I have been trading my own accounts for a decade now and I continue to learn more with each passing day. However, I never thought that a game, a hobby of mine, would advance my understanding and the importance of expectancy and position sizing as much as playing poker. Trading the markets and playing poker both require strict money management rules, stable emotional balance and a solid game plan. If you don’t consider and employ these tools, you will most likely fail sooner rather than later and lose a lot of money along the way.

So, how could a person learn so much from a game that most people consider luck? And why do some traders continually profit year after year while others lose their shirt while making the same mistakes? I will discus the basics of position sizing and expectancy and show you how both items are extremely important when trading and playing poker for profits. I will also close the gap of how each entity (trading and poker) have helped me become better at both.

Many people consider trading and poker pure luck but this is not an accurate observation. Average traders and average poker players taint the outside world with images of luck, quick riches and pure fantasy of the actual grind that is required to succeed. Many factors run parallel with poker and trading but the average Joe would never understand ‘why’ because he or she just listens to what the “talking heads” of television say. Luck may and will play a small part under certain circumstances but rules, odds, risk and money management are the largest components of the two entities.

It’s a grind; trading for a living and playing poker for a living is a grind – a full time business.

I don’t trade for a living but I do trade/ invest to grow my personal wealth. The savings and income from my main career is put to work through investing.

When investing in the stock market, it is essential to have a sound set of rules or a system that has been tested in real time, (back testing or historical testing is not required but can be used, my opinion of course). Back testing helps but playing sports has taught me that Monday morning quarterbacking is for theorists. Once a system has been tested profitably in real-time, the trader or poker player must follow clearly defined rules in order to preserve capital and cut losses. Both traders and poker players must consider the odds of their stock or hand making a gain or making a loss. Price objectives and targets should be a large part of every investor’s system but it is not the essential ingredient to success. Understanding how much to trade or how much to bet and exactly when to make that bet will be based on the system’s expectancy – and this should be the top priority.

So where does system development start? It starts by properly understanding position sizing techniques and calculated expectancies. Using these tools, the investor will be armed to trade only in situations where the odds are in his/her favor. A system that has been tested will have an approximate expectancy that will tell the trader or poker player how much will be gained or lost during each trade or hand over a period of time. Using this as one part of the equation, the investor or trader will now determine how much risk to undertake by calculating a position sizing algorithm that tells them how much to place on a specific trade or poker hand. The word “algorithm” may scare many people away but I have developed very simple position sizing and expectancy spreadsheets that can be found as a link on my blog. They can be downloaded, studied and tweaked without any advanced mathematical experience. This spreadsheet is strictly for trading, not poker.

Most traders and poker players look for three major factors when developing a system:

• How much to trade or bet
• The right odds or positive expectancy
• Multiple trades or hands to play (opportunity)

How do we Calculate Position Size (stock trading example)?

We can determine how much to place on each trade by assuming a $100,000 account with 1% risk on each trade. Using a basic CANSLIM style trading approach, I will place my stops approximately 7-10% below the ideal entry area or pivot point (8% in this example).

$100,000 Account
1% Risk = $1,000
8% Stop Loss
Position Size will be $12,500

We calculate the position size by dividing the 1% risk by the 8% stop loss or
$1000 / 8% = $12,500.

If the stock we are watching has an ideal entry of $50, we now know that we can buy 250 shares or $12,500 worth of stock. Our stop loss is $46 or 8% of $50 and our maximum loss is $1,000 of the original $100,000 portfolio. We can now start to develop system expectancy if we use this basic position sizing algorithm with every trade.

What exactly is expectancy?

Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. Most games at a casino are completed in a short period of time so they can increase their odds of winning. The only game that does not benefit the casino is poker because the game is played between individuals, not against the house. They do take a rake or a percentage of each pot so we will consider this commission fees. The same holds true for investing. If your expectancy is positive; you can make more money with multiple trades in shorter periods of time. Make sure this style suits your personality before trading or playing poker for a living.

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use an example of Expectancy from Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

Expectancy = (PW*AW) less (PL*AL)
PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example using a basic CANSLIM style approach (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):
If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $2,500) – (0.6 * $625) =

$1,000-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%

(40% * 20%) – (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

With the basics of position sizing and expectancy explained, I would like to explain why poker has made me a better trader. I will start by taking you through a game plan that has helped me use expectancies, emotional balance and position sizing to consistently win money at the tables. I admit that I am not a high stakes poker player but I can hold my own when I feel comfortable with a decent amount of money risked in any one hand ($1-$2 or $2-$5 no limit is my preferred choice – cash games only). As with investing, don’t over trade or trade more money than you are comfortable with. Tournament play is similar to options as a premium is paid up front in exchange for chips or the right to exercise those chips during a specific hand.

As I sit and start to play, my first goal is to become familiar with the character traits of the players around me. Typically 9 or 10 players will be at the table so I will have plenty of time to evaluate the people I am playing with, without risking a great deal of money. After several rounds of play, I will be aware of the character traits of the people I am playing with and will understand that some players may be tight and only bet high odd hands. These players may typically be edgy and nervous and fold cards with force as I have observed in the past. Other players may also play hands with high odds but will mix it up and call bets with cards that carry more risk along with lower odds. Every table has the quintessential bluffer that typically talks a big game, smirks a lot and sports a pair of dark sunglasses. You also may meet the hot shot, “TV-type” player that wants to win the World Series of Poker on ESPN. These players are very similar to traders that buy late night trading systems from infomercials and lose most of their money by incorrectly trading the system or making impulse trades. They also remind me of the people that scour internet web forums, blogs and twitter looking for justifications on their trading ideas or they simply pump their own ideas without following basic rules.

When playing poker, you must pay to gather information from certain types of players and this means calling a hand that you know may lose but the risk and money committed is minimal. Essentially, your overall position size relative to the pot odds justifies the call which allows you to make better or more informed decisions later in the game or tournament. The same holds true when trading. You may have a setup flashing on your screen so you take the trade but it quickly reverses so you close out the position. Don’t consider this a loss; consider this valuable information that warns you that the ideal entry is not now. Instead, you cut the loss while it is small and continue to monitor the situation so you can place another position if the ideal opportunity arrives in the future. You must pay for information in the trading and poker worlds; it will only make you understand the games better.

Don’t forget this rule:

“You must pay for information in the trading and poker worlds; it will only make you understand the games better.”

While poker players are their own characters; stocks are made up of human character traits, similar to the type of people that trade them. Some stocks are risky and volatile while other stocks are conservative and predictable. The market repeats cycles and specific chart patterns because humans repeat their actions and character tendencies. By learning how to target character traits at the poker table, I have started to understand that certain stocks act in predictable ways because the people trading them can’t change their emotional make-up. Many poker players will make the same mistakes and place the same erratic bets no matter how much they try to play differently. Most stocks will act according to historical patterns and follow the trend no matter how much you think the chart will do otherwise.

I won’t get into the exact rules of playing poker but I can tell you that only two players are required to bet per round while the other eight can view their first two cards without risking a cent (my game of choice is Texas Hold’em). The two players required to bet represent the big and small blinds. The dealer and all other player at the table can view the first two cards for free without a bet. If the hand is weak, you can fold and keep your gambling stake.

Here is where it gets interesting; if I have a decent hand, I can decide to call the larger blind and see the next three cards on the flop, which is still a low risk investment. If the flop doesn’t provide me with the cards I need, I can immediately cut my losses short by folding and wait for the next game. The same is true in investing; I can cut a loss short and wait for the next opportunity without risking the farm if I realize an immediate loss. If the cards are good and my probabilities of winning the hand are high, I can call or raise the bet. When I place a trade and it shows a profit, my belief was correct and I will consider adding to the position.

A fourth and fifth card (the turn and the river) are placed on the table after the flop and betting continues with each round. Again, I can decide if I would like to call, raise or cut my losses. The connection I am trying to make with investing in the stock market and playing poker relates directly to cutting losses short (capital preservation and money management) and my odds of winning the game (in the stock market this is called expectancy as explained earlier).

All investors and poker players bring emotions to the table, some people control them better while other people employ more efficient systems and understand the odds on a higher level. The bottom line is to understand the situation around you and to use a sound system to raise your odds. Never bet a hand that represents a low chance of winning and never ride a loss that could multiply overnight. Cut losses short and get out of the game and wait for the next opportunity because they are always around the corner.

While watching a re-run of the 2005 US Poker Championships, a statistic caught my attention so I paused the show, wrote it down and thought to myself that it would serve as an excellent example on expectancy.

Poker expectancy example (this relates directly to trading):
Nine players at the table
34 total hands were played in this round

Player A saw the flop 28 of 34 hands or 82% of the time
Player A won hands 16 out of 28 tries for a 57% winning percentage

Player B saw the flop 11 of 34 hands or 32% of the time
Player B won hands 4 out of 11 tries for a 36% winning percentage

Looking at these numbers and assuming that both players had equal chips (they were close), who do you think made more money during the round?

Most people would guess Player A due to the 57% winning percentage on 16 hands. Player B fails in comparison with only 4 wins, a quarter of the wins of Player A.

Well, Player A actually had a net loss of 5,500 chips while Player B actually had a net gain of 10,000 chips.

So what is my point?

The point is that being active is not a way to guarantee success unless you are following a system with a profitable expectancy. You must formulate a positive expectancy system that balances the opportunities with minimal risk and maximum gain. Player B took on less opportunity but made the most of it when the opportunity arrived.

Player A was erratic and played several hands that gave him poor odds and this is what I see so many traders do when the market is weak. They trade for the sake of trading and they lose. Traders must battle their patience and stick to their rules so they don’t trade erratically and play the game for the sake of playing.

By playing poker, I have cemented my understanding of how people act, how to play the right odds, how to develop expectancies based on the cards I am dealt and how to position my trades properly. Watching these techniques and rules in a live situation really drove home the importance of a system that follows the proven rules. Trading can be a long, tedious and impatient road to travel but following the rules and employing proper position sizing and expectancy calculations will almost guarantee success if the rest of you system does it’s job. If your system is broke, find one that works and understand that you won’t go broke by properly placing your trades or bets and understanding how much you can and will win from each trade and/or bet.

Good luck trading and playing poker!!

It’s times like these when trend traders grow impatient and fail to cut losers and then impatiently take profits too soon (most likely shorts in early 2009). It doesn’t matter if you have multiple losing trades over the past several months as long as your overall risk on each trade is less than 2%. The Pareto Principle will even out your results in due time, assuming you have developed a known expectancy on your system and employ risk management (position sizing).

You may have an expectancy of 40% winning trades but I can almost guarantee that 80%-90% of your year-end profits come from 10%-20% of your successful trades. For example, you may have 4 winning trades out of every 10 but only 2 of those trades will supply you with at least 80% of your profits. The other two winners will be minimal or cancelled-out by commissions, slippage and taxes.

On the other hand, it’s probably likely that 90% of your losses will result from 10% of your trades because you ignored sell rules, threw good money after bad or had stops jumped. One or two in ten trades will be the culprit(s) for bringing on the most damage to your portfolio. The other losing trades will be minimal and cut quickly as you realize that they are not working out as expected.

So what is the Pareto Principle?
“The Pareto principle (also known as the 80-20 rule, the law of the vital few and the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes.

The original observation was in connection with income and wealth. Pareto noticed that 80% of Italy’s wealth was owned by 20% of the population. He then carried out surveys on a variety of other countries and found to his surprise that a similar distribution applied.

Because of the scale-invariant nature of the power law relationship, the relationship applies also to subsets of the income range. Even if we take the ten wealthiest individuals in the world, we see that the top three (Warren Buffett, Carlos Slim Helú, and Bill Gates) own as much as the next seven put together.

A chart that gave the inequality a very visible and comprehensible form, the so-called ‘champagne glass’ effect, was contained in the 1992 United Nations Development Program Report, which showed the distribution of global income to be very uneven, with the richest 20% of the world’s population controlling 82.7% of the world’s income.” – Wikipedia

Researchers find that the top 20 percent of people, natural forces, economic inputs, or any other causes we can measure typically lead to about 80 percent of results, outputs, or effects.

Here are some other illustrations:

• In poker, 20 percent of the players will walk away with at least 80 percent of the stakes.
• In retail, 20 percent of the sales staff will make more than 80 percent of the dollar value of sales.
• Studies consistently show that 20 percent of customers lead to more than 80 percent of profits for any particular firm.
• More than 80 percent of scientific breakthroughs come from fewer than 20 percent of scientists.
• Crime statistics repeatedly show that about 20 percent of thieves make off with 80 percent of the loot.
• In horse racing, 80% of races are won by just 20% of jockeys.

Note that 80/20 is simply shorthand for a very lopsided relationship between causes and results. The numbers don’t have to add up to 100. In some cases, 30 percent of causes may lead to 70 percent of results. Other examples may show a 70/20 relationship: 20 percent of causes lead to 70 percent of results. Or the split may be 80/10, or 90/10, or even 99/1.

Ride the winners and cut the losers and never be discouraged that more oftern than not, the majority of your trades will be losers and the great majority of your trades will be a wash (smaller winner or small loser). It’s the small minority of trades that will make you a consistent winner at the end of the year and over the course of a lifetime. Trend trading is boring and will probably give you a home run every one in ten trades with a couple doubles and triples in between.

Remember this – Stepcase Lifehack:

I’ve seen a few times where people try to create a diagram explaining the 80/20 rule with a pie chart. One fifth of the pie chart is labeled 20% and the rest is labeled 80%. While those of us with basic math skills can see how this adds up to 100%, the calculation undermines what the rule is about.

The 80/20 rule argues that 20% of the input creates 80% of the output. Inputs and outputs aren’t the same thing, and therefore can’t be made into the same pie chart. The 80/20 Rule could just as easily been called The 55/3 Rule, if 55% of the results were created by 3% of the inputs.

Don’t get caught up on the numbers. Both 80 and 20 are just examples of one type of uneven balances. The fact that they add up to 100 is a coincidence.

Be patient, you will be rewarded and don’t get caught up in the numbers but do understand the principle!

Does the 80/20 rule apply to your trading and life in general? How about your business or career?

What exactly is expectancy?
Expectancy tells you what you can expect to make (win or lose) for every dollar risked. Casinos make money because the expectancy of every one of their games is in their favor. Play long enough and you are expected to lose and they are expected to win because the “odds” are in their favor. Most games at a casino are completed in a short period of time so they can increase their odds of winning.

• Position Sizing Spreadsheet
• Expectancy Spreadsheet
• Interactive Portfolio Spreadsheet

The same holds true for trading. If your expectancy is positive; you can make money with a certain number of trades within specified periods of time.

Expectancy is your profit percentage per win multiplied by your win rate minus your loss percentage per loss multiplied by your loss rate. I will use an example of Expectancy from Dr. Van K. Tharp’s Book: Trade your way to Financial Freedom:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss) Expectancy = (PW*AW) less (PL*AL)

PW is the probability of winning and PL is the probability of losing.
AW is the average gain (win) and AL is the average loss

So let’s do an example using another basic approach (assume $12,500 per position, a $100,000 portfolio using 1% equity risk):

If my trades are successful 40% of the time and I realize an average profit of 20% but I lose an average of 5%, my expectancy is $625 per trade.

(0.4 * $2,500) – (0.6 * $625) = $1,000-$375 = $625

I lose 60% of the time yet I show a profit of $625 per trade. If I have a system that produces 65 trades per year, I would realize an annual gain of $40,625 (hypothetical scenario). A 40% gain on the original $100,000 (minus all commissions, fees, taxes and compounding).

Let’s look at the calculation one more time using only percentages:
PW: 40%
AW: 20%
PL: 60%
AL: 5%
(40% * 20%) – (60% * 5%) = 5.00%

What this tells me is that I have a positive expectancy of 5% or $625 per trade from the original $12,500. It doesn’t mean that I will make $625 on every single trade but my system will average a profit of $625 per trade over the course of a year with a combination of winners and losers. I can always make more trades or fewer trades in a year so my total profit will be adjusted accordingly.

Wikipedia Definition:

In probability theory the expected value (or mathematical expectation, or mean) of a discrete random variable is the sum of the probability of each possible outcome of the experiment multiplied by the outcome value (or payoff). Thus, it represents the average amount one “expects” as the outcome of the random trial when identical odds are repeated many times. Note that the value itself may not be expected in the general sense – the “expected value” itself may be unlikely or even impossible.

In simpler terms:
Expected Value (EV) is the amount of money you can expect to earn over time by making a calculated decision in a specific situation.

The expected value from the roll of an ordinary six-sided die is 3.5 (how do we get here):

Rolling each number has a probability of 1/6.
Multiplying the values with their respective probability gives us 3.5 or:
1 * 1/6 = 1/6
2 * 1/6 = 2/6
3 * 1/6 = 3/6
4 * 1/6 = 4/6
5 * 1/6 = 5/6
6 * 1/6 = 6/6

We get to 3.5 by adding them together:
1/6 + 2/6 + 3/6 + 4/6 + 5/6 + 6/6 = 3.5

What if the die was weighted and we know that the number “6″ has a 50% chance of coming up? We will assume that the other five numbers still have a uniform distribution (equal chance of coming up in regards to each other):

1 * 1/10 = 1/10
2 * 1/10 = 2/10
3 * 1/10 = 3/10
4 * 1/10 = 4/10
5 * 1/10 = 5/10
6 * 1/2 = 3

The expected value from the roll of this weighted die is 4.5.
We can now bet a weighed and non weighted die and know the outcome of our bets and determine the profitability, if any.

Now, let’s pretend we are flipping a coin with two betting scenarios:

Scenario #1:
We bet on the outcome, and receive even-money (we bet $1, we will win $1) on our bet. In this case, if we flip the coin 100 times, we can expect to win 50 times, and expect to lose 50 times. Overall, we win $50, and lose $50, breaking even. We have neither won nor lost any money (and over time, we will not expect to win or lose any money), so our EV is 0.

Scenario #2:
We bet on the outcome, and receive 2:1 odds (we bet $1, we will win $2) on our bet. In this case, if we flip the coin 100 times, we still expect to win 50 times, and expect to lose 50 times. But, the 50 times we win will earn us $100 (50 * $2), and the 50 times we lose we will still only lose $50. So, over 100 flips, our profit will be $50, or an average of $.50 ($50 / 100 flips). Our EV is the average win/loss per flip, or $.50. for every time this flip occurs so we can expect to make $.50.

Like expectancy in trading (a couple of trades will not give you the anticipated outcome of your system), you must understand that these EV outcomes will only take place over time, the long run. Both expectancy and expected value do not apply to short term results (we must make hundreds, if not thousands of trades, flips or rolls to expect the calculated outcome of the game.

I once read this from a poker article:
“ it’s not important to know the exact EV of a situation (in fact, with all the variables and unknown in poker, it’s generally impossible), but it is important to know whether a situation is +EV (i.e., you’ll make money long-term) or –EV (i.e., you’ll lose money long-term). It’s also generally helpful to know if a +EV situation is very +EV (i.e., you’ll make a lot of money long-term) or marginally +EV (i.e., you’ll make a little money long-term).”

I couldn’t have said this better when it comes to making trades for a positive expectancy system. We will never know ALL of the variables in the market so the most important part of a trade is to understand if the risk/reward is positive, very positive or negative.

You will be well on your way to consistent profits by understanding the risk and the potential reward of each and every trade you make. As in poker, dice or coins, a +EV or –EV can be determined even if every variable is not known. The name of the game is to play when you know it is a +EV situation or trade in our case.

Traders and investors always seem to blame their systems and/ or indicators for poor performance when 99% of the time they should be looking in the mirror. They need to look in-between the ears to locate the problem. As I have explained in the past, the system is not the Holy Grail of Trading. I wrote a post last year that was missed by many since it was written shortly after the fourth of July holiday. Now seems to be the time to discuss this topic, more so than last summer.

• What do you think?
• What is your Holy Grail of Trading?
• Has your system stopped working or have you disconnected with the changing market environment?

Original Post:
Do you have a wonderful trading system, one that consistently makes you money? You probably believe that you have found your holy grail but this couldn’t be further from the truth. Your system has very little to do with consistent profitability in the markets.

I often here amateur investors talk about that the “best way” or “only way” to invest and argue why their way is better than everyone else’s. The passion and energy exuded by these novice investors is wonderful but they are missing the point completely. No one can say that options are better than stocks, commodities are better than options or forex is better than everything, etc… Each investor develops a system that is suited to their own personal character traits and they use a vehicle (stocks, options, forex, commodities, real estate, etc…) that can help them reach their goals.

Investors also debate systems within a market such as: trend trading, swing trading, scalping, shorting, day trading, buy and hold, fundamental trading, technical trading, Elliot wave theory, moving average crossovers, etc… They all work if the “person” understands the holy grail of trading. And that is being able to understand YOU and how your mind works.

However, it is not the system that makes one successful. It is YOU that makes the system work properly. What do I mean? Each individual must master their own personal psychological impacts on their trading results. You must work on YOU to become consistently successful! I recommend reading The Disciplined Trader by Mark Douglas if you would like to understand the psychological trader in you.

To say that one system or vehicle is the “way to go” is ignorant.

Pick up any Market Wizard book and read how these men and women made hundreds of millions in the markets using different systems. The only thing they all had in common was money management and risk management. That’s ALL! Every one of them traded in different ways and used different vehicles but they all watched their risk, calculated proper position sizing techniques and understood their system’s expectancy.

Money management, also termed as risk management is a major part of the holy grail of investing, NOT THE SYSTEM! Novice investors will eventually understand this after many years of trading (some quicker than others).

So, if someone ever tells you that their “system” is better than yours, turn away and run and run fast because they don’t know what the hell they are talking about.

Here are some examples supporting this idea from the Market Wizard books:

• Michael Marcus turned $30,000 into $80 million trading futures
• Michael Steinhardt ran a fund that averaged 30% annual return over 21 years trading stocks
• Tom Baldwin started with $25,000 and eventually traded $2 billion a day in T-bond futures on the floor or in the pit.
• Paul Tudor Jones ran funds that averaged triple digit returns for five consecutive years trading multiple markets
• Ed Seykota realized an astounding 250,000% return over 16 years (yes that says 250,000%) managing accounts trading in the futures markets – possibly the best trader of our time
• Bill Lipschutz traded currencies with a staring account of $12,000 (started out as an architect – very motivating for me since I started the same way).

The list can go on forever but the point remains the same; they all traded different markets with unique systems from different locations (the floor, an office or their home in the mountains) but they all had one major factor in common: money management and risk management.

Just about every market wizard refers to position sizing as a major part of the “holy grail” of trading. Van Tharp (also featured in Market Wizards) coined the phase in the first edition of his book but he only realized that money management was the holy grail after studying and speaking with hundreds, if not thousands of very successful traders. Tharp’s Book, Trade Your Way to Financial Freedom, is a must read if you would like to understand position sizing and expectancy and learn more about understanding “you”.

Top 20 chrisperruna.com Posts

• Listen to My Audio Interview
• My Interview at StockTickr
• Position Sizing and Expectancy
• The Holy Grail of Trading: It’s not your System
• How to Create a Successful Stock Watch List
• My CANSLIM Screening and Buying Strategy
• Fundamental Screens and Scans
• CAN SLIM Breakdown
• Understand the ‘M’ in CANSLIM
• Paper Trading: Nothing to Lose, Nothing to Learn
• Focus on Decisions, Not Outcomes
• Could you Trade Full Time?
• Position Size to Determine How Many Shares to Buy
• Trading Mistakes: Avoid at all Costs
• How to Calculate a Stock’s Pivot Point
• Do Not use Fundamental Analysis Alone!
• How to Short a Stock
• Learn to Focus when Investing
• Markets are not Efficient
• Point and Figure Charts

Let me know if I am missed an article that you believe should be on this list.

The six secrets are:

• Act as an entrepreneur not a gambler
• Make the best use of available resources
• Only bet when there is a significant edge
• Manage bankroll effectively to maximize advantage
• Know how to handicap yourself using effective record-keeping
• Effectively handle emotions as well as money

Chapter Titles:

• Chapter 1 – A Hard Way to Make An Easy Living
• Chapter 2 – The Information Edge
• Chapter 3 – The Never-Ending Quest for Value
• Chapter 4 – If I Only Knew How to Bet…
• Chapter 5 – Woulda… Coulda… Shoulda… Doesn’t Get it Done
• Chapter 6 – It’s One Long Game
• Chapter 7 – The Road Ahead: Issues Facing the Game

Charter six, It’s One Long Game, started with the title phrase of this blog post:
Focus on Decisions, Not Outcomes.

I quickly reminded myself how true this is when trading as too many investors focus on the short term results or the money won and lost in each trade rather than the net result.

The idea of the game is to make the right choices and understand that some of those choices will turn out to be losers. Losers are part of the game and must not affect you emotionally as long as the decision was correct. You must study, analyze and focus on your decisions, not on the amount of money won or lost on each individual trade. As long as your decisions are correct and consistent, you will be a winner over the long term.

Chapter six has been appropriately titled to translate to the trading world:
It’s One Long Game – GET USED TO IT!

On another note, I also started to read a book titled The Wolf of Wall Street while at Barnes and Noble and it had an interesting start but turned into a complete story about a scum bag from the late 1980’s and early 1990’s. I can only imagine what’s going on in the sleazy Hedge Funds of today. I put it down after I realized the guy was only interested in talking about Quaaludes, cocaine and ridiculous drinking. He scammed people out of tens of millions of dollars, cheated on multiple wives, admits he lied for a living and went to prison (he sounds very proud of the accomplishments mentioned). I feel bad for his children. He was in it for the short game – get rich quick! Loser is all I can say.

What do you do in a market like today when you have profits in multiple positions but you don’t want to give it all back? You want to continue to ride the winners but at the same time, you want to maintain the unrealized gains in your account.
HOW?

Most investors and many more market pundits continually talk about setting stops; they range from physical stops to mental stops to trailing stops to support stops to retracement stops or even moving average stops. It is easy to set a mental stop before you enter a position based off of your money management rules such as position sizing and expectancy but will you do it.

If you have a $100,000 account and want to risk 1% of the account on a $50 stock with an 8% stop; we know that the trade will allow you to buy 250 shares with a worst case scenario sell stop of $46.00 (assuming a 1-R risk of $4). This is wonderful but what should a trader do once the position gains 20%, 30% or 50%?

Where should the profit-taking-stop be placed? We want to eliminate the chance of losing the unrealized gain without cutting the stop too tight. We don’t want to sacrifice our possibility of riding a real winner, otherwise known as a home run stock (a 10-bagger as Peter Lynch calls them)! Loosen the stop as you feel comfortable as longer term trend traders will allow for larger swings and draw-downs from peak gains. Shorter term swing traders may agree with the tighter retracement stops explained below.

Many books attempt to explain how to take profits and several academics offer advice but most of it is fluff and biased to opinion. I have heard traders claim that they take a third of the position down after making a 20% or 30% gain while other traders take down half the position once a gain reaches 50%; but is this the correct way to manage money and positions?

Keeping things simple, we could implement a combination of a trailing stop and a retracement stop based upon the actual gain at any point in time. In a bull market (like 2007), I will allow the system to loosen itself so I can handle a healthy pull-back without selling before a possible larger move. I would increase the size of the profit retracement stops when things are trending higher on a weekly basis. Let’s focus on a method for locking in profits without giving back too much as a swing trader.

For the sake of this example, I will continue to use the trade suggested above as the round numbers should be easy to follow.
Account Size: $100,000
Risk: 1%
Stop Loss: 8% (varies based on risk/reward setup)
Share Price: $50

Shares to Purchase: 250 or $12,500
Sell Stop: $46.00
Worst case loss: $1,000 or 1%

If you are unsure of how I came up with the numbers in this example, please take the time to visit my position sizing calculator and the post titled: position sizing and expectancy.

Assume we place a position and it is up over 20% after the one week of trading. What should I do to protect the profit I have already made?

Scenario #1:
At $60, I will set a stop based on a 30% profit retracement.
To do this, you need to multiply the profit of 20% (or $10) by a 30% stop: $10*30% = $3
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3 from the $20% threshold ($60 in this case). My trailing stop is now $57 which guarantees me a total gain of 14%.

Scenario #2:
At $65, I will set a stop based on a 25% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. Again, this can loosen in bull markets and is also subject to longer term support and/or resistance lines. For the sake of this article, we will ignore all other variables.

To do this, you need to multiply the profit of 30% (or $15) by a 25% stop: $15*25% = $3.75
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3.75 from the $30% threshold ($65 in this case). My trailing stop is now $61.25 which guarantees me a total gain of 23% if the trailing stop is violated.

Let’s do this one more time with a 40% gain:

Scenario #3:
At $70, I will set a stop based on a 20% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. As you can see from the three scenarios, my profit retracement has dropped by 5% as my profit has risen by 5%.

To do this, you need to multiply the profit of 40% (or $20) by a 20% stop: $20*20% = $4.00
At this point in time, I will look to close the position and lock in gains if the stock drops more than $4 from the $40% threshold ($70 in this case). My trailing stop is now $66 which guarantees me a total gain of 32% if the trailing stop is violated.

Longer term trend trading investors will use wider stops while shorter term swing traders will substitute numbers that make more sense based on your own system and money management rules.

Outside of these selling rules, I also employ additional selling rules that use the long term 200-day moving average and long term support levels and trend lines. In a bull market, I will loosen the tight stops and look for longer term sell signals such as the moving average, a channel breakdown or even strong volatility movements that don’t agree with the overall pattern (these may be obvious reversals on the daily and/or weekly charts).

Whatever the case may be, the idea is to capture profits while allowing them to grow within a reasonable risk/reward money management system that you have developed. Only you know what your objectives are, design a system that will allow you to achieve them!

This is not meant to poke fun at anyone in particular, especially based on economic class, but I would like to set the record straight as to why we all have proof that the markets are inefficient. Markets are not random.

While reading market wizards on a train last night, I once again enjoyed the Larry Hite, Ed Seykota and Michael Marcus interviews which inspired me to write this post. Market Wizards are the best books to bring on short trips, doctor office visits and anywhere else you don’t need to concentrate but gain great insight.

Larry Hite Notes (points below from his interview):
*Larry Hite started Mint Investment Management Company in the 1980’s and averaged an annual compounded return of over 30 percent starting in 1981 (data from time of published book in mid-1988). They began with $2 million in 1981 and managed over $800 million in mid 1988, a very large sum for a futures fund in the late 1980’s. The size of the fund didn’t hinder the consistent results either, making it all the more impressive.* – the original Market Wizards book

Academia (and the like) claim that markets are efficient and argue that if a person or firm can develop a winning system on a computer, so could others, and we would all cancel each other out.

So what’s wrong with this logical argument?

• Well, people develop these systems and people will ALWAYS make mistakes.
• Some will alter their system and jump from system to system as each one has a losing period.
• Others will be unable to resist second-guessing the trading signals

People will never change as human psychology always stays the same, therefore, patterns will exist and the markets will never be random.

Can you argue that people change? You can’t! Examples:

• Tulip craze in Holland in 1637: they sold for 5,500 florins and then crashed to 50, a 99 percent loss
• Crash of 1929, stocks such as Air Reduction traded as high as $233 but then fell to $31, a decline of 87%
• Texas Instruments traded as high as $207 in 1961 but dropped below $50, a 77 percent loss.
• Silver shot as high as $50 in 1980 but fell 90 percent to $5
• During the bubble bust of 2000, stocks such as Cisco (CSCO) reached a peak of $82 but fell to $8.12 for a loss of 90%.

You should be getting the point by now: Humans will NEVER change and markets will form patterns and form booms and bust forever! We (the mass majority) don’t learn from the past because we didn’t live in the past so we will always make the same emotional mistakes regardless of the technological advances in trading.

If markets were efficient, no one and I mean NO ONE could sustain consistent returns in the market year after year. Traders such as Hite, Seykota, Marcus and others would have never been able to make returns of 30% or greater for extensive periods of time (20+ years in some cases). If we were trading random markets, a new master trader would prevail each year, leaving the others to random chances for success. It would be a crap shoot and expectancy would be thrown out the window because nothing would be consistent.

Markets will change but people never will!

I now leave you will some additional quotes from Larry Hite:
“What makes this business so fabulous is that while you may not know what will happen tomorrow, you can have a very good idea what will happen over the long run”

“If you never bet your lifestyle, from a trading standpoint, nothing bad will ever happen to you”

“If you know what the worst possible outcome is, it gives you tremendous freedom. The truth is that, while you can’t quantify reward, you can quantify risk”

“You can lose money even on a good bet (trade). If the odds on a bet are 50/50 and the payoff is $2 versus a $1 risk, that is a good bet even if you lose”

“It is incredible how rich you can get by not being perfect”

“Anyone can sit down and devise a perfect system for the past”

I don’t want to confuse the concept of conserving one’s wealth by employing proper money management techniques and the actual fear of going broke. Fearful investors base their entire system, thoughts and style of investing on a negative thought process or a negative mental attitude. Successful investors, whether it is stocks, real estate or businesses, always develop strategies to protect from the down-side by focusing on the reward versus the original risk. Successful investors develop systems with expectancies that allow them to negate emotional fear by knowing what can happen if the investment fails. Successful investors are emotionally prepared to handle the side effects of losing money. Unsuccessful investors think about losing the initial investment and more often than not, pass up on a potential golden opportunity.

How many times have you heard a person say: ‘if I only put my money into that stock or that piece of real estate”? These same people are also the ones that continue to pass up on potential opportunities today because they are scared to lose. Nothing comes easy and life rarely serves up a free pass without some form of risk attached. When speaking in terms of stocks, an investor must place money after their best ideas or they will never know if they have a winning system. Many people paper trade and claim they can pick winners but I view them as fearful of losing money. The fear of money and the fear of losing are two of the main reasons why so many people go broke on Wall Street.

If you don’t fear money and can accept losing as part of the game, you will eventually become successful.

A scared poker player can serve as a perfect example of the type of person that fears to lose money. Take the time to sit at any $1-$2 no-limit hold’em game at a casino and you will quickly realize who fears money and who plays without fear. Good players may continually lose because they fear the dollar and fail to play according to their strategy. I have seen several bad players win lots of money at the tables because they bully the scared players out of their hands. They essentially make suckers out of the better player so in the end; the better player goes home broke and emotionally damaged.

For example: let’s say you are dealt a KK and raise on the first bet but one of these fearless “garbage bully players” re-raises all-in to scare you out of the pot.
Would you fold?

I have heard many stories of players folding high quality hands due to their fear of getting a bad beat. In this case, the bully can only represent one hand that can beat yours, so the odds are heavily in your favor so you must call and call quickly (don’t have fear when the odds say you should win). Two remedies exist for the fear of a bad loss: a bankroll that can withstand a few bad beats and a strategy that capitalizes on hands with high odds for potential winners. Over the long term, you will be a consistent winner but must understand that beats will happen and some of them will be large (if it is a bad beat). Assuming that you let go or cut poor hands short, these larger losses can be avoided consistently. In poker and in life: scared money is dead money!

The same principal holds true in investing and in life. The people that assume the risk and calculate the odds of success are typically the ones that come out ahead with larger bank accounts. They don’t focus on the losing aspect of a deal and never blurt out the words “what-if”. To repeat, they don’t ignore possible failures as they prepare for the worst and expect the best. I will not deny that I have been in situations where I was scared to lose but that helped me seek out the answers to consistent winning. Losing will always sting but I now accept losing as part of the game.

I expect to win each trade but ultimately understand that some will fail and it’s ok as long as I don’t let it become catastrophic. I have learned to accept losing trades, losing money and I have challenged the fear of money. I place risk under control by developing and using a positive expectancy system, position sizing and money management techniques that eliminate my fear of losing money. I may lose many small battles but I depend on my system to win the ultimate war. I am a trend-trader so my wins are large in a market similar to what we have just experienced.

Read this quote from the movie Rounders:

“In “Confessions of a Winning Poker Player,” Jack King said, “Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career.” It seems true to me, cause walking in here, I can hardly remember how I built my bankroll, but I can’t stop thinking about the way I lost it.”

That quote can be tied to investing with great accuracy.

One more quote that fits with the article I have written about the fear of losing money:

“They’re trying to goad me, trying to own me. But this isn’t a gunfight. It’s not about pride or ego. It’s only about money. I can leave now, even with Grama and KGB… and halfway to paying Petrovsky back. That’s the safe play. I told Worm you can’t lose what you don’t put in the middle. But you can’t win much either.”

What are you afraid of?