Yesterday I wrote that VISION, goals etc had their counterpart in out trading.
VISION is found in two components:
Our trading philosophy. Consciously or unconsciously our philosophy, Ayn Rand’s ‘sense of life’, governs our actions. So too with our trading, consciously or unconsciously, our trading philosophy governs our actions from the plans we choose to our position size to the actions we take to execute consistently our trading plan.
I adapted the statement of my philosophy when I first read it in Trader Vic – Methods of a Wall Street Master by Victor Sperandeo. The articulation there of Sperandeo’s philosophy strongly resonated with my values. So with a small amendment, I adopted it:
- Preservations of Capital
- Consistent Execution (leading to consistent profitability)
- Superior Returns
You’ll see the three ideas reflected in all that I do. Our trading philosophy forms one part of our VISION.
The other component is found in the rational for a trading plan. We need a trading plan for two reasons:
- Before entry: it tells us when the probabilities favour our trade
- After entry: it tells us when the probabilities are no longer in our favour and we should quit a trade.
Both components are essential to our trading success. The key analytical insight to our success is found in the expectancy formula; the formula that tells us we can expect to make, on average, on each trade. Unless the sum is positive, we don’t have an edge i.e. we are doomed to fail in the long run. The most basic formulation of the formula finds its expression in:(Avg$Win x WinRate) – (Avg$Loss x Loss Rate) = Expected Trade Result
- Avg$Win = Total $ profits/Total number of Winning Trade
- WinRate = Total number of Winning Trades/Total Trades taken
- Avg$Loss = Total $ losses/Total number of Losing Trade
- LossRate = Total number of Losing Trades/Total Trades taken.
Most newbies focus on the Win and Loss Rate. But in my view, this is the more difficult part of the equation to control. Why this is so is best described by a story I heard about while learning Drummond Geometry (P&L Dot):
One day an ex-floor trader was told by an apprentice he had taken under his wing: ‘The 1-1 support WILL hold this decline”! The market was heading south towards what P&Lers called 1-1 support.
The ex-floor trader replied: “What are the probabilities?”
The apprentice said: “It WILL HOLD, I am certain!”
The ex-floor trader said not a word; instead, he picked up the phone and said: “Sell me 3000 Dec contracts at market”
Needless to say, the market went through the 1-1 support like knife through butter. “Remember this” said the ex-floor trader, “ we think in probabilities not certainties”.
This is a great tale. It tells us that the trading is in the realm of probabilities and as such the win/loss rate is less under our control than the Avg$Win and Avg$Loss. Both of these depend entirely on our decisions to enter and exit.
Notice that the formula explains why someone with a 90% win rate can still lose money. Let’s see why. Let’s say the Avg$Win is $10 and Avg$Loss is $100 and the win rate is 90%. The sum of the formula is:
($10 x .90) – ($100 x .10) =
(S9) – ($10) = -$1.00
So over the long term, over a large sample size, each trade we take will lose -$1.00.
Our VISION allows us to imagine a number of critical events:
- What does a trade need to look like – what does it have to do after entry – for me to remain in a trade?
- What does a trade need to look like for me to exit a trade?
- What does a trade have to look like for me to stop and reverse?
By visualizing the answers to these questions allows me to exit trades BEFORE my stop is hit. The technique allowed me to return 46.64 on capital (ROI) for 2007 an average dollar profit per trade of US$181.00.
By keeping detailed statistics, I am able to CANI (constant and never-ending improvement) my entry and exit. This is not to say I won’t have losses; of course, I will. My loss rate for 2007 of 50.44 attests to that. But by keeping a margin of 2:1 for my Expectancy Ratio (same formula except we divide the Avg$Win component by the Avg$Loss), I was able to return a fabulous 46.64% ROI.
In the next post, I’ll look at a trading plan and its components.