I want to talk about trading this
week. Not trading strategies or where to put the stop-loss or what derivative
product to trade or time frame to use – rather, I want to start with a simple
analogy that will hopefully help you understand the simple probability involved
By implementing some basic rules, we can use this to our advantage.
Let’s start by tossing a coin,
and letting it land on the ground. Every time it lands on heads we make 100c
and every time it lands on tails we lose 100c. After enough coin tosses we'll end up with an equal number of heads and tails, and we would have made zero profit.
Equally, we would have made zero loss. We'll be exactly where we were when we started.
Now let’s add a coloured square on the ground, covering about a fifth of the total area where the coin is landing. If the coin lands in that square after we toss it, our profit or loss will be tripled.
So, we’ll make 300c when it lands on heads and lose 300c when it lands on tails. If the coin lands outside the square the normal rules apply – a profit of 100c for heads and a 100c loss for tails.Again, after enough coin tosses we’d have made no profit with the losses offsetting the winners.
What if we change the scenario? So every time the coin landed on tails in the square, instead of losing 300c, we only lost 100c.
Now we have two ways to lose 100c, one way to make 100c and another in which we make 300c. After enough coin tosses we would have made a profit as the coin would have landed on heads and tails within the square an equal number of times, but on tails we only lost 100c and on heads we made 300c.
Now we substitute individual trades for coin tosses. Trading is about probability; it is very important that we accept we cannot know the outcome of a trade before it is completed and in fact we do not need to do so if we have a plan and risk management.
The question is how we turn those 300c tails into only a 100c loss. The answer is simple. We use a stop-loss.
Individual trades are randomly dispersed and we never know which will make us a profit or a loss. But if we always limit our losses to 100c, then the winner at 300c suddenly makes all the difference.Of course, this assumes two things.
First, that we have a trading strategy with a 50/50 win-loss ratio. Yours may be slightly better, or like my All Share Index (Alsi) system, you may have a slightly worse win-loss ratio. (My 7/21 Alsi system has a win rate of around 42% after costs. See justonelap.com for more information.)
But even with a 42% win rate, by limiting my losers and finding the occasional large winner, it makes a profit.
The second point is about costs. This is in the form of brokerage fees, interest if derivatives are being traded, and the spread (difference between the buy and sell price).
These costs have the effect of reducing the profit in winning trades and increasing the loss in losing trades. But again, if we limit the losers to just 100c, we’ll come out ahead.
So back to the beginning. Trading is about probability and we trade when our system says that probability may be in our favour.
As long as we control how much we lose in the losing trades, we’ll come out ahead. No rocket science is required, just a plan and discipline.