Den of The Lion Investor

Continuing on from my previous post on trading by Ray Barros, this post covers on the topic of money management. 

Ray Barros mentioned that 80-90% of newbies will show a loss in their first 12 months of trading. 3-6% even lose their entire trading capital. The single most important reason why this happens is unrealistic expectations.

Professional traders try to make money slowly. Amateurs try to make it quick. For example, making a 10-20% return in a year can be considered a pretty decent return. Some newbies expect to make that same kind of returns in a month. This leads them to take larger positions then they should be taking — often with disasterous results.

A proper money management system defines the risk (amount of capital) you risk per trade by helping you to determine the correct position sizing to take. The factors that affects it include your capital base, the volatility of the market and the expectency of returns.

The expectency can be calculated by taking:

Average $ win x win rate - average $ loss x loss rate

You cannot control your win rate, but you can control your entry and exit prices. These set prices help you to determine the risk you put into every trade, and the maximum reward you can get.

A good risk to reward ratio is crucial for getting consistent results from trading.

Depending on the time frame you are trading, the risk to reward ratio will be different.

The shorter the time frame, the lower the profit you can make on each trade, and the higher your win rate has to be. For example:

Type of trader : risk reward ratio : win rate required

• Scalper : 0.5-1 : 80%
• Day trader ; 1+ : 70%
• Position trader : 1.8-2.5 : 50%

Ray Barros shared with us two methods for determining the correct position sizing. The second method is more complicated and requires data from your trading records, so I will just talk about the first one here.

Decide on the risk you will take on each trade. Typically, this is about 2-5% of your trading capital. Using an example of $10,000 as trading capital and risk of 2%, this works out to be $200. 

Suppose then that I enter a trade at a price of $100. Based on technical indicators, I determine the take profit price to be $120 and the cut loss level to be $90.

This trade has a good risk reward ratio of 2. 

As the cut loss level leads to a loss of $10, the maximum number of contracts that can be taken is $200/10 = 20 contracts

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During the Invest Fair a couple of weeks ago, I had the opportunity to attend two talks by Ray Barros, a professional trader and fund manager.

It wasn’t the first time I had attended his talk, and it certainly won’t be the last. I had always enjoyed his sincere sharing of knowledge with no hype and sales pitch.

There are three elements to being a successful trader.

1) Psychology

This contributes 60% to the equation and part of it means creating an environment where you will consistently execute your plan.

2) Trading Plan

Unlike what most people think, the trading plan contributes only about 10% to the success of the trader. Trading the market is a probability game and a written plan with an edge helps put the probability in your favour. The plan helps to define both your entry and exit points.

3) Money Management

This forms the last 30% of trading. Good money management helps to maximize profitability while at the same time minimizes the risk of blowing your trading account.

In his first session at the Invest Fair, Ray Barros focused more on the second element - the trading plan.

The function of an trading plan is to help you identify an entry point when the probability is in your favour. It will define your zones, entry and initial stops, and risk management.

Identifying the trend is also important as the strategy for trading each trend is different.

• Sell rallies in a downtrend.
• Buy correction in an uptrend.
• Exercise patience in a sideways market. Trade only the top and bottom band. The middle band should be avoided. One way of calculating the band is to put the daily range and divide it by 8.

Ray then taught us a system for identifying trends using the relative strength index (RSI) as an indicator.

In an uptrend, the RSI should reach at least 75 and go no lower than 35.

In a downtrend, the RSI should go no higher than 65 and and should go down to at least 25.

The criteria for identifying a change from downtrend to uptrend:

1. Price break a significant high.
2. RSI goes to 75.
3. RSI doens’t go below 35 after that.

The criteria for identifying a change from uptrend to downtrend:

1. Price breaks a significant low.
2. RSI goes to 25.
3. RSI doesn’t go above 65 after that.

In an uptrend, the buy zone should be when the RSI is between 35 and 40.

In a downtrend, the sell zone should be when the RSI is between 60 and 65.

The next session by Ray Barros which was more on money management will be covered in another post.

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Another talk that I attended on the first day of the Invest Fair was by Tom Gentile, the senior vice-president and chief market strategist of Optionetics. The title of his talk was “Terminating Inconsistency in 5 Minutes“.

Tom Gentile spoke about the use of a trading system, where it’s

• 100% mechanic with no human inteference.
• Based on repeatable and tradeable patterns.
• Able to be back tested.
• Able to be scanned for efficiency.

He then shared with us a system that he uses. It’s pretty easy to implement.

1. Look for a volume spike of more than 300% on any particular trading day. Record the price limits for that day. We shall call them L (low price) and H (high price). The range (R) is calculated as H - L.
2. After a volume spike, the market tends to move in momentum one way or the either.
3. Following the volume spike day, wait for a day until the price breaks either L or H.
4. If H is broken on the upside, initiate a long trade. Stop loss is at L. 50% profit level at H + R.
5. If L is broken on the downside, initiate a short trade. Stop loss is at H. 50% profit level at L - R.

Actually, I was expecting Tom to touch a bit on psychology, since it’s one of the major contributor to trading inconsistency. I suppose there’s a limit to how much he can cover in one hour.

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Many people have asked whether it is possible to make money by trading forex.

Every day, you can see advertisements promoting forex trading (or other instruments) seminars with the promise of making a full-time income using the techniques they teach.

I have not paid money to attend any of these seminars so I am unable to tell you for sure whether the methods taught at these seminars actually work. Personally, I don’t believe that attending a two or three-day event will make anyone a consistently profitable trader. It takes much more than that.

What I can tell you for sure is when the claims on the advertisements are untrue to the point of being ridiculous.

Here’s one:

Generate 20-40% returns monthly.

Let’s work out an example. If you start with just $1000, the numbers below show the money you have at the end of every year if you can achieve a 20% return every month.

1 year $8,916.10
2 years $79,496.85
3 years $708,801.87
4 years $6,319,748.72
5 years $56,347,514.35
6 years $502,400,097.98
7 years $4,479,449,738.82
8 years $39,939,223,824.27
9 years $356,102,131,442.61
10 years $3,175,042,373,780.32

At the end of 5 years, you will have $56 million dollars.

At the end of 8 years, you will have $39 billion dollars.

At the end of 10 years, you will have $3.1 trillion dollars.

At the end of 20 years, you will have $10,080,894,075,300,600,000,000. There is an outside chance this could be an amount greater than all the money in the world put together.

If anyone makes these kinds of claims to you, be wary - very wary.

Hopefully, MAS will one day start regulating such kinds of advertisements.

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Macquarie has just launched their 2nd Macquarie Warrant Hotshot Competition. This stimulated live warrants trading contest starts on 14th July 2008 and will run for a period of 8 weeks.

There are four categories you can sign up and compete in:

• Dealers
• Investors
• Media
• Students

Each group of participants will compete for the weekly prize of $200 and category prize of $3000. There will also be a grand hotshot prize of $20,000 for the overall winner.

Click on this link to register for the competition.

Generally speaking, trading for a competition requires a different set of strategy compared to trading your own portfolio.

In the former, the aim is to generate the highest possible percentage gains (in a short time) while taking on the corresponding downside risk.

In the latter, consistency of gains over time is much more important.