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Risk Management For Traders

One of Sun Tzu’s most famous quotes is: “Every battle is won before it is fought.” The phrase implies that it is planning and strategy that wins wars and not the battles themselves. Similarly, successful traders commonly quote the phrase: “Plan the trade and trade the plan.” Just like in war, planning ahead can often mean the difference between success and failure.

Stop-loss (S/L) and take-profit (T/P) points represent two key ways in which traders can plan ahead when trading. Successful traders know what price they are willing to pay and at what price they are willing to sell, and they measure the resulting returns against the probability of the stock hitting their goals. If the adjusted return is high enough, then they execute the trade.

Conversely, unsuccessful traders often enter a trade without having any idea of at what points they will sell at a profit or a loss. Like gamblers on a lucky or unlucky streak, emotions begin to take over and dictate their trades. Losses often provoke people to hold on and hope to make their money back, while profits often entice traders to imprudently hold on for even more gains.

 Take-Profit Points, trading greed, trading fear, trading emotions, financial behavior 


A stop-loss point is the price at which a trader will sell a stock and take a loss on the trade. Often times, this happens when a trade does not pan out the way a trader hoped. The points are designed to prevent the “it will come back” mentality and limit losses before they escalate. For example, if a stock breaks below a key support level, traders often sell as soon as possible.

On the other side of the table, a take-profit point is the price at which a trader will sell a stock and take a profit on the trade. Often times, this is when there is limited additional upside given the risks. For example, if a stock is approaching a key resistance level after a large move upwards, traders may want to sell before a period of consolidation takes place. (more…)

Patience, Preparation and Performance

Everything is difficult before it becomes easy.

With the current volatility of the financial markets, it is extremely important that each of us resolve to be patient in our decisions and not make snap judgments. These can create future disaster.

The most successful individuals around the world have a foundation of processes that they utilize consistently, no matter whether the markets are trending with clear direction or being extremely volatile.

Each of us needs to be patient and allow the trading plans that we use to provide points of execution for trades. We need to be prepared for any and all movements in the market, yet stay committed to our plan and then perform with a self-confidence that ensures that we do not stray away from the steps of our plan.

Patience, preparation and performance surrounded by a solid trading plan along with money and risk management will produce the highest probability for profitable success.

Preparation combined with Opportunity creates a new word I would like to give to you — Prepartunity. Every day provides new opportunities for us. If we are prepared then we will receive the highest results possible.

Expectancy

If you perform an internet search on how to calculate expectancy as it relates to trading systems, you will most often see the following:

Expectancy = (probability of win x average win) + (probability of loss x average loss)

The average win and average loss can be either percent gain or loss or it can be dollar values. For example, following are the performance statistics for one of my trading strategies:

  • Probability of win = 71.7%
  • Average win = 2.72%
  • Probability of loss = 28.3%
  • Average loss = -3.59%

I can calculate the expectancy in percentage terms as follows:
Expectancy = (0.717 x 0.0272) + (0.283 x -0.0359) = 0.93% (more…)

Gambling vs. Trading

“Gambling is taking a risk when the odds are against you.  Speculating is taking a risk when the odds are in your favor.”  Victor Sperandeo

“the only difference between gambling and trading is that your amount at risk and amount of potential reward varies with trading.”  I agree, but there’s more to it.  The parallels are obvious, from the lack of control over outcome to the illusion of knowledge to the physiological effects of having a stake in the outcome.  However, the differences are substantial…and mostly mathematical.

The expectancy in gambling is ALWAYS terrible, while market speculation at times offers outstanding opportunities.  To get a 2:1 or 3:1 opportunity in gambling, one needs to accept incredibly low odds of victory.  In financial markets, those 2:1 or above opportunities come around like clockwork and offer high enough probability that long-term positive expectancy is possible.  Not only that, but the market speculator has the opportunity to adjust his or her position after the game begins…when was the last horse race where you could take a little off the table after the first turn?  Or reclaim most of your bet when your horse stumbles out of the gate?

I’ll leave the neuroscience to the experts, but it seems to me that we need to coordinate our left brain(rational) and right brain(experiential) in laying out the role of each.  We want to allow our intuition to shine through, but within the overall structure of positive expectancy.  No matter how hard one tries, the math of gambling can’t come close to touching the opportunities for building a business out of the markets.

Nassim Taleb's Six Rules For Succeeding In Life

TalebSuccess in all endeavors is requires absence of specific qualities.
1) To succeed in crime requires absence of empathy,
2) To succeed in banking you need absense of shame at hiding risks,
3) To succeed in school requires absence of common sense,
4) To succeed in economics requires absence of understanding of probability, risk, or 2nd order effects and about anything,
5) To succeed in journalism requires inability to think about matters that have an infinitesimal small chance of being relevant next January, 
…6) But to succeed in life requires a total inability to do anything that makes you uncomfortable when you look at yourself in the mirror.

Be Imperfect

As a trader – or an investor – you will not be right all of the time. If you can accept your imperfection, and work within it, you will be much more successful:

If you have a perfectionist mentality when trading, you are setting yourself up for failure, because it is a “given” that you will experience losses along the way. You must begin to think of trading as a game of probability. Your losses ( that you hope will return to breakeven) will kill you. If you cannot take a loss when it is small ( because of the need to be perfect), then you will watch that small loss grow into a larger loss and so on into a vicious cycle of more and more pain for the perfectionist. Trading on hope does not work. The markets can remain irrational for a lot longer than you can remain solvent.

The object should be excellence in trading, not perfection. Moreover, it is essential to strive for excellence over a sustained period, as opposed to judging that each trade must be excellent. This is a marathon…not a sprint.

The greatest traders know how to take cut losses and let winning positions run. Perfectionists often do exactly the opposite. They get in at the wrong time, stay in too long and then get out the wrong time. Perfectionists are always striving and never arriving. The market will find the flaw in a perfectionistic trader and exploit it day after day.

Perfectionism And Trading

 

Perfectionism: Many traders try very hard to always be right. If the market shows that they are wrong with a loss, they work very hard to turn that loss into a profit. They may average down on a losing position or just hold the stock after their stop price has been exceeded with the hope that the market will turn around and turn their loser into a winner. It is the pursuit of perfectionism that causes us to ignore that trading stocks is a matter of probability. Trying to always be right leads to failure, for eventually, one of those losers fails to turn around and gives the trader a portfolio crushing loss.

LESSONS FROM TRADING IN THE ZONE BY MARK DOUGLAS

1.) When it comes to trading, it turns out that the skills we learn to earn high marks in school, advance our careers and create relationships with other people, turn out to be inappropriate for trading.  Traders must learn to think in terms of probabilities and surrender all of the skills acquired to achieve in virtually every other aspect of life.

2.) Within 9 months of moving to Chicago, I had lost nearly everything I owned.  My losses were the result of both my trading activities and my exorbitant lifestyle, which demanded that I make a lot of money as a trader.

3.) You don’t need to know what’s going to happen next to make money.  Anything can happen.  Every moment is unique, meaning every edge and outcome is truly a unique experience.  The trade either works or it doesn’t.

4.) More or better market analysis is not the solution to his trading difficulties or lack of consistent results.  It is attitude and “state of mind” that determine his results.  A winner’s mindset means learning how to think in probabilities.

5.) The edge means there’s a higher probability of one outcome than another.  The greater your confidence, the easier it will be to execute your trades.

6.) Do you ever feel compelled to make a trade because you are afraid that you might miss out?

7.) People , expressing their beliefs and expectations about the future, make prices move- not models.  The fact that a model makes a logical and reasonable projection based on all the relevant variables is not of much value if the traders who are responsible for most of the trading volume aren’t aware of the model or don’t believe in it.  In other words, people who trade don’t always act in a rational manner.

8.) Price movement could be so volatile that it would be very difficult, if not impossible, to stay in a trade in order to realize the fundamental analysts’ objective. (more…)

Waiting for Confirmation

Many times we enter a trade with a high degree of certainty that the stock will move in our chosen direction.  All of our indicators can be screaming to buy or sell at a particular moment in time; however, there is no certainty that these indicators will function as intended.  In order to combat this, start by entering a trade with a small percentage of your maximum size and wait for a move in your direction to confirm that the expected move is actually occurring.  While you may miss the very first piece of the action, waiting for confirmation will significantly improve the probability of success.  Remember, you don’t have to be the first to the party; showing up fashionably late almost always works out best.

Brooks, Trading Price Action Reversals

The third and final volume of Al Brooks’s series is Trading Price Action Reversals: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012). A trader does indeed have to be serious to read all three volumes because, according to the author himself, the task is daunting: some 570,000 words.
Only half of the final volume is about trend reversals. The rest deals with day trading, the first hour (the opening range), and putting it all together, including 78 trading guidelines, some of which you may not have encountered elsewhere.
This volume is the most accessible of the three, but then my very tired eyes did a lot of work before getting here. It would be difficult to skip the first two volumes and expect to understand the third.
Brooks himself is not primarily a reversal trader. As he writes, “I prefer high-percentage trades, and my most common trades are pullback entries and trading range fades. I especially like breakouts because when they are strong the probability of follow-through is often more than 70 percent. I look less often for reversal trades, because most reversal attempts fail, but I will take a strong reversal setup.” (p. 463) (more…)