The Basic Truths of Trading

**This is the second in a series of posts from Bruce Bower related to “Peak Performance” the topic of his new book that SMB U will be releasing April 20th**

**SMB will be hosting a free webinar on April 13th in which Bruce will discuss in depth the concept of “Peak Performance” and how it can be applied by all successful traders and investors. Sign up HERE.**

By Bruce Bower

In “What does A Winning Methodology Look Like?” I suggested that to be successful in investing or trading, we need a process. A methodology.

All good methodologies have in common several traits beyond just a checklist. These are fundamental principles that you will hear successful investors and traders repeat over and over. In addition, they make logical sense. They are so fundamental that I’ve called them the Basic Truths of Trading (BTTs). Here are the seven:

  1. Well-defined objectives. Are you trying to beat a certain return hurdle, like inflation or an index? Are you trying to generate 5% or 50% returns per year? You have to understand what you are trying to do and then bend your investment process around it. The other way around isn’t possible.
  2. An understanding of the markets that you will be operating in. Stick to what you know. Narrow your focus so as to make the most of your efforts. You need to know everything about the markets where you’re taking positions.
  3.  A clearly defined methodology for getting into and out of positions. This includes which indicators, news items, fundamental data points you look at and when you take action. This is your checklist—you should have it so well defined that you can be sure of the exact steps along the way. You need a game plan so that you stay consistent and disciplined and don’t get flustered under pressure. It should become automatic and engrained.
  4. This methodology must utilize your strengths and skills and suit your personality. A cerebral, research-driven economist should put that to work, instead of becoming a swing trader based on technical analysis. An adrenaline-fueled athlete should be an intraday trader, not be a long-term trend follower. Remember, every successful trader has a methodology of their own which plays to their strengths and their personality.
  5. This methodology has a positive statistical expectancy– the gains from winners more than outweigh the losses on losing trades. Use your own statistics and the Kelly Formula for a rough guide as to whether or not you have positive statistical expectancy.  On average you want to expect to win on an individual trade, meaning that your expected wins outweigh your prospective losses. That doesn’t guarantee that you will actually profit on each trade, it just means that over a sufficiently large quantity of trades, you will come out ahead.
  6. A well-stated risk management policy for when you get out of losing positions and how you manage risk overall. Cut losers. Let winners ride.  Many people have tried to overthink this rule and ended up losing as a result. Furthermore, you never want to put yourself in a position where you can blow up, so you need to be thinking how you can avoid taking excessive risk in the first place. Just remember Warren Buffett’s Two Rules:
    1. Never Lose Money.
    2. Never Forget Rule #1.
  7. A framework for sizing positions. This is related to risk management— obviously, you don’t want to take a position that’s over a certain size, ever. But you may also want to size positions according to certain specific critieria, such as your conviction in the position or volatility in the market. Or they could all be the same size. Nonetheless, your methodology has to be able to address it and come up with a well-reasoned answer.

Together these are the BTTs which should feature in any discussion about any methodology. They are that fundamental and basic for success. In the book, I go into extensive detail about all of these points. I also take the examples of three real traders and their processes, and we walk through them step by step to review and analyze them.

Of these, BTT number five is actually the easiest of these to dive into, because it’s simple math. The formula that we use to guide is the standard one for statistical expectation:

Statistical Expectation = (Winning %  x  Profit Per Winner) – (Losing %  x  Loss Per Loser)

Unless you have a 100% win rate, you will not be a winner on every trade. Instead, you will face losses from time to time, and that’s ok. By thinking in terms of expectation, we are balancing the odds of winning versus losing with the payoffs of wining versus losing. Basically, if a losing position, on average, makes more than your average loser, then you are making money over the long term.

To illustrate this, think of a coin flip where you make $2 when it’s heads and lose $1 when it’s tails. On any given flip, you stand a 50/50 chance of heads versus tails. But you know two things: 1. That over long run, the win rate will be close to 50%; 2. That you will be a huge winner because the $2 payout on heads gives your overall expectation a big boost. In the markets, we want to accomplish the same strategy. We want to know that over a sufficiently number of positions, we can’t help but win.

Closely related to this is the Kelly Formula, which explores how much we should risk on any single trade. The formula looks at the likelihood of a trade working versus the edge, i.e. expectation that we have on it. The reasoning behind it is simple: even if we have enormously favorable risk/reward ratios, then if we bet too much on a single transaction, we could be wiped out. How do you balance the competing forces of greed and fear? The Kelly Formula gives a mathematical exploration of this relationship. Just like any methodology is guided by proper risk management and position sizing, the Kelly Formula puts some mathematical skin on the bones. While it is not a strict rule, we should take it into consideration, and the book explores some of the major pros and cons.

Building a winning methodology can seem like a daunting challenge. It’s certainly a key component of any successful trader’s journey in the markets. Hopefully these tools and thoughts give you the framework and tools to start on that journey.

Stay tuned for the book, which will delve into all of these topics in greater detail. It will also tie this together into a section called “Planning the Trade”, which is about getting your methodology sorted before implementing any trade.

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*No relevant positions

Attend our next FREE webinar on “Peak Performance Trading & Investing” on April 13th Where Bruce will reveal the keys to developing a successful system for attacking any market in any time frame. Register HERE

 

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