So you are looking to get into the markets or you have just started getting into the markets? So what is your opinion on how to invest? Do you like the sound of day-trading with it’s manic buying and selling or perhaps you really like the idea of buying a bargain to see it’s true value emerge later? Do you devour the words of Warren Buffet with zeal or are you more into reading tomes on Technical Analysis like Candlestick Patterns and Donchian Breakouts? Or perhaps every word I have just said is all mumbo jumbo and you just want to know what you should be buying right now?
This article is designed as an overview of the elements you need to develop a trading system that will allow you to become a successful trader, and to point out some common misconceptions and mistakes people make along the way.
OK, so which style is the best for trading? Well that really depends, there are people out there making money from short term trading and from mid-term trading and from long term trading and every increment in between. However, the thing to remember is there are far more people losing money regardless of the investing style.
So, what separates the winners from the losers? That is quite simply that the good traders are the ones that have a trading system or style with an edge and are disciplined enough to exploit it. Now just to make sure we are all on the same page, for the purposes of this article an edge is the amount you will make on each trade on average allowing for expense such as the cost of executing your trade and tax. This edge is what your trading system is built around so you need to understand exactly how your edge works to design your trading system.
However, when most people start trading they only consider the entry. I cannot remember how many times I have been asked for stock tips, but unless the person understands how much to invest, when to sell etc. this is useless information. In fact in the excellent book Trade Your Way To Financial Freedom there is a trading system that makes money based on randomly picking a stock and buying it but due to the exit criteria and position sizing, over the long term it will make money. You need to remember it is the entire trading system that gives you your edge and must describe what will happen at every point of your trade – how you enter a trade, how much you put at stake and under what conditions you exit the trade.
As an analogy lets do a comparison between a supermarket and a jeweller. Supermarkets have very low margins, usually only a few percent on each item, whereas a jeweller can have margins of 100% and more. So, if that is true how do supermarkets survive when their margins are so much smaller than those of a jeweller? You’ve guessed it, supermarkets sell many more items in the same time that the jeweller sells one.
So let us consider two trading systems, one that makes 10% per trade and the other that makes 100% per trade. Now let us assume we can make one 10% trade per day and a 100% trade every 10 days and start both trading systems with $1000. At the end of 10 days our 100% trade has taken our account to $2000, a 100% gain. However each 10% trade will make us $100 and we can do one of these each day. This means we have made 100×10=$1000, so both accounts have $2000 at the end of the 100 days?
In fact this is not the because we have the power of compounding working for us in the second example. Compounding is the ability to use your gains as part of the investment on your next trade to increase your gains. So for example if we do our first trade we now have our initial $1000 plus the gains from the first trade, which is $100, so we now have $1100. If we now use this for the next trade we will make 10% on this, which is not $100 but $110 (10% of $1100) If we keep doing this we do not end up with $2000, but actually nearer $2600…quite an improvement! This is an example of what I meant about understanding your edge – at first glance the two trading systems appear to be equal, but we now see that the second has a distinct advantage.
Now this all looks very simple, this edge thing – your percentage multiplied by the number of trades you can make, easy? Not quite, remember I mentioned that your edge was your average gain per trade. this means some will lose and others will win. So we can assume that getting a high percentage of trades ‘right’ will make a more profitable trading system than one that gets a lower percentage of trades ‘right’? As you’ve probably guessed already this is not always the case.
To ease the confusion let us consider a game with a 6 sided dice in which you and your opponent have 100 pebbles. Let’s say you are the thrower and on each throw of the dice you can bet as many or few of your pebbles as you like. On each throw the non-thrower keeps your stake, but if you roll a six they must give you 10 times your stake back. So who will usually get all the pebbles? If you are the thrower you will lose 5 out of every 6 times on average, so this must mean you will lose?
OK, you are probably already ahead of me, but let’s do a quick piece of math to test it. Let’s say you bet 1 pebble on each throw, so over 6 throws you will lose 6 pebbles, but on average you will hit one six during that time in which case the non-thrower will give you back 10 pebbles. This means that over 6 throws you will win 10-6=4 pebbles. So even with a failure rate of 5 in 6 you are a winner and the non-thrower, with a success rate of 5 out of 6, is a loser!
This is great, so we have a winning strategy for this game, bet one pebble and wait for the other guy to go bust. But wait, the market doesn’t go bust, so if we play against the market and bet more than 1 pebble at a time we will win more on each throw. Say we bet 10 pebbles and win, then we get 100 back. If we bet all 100 of our pebbles then we will get back 1000 and just imagine what you could do with 1000 pebbles…OK, not too much unless you find yourself under siege from an army of Goliaths! Where were we, yes betting all 100 pebbles – that was a dumb idea! We know that 5 times out of 6 we will lose all our pebbles and then we cannot play anymore. However if we bet just one, we aren’t making as much as we could.
So how many should we bet each time to make sure we do not go bust, but still make the best return we can? This is actually a hard question to answer and in trading system terms this is called your position size. So how about we bet 10 pebbles, this means we can make 10 bets before we go bust and since we will win one in every 6, this is fine? Well we know that if you roll a dice 6 times it is very rare you get 1,2,3,4,5,6 – in fact this is just as rare as rolling 6,6,6,6,6,6. So the chances of getting exactly one of each number in your 6 throws is very low. This means there are going to be some long runs where you do not roll a six. So it might be that most of the time you get away with betting ten pebbles, but if you roll a string of ten losses you wipe out completely.
Now let’s say you did get some winners under your belt and that you have been successful and made it up to 1000 pebbles and you are still betting 10 pebbles – this is in fact the same proportionally as betting 1 pebble when you had 100. So if we always bet 10% of our pebbles, will that work? How will that perform against betting 20% of our pebbles? See what I mean about this being hard to answer?
So your trading system is all about your edge and how it actually works right down to your position size.
There is one last component of your trading system, which is often the hardest to nail, it’s the discipline to follow through and execute your trading system. It has been shown that human beings take losses far harder than gains, in fact almost twice as badly, so if you win one and lose one you will usually feel worse than had you not done anything at all! Going back to our dice game, although we know this is a winning trading system, can you really put up with a 1 in 6 win rate? We know that sometimes you can easily roll twenty or thirty times and not see a six, but if you are trading this system, at what point do you think your trading system has stopped working and give up?
Each one of those losers is your money going down, when do you throw in the towel – after 10 losers, 20 losers, 30 losers? Of course if you understand your trading system and should therefore plough on, but it is hard to take mentally. The best traders appreciate this and admit they are human. When things go against them and make them feel bad they simply walk away for a while to recharge their batteries. They know their trading system is still there and they can come back to it. The psychological element is at least as important as the other elements in your trading system. If you construct a trading system with an edge, but one that you are not psychologically able to trade, then it is not a successful trading system for *you*
So a good trading system gives you an edge which you can exploit and understanding this edge is vital to give you the confidence to trade it, even when things are going against you. Understanding this edge means you can build your trading system, defining your entry, exit and position sizing criteria, which ensures you know what will happen at each point of each trade. These criteria will allow you to thoroughly test and optimize your trading system. Finally you should consider the psychological elements during the testing – can you execute this in the same manner as a model portfolio? For example let’s say your trading system states you need to do something everyday just before market open – can you do this reliably? If you know your trading system will regularly generate draw-downs of 33% – so a $100 000 portfolio, this means you might loose $33000 – can you mentally handle losing this amount of money?
This article may have made you go ‘oh no’ but the simple fact is that all good things need work. If you are looking to get some $97 eBook from the internet that will make you millions for doing nothing, then you are probably better off replying to those e-mails from Nigeria promising to transfer millions to your bank account.
Sure you can make large amounts of money making big bets on penny stocks, but you can also loose your money and if you have no money you are out of the game and you cannot make anymore. Warren Buffet has made himself one of the richest people in the world with an annual compound growth rate of far less than the 100%+ promised on each trade by many stock tipping newsletters.
Chasing gains with no attention to the risks will destroy your chances of making good returns as losses affect your performance far more than gains. To demonstrate, the US Stock Markets return somewhere around 10% compound growth over the long term. So let’s say you take an aggressive strategy to beat these returns. You take your initial $1000 and gain 100% in one year, then lose 50% the following year. Another person just puts their money into an index tracking fund and gets the 10% returns, who ends up with the most? A quick bit of math shows us that after the first year we made 100% of $1000, which is $1000, so we now have $2000. The second year we lose 50% of $2000, or $1000, so we have a total of $1000, we are back to where we started! Compare this with the person that just put their money into an index tracker and got the average returns from the market. They now have $1000 plus the $100 from the first year, which is $1100, then the 10% on this from the second year, which is $110, so they have $1210!
In fact if you can’t construct a good trading system of your own, you can do worse that just following this strategy as at this rate you will turn $1000 into $2593 over ten years. However, if you can design a trading system that returns 20% then you will end up with $6191 over the same period. If you can find a trading system that lets you mix it with the likes of Warren Buffet and return 30% then you will have $13785 over ten years – over 1200% gains in ten years! So as you can see a trading system that can improve your returns by even relatively small amounts will make your long term gains vastly superior.
In the often quoted words of Thomas Edison “The reason a lot of people do not recognize the opportunity is because it usually goes around wearing overalls and looking like hard work.” But the hard work in building you a good trading system will repay your efforts many times over.