdown in your capital, it may be worth considering applying the first principle approach to your trading.
What does first principle mean?
The first principle is the fundamental concept or assumption on which a theory, system, or method is based. It is the foundational proposition or assumption that cannot be broken down to any other assumption. In other words, we cannot deduce the first principles from any other proposition or assumption.
Using the first principle approach, you are forced to break things down into their smallest pieces and look at each component as its own individual moving part. By breaking things down in such a way, you can look at them with a different perspective so you can generate fresh ideas on how to tackle the problem at hand.
It is about solving problems using the most effective but not necessarily the quickest way. You start by establishing the fundamental truth about the problem or components of the problem. Then, you establish the reason for them and seek the best available solutions.
As you can see, using the first principle way of thinking is one of the most effective ways to solve problems simply because it forces you to break down complex issues into small bite-size steps. And doing so may help you find the quickest path to a solution because it seeks out the foundation of the problem. Unlike modeling, which may seem like a quick fix but may not fully solve the problem as it also copies the mistakes of the prototype being modeled, the first principle approach.
Throughout history, many eminent thinkers have used the first principles approach to create solutions to world problems. One common example is Elon Musk (we mentioned him earlier) who used the approach to create cheaper batteries for electric vehicles and home power needs. Another example is Johannes Gutenberg who invented the printing press. Both men used the first-principle thinking.
You can see, that approach of boiling things down to a binary level has had a tremendous effect on people’s ability to make decisions and foster change. Why breaking ideas down is such a revolutionary idea is because people spend most of their time looking on the surface without getting to the source of the problem to look for ideas that can solve them. Since the ideas don’t sit on the surface where everyone else is looking, most people never look where the ideas are. It takes someone who is determined to find lasting solutions to break things down and start from the basis.
Applying first principles to trading will help you to understand how the market works and why traders react the way they do. This is because you will be breaking the market down to the fundamental reasons why traders decide to trade when they do and how they arrive at that decision. To become profitable in trading, you have to apply the right principles and strategies over some time. Trading the right way is not about opinions, predictions, and just being good at it.
Very few traders make use of this approach. Many just want to model what others are doing, which they find on the internet or read in trading books. While there may be some logic to modeling other people’s approaches — it’s certainly easier and quicker — it has some disadvantages too because you also copy their mistakes and imperfections.
Are you losing money in the markets or having a large drawdown in the capital? It could be a good idea to go back and return to the first principles. But first, let’s understand how first principles work in trading.
Understanding the first principle approach to trading
In today’s modern world, not many people want to start from a position of nothing to something. For most people, it’s about modeling what others have done and probably tweaking it. Of course, there’s some logic to modeling other people’s success, but there’s the problem of also copying the imperfections in the model.
With first principles thinking, however, you tear the problem apart to look at each basic component and decipher what can work and what can’t. This way, you find errors as places for improvements by looking at the most basic principles that lead to success or failure. To apply the first principle, you must remove all personal biases, opinions, beliefs, assumptions, traditions, and predictions so as to get to the root of the matter. That is, you look over the skewed filter of experience and try to find out the real drivers of success in what you’re dealing with. In our case, it is trading the financial markets.
Using the first principle approach in trading implies trying to understand what happens in the exchanges of the markets you intend to trade — stock exchanges, futures exchanges, etc. The aim is to understand the behavior of buyers and sellers and how that moves prices, clarify the different conditions of the market and what leads to them, and also access your own ability to buy and sell positions during the various market conditions.
You can also go further to get the first principle of price movements, which is that the price can be in a trend or move sideways and can exhibit high or low volatility. A trend can be an uptrend or a downtrend, and where one trend stops, another starts — market trends eventually top out or find a bottom in price. Also, the market can be liquid with tight bid/ask spreads or illiquid with wide bid/ask spreads, while the volume of trades can increase and decrease.
With all these in mind, a first principle thinking trader looks at how to connect and combine the math of the price action to create a profitable trading strategy that is backtested on the historical price movement. This strategy can be systematic or a discretionary one or even a mixture of the two. For a trading system to be profitable, it should either have big wins and small losses or a high win rate with losses equal to or smaller than wins.
By applying first principle thinking, a trader can think outside the box and create new systems or improve on existing systems — as new data and outcomes become available it is integrated into the systematic thinking to adjust and improve on potential outcomes. This trader can also then employ statistical variables to develop a quantified trading system that has an edge in the market. While many traders try to do what every other person is doing — trading based on predictions, opinions, emotions, and ego — someone who uses first principles tries to find something that works and why it works. Of course, anything that is not fact, science, or math is an opinion.
There are questions you can ask yourself when you want to find the first principles of trading success. These are some of them:
- How did successful traders achieve success; what did they do differently?
- What really makes successful traders profitable — what are their edge, system, risk management, and trading psychology?
- What is the basis of historical price movement, and how can you create a profitable system based on that?
- What is the best method for you to trade based on your own risk tolerance, return goals, belief system, and available screen time?
- How does each trade fit into your trading system, and how can you manage your trades to create good risk/reward ratios on each trade?
- What does the backtesting of your trading system show — can the system be profitable, and in what conditions does it work best?
- What are your overall risk exposure and position sizing, and does that expose your trading system to having a large drawdown or even blowing up?
- What impact does stress have on traders and how can you manage it?
- Are all your beliefs about trading and the markets correct based on fact?
- What other things do you need to learn more in trading?
- Do you consider the tax implications of your style of trading?
By the time you finish answering all these questions, you would have been able to create a trading system that is based on facts and not opinions or premonitions.
Steps to follow when applying the first principle approach to your trading
If you want to become a profitable trader, you need to focus on first principles so you can fix all the pieces together and build up your path to profitability step by step. Before we talk about the steps, let’s consider the components of a profitable trading system. These are some of them:
- A list of the markets to trade: This consists of the markets you intend to trade, which can be the stock market, futures market, etc.
- A watch list of the instruments to trade: This is a list of the stocks, ETFs, commodities, and other instruments you noticed emerging trading opportunities. It’s good to have a watch list that is diversified across different charts, sectors, and markets.
- Trading signal: There should be different types of trading signals, including the ones for buying dips and trading momentum, as well as for swing-trading and trend-following strategies.
- Entry point: This specifies when to enter a trade — it can be at market close or open or a particular level.
- Stop loss: This is used to keep the loss small if a trade doesn’t work.
- Profit target: This is the level in the market where you want the trade to be closed with profits. It helps to maximize the gains from a winning trade if the price moves as expected.
- Trailing stop: You use this to lock in a winner if the price reverses.
- Position size: This is the quantity of the instrument you buy or sell in each trade.
- Maximum risk: this is the limit you set for maximum risk exposure on multiple positions.
To follow a trading system and implement all these components with perseverance, you need a lot of discipline. With the first principle approach, you are interested in the core of what makes a system work and avoids the noise that doesn’t matter. So, you should regularly research and review your trading to improve and adjust your system based on new data.
Now, let’s look at the steps you should follow when trying to apply the first principle approach to your trading:
- Learn how the market works: The first step is to learn the principles of price movements — how the price moves and when it moves — so you can find a way to exploit the price movements.
- Do your research: After understanding how the market works, the next thing is to find an edge in the market. An edge is a consistent anomaly in the market that can be exploited. You can find an edge by studying the markets of interest or checking financial trading academic journals where scholars post anomalies they studied in the financial markets.
- Create a trading strategy: Having found a trading edge, it’s time to use it to create a trading strategy. Your strategy should have the criteria for trade entry and exit, as well as other parameters. Your strategy should have a good reward/risk ratio of up to 2-3.
- Specify how to manage your account capital: Here, you state the percentage of your trading capital you risk in each trade. You then use it to calculate your position size for each trade. Trading the right position size for your account capital is necessary to avoid blowing your account if you have a losing streak.
- State your risk management parameters: You should know the usual size of your stop loss order and note it. It is necessary to use stop losses on each trade to prevent a catastrophic loss in case the market moves against you.
- Backtest your strategy: Having noted the major parameters of your trading system, you can now backtest the strategy. You can do this manually, but it’s best if you can code the strategy into a trading algorithm and then backtest the trading algo. Backtesting enables you to apply your strategy to the historical price action to know if it can make money. However, a strategy that performs well in historical price action may not necessarily perform well in the real market because market conditions do change.
- Review your backtesting results and optimize your strategy parameters if necessary: When you finish your backtesting, you review the results. Take note of the following
- The winning percentage: This shows the percentage of the total trades that were winners. It gives you an idea of the profitability of the strategy.
- Average win/average loss: This gives you an idea of the reward/risk ratio of the strategy. Traders also use it to estimate the profit factor, which is a measure of the profitability of the strategy.
- The return on capital: Check how much money the strategy made over a given period. Your goal for returns will help you set your trading parameters. But don’t just focus on this at the expense of drawdown.
- The maximum drawdown: Apart from the profitability factors, you need to check the drawdown. The drawdown is often a function of position sizing and the losing streaks the strategy can have. Understanding the potential drawdown from your equity peak is necessary to determine whether to use the system in real trading. You must be able to handle your maximum drawdown mentally and emotionally.
If the results are not good enough, you may tweak the parameters of the strategy a bit (optimization) and retest it again. To avoid curve fitting, you retest the strategy after optimizing the parameters in a different set of historical data that was not used for the initial backtesting — this is known as walk-forward optimization.
- Develop your trading plan: When you are fine with your strategy, you can then create a trading plan that encompasses your trading strategy, money management, and risk management parameters, as well as how you keep and review your trading journals.
- Start trading with real money: It’s time to test the waters with a small amount first until you master your game.
- Keep a trading journal: You should record every of your trade so that you can review them later to know how the strategy is performing in live trading.
- State how often you review your trades: It’s necessary to state how often you want to be reviewing your trades. It could be after every 30 or 50 trades.