Saturday, August 29, 2009

Part I - The Basics of Profitable Trading

Perhaps the most basic concepts necessary to achieve profitable trading are to cut losses and let profits run. The idea is obvious and simple on its face, but it seems that many traders have no idea how to accomplish either objective. In fact, I would hazard a guess that a majority of retail traders do just the opposite. They cut profits and let losses run. That is an almost certain road to losses and frustration.

Recently, a commentator on the blog took me to task and suggested that I use the concept of cutting losses and letting profits run as a tease and suggested that I write a little about exactly how to do those things. I can only guess that he has not been following my articles for very long and has not read my books because I have tried to deal with the "how to" aspect many times. My coaching sessions focus specifically on those actions as they apply to the individual with whom I am working. Accepting all that, I, nevertheless agree with the comments insofar as I believe it could be extremely helpful to at least some readers to discuss specific ways to cut losses and specific ways to let profits run. This article, therefore, is the beginning of a three part series in which I'll try to suggest ways in which the individual can set up his or her trading so that they do cut losses and let profits run in ways that could work for them.

The blogger suggested it would be a cop out to say that the "how" of cutting losses and letting profits run is an individual decision. In that regard, I believe he is mistaken. Each of us must determine the methodology that fits our personal risk tolerance, our goals, our available time, our knowledge base, and the strategies we utilize and with which we are familiar. For example, someone who only trades stocks may have a much different loss cutting strategy than someone who trades call ratio backspreads and someone whose primary strategy is selling options may have a different approach than someone whose primary strategy is buying options.

Recognizing that how we cut losses and let profits run is, indeed, a personal decision and should be part of an individual plan, we can still explore some of the basic concepts that we might consider applying no matter who we are or what our strategy might be.

As many of you may know, in addition to private coaching, I have taught a number of trading seminars over the years. In addition, I often get calls from other traders and often speak with people who have questions regarding trades or investments. With that background I would suggest that it is fairly common that retail traders generally buy stock with the hope that it goes up in price. They tend to enter positions for a variety of reasons, and, among those reasons, may rely on something they have read or heard on TV; they may get a tip from a friend who already owns a stock or is about to buy it; they may act upon a broker's suggestion; or they may have some personal knowledge gained through research or some first hand experience. In many of those cases they are buying a story; a story usually with some basis in fundamentals. When they buy, they give little or no consideration to their entry price, particularly as it might relate to an initial exit in the event the stock turns against them right away. The entry is made with little consideration of how much is actually at risk and with little or no consideration of how much they are personally willing to risk in the trade. Often these are the people who have been taught that the only way to invest is to buy and hold and they will defend "buy and hold" with great fervor.

In its purest form, the strategy of buy and hold generally has no plan as to when or how to cut losses. Positions are simply to be held no matter how much the stock drops. Any exit strategy is ordinarily based on need or whim. The question I always ask buy and hold investors is: "Hold until when?" I usually get a blank look. Hold until death is certainly a strategy and one that may be wonderful for the heirs, but maybe not be so good for the investor. Using this strategy, profits may well run and that is generally something we want to achieve, but so too do losses. Anyone who held the likes of Lehman Bros., or Enron, or Bear Stearns knows exactly what I am writing about. So too, albeit to a lesser extent do longer term holders of issues of even great companies like GE or CAT or MSFT. Of course they may "come back" and hopefully they will. But why hold them during the downdrafts; why let big profits turn into big losses?

If you accept my arguments so far, it only seems logical that you would agree that the first part of cutting losses and letting profits run is to have a plan. Using a plan, you can create a disciplined structure in the beginning that will dictate at what point to get in and at what point to get out. In other words you can set yourself up before entering the position with a trigger mechanism that extricates you relatively quickly from a losing trade and keeps you in a trade that is winning until it turns against you. I discuss precisely how you can create such a plan for yourself in "Trade Your Way to Wealth" and in "Smart Investors Money Machine." In my view, without such a plan one has no disciplined basis upon which to cut losses and no way to make sure profits are permitted to accumulate.

The first key is to recognize that cutting losses and letting profits run can be instrumental in realizing success in trading and investing. Once accepted, the next step is to create a plan for yourself whereby you set out where and how the losses are to be cut. That involves some system to determine the level of loss you are willing to accept and that will be the subject of Part II of this series. Next week, we will look at very specific ways for you to determine the "where" of the loss cut. In addition, we'll address certain orders that traders and investors might consider to implement the loss cut. Once the initial level of acceptable loss is determined, we need to structure the trade in such a way that we try to attempt to avoid cutting profits. In Part III, I'll discuss specific ways a trader can attempt to continue to capture profit while letting the play continue so that profits that are running can continue to do so.

As these articles are published, I expect to be traveling in Ireland so please don't expect me to respond as regularly on the blog as I ordinarily do. Feel free to have an open civil discussion. Let me suggest that there are many, many ways to accomplish the objectives we are discussing here and there is probably no one perfect way. Be tolerant and open to the suggestions of others. We always learn more when we are willing to listen than when we try to force our own beliefs down someone else's throat.

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


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To comment on Bill's article click on the "comments" link below.

15 comments:

Monty Z said...

OK Bill, and yes it is a very easy concept to grasp. But, here is the problem: while it is easy for a stop loss exit strategy (you know the current price, and you can use some kind of a %, a moving average, or a pivot to control your losses), the real test is how far you let your profits run (20%, 50%, 10 bagger). I would like to see how you would apply all of this to daytrading?

Have a nice trip Bill,

Robin M. said...

Hi Bill:

I have been following your newsletters, and really appreciate your style. I am usually in agreement with you, and have found you to make the most sense of several newsletters I have watched.

I read on how you plan to write about specific ways to cut losses and allow profits to run.

If possible I wonder if you can comment concerning this:

I have set up a lot of trades with stop loss orders, but it has been quite frustrating for me. Many times when I do this, I find the trade seems to gravitate to my stop loss, trade me out, and promptly go higher. When I set a wider range on the stop loss order, it still seems to do this. I don't know if you have experienced the same phenomenon. This has happened to me particularly with the QQQQ ticker symbol.

Lately I have been trying to cover my option trades, by buying options on both call and put sides, such that if the stock moves against me in either direction, it will cover the other, with GTC profit exit orders in both directions. This seems to work a little better, but it is difficult to calculate the best way to do this.

Please let me know if you can shed some specific insight and examples on this, and also if you have experienced the same phenomenon at times with stop loss orders, or if you think this phenomenon is only coincidence.

Best Regards,

Robin Martin RN, LNCC

Anonymous said...

Bill,

Great article on cutting losses! Also, hope you are enjoying Ireland, and all it has to offer! I'm from Dublin, and here in the U.S.A (aka The Promised Land!)living for 18 years, and hope you get to visit Dublin and Trinity College:)

Anonymous said...

test

Anonymous said...

In response to Robin's comment. Most pro's don't do much better than 50/50 on there win losses so you have to realize you will be stopped out alot.It sounds like your entries are at the top of a run,and your getting retracement moves right after your entry.Not sure if your day trading but if you are your stops are pobably very tight and more likely to be hit. The lower band on the bollinger and MACD in "Sping" can make a good entry indicator.
I'm still a learning amateur so maybe Bill could shed some light on my thoughs.

thanks

Morris

Anonymous said...

Hello Bill,

I have been reading your first book and I am stuck at page 88. I can't get past it because I don't understand.

I have no experience with option spreads nor collars so I need a little help here.

You mention you sold the $250 GOOG call for $40.40 as part of a collar you assembled, and two months later you bought the call to close that leg of the collar. GOOG had soared from $231 to $380. What I don't get is how you could have purchased the $250 call for $61.20. From what I have read in previous chapters of your book, if GOOG is at $380, the $250 call would be worth at the very least $130 dollars assuming it had no time value, which was not the case.

I keep thinking and I figure may be you meant to say $161.20, not $61.20, but then you would not have made a loss of $20.80 on that leg, instead you would have lost $120.20. The overall profit of that trade would then be $13.60, or a 5.7%, which is not bad for a period of 2 months, but it is not 58%.

Thank you for your weekend newsletter which I look forward to every Saturday.

Alf.

Bill Kraft, MarketFN.com said...

Hang on for Part III, Monty and you will see some specific suggestions on how I try to let profits run. Thanks for writing.
Bill Kraft

Bill Kraft, MarketFN.com said...

Robin, thanks for writing and Morris, thanks for your helpful answer. Stops are one of the most difficult things in trading because they generally involve subjectivity. As you note, Morris, it is not unusual for even very successful traders to have only 50% winners. As I have discussed in past articles and will discuss in future articles, the important keys are establishing appropriate reward to risk ratios and money management.
Bill Kraft

Bill Kraft, MarketFN.com said...

Anonymous, Ireland is just great. We just left Dublin and did visit Trinity College and saw the book of Kells among a number of other delightful things.
Bill Kraft

Bill Kraft, MarketFN.com said...

Alf, I don't blame you for being stuck. I made a mistake on the math on page 88 and have tried to correct it both in former Newsletter articles and in Amazon contents. I am truly sorry. The principles, however, are accurate.
Bill Kraft

Charles Maley said...

Thanks Bill

.....and I thought I would comment further on the simple yet very powerful concept.

It all starts with the 4 possibilities. Once you put on a trade only four things can happen:

1- You can win big

2- You can win a little

3- You can lose big

4- You can lose a little

The goal is to eliminate number 3. What do we do?


Number #1- First form a hypothesis.

Your hypothesis can be as simple as this.

1- You (or your system) think the stock or future is going up.

2- You (or your system) think the stock or future is going down.

How you arrive at this conclusion may be based on your analysis of fundamental indicators, technical indicators or a trading system. You might even be in agreement with someone else’s analysis. For example, you might agree with Morgan Stanley’s opinion that crude oil is going much higher.

However, what you do next is extremely important.

You need to determine how much money you are going to risk on this particular trade. The easiest way to do this is to use a percentage of your account value. For example, if your account value is $100,000 and you are going to risk 1% of this value, you are going to risk $1000. You do this because your hypothesis might be wrong or you might be just early. By defining and accepting your risk, you hopefully eliminate the possibility of the big loss.

Number #2-The trend should confirm your hypothesis



This is done for two reasons:

1- If you are trading against the trend, you may not be in sync with your hypothesis and you either going to get stopped out often or suffer a big loss.

2- If you are trading with the trend, you know anything can happen. You are positioning yourself for the possibility of winning big.

Winning big is what will eventually make you a successful trader.

Number #3-You think in probabilities for two reasons:

1- It is unreasonable to believe that every individual trade is going to be profitable. It is equally unreasonable to believe that you will be able to identify only the successful trades. However, each trade has a probability of being profitable. The way to determine how your trading is doing is by evaluating a series of trades over time.

2- Evaluating your trading over a series of trades will also confirm or not confirm your hypothesis. If after a series of trades you are losing money it might be time to review your hypothesis.

Bill Kraft, MarketFN.com said...

Thanks, Charles, for your thoughtful contribution.
Bill Kraft

Anonymous said...

Great post Charles very insightful.

As Bill notes concept of trading is simple. ( no big losers )

but definitely not easy

Morris

Anonymous said...

One thing about trading that bothers me is no one is up front about there profit or loss.I have yet to meet anyone whom makes money trading except for you Bill and some other T.V personalities.
I know Bill you mention you make a nice living and I assume that is true.I wonder what percentage of traders are making a living.

I can only surmise that a succesfull trader might make 20% per year on their accounts.Not sure if they could do it year after year.
If that was true I would need 250,000 in my trading account to make a simple living of $50,000.

Anyone personaly know someone doing this ? Any comments that could help enlighten me would be appreciated.

Morris

Bill Kraft, MarketFN.com said...

Thanks for writing, Morris. I believe it is a pretty well recognized fact that the large majority of traders do not make a living trading and, in fact, lose. There are certainly a number of reasons for those failures, and among them are the failure to start with a plan, the failure to utilize an appropriate reward to risk ratio, lack of money management, and permitting fear and/or greed to rule their trades.
Bill Kraft