LONG ANSWER
There IS a Holy Grail – and I’ve found it!
On T2W, there are a few threads with attention grabbing titles like this or ‘100% Winners Guaranteed’, ‘Never Lose Again’ and ‘Profit on Every Trade’ etc. In many cases, the title is not meant to be taken too literally. However, occasionally, the thread starter – or opening poster (OP) - is not only serious, but intent on convincing the rest of the membership of it as well.
Collectively, these threads come under the umbrella of ‘Searching for the Holy Grail’. Secretly, most traders admit to having done this at one time or another. Every once in a while, one or two of them claim to have found it. Almost always, they utilise the same techniques – or combinations of techniques – to achieve their jaw dropping results. Needless to say, at the heart of them lies a flaw so serious that, sooner or later, catastrophic loss is inevitable. The detail of these flaws is (nearly) always exposed by those members who know what they’re talking about on the threads concerned, so there’s no need to go into specifics here. However, at the heart of many Holy Grail strategies lie two deadly sins of trading: not using any kind of stop loss and adding exponentially to losing trades; a practice known as ‘averaging down’. The idea is that eventually, price will reverse, permitting the trader to at least get out at break even and possibly with a profit. It’s the same as betting on black with each spin of the ball at a Roulette table. Each time the ball lands on white, you increase the size of your next bet to cover the loss on previous bet(s) and still make a profit on the ensuing one. Sooner or later, one of two things will happen: either you’ll run out of money or you’ll reach the house limit set by the casino. (See the link to ‘Martingale Strategy’ in the next post.)
The house limit for traders is governed by the size of their accounts. Their pockets aren’t infinitely deep and, eventually, there WILL be an unprecedented move in the market that catches them out. The oft’ quoted axiom by John Maynard Keynes sums this up perfectly: “The markets can remain irrational longer than you can remain solvent”. Etch these wise words on your mind, or ignore them at your peril!
No Holy Grail – just calculated risks
So, while you might do quite well for quite a long time, the day will dawn when you will lose your entire account. Guaranteed. So, be very wary of any trader who claims not to use a stop loss of any kind – ever – and of those who average down with increased size in order to bring the point at which they break even ever closer to where the market is currently trading. Having said all of the above, experienced traders can manage their positions in such a way that they work areas of price by adding to - or taking off - part of their trade. However, this practice is not recommended for new traders, especially those with small accounts.
Trading is all about taking calculated risks in which a favourable outcome is more probable than an unfavourable one. When a sales person makes a cold call, they have no idea what the outcome of that individual call will be. However, their records tell them that for every ten calls they make, they secure three appointments which results in one sale. The same principle applies to many sportsmen and women. Roger Federer doesn’t know whether or not he will win the next game, let alone the next point. However, his records indicate that the probability of him winning the match is usually very high and ranges from excellent (against a low ranking player) to perhaps only 50:50 (against one of the world’s top five). One thing is absolutely certain, even against very poor opposition, Roger Federer will lose points. Equally, all sales people the world over make calls that don’t even result in appointments– let alone actual sales. Trading is exactly the same. Being a consistently profitable trader does not mean that every trade taken is a winning one.
Embrace risk and accept (small) losses
All traders have losing trades; some more than others. A handful of traders have strategies with a success rate of 80% or better. Some have a success rate of only 40% or less but, quite possibly; they’ll be more profitable overall than the trader with an 80% success rate. Regardless of which camp you fall into or, more likely, if you’re somewhere in between, one thing is certain: losses are inevitable. By definition, the mythical trader that never experiences a loss – never takes a risk. And the only way to completely eradicate risk is to know the future. This negates the natural law of physics. This is the realm of fiction writers and Hollywood producers; it’s completely divorced from reality. No trader can know the future, therefore they cannot eradicate risk. It’s impossible. Risk is to traders what ornithology is to birds. If you can’t embrace risk and all that it involves, then trading is not the business for you.
Hopefully, you accept and are comfortable with the idea that, as a trader, you’re going to take calculated risks with a probable favourable outcome and that some of your trades will lose. This leaves two variables to work with:
Success Ratio.
This is the number of trades that you close out with a profit, relative to the number of trades that you close out with a loss. For the majority of consistently profitable traders, this will usually be somewhere between 40% and 80%.
Profit Ratio.
This is the size of the average loss on the losing trades, relative to the size of the average gain on winning ones.
Self evidently, if your strategy only wins 40% of the time, the average gain made on winning trades needs to be 1.5 times that of the average loss on losing trades - just to break even. After commissions and expenses, realistically, such a strategy needs to return gains that are at least twice as big as the losses. The reverse is true on an 80% system. In theory, you could lose twice as much on losing trades that you make on winning ones and still remain profitable.
Big losses – what causes them and how to prevent them
So, let’s try and put all this together and answer the central part of the FAQ which is: does the new trader have to accept BIG losses when they start out? The simple answer is an emphatic NO! However, the reality is that a great many of them do. The best way to ensure that you’re not one of them is to look at the reasons why big losses occur and to take the necessary steps to ensure you don’t repeat these same mistakes. The list below of seven potentially fatal errors is by no means comprehensive, but it does cover the main reasons why traders tend to incur big losses early on . . .
1. Risk per Trade
New traders tend not to have a good understanding of risk management principles and risk too much of their account equity on any one trade. This often occurs after a string of early successes. They then look at their meagre profits and bash away on a calculator to work out what their account size would have been had they bet £10.00 or £20.00 per point instead of only £1.00 per point. So, they drastically increase the amount risked on the next trade and that’s when disaster strikes.
2. Setting a Stop loss
Most experienced traders agree that novices should set a hard stop loss to protect them from trades that go against them. Not setting a stop loss of the correct size and in the correct place can lead to heavy losses. Not setting one at all is highly likely to result in a sudden and premature end to a new trader’s career.
3. Moving a Stop Loss
Moving a stop loss further away from price to give the trade more room to ‘breathe’ is so tempting that even very experienced traders do it. Every trader the world over has had the frustrating experience of being taken out by a stop loss at the high/low of a move before price then goes in their intended direction. On the next trade, the temptation to move the stop as price gets closer to it is huge. Stick to the rule that stop losses should only ever be moved in the direction of the trade – and never against it. Ever!
4. Beginners Luck
Many new traders are seduced by what they see on the TV and the internet. Trading is portrayed as being glamorous and – above all - easy. Who doesn’t want to earn shed loads of wonga by spending ten minutes a day on their laptop while sipping Martini’s by the pool? This view is then endorsed by some early successes which leads to complacency and bad habits. In turn, this leads to heartache and a severely depleted trading account. Be under no illusion that making consistent profits over time is no easy task and will require dedication, discipline and persistence.
5. Poor Preparation
Many activities rely on the ‘6 Ps Rule’- none more so than trading. Proper Planning Prevents pi$$ Poor Performance. At the heart of this is a poor understanding of the market itself and the tools used to trade it - e.g. the trading platform. One of the most common clichés written on forums like this one is ‘plan the trade and trade the plan’. It’s also the one least adhered to. Make sure you have a proper trading plan and stick to it at all times.
6. No Methodology
Part and parcel of any trading plan is to have a well thought out methodology. Once this is established, it’s a good idea to paper trade it first to see how it performs in a simulated environment. Many traders don’t like paper trading on simulated platforms because it doesn’t help them when it comes to trading real money. This is a valid point. However, one thing is for certain: if you can’t make paper money with your strategy, you definitely won’t make any real money either! When you are ready to trade real money, start with small amounts and build up to larger size slowly and only when you have a consistent record of success. Wading into the markets and trading large size with an unproven strategy is a recipe for disaster.
7. Know your Ratios
Don’t trade with real money until you’ve established your
Success Ratio and your
Profit Ratio. Almost certainly, this will save you a lot of money. These are expanded upon in the
Essentials Of First Steps Sticky, along with some other cornerstones of any successful trading methodology. Once you know these ratios, keep monitoring them on an ongoing basis. There are three possible outcomes:
1. The ratios remain fairly constant over time and this will be reflected in a steadily rising equity curve.
2. The ratios will fluctuate wildly from week to week or month to month. This is indicative of a trader who hasn’t got a thorough plan in place or, if they have, they’re unable to stick to it. Their equity curve is likely to be up and down like a yoyo. However, over the longer term, it’s virtually certain to head south.
3. The ratios remain fairly steady and consistent for a long time but then change. The change can be very sudden or it can be very gradual over an extended period of time. The former tends to indicate a one off event; e.g. a radical departure from your trading plan such as a gamble that didn’t pay off. Or it could be a ‘Black Swan’ event like 9/11. If you were long that day, even with stops in place, price waterfalled so fast and so far that your stops might not have been triggered, resulting in a big loss. A gradual change is indicative of a change in the market. For example, a moving average cross over system will work well in a strong bull market, but it won’t work in a market drifting sideways. In this scenario, you must look at the principles that underpin the strategy and ensure that they are aligned to the market(s) being traded.
The good news is that all of the above are all totally preventable. So, while a certain number of losses are inevitable, they don’t have to be big. Not only that, but you can have a lot of losing trades – 60% or more – and still be profitable over all. However, if you’re experiencing a lot of losing trades and you have a poor profit ratio, your equity curve will slope down and you have a problem. To solve it, you will either have to reduce the number of losing trades, increase the profit on winning trades (relative to the loss on losing ones) – or a combination of the two. Slice ‘n dice it any way you want, the key to success lies in balancing these two ratios.
