Saturday, January 10, 2009

Welcome 2009

I hate to see any year end because every one has provided wonderful experiences and pleasant memories. 2008 was no exception in those categories, but most of us are glad it is over from a market perspective, at least. The Dow finished down 34%, the S&P 500 lost 38% and the Nasdaq and NYSE both fell 41%. Most of the calls I received from prospective coaching students included comments that they wanted help because their accounts were down significantly.

In mid-December, I received an email from Dr. Alexander Elder (author of several excellent trading books including "Trading for a Living" and "Come Into My Trading Room") pointing out that up to that time, none of the U.S. Stock Mutual Funds tracked by Morningstar, not one, was up for the year. In fact, the average performance was a whopping minus 43.63%. That information underscores the importance of cutting losses, paying attention to reward to risk ratios, and of money management, topics I have repeatedly addressed over the years in these articles. If we are down 50%, it means our position must gain 100% just to get back to even. That is a significant problem with the buy and hold philosophy.

It has often been said that even the best traders only win about 1/2 their trades. If that is so (and I believe it is) how can they succeed? First, they can cut losses so that the amount of gains, in general, exceed the amount of losses. One important way to do that is to pay attention to the potential reward versus the risk assumed in any given trade. If, for example, we enter trades where the potential reward is 2.5 times the risk we are taking, we can lose 70% of our trades and still make money. Looking at the Table below, we can see that if we lose $1 on each losing trade and make $2.50 on each winning trade, in 10 trades, even if 70% are losers, we would still make a little.

    Lose                  Win
1.  -$1
2.  -$1
3.  -$1
4.  -$1
5.  -$1
6.  -$1
7.  -$1
8.                          +$2.50
9.                          +$2.50
10.                        +$2.50
_____                    ______
   -$7                     +$7.50

Of course, in some cases, the winners would run beyond the $2.50 while the losers can most likely be kept fairly close to the loss set at the beginning of a trade.

All that aside, I reviewed my trades in the three subscription services I edit for MarketFN and found that I did not trade particularly actively as a result of market conditions. I closed 19 trades in Trend Trader, 27 trades in Option Trader, and 28 trades in $10 Trader. Not surprisingly, in light of the downward direction of the market, Option Trader had the highest percentage of winning closed trades with 63%. $10 Trader came in a close second with a winning percentage of closed trades of 61% and Trend Trader with a not too shabby 53% profitable trades. Both Trend Trader and $10 Trader are services in which I am looking to buy stocks so they are directed more to bullish plays where I want to buy the stock and then have the stock price increase. 53% and 61% winners, respectively, in those services when the Nasdaq fell 41% and the Dow 34%, and not a single mutual fund followed by Morningstar had made money by the middle of December seems pretty decent all things considered.

What will 2009 bring? I can assure you that absolutely no one knows. One thing we can do is add to our knowledge. I guess I wasn't surprised when the publisher of my book "Trade Your Way to Wealth" told me that sales of trading books were down this year, but it seems to me that it is exactly at times like these when people should be reading books, adding to their knowledge, learning how to cut losses and let profits run rather than throwing unopened brokerage statements into the trash. I feel assured that those who took advantage of my reduced price offer for private coaching all came away with added knowledge about risk management, discipline, money management, and methods by which they could cut losses and ways to avoid cutting profits. All trading is risky, but the more effort we make to learn, the better chance we give ourselves to succeed.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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sam said...

I read your book and it should have been one of the first books I read. You give a clear description of what you are talking about.Keep up the good work.
Keep Smiling, Sam Stote

Anonymous said...

Trying to draw a comparison between % winning trades and performance of frequently-touted benchmarks seems somewhat meaningless. What proportion of stocks in each index gained or lost for the year? That would be a more apropos comparison with your % wins.

More importantly, though, is a great point illustrated by your table: when it comes to performance, you must take both average win/average loss ratio into account as well as your winning percentage. One without the other does not provide a complete view. In this blog post, I wonder why you presented % wins rather than average win/average loss as well.

DrQuien said...

One of the dilemmas I have come across with active trading is that your wins have to compensate for your losses and simply getting a 50/50 win loss ratio will not work. Let me explain why. The example I will use uses a somewhat exaggerated scenario to prove the point.

Say you starting principal is $1000 and you invest the entire amount and the first trade you make results in a 10% loss (I know this should not happen because of a stop loss provision, but for the sake of this example, just bear with me). Your account would look like this:
Invest $1000 and lose 10% = loss of $100, your new principal = $900

Now, invest the $900 and this time GAIN 10% = gain of $90, your new principal balance after this wining trade is $990.

Using this 50/50 win loss ratio, you are still down 1%. In order to compensate for this eroding drift you would need 52% wining trades just to stay even. Or, as you say “in some cases, the winners would run beyond the $2.50 while the losers can most likely be kept fairly close to the loss set at the beginning of a trade.”

It goes back to your persistent mantra of not just picking winning trades but managing your trades with stop loss and targeted entry/exit points.

Thanks for listening
Christopher Cerda
Author “Serious Money Investing”

Bill Kraft, said...

Thanks, Sam.
Bill Kraft