Saturday, April 03, 2010

Some Necessities of Successful Trading

In the last couple of articles, I've been writing about some of the things that I believe are critical elements to good trading. Last weekend, I wrote about some general requirements -- knowledge, plan, discipline and patience -- that I would suggest can be critical factors in successful trading. In this article, I am going to discuss a triumvirate of elements that I believe are also extremely important in attempting to achieve success in trading. They are exit strategy, reward to risk ratio, and money management.

In most cases we can't know how we've done in a trade, whether we've made a gain or suffered a loss, until the trade has ended. In other words, success or failure is ultimately determined by the exit. Until then, anything could happen. It seems pretty clear, then, that the exit is one of the more important things we can do. The next question for me is when should I formulate my exit strategy? My answer is that I should have my strategy in place even before I enter a position and then have the discipline to adhere to the strategy.

Reward to risk can definitely separate the winners from the losers. A trader who consistently enters trades with a 1:1 reward to risk (meaning he is risking a dollar to make a dollar) might well be doomed to ultimate failure if he is right on 50% of his trades. He will win a dollar, lose a dollar, win a dollar, lose a dollar, etc. and be around breakeven except he would be paying a commission on every trade and ultimately run out of money from paying commissions. On the other hand, finding candidates where the potential reward appears to be 2 and 1/2 times (or greater) than the risk (2.5:1) would permit the trader to lose 7 out of 10 trades and still wind up with a modest profit.

Of course, the reward to risk can work assuming that the trader's plan include some method for money management. If money is invested without thought to management, the trader runs the risk of things like seeing the larger positions lose and smaller positions wind up as winners or being wiped out by a single loss or having one loss erase a series of wins. The trader who incorporates money management in his plan has a much better chance of staying in the game and may well increase his chances of overall success. Failure to incorporate an element of money management can expose the trader to some serious additional risk.

For those who are interested, detailed discussion of much of what I have written in the last three articles can be found in my first book, "Trade Your Way to Wealth."

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved

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LUNA said...

I would like to know how you quantify Reward-to-Risk ratio. It was an eye opener that a 2.5:1 ratio lets you be in the game 7 out of 10 times! That is not very apparant.

How how do you calculate the ratio? I mean how do you determine before entering a trade that you have a 2.5 times advantage? I trade on a judgment that a trade has say, "strong" or a "medium" or a "weak" chance of making the move in my direction (long or short) but I wouldn't be able to put a mathematical number to it. How do you do it?

Second, what percentage of your capital is invested on a given day? Typically what are the low/medium/high percentages?

Third, do you predominantly day-trade or swing-trade?

Finally, I believe the days of buy-and-hold are gone. There are too many Enrons, Worldcoms, Madoffs and Lehmans out there. Investors Beware - that's the mantra of today. If you go hunting big game on the plains of Africa, you can't afford to sleep on the ground. Makes sense?

Thank you.

Bill Kraft, said...

Thanks for writing, LUNA. Yours are some good questions and comments. First, I should say that it works out that I am a swing trader though I generally have no pre-conceived notions of how long I will be in a trade other than perhaps an option expiration date (and it is rare that I am in a long option position until expiration). Instead, I let the movement of the stock take me out. My reward to risk calculation is based on the distance from my entry to my initial exit based on my exit strategy (risk) and the distance from my entry to what looks like the first serious resistance (reward). Obviously, this approach is not infallible, but it does give me a good handle on the potential. In that regard, I'm wondering how you make your determination whether a trade has a strong, medium, or weak chance of making a move in your direction. The question about how much of my capital is invested on any given day is very difficult to answer since it can vary quite widely. In a particularly indecisive market, it ordinarily would be a very low percentage, perhaps on the order of 5% to 10%. Conversely, in a strongly trending market it might be much higher, perhaps on the order of 85%. It could be anywhere in between. Anyway, hope that helps. I think I'll use your questions as a springboard for a future article. Thanks.
Bill Kraft