30 people in a room, everyone gets the same exact trades in the same exact sequence. How many different outcomes will result?
Years ago I did a lot of work with Van Tharp, one of the original Market Wizards from Jack Schwagers books. Van had game where he had 100 marbles in a bag, each representing a trade. Each marble (trade) was denoted with a return that was a multiple of the risk (know as “R”) taken on that trade, +1R, -2R, + 5R, etc. 60% of the marbles (trades) were winners. The unknown was the amount of the gain or loss from each trade. Participants were each allocated $100,000 and instructed to bet a percentage of their equity on each marble pull. The range of results was astounding. Some made huge multiples of their equity some made a solid return, some had small losses and some blew out. In all there were 30 different results
How could this be? How could some lose money when 60% of the trades were winners? How could someone blow out? And how could some double or triple their equity while others had small gains or losses? They were all taking the same trades, akin to everyone buying a stock at exactly the same price and time. Well in Vans bag of marbles was a 10R loser, the equivalent of being short a stock that gets a takeover bid, but there also were 2 10R winners and 1 20R winner, like being on the right side of a takeover, along with trades in between. The market is the same; you don’t know what is going to happen on any individual trade. This may be the big one, good or bad! But how could the results vary so widely? Well the answer to the question is position sizing. That alone is the determining factor in how the results of the 30 traders differed. Did you buy 300 shares or 3000 or short 1000. Does your position size increase dramatically after a few losers because “you’re due”? Well here’s some numbers for you. Even in a 60% system, after 1000 trades it is likely that a run of 7 or 8 losses will have occurred. In fact, 5 losses in a row are very likely during just 100 trades on a 60% winning system. Increasing your risk after a few losers is called the “Gamblers Fallacy” and it has caused the ruin of many. If you flip a coin and it comes up heads 10 times in a row, what are the odds for the next flip? 50%, that’s it. The coin doesn’t know that 10 heads have come up in a row. It just knows that it has an even chance of being heads or tails on that flip. In Vans game that day 5 people blew out and lost everything, and 60% of the trades were winners. Clearly they were risking TOO MUCH! More than likely after a run of losers in an attempt to “get their money back” . This game was played after a day of tutelage had been given on the risks of improper position sizing. And people still had the temptation to increase size beyond reason. This all happened without the pressure of it being real money. It was just a game. The pressure to increase size after 4 losses in a row is much greater. The temptation to rationalize more risk at that point is intense. The thought that this trade may be the 10R loser seems to get lost, but it just might be. You don’t know. You think you know, but you don’t.
So what is the solution? The solution is a money management plan that allows you to take advantage of the nuances of your trading system. Don’t have a system, a rigid rules based plan? Just wing it on gut or feel? Do you sit in on a trading room and follow along with the trades of the whoever runs the room? That’s ok; you can still employ risk management and trade safer. The initial $ risk on every trade should be the same. And it should be a small percentage of capital as you just don’t know whether the next trade is the big one, the 10R or more loser. The most important part of winning is staying in the game.
I’ll do a future post about different types of money management schemes, but for now a simple, relatively safe methodology is the Percent Risk Model. It risks 1%-2% of your equity on any trade. Many may say “That’s way to small, I need to make more money than I will with a trade that small”. Maybe, but the market doesn’t really care what you “need” to make. It is going to do what it is going to do, just like it did before you started trading, and like it will do after you are done. And if you risk a lot more than this you will be done at some point. Ed Seykota, another Market Wizard, said that risking more than 3% of equity is gun slinging, and he was right, with the gun pointing directly at your own head.
If you risk more than a small amount of capital, at some point
1) You ignore your stop because you don’t want to lose that much money on that trade.
2) When you ignore your stop you add to your losing trade in an attempt to get back to breakeven.
3) When you add to your loser you add again in an attempt to get back to a smaller loss.
4) When you add again you add one more time because it can’t go down forever and your wife is going to kill you.
5) When your wife is going to kill you you puke it all out at what you later realize it the low of the move.
6) When you puke it out at the low you put Ed Seykota’s gun to your head.
7) Don’t put Ed Seykota’s gun to your head. Get Direct Cable.
8) Ignore the last part of #7, I couldn't help it, I love those commercials.
Here’s how not to get caught in that vortex: Assuming an account at $100,000 a trader willing to risk 1% of equity and looking to place a trade in AAPL would 1st determine his stop. So if he decided to buy a breakout over 574 and use the low of the morning at 572 as his stop, he would be risking $200 per 100 shares. 1% of equity returns $1000 which equates to an allowable position size for this trade of 500 shares. Maximum loss will be $1000 plus slippage & commissions. Stops should be raised as price rises.
Do this for a while and chart your results. Attach an R value to each trade. A loss of exactly $1000 would be –1R. Include your actual slippage in the computations as it can be significant. Assess yourself, try to keep all of your losses at 1R or lower. Allow your profitable trades to run. And don’t put Ed Seykota’s gun to your head!