The article is from Market Advance newsletter, issue 3

Three aspects of trading

In last article we explored three parts that in my opinion make up a successful trader. The most general assumption is that trading is about analyzing the market and predicting where the price will go. As we discussed, being an analyst is important – you do need a plan to execute in the market. However, that’s where most traders are stuck – finding a method they believe will make them rich, taking a couple trades that do not work out and then jumping to another method, assuming that they do not have sufficient knowledge about the market and therefore cannot open “the right” trades. The belief that I found to be groundbreaking in my own trading, however, is that there are NO “right” trades. There are simply trades offered by your method of market analysis and you have to take them all, before you make any judgments.

Therefore, the most essential addition to the set of skills of any trader, who desires to make profit consistently, is his ability to execute the trades with no hesitation, trade the plan exactly as his rigid rules are saying to trade it. The plan might as well be faulty and simply not provide the trading edge necessary to win, but without executing a sequence of flawless trades (not from the profit/loss perspective, but in terms of absolute discipline in following the system’s rules) you will never know that and very likely will switch to another Holy Grail only to find yourself with another set of potentially good rules that you cannot follow.

Five or even ten trades is not enough to judge any trading method. Your edge is not going to be visible and such a small set of data bears little to no statistical significance. Imagine a casino operating a slot machine with 4% advantage (meaning that they win 56 times out of 100 on average) calling a mechanic to repair the machine, or suing the gambler for somehow rigging it, just because after 10 customers the casino is in net loss.  Changing the machine after each 10 customers if their gambling produces a loss is just as absurd as changing your system after you have a couple losses in a row, especially if you “jumped the gun” on half the trades.

Mastering trade execution and getting a method of analyzing the market that provides you with some consistent edge are essential for any good trader. However, there is another aspect to trading we briefly discussed in the previous issue and arguably it can be even more important because unwillingness or inability of learning that aspect can help you decide pursuing a career elsewhere, long before you leave your life savings in the market.

Trading is a business

Like in any business, in trading it is most important to stay in control of what you do. First of all it implies having control over yourself, getting your mindset right and acting appropriately on each trading opportunity the market is offering. But when we see that opportunity and ready to enter in our direction, what do we really control in that trade?

I prefer to think of the trader as a small business owner. Anyone can open a small shop as a pursuit of having more freedom in one’s life, but interestingly enough 50% to 80% fail in the first 3 to 5 years. In trading I would argue that the failure rate is closer to 90%. My belief is that the reason for their failure (in business or trading) is defined primarily by the attitude they start with.

As we discussed before, the entrepreneurial freedom NEVER implies freedom from responsibility. In fact, starting out on your own increases the responsibility in almost all areas of your life:

1. Your level of income
2. Your medical insurance
3. Your taxes and book keeping
4. How you manage your time
5. Your own development

It is my opinion that the understanding and full acceptance of this responsibility is what defines you as a success or a failure in business or indeed in trading.

In this issue we start our detailed discussion of managing your trading like a business. Being in business means being in control and yet I find that most traders have none –  often unknowingly giving up the only thing they have true control over in trading.

Being in control

If you are a small store owner and you are just starting out you can control quite a few things. First of all you control the stock in your store. You decide how you spend your initial investment. In trading that is your starting capital and in turn you control your Money Management and decide how many positions you can hold simultaneously.

In the store, when you spend $1000 to stock up, how do you know what your returns are going to be? Well, you know for a fact:

1. The rent you are going to pay this month
2. The salary to your employees
3. You know the average bills you have to pay
4. The advertising costs to attract the customers to your store

It is obviously an oversimplification, but it will do for our comparison. With that information on hand you add it to $1000 you just spent and now you know the amount of money you need to make in order to breakeven. Let’s say it is $1500. Everything above that is your profit (don’t forget the best part – the taxes!). Now, if you want to get $500, you have to sell your stock for $2000.

At that point you’ve already done your research and know that compared to your competition it is a reasonable price tag and given your location you should have no problem selling it at that price point. If (and it’s a big “if”) everything goes well, you just figured out your profit for the month.

Now, in trading you have some benefits, such as:

1. No additional rent is needed (unless you like working in the office)
2. There is no one to pay the salary to
3. The bills are the same as if you would be living your normal lifestyle
4. You have no product to advertise

In other words, you don’t have that extra $500 minimum you need to make this month just to get out in breakeven. In fact, the only thing you need to do in to order to stay breakeven is to do nothing!

The bad news though is that you have no expectancy for the amount of money you are going to make this month. On the one hand, you know your statistical results over the past months and if you are extremely consistent they can give a good average expectation for your profit (or loss). While the store owner can try to increase his sales in numerous ways by expending more money into advertising, introducing new services, etc., we can only do trades, and usually trying to trade more actively than our system allows will not increase the income by the end of the month – quite on the contrary, you stand a good chance to lose what you earned while following your system as it is.

When a customer enters into our hypothetical store, we don’t know what he is going to buy, if anything. He can go away empty handed or leave half his savings with us. We do know, however, that on this day we already invested ~$500/30 (our monthly expenses divided by the amount of days in this month) into our business in bills alone. We never know how this money is going to come back to us.

When you start your trade, similarly you have no idea what it produces. Yes, your edge provides you with statistics, saying that 12 trades out of 8 will make money, but you can never know the exact winners before they are closed and cashed in.

In reality, when you open your trade, there is one and one only variable that you have certain control over: how much money you are willing to pay the market in order to find out if the trade is going to work. In other words, your risk on that trade. You put your stop and you know where you get out if the trade doesn’t work. Everything else is only your expectation.

Giving up the control

Imagine that in our little store we decide to cut the costs on the salary by declining the medical insurance to our employees and instead paying the direct costs for any accidents they have. Yes, we are happy to know that we saved $100 extra every month but now we never know the costs of doing business. Another unfortunate day a fridge falls down and crashes our clerk’s leg, resulting in $100 000 hospitalization costs and ruining our business, all our savings – our car and the house taken away in addition.

Trading without a SL is exactly the same. If you give up control over the only variable you have in your hands in the market, you are going to do fine until one day you lose it all.

To emphasize the point, I offer this quote by Larry Hite in his interview in Market Wizards:

         I will tell you another story. I have a cousin who turned $5,000 into $100,000 in the option market. One day I asked him, “How did you do it?” He answered, “It is very easy. I buy an option and if it goes up, I stay in, but if it goes down, I don’t get out until I am at least even.” I told him, “Look, I trade for a living, and I can tell you that strategy is just not going to work in the long run.” He said, “Larry, don’t worry, it doesn’t have to work in the long run, just till I make a million. I know what I am doing. I just never take a loss.” I said, “OK…”

In his next trade he buys $90,000 worth of Merrill Lynch options, only this time, it goes down, and down, and down. I talk to him about one month later, and he tells me he is in debt for $10,000. I said, “Wait a minute. You had $100,000 and you bought $90,000 in options. That should still leave you with $10,000, even after they expired worthless. How could you have a deficit of $10,000?” He said, “I originally bought the options at $4k. When the price went down to $1k, I figured out that if I bought another 20,000, all it had to do was go back to $2k for me to break even. So I went to the bank and borrowed $10,000.”

Summary

The difference between any entrepreneur (traders included) and usual paid worker is in the acceptance of the risk and the responsibility. Most people prefer to live in the comfort of some assurance in life that they get a pay check every month as long as they follow the rules – and in the current economy that assurance is very tiny indeed. Any entrepreneur accepts and embraces the risk, giving up that assurance in exchange for control over his or her life.

As traders we can learn a lot in regular business. The costs of doing trading business must be defined as rigidly as possible.

We can:

1. Set our monthly loss limit
2. Set our daily loss limit
3. Given the expected activity of our trading system, work out the amount of money we can risk in each trade, so that we do not exceed our daily loss limit after we fail a couple signals in a row

We cannot:

1. Set a rigid profit expectation for every trade
2. For every day
3. Even for every month

Unfulfilled expectations will lead to frustration and mental disturbance, undermining our success in trading.