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This extract from Adaptive Analysis for Australian Stocks by


NickRadge was first published in 2006 by Wrightbooks !xtract has
been updated and published in 2012 by Radge "ublishing
# Nick Radge 2012 $ll rights reser%ed &ou may copy' distribute
and transmit this material in its original format &ou may not alter'
transform or build upon this work
Radge "ublishing
"( )ox *21 Noosa +eads ,-. /06*
$ustralia wwwr a dgepublishingc o m
12)N3 4*504505*12/1 6!)ook7
8o%er
design3 9ach Radge
Disclaimer:
The material in this publication is of the nature of general comment only and
does not represent professional advice given by the publisher. It is not
intended to provide specific guidance for your particular circumstances and it
should not be solely relied upon as the basis for any decision to take action
or not take action on any matter for which it covers. While the Author is a
licensed financial professional, the publisher advises readers to obtain
professional advice where appropriate and which considers your eact
situation, before making any such decisions. The publisher makes no
representation or warranties with respect to the accuracy, applicability,
fitness, or completeness of the contents.
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2
Important Information
This book may contain ad%ice that has been prepared by Reef
8apital 8oaching 6$:2- 2552007 )eing general ad%ice it does not
take into account your ob;ecti%es' financial situation or needs )efore
acting on this general ad%ice you should therefore consider the
appropriateness of the ad%ice in regard to your situation We
recommend you obtain financial' legal and taxation ad%ice before
making any financial in%estment decisions
This material has been prepared based on information belie%ed to be
accurate at the time of publication 2ubse<uent changes in
circumstances may occur at any time and may impact the accuracy of
the information
"ast results are not a reliable indication of future performance
$ll results are considered to be hypothetical unless otherwise
specified +ypothetical performance results ha%e many inherent
limitations =nlike an actual performance record' simulated results do
not represent actual trading $lso' since the trades ha%e not actually
been executed' the results may ha%e under or o%er compensated for
the impact' if any' of certain market factors' such as lack of li<uidity
>
Contents
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61
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INTRODUCTION
This e?book is designed to show you an alternati%e way of looking at
profitability and your own trading @y reputation in the retail
marketplace is as a specialist in risk management and systematic
trading strategies While systematic trading may sound complicated
to the new trader' it simply means a strategy that is defined by %ery
specific rules D rules to define the trend' enter and the market and
manage risk This is the way 1 ha%e always traded and 1 am happy to
share my insights into trading the global markets
1 deal with technical analysis rather than fundamental analysis 1tEs
my belief that the picture of a stockEs current price action and price
history cannot be disputed D it is a 100 per cent certainty $
companyEs balance sheet' earnings and disclosures' howe%er' can
be disputed )ear 2terns' -ehman )rothers' @: Blobal and !nron
are some better known and recent examples where many
fundamental analysts got it plain wrong and' unfortunately' in%estors
paid the price for the poor analysis (ther examples are ;ust as bad
and 1 collected a huge number of examples in the early 2005 deluge
of earnings downgrades We can see the same trend of poor
disclosure throughout the world While an in?depth look at all of
these examples is beyond the scope of this book' suffice to say 1
belie%e the reliance of many analysts on company disclosures is
<uestionable
1 readily accept that the application of both types of analysis is
e<ually sub;ecti%e 1n order to establish a fair %aluation for a stock' a
fundamental analyst must make assumptions on future earnings
growth and other contributing factors' such as the expected period of
growth' non?growth periods and benchmark interest rates (nce
these assumptions ha%e been plugged into analystsE models' the
resulting %aluations %ary considerably These %aluations are easily
accessible by re%iewing consensus data +owe%er' the same applies
for the technicians The way one pattern is read can %ary among
analysts 1n this area' 1 see technical analysis and fundamental
analysis standing side by side
+owe%er' the main benefit of technical analysis o%er fundamental
analysis is that the charts pro%ide a %ery specific right or wrong point
0
where protecti%e stops can be placed and monetary losses can be
limited $s youEll see shortly' the limitation of losses is paramount to
the success of a trader and an in%estor' both financially and
psychologically
"eople may be forewarned of situations such as the collapses of
)ear 2terns and !nron by the deteriorating price action Anowing
when one is wrong using fundamentals' though' is a %ery grey area
.epending on the style of analysis employed' the lower a share
price goes below its %aluation may mean the better %alue the stock
becomes (n the other hand' it may mean the %aluation was
incorrect to begin with 1tEs a hard ask for any analyst to amend his
or her analysis and %aluation in the face of a plunging share price D
they are usually only forced do so after the fact and after the
monetary damage is done
$t the time of writing' 1E%e been trading and in%esting since 1450' a
total of 26 years' or ;ust o%er half my lifetime 1 ha%e personally
traded many lobal instrumentsF from stocks to bonds' from
commodities to foreign exchange and !T:s 1n the early 1440s' 1
worked in the pits of the 2ydney :utures !xchange -ater' in the
mid?1440s' 1 worked in dealing rooms in -ondon and 2ingapore
before starting a hedge fund in 1445 1n 2001' with ad%ancing
regulatory conditions' 1 decided to mo%e to another in%estment bank
where 1 became an associate director and managed accounts using
systematic trading approaches built around technical analysis
1t was in the day?to?day dealing with retail clients that 1 realised the
extreme psychological factors that play ha%oc with their decisions
The need to almost always be correct' the inability to realise when
analysis is wrong and then to take the appropriate action to defend
an account' the fear of losing money' the o%er?reliance on unpro%en
theories' or any mundane theory for that matter D all are products of
psychology' and the list goes on +owe%er' one factor clearly stood
out abo%e all others to create the most ha%oc D not understanding
that profits can be generated regardless of what tools or analysis are
used
This ebook is about understanding how to make profits
$s weE%e mo%ed further into the era of self?managed capital and
6
personal responsibility for oneEs own financial affairs' it has always
been pleasurable to hear how my analysis has made at least a small
difference
(n a final note' remember D there is more to life than trading The
markets and the opportunities found within them will always be there
tomorrow
*ick #adge
www.thec ha rtis t.c om.
au
*
CHAPTER 1 - AIMS
&our aim is to be profitable
@y aim is to help you understand how to make yourself profitable
There may not appear to be a profound difference in the abo%e
statements' but letEs remember that the %ast ma;ority of traders' and
acti%e in%estors for that matter' are losers D or' at best' marginal
winners 2ome people pay educators up to G20000 to help them find
an edge or the secret to generating profits in the markets They listen
to poor ad%ice' perhaps from non?licensed practitioners' and rarely
take any responsibility for their own actions 1f you are like many other
beginners' you probably already feel as though youE%e been through
the ringer' trying many different methods and reading any book you
could get your hands on 1 call this the beginner's cycle D mo%ing
back and forth between methods and ideas that ;ust ne%er e%entuate
into any concrete or consistent profits 1t can be an expensi%e and
long ;ourney but' more importantly' itEs an extremely frustrating
;ourney that causes many to gi%e up
While finding a trading or in%esting style that suits you is important' it
is more important to understand and accept why profitability occurs 1
say EacceptE because what 1 put forward here is usually dismissed for
simplifying a so?called complex concept )ut simple works through
thick and thin' good and bad 6(f course' psychology is also
extremely importantF howe%er' as 1 am not an expert in that field' 1
wonEt be exploring that side of the e<uation in too much depth7
What 1 would like to do is to realign the thinking processes that most
likely operate within you To start with 1Ell work through a few issues
and hopefully get you thinking differently about them What 1Ed like
you to do as you read through is ask <uestions of yourself and those
in the trading community you may ha%e come in contact with Rather
than simply agreeing or disagreeing with my points' see if you can
actually relate to them and understand the conse<uences of my
arguments Trading is about opening your mind to possibilities $fter
26 years in the markets 1 am still learning' still researching and still
passionate "assion is the most important thing to de%elop D from
there' profitable trading will flow to you
5
Trading tools and indicators
1f we placed 100 consistently profitable traders in a room and asked
each to discuss his or her trading style and techni<ues in fi%e
sentences or less' in my experience' whilst each person would use
different tools and styles' they would all be trying to achie%e the same
goal D that is' to generate profits
!%ery time you speak with another trader 6regardless of whether he
or she is successful7' e%ery time you read a trading book' e%ery time
you recei%e ad%ice' there will always be new information to take in D
usually about an entry techni<ue' or a new style' method or indicator
!%eryone has an opinion There are many successful traders D or at
least people who ha%e had ;ust one profitable trade D and they ha%e
achie%ed this success e%en though they all use different tools and
techni<ues
(ut of our sample of 100 consistently profitable traders' /0 may use
fundamental analysis' /0 may use technical analysis and 20 may ;ust
use intuition or gut feel !%en then' the /0 who use fundamental
analysis may use different aspects of that field 2ome may rely on
%arious ratios' while others may not take any ratios into account and
rely solely on insider acti%ity The list and combinations are infinite
(f the technical traders' some will rely on mo%ing a%erages' some on
an R21 or other indicator' while others will rely only on price patterns
and %olume &et again' the pieces to the puHHle can be infinite @y
point is that each profitable trader will use a different techni<ue' style'
in%estment time frame' information sources and tools 1f all of the 100
traders are profitable through using different techni<ues' the common
denominator cannot be the tools being used 1t must be something
else Think about four profitable traders or in%estors who you know or
ha%e read about
Think about )uffett or 2oros Think Tudor Iones $re they the same
in their approachJ Their tools' their time frames' their ob;ecti%esJ (f
course not 2o 1 reiterate the common denominator must be
something else
1f you agree with the abo%e' it becomes easier to suggest that it will
not matter which indicator' tool' time frame or software package is
4
superior' and itEs certainly not a tightly held secret or insider
knowledge that makes them all profitable $ll indicators' all technical
analysis techni<ues' all fundamental analysis techni<ues' all software
D e%erything you use to trade and in%est D are nothing but tools
The tools you use to trade do not maketh the moneyK
-et me use a simple non?trading analogy' shown in table 11
Table 7.7: trading versus travel analogy
Travel Trading
0oal Bet from point $ to point ) )e profitable
Tool 8ar' )oat' "lane' walk'
train
Technical analysis' fundamental
analysis' guess work
(ur first non?trading goal is to tra%el from point $ to point ) The
tool to achie%e that goal can be any mode of transport' such as a
car or boat $s you are well aware' there are many kinds of cars
and boats and when choosing one' our decision is largely based on
our personality and financial circumstances The same goes for
trading The goal of trading is to be profitable The tools used to
achie%e this will %ary depending on our personalities' financial
situations' attitudes to risk and beliefs Therefore' what you use to
trade with are simply tools of the trade and not the reason why you
will be profitable
1f you understand why profits occur' youEll be in a position to
understand what tools are needed for you to achie%e profitability
$s a result' you may regret attending all those courses and
seminars D or' better still' you may think twice about attending one
in future
The common ground among profitable traders
&ou may think that after setting aside the tools' there will be
nothing left Wrong There are two things D one is psychology ' the
second is mathematics
10
WeEre brought up with a huge focus on being right or wrong $t
school we learn We are then tested on that learning with exams
and assignments This continues all the way through our education
D primary school' high school and college Right and wrong3 itEs
ingrained in us from the word go When we enter the trading arena'
howe%er' being right or wrong has nothing to do with being a
successful trader and making profits 1f you are like most people
and belie%e that the most important aspect of successful trading is
being correct' unfortunately' itEs only your ego youEre caressing
&ou can be a highly profitable trader and lose more often than not
D indeed' some of the worldEs top traders lose more often than not
This concept' though' ;ust doesnEt sit well with most people
because itEs their belief that in order to be profitable you must be
right This line of thinking for an aspiring trader is %ery' %ery wrong
Trading profitably is best understood when broken down into
indi%idual and simple pieces Regardless of the complexities you
build into your trading plan and routine' there is one constant
underlying truth as to why you make a profit D the basic maths
behind the result $ll traders' regardless of how or why they trade'
will need to understand the mathematics known as expectancy
!xpectancy as a term is probably nothing new to you That may be
the case' but it is e%erything $longside psychology' itEs the
common denominator among e%ery profitable trader 1tEs not a
fundamental ratio' a technical indicator or the +oly Brail 1tEs basic
maths The following <uestion can make it easier to understand D
would you prefer to risk G1 to make G2' or risk G1 to make G0J
The answer is <uite straightforward D of course' weEd prefer to aim
for the higher reward for the same risk +owe%er' once the
probability of success' or accuracy of that potential outcome'
enters our mind D that is' the possibility of actually being wrong D
we tend to change the way we think We re%ert back to our core
beliefs of right and wrong )ecause we are usually re<uired to be
right in order to achie%e reward' we then start thinking that we
could be wrong D and so lose money as well D and it becomes a
difficult issue to deal with
11
:igure 11 shows a %isual representation of the expectancy cur%e
This cur%e is made up of two core elements D the win percentage
and the winLloss ratio The win percentage is self?explanatory and
simply means the accuracy of your trading The winLloss ratio is
calculated as the a%erage profitable trade di%ided by the a%erage
losing trade 1f after 20 trades the a%erage winner is G200 and the
a%erage loser is also G200' the ratio is 131 1f the a%erage win is
G/00 and the a%erage loss is G200' the ratio is 231 The goal is
ob%iously to be in the upper portion of the graph shown in figure
11 D or the positi%e expectancy' and therefore profitable' area
@ost people find they hug the di%iding line between profitable and
unprofitable trading and' as a result' spend their time alternating
between being a marginal winner and a marginal loser 6Iust as a
side note' no manner of money management will sa%e you if you
operate on the negati%e expectancy side of the cur%e7
%igure 7.7: the epectancy curve 8 the bottom line
This alternating between marginal winning and losing is what
causes us to continue to search for a better method When the
normal %ariance of returns takes us below the line' we tend to get
12
ner%ous and drop the method' or add more indicators in an attempt
to increase the winning percentage This is our ingrained learning
coming back into the e<uation and is the beginnerEs cycle operating
The thought Ethere must be a better wayE always comes back to
haunt us $s soon as we think weE%e found a better way' we slip
back below that line and so start the process all o%er again The
correct course of action' howe%er' is to allow more room for error
(ur aim should be to create a method that falls deep within the top
section of the cur%e' well abo%e the line rather than hugging it That
way we wonEt get ner%ous when the normal %ariance of returns
takes us below the line
1t is important to remember that no method can be correct all of the
time !%ery in%estment instrument D property' shares' trading
systems' etc D will go through periods of growth 6generating profits7
and consolidation 6treading water7 8ard counters at the black;ack
tables also ha%e the same issues @arkets are dynamic They
change their spots whene%er they feel like it and as such no method
can dynamically change with them To continue to search for a
method that is consistently right will simply be an exercise in
frustration and wasted energy 1n order to trade deep in the upper
expectancy area' an experienced trader will concentrate on the
winLloss ratio' not the winning percentage 6or accuracy7 of the
strategy
1 recently watched an infomercial ad%ertising a well?known
in%estment newsletter They claimed an accuracy rate of *> per cent
with an a%erage profit of 10> per cent per recommendation
(b%iously' the company hoped that this would encourage people to
think they would make money by following the tips and they would
therefore subscribe to the newsletter What the company failed to
mention was how much on a%erage they lose on the other 2* per
cent of their recommendations 1s this EslightE o%ersight not a prime
ingredient in the expectancy cur%eJ (f course it is 1f their a%erage
loss on those wrong recommendations exceeded 2* per cent' they
would be net losers 1 donEt remember them mentioning that part'
though
8learly' theyEre playing up to the ingrained rightLwrong psychology
that manifests itself in less experienced traders 1 am far from
arrogant in terms of my skills as a stock picker @y line of thinking is
1>
that 1 am no better than a coin toss 1 am no better than random D
that is' 1 ha%e no better chance of getting a winning trade more than
00 per cent of the time That may sound harsh' and you may be
thinking that the four years you spent at uni%ersity must make you
better than random To me' howe%er' it is irrele%ant @y discussion
here is not one about random trading or the merits of not making a
conscious decision to place a trade What is most important is to
shift the focus away from accuracy and toward the winLloss ratio'
because thatEs the only way to really mo%e into the deeper area of
the expectancy cur%e
The win6loss ratio
+ere is an exercise you can try with an !xcel spread sheet !nter
the following formula in cell $23
MR(=N..(WN6R$N.67N10'07
8opy this formula down column $ 6&ou can continue this as far as
you wish to' but more than 1000 is certainly better than 1007
1n cell )2 enter3
Mif6$2O0'6R(=N..(WN6R$N.67N10'077'?17
$gain' copy this down column ) aligned with column $ 1n cell )1
we need the total of all the numbers in column ) 1 will assume you
ha%e copied down a considerable way' so use this formula in cell
)13
M2=@6)23)10007
Now repeatedly press the :4 key while watching the number in cell
)1 1t will ne%er be a negati%e
-etEs discuss what all this means Pery simply' the formula asks the
computer to select a random number between Hero and nine !%ery
time you hit :4' the computer will again calculate another random
number for you 1f that number is more than four 6that is' fi%e' six'
se%en' eight or nine7 the computer will then assign E?1E to that cell
This E?1E means a one? unit loss to our trading D e%ery time we ha%e
a loss' we lose one unit of our capital $ loss will usually always be
the same amount' as long as we always apply appropriate risk
management to our trading 61 say usually because there are certain
times where prices may gap through a protecti%e stop7 Risk
1/
management will be discussed in more depth in 8hapter / To any
number that was less than fi%e 6that is' Hero' one' two' three or four7
the computer then assigns yet another random number This
assignment represents a profitable unit to any of those numbers and
that profit can be anywhere between Hero and nine units
2o we ha%e a scenario that will produce a fifty?fifty chance of a loss
or a win We control the loss by limiting it to a single unit' and when
we make a profit we limit it to nine units in this exercise 6this is only
for our exercise D in the real world' there are no limitations on
profits7
$s long as we allow this pattern to be repeated o%er the long term' it
can ne%er create a negati%e number or a loss 8learly' 1 ha%e not
accounted for trading expenses such as commissions or slippageF
howe%er' the theory stands nonetheless
The a%erage win and the a%erage loss of your trading are directly
related to the win percentage "rofitable trading will only emerge
when the trader aligns these basic attributes to get a positi%e
expected result
Win6loss ratio versus percentage of profitable trades
"erhaps youEre thinking 1Em not that smart or that 1 ha%enEt thought
things through enough D surely if 1 had' 1 could win more often than
00 per cent of the time +owe%er' after many years of computer
simulation' real trading and reading almost e%erything written on the
topic' the same conclusion always comes forward D maximise the
winners' minimise the losers
)elow 1 test the theory again' this time with a basic trading system
The idea here is that if simple concepts are used' the results will
always re%ert to random D that is' a win percentage of somewhere
around 00 per cent Today it is common knowledge that the %ast
ma;ority of fund managers fail to beat their respecti%e benchmarks
What this suggests to me is that mediocrity e%entually becomes
normal @any fund managers' e%en with their complicated
strategies' e%entually re%ert to the index and therefore donEt add any
%alueF essentially' theyEre hugging the expectancy cur%e TheyEll only
make money if the benchmark index makes money' and theyEll also
10
lose money when the index loses money
-etEs use a computer to generate a basic simulation 1 ha%e selected
the price mo%ements of a ma;or stock index o%er a 0Q year period
of time .uring this time' the index increased in %alue by /10 per
cent 1 then told the computer to buy at the open of e%ery single day
D all 1>0> of them D and sell on the close each night
(b%iously' this method created a profit' as the trend was certainly
up during that timeF howe%er' of interest was the winning percentage
or the number of days the index was up compared to how many
days it was down This percentage is shown in the following results3
R total net profit G1606
R gross profit G1640>
R gross loss 6G1026/
7
R total number of trades 1>0>
R per cent profitable 9:.;;<
R number of winning trades *26
R number of losing trades 62*
R ratio average win6average loss =.>;
R maximum consecuti%e winners 11
R maximum consecuti%e losers 5
R maximum intraday drawdown 6G12027
R profit factor 111
R maximum number of contracts
held
15
R account siHe re<uired G1202
R return on account 1>*5/S
.uring this fi%e?year bull period' *26 days closed abo%e the open
and 62* closed below D or 0>66 per cent were up days The
winLloss ratio is 046 or' for argumentEs sake' 131 What this is
saying is that all the net profits were made by ;ust a %ery small
percentage of the total days D ;ust 44 out of the 1>0> ThatEs a lot
of peripheral work to find those profitable days
1f you go back to the expectancy cur%e in figure 11' the results of
this %ery basic test can be plotted right in the middle of the box
16
thatEs hugging the cur%e $s such' any small %ariation in market
conditions could take you below that cur%e at any time Remember
also that 1 ha%e not included commissions' which would dilute the
profitability considerably While small mathematical edges can
make a great system' you need a lot of patience' a lot of capital
and a %ery cheap commission rate to fully take ad%antage of them
$ lot of people' because they are human and belie%e that they are
smarter than the market' will see a 0> per cent profitability rate and
try to tweak the entries and exits to create a better profitability This
is normal D and you could spend the rest of your natural life doing
it 2o letEs speed the process up for you so you can actually en;oy
your life
-etEs say that weEll buy the
$ustralian market if the =2
market was up the prior night
R total net profit G0*6
R gross profit G102
R gross loss 6G0*6
7
R total number of trades 4/
R per cent profitable ?:.@=<
R number of winning trades 64
R number of losing trades 20
R ratio average win6average loss =.?A
R maximum consecuti%e winners 11
R maximum consecuti%e losers /
R maximum intraday drawdown 6G02>7
R profit factor 144
R maximum number of contracts
held
1
R account siHe re<uired G02>
R return on account >25>2
S
The win rate is o%er *> per cent Now this may refute my random
theory' but look what happens to the winLloss ratio D it goes down
1f you look back at the expectancy cur%e in figure 11' you can see
where these numbers fall WeE%e mo%ed up the cur%e a little' but
weEre still hugging that line $lso of interest in these two examples
1*
is that while weE%e managed to increase the accuracy to *> per
cent' weE%e decreased the net profitability by a whopping 40 per
cent 6from G1606 to G0*67 $part from wasting time' what exactly
ha%e we achie%edJ We ha%e achie%ed a le%el of comfort for our
rightLwrong mentality' but paid for it with a large proportion of our
profits 1 trade for profit 1 donEt care about the accuracy What this
tells me is that 1 should trade for the greater profit' but be prepared
for the bad times when they come along $s opposed to not
wanting any bad times' 1 ;ust want to be profitable
1 could fill this whole e)ook with similar examples We could make
our systems more and more complicated to help impro%e those
numbers and' hopefully' profitabilityF howe%er' the more you
attempt to impro%e the numbers by tweaking the entries and exits'
the more you adapt your approach to historical price mo%ements
This is called data mining and it is a %ery serious trap for new and
experienced traders alike
.ata mining relies on the benefit of hindsight 1t means you ha%e
adapted your system to the market conditions of the past and' as
we know' the market will ne%er exactly repeat itself $s a result'
e%en if it can be shown that a system would ha%e been great in the
past' it will not necessarily be worthwhile or profitable in the future
There are se%eral well?known authors preaching the back?testing
concept' and there are certainly a myriad of %endors selling
systems that seem astounding when tested' but that collapse in
the real world
We need a method that will work in %arying market conditions and
economic cycles The catch is that such a method is in the maths'
not the tools
In summary:
1 !%eryone can profit in the markets' regardless of their tools
2 "rofits are deri%ed from understanding the concept of positi%e
expectancy
> $ttempting to be correct more often than not does not
necessarily make you more profitable
/ The amount you win when you win %ersus the amount you lose
15
when you lose is more important than trying to be right
0 )e wary of infomercials and data miningK
14
CHAPTER 2 - SKEWING THE NUMBERS TO WIN
Theory is great' but letEs look at practical ways to increase
profitability and mo%e deeper into that profitable area on the
expectancy cur%e To do this' you must increase the winLloss ratio'
or as 1 like to say' skew the numbers in your fa%our There are
probably many ways to do this but outlined below are a few simple
ones that 1 use
.owBrisk entry
$ low?risk entry means the distance between the entry point of the
trade and the protecti%e stop is small relati%e to another trade The
smaller this distance is' the larger the position siHe can be' as the
risk remains the same 1f you capture a successful trend with a
larger position' the a%erage win will increase with no increase in the
initial risk and therefore the a%erage loss will remain static 1t really is
that simple
There are two ways to do this3
1 The first method is to tighten the protecti%e stop )y tightening
the protecti%e stop you can trade more shares for the same risk
!mpirical e%idence can be created %ia computer simulation D for
example' refer to appendix $ and )' which show a crude
computer test of this theory 1 simply told the computer to
buyLsell at open' exit at close and test protecti%e stop lengths
from one point to 00 points Note that as the distance between
the entry and protecti%e stop is reduced' the winLloss ratio
increases 1 agree that ha%ing a one?point stop would be
impossible in the real world' but the test is designed to show the
impact tighter stops ha%e on the outcome
$part from the winLloss ratio increasing' se%eral other things also
occur as the stop gets tightened The win rate or accuracy
decreases' the net profit and loss decreases' and the maximum
drawdown decreases 6@aximum drawdown refers to the largest
peak to trough dip in your account balance7
1mportantly' the profit factor increases The profit factor
measures the mathematical comfort le%el of your trading and is
20
calculated by di%iding total net losses into the total net profits
The higher the number' the better the method and the easier it is
to trade
The test shows that while the net profit and loss has declined'
the risk has also declined D and at a faster rate' suggesting the
low?risk entry creates a better riskLreward proposition The better
riskLreward proposition means you can regain the lost profitability
by trading at a higher risk What this means is that the ;ourney to
profitability is a lot smoother and' as such' you can trade with
slightly more risk in order to regain the losses without increasing
the maximum drawdown 1nstead of trading with 2 per cent risk'
for example' you may opt to trade with > percent risk
2o what is more profitable D a low win percentage 6accuracy7
with a higher winLloss ratio' or a high win percentage 6accuracy7
with a low winLloss ratioJ The answer is the former $ lower win
percentage with a higher winLloss ratio will be more profitable
2 The second way to gain a low?risk entry is start with the
protecti%e stop point and work backward to the entry point This
means that' although you may identify an entry set?up' you need
to pinpoint the protecti%e stop point first (nce you ha%e done
this' ensure the entry point falls within the low?risk criteria
)reakeven stop
)eing able to mo%e the stop to the breake%en point as soon as
possible offers a psychological ad%antage because you can
participate in a trade that' theoretically' has no risk @ore
importantly though' o%er time' the a%erage loss will decrease if and
when the breake%en stop gets acti%ated This will naturally increase
the winLloss ratio and add further buffer to the expectancy cur%e
&ou might think that a breake%en stop would increase the loss rate
1t will to a point' because as the stop is closer to the current price
action you ha%e greater chance of getting stopped out due to day?
to? day price gyrations )ut it also has an important psychological
role to play 1t stops hope from entering your trading &ou should
ne%er hope that a trade will come good D the trade will either go in
your fa%our immediately or it wonEt 1f it doesnEt' you need to take
21
defensi%e action
+ere are two simple guidelines that 1 use to apply a breake%en stop3
@o%e the protecti%e stop to breake%en if the position mo%es in
your fa%our by 10 to 2 times the initial risk :or example' if the
initial risk on the trade was G/00' mo%e the stop to breake%en
when the unrealised profit is between G600 and G500 While you
may occasionally get stopped out at breake%en as the market
re%erses' ha%ing your breake%en stop at this point will decrease
the a%erage losing trade and therefore increase the winLloss
ratio :urther' if you ha%e the trade entry point correct' prices
should not re%erse that far
@ake the market pro%e your position through prices mo%ing in
your fa%our 1f it doesnEt' mo%e the stop toward breake%en after a
few days .onEt hope D there is no point allowing a position to
wallow around your entry price 1f you do allow the market some
scope and so lea%e the initial stop where it is' you are starting to
hope it will e%entually mo%e in your fa%our 1t is often said that a
great trade will mo%e in your fa%our immediately 1f it doesnEt' get
out' decrease the loss 6and therefore the a%erage loss7'
reassess and try again )y doing this' youEre keeping your
losses down and not wasting your time waiting for a trade to
come good 1Ed rather take four G100 losses rather than one
G/00 loss D that way' 1 get four times the opportunity to make a
big win without any additional risk
,apture a bigger trend
(ne of the most difficult aspects of trading is gi%ing back open profits
D that is' gi%ing back unrealised profits as the markets mo%e against
you +owe%er' the more you can withstand it' the larger the trend you
will be able to capture and' in turn' the greater the a%erage win will be
for an initial limited risk The fear of losing unrealised profits D and so
selling too soon D is possibly the biggest failing of new traders
No?one knows if prices will mo%e up or down tomorrow Remember
the simulated test we did earlier where we bought each day on the
open and exited at the closeJ The win rate was 0> per cent' which
pro%es that on any gi%en day the market might finish up or it might
22
finish down 1f this is extrapolated out to when youEre riding a position'
on any gi%en day the chances are that the position will either keep
going in your fa%our or it wonEt Therefore' to be scared of gi%ing back
open profits makes no sense D youEre only thinking about one
scenario out of a possible two Thinking like this is not only illogical'
itEs emotional 1t suggests you are placing more emphasis on the
current profit than the potential profit if the trend continues in your
fa%our 8oncentrate on the next 1000 trades' not ;ust the immediate
one
To take ad%antage of the trend while also protecting profits' we can
apply the first two rules abo%e D a low?risk entry and the breake%en
stop D and then use a %ariety of trailing stop techni<ues $ trailing
stop enables you to mo%e your stop up behind the market price and
so protect profits as the market mo%es in your fa%our $ trailing stop
using a mo%ing a%erage is what 1 find the simplest and most robust $
wide trailing stop will enable substantially more trend to be capturedF
howe%er' if this type of stop is used' more short?term market noise
needs to be withstood and it may mean gi%ing back large open
profits
.ength of the moving average trailing stop
@y experience suggests most people can withstand a mo%ing
a%erage 6@$7 style trailing stop out to about 20 to >0 days in length
)eyond that' many people find it becomes difficult to remain focused
on the trend because the open profits start to play a role 1 use a 0(?
day @$ trailing stop for some of my e<uities and futures models' and
this can enable trends of beyond a year to be caught :igure 21
shows the difference between using a wide stop and a tight stop
@arkets naturally ebb and flow' so if you wish to capture large
mo%es' the stop needs to be wide enough to allow these flows to
occur $ tight stop will not allow open profits to be gi%en back' but nor
will it allow a larger trend to be ridden 1f you are a serious acti%e
in%estor' you may use up to a 200?day @$ trailing stop to capture
sustained trends
%igure A.7: A sustained trend can be ridden with a wide stop
2>
$ computer can test the abo%e theory 1f we use a basic mo%ing
a%erage breakout system where the entryLtrailing stop inter%al is
tested from 10 days to 100 days' as per table 231' it is possible to
identify some important traits The system was tested on a ma;or
stock o%er a 20?year period with a G10000 in%estment used per
trade $s the number of days used for the @$ trailing stop
increases 6and therefore the profit potential compared to the initial
risk increases7' the winLloss ratio also increases from >05 to 1/5*
and the a%erage trade mo%es from G14/ to G2221 The net profit
mo%es from G20445 to a whopping G*>>05 $lso note that the
maximum drawdown remains relati%ely static and' again' that the
profit factor increases This example is not a one?off 2uch trends
within statistics occur across all strategies and time frames therein
Table A.7: +oving Average breakout system
.ength *et /rofit
and .oss
*o. of
trades
Win
<
Avg.
win6
loss
Avg.
trade
+a.
drawdown
/rofit
%actor
10 20'44560 1>/ >5 >05 14/02 ?/05402 154
20 0/'62/0/ 42 >0 606 04>*0 ?/05412 >>4
>0 60'220/6 6* /4 015 54554 ?>20400 002
/0 02'4/044 6/ /0 062 52*2 ?>52565 >50
00 /6'1/*52 61 >4 001 *0602 ?>21>64 >20
60 />'**2/> 04 >0 05* */141 ?005>42 >2/
*0 0/'>4156 02 >0 46* 10/60 ?/*11/2 />
50 0/'>0>01 00 >0 454 105*06 ?0/>20/ /2/
40 0>'51460 /> >* 5>6 120162 ?060125 /40
2/
100 6*'0015* >* >2 1/>0 152/>* ?00500/ 654
110 61'6010/ >* >2 114/ 166626 ?0*0>5/ 0*>
120 62'/644> >6 20 164> 1*>025 ?/*>/14 06/
1>0 04'*0/2/ >1 >2 1150 14204/ ?/0*1*2 06/
1/0 6>'//242 >6 2* 1/2 1*62> ?/0//20 0/6
100 *>'>05*6 >> >0 1/5* 2221/5 ?/0//05 6/6
-etEs think about this for a moment 1magine if you made 00 trades and
out of those >0 were winners and 20 were losers 6representing 60 per
cent accuracy7 !ach win was 10 times the loss 1f you stake G1 on
each trade' the net profit after 00 trades would be G20 The profit factor
would be 220
1magine you made the same 00 trades' but this time you had ;ust 20
winners with >0 losers 6/0 per cent accuracy7 Remember that the
winLloss ratio is directly related to the accuracy Therefore' it is highly
unlikely that your winLloss ratio would be 10 times in this example
-etEs assume it will be three times' which is more realistic' e%en for
shorter term methods 1n this situation' the net profit would be G>0' 20
per cent higher than the first situation' e%en though accuracy has
dropped
$s at the time of writing' 1 ha%e entered trades with winLloss ratios
exceeding four times This is where the money is made 1magine if a
system made four times the initial risk and was right /0 per cent of the
time The net profit would be G00' 100 per cent higher than the first
example through being right less oftenK The e<uation is simple D most
important is how much you win when you win' and how much you lose
when you lose :orget right or wrong Think about expanding that profit
compared to the initial risk taken ThatEs what itEs all about ThatEs all
that counts
$ou can be assured of one fact regarding trailing stops and
taking profits 8 you will never make a large profit by taking small
profits. Allow yourself to run a minor profit into a large one .onEt
20
think about the money D think about the process :orget e%erything
elseF ;ust try to get that winLloss
ratio out as far as you can 1f you can do it once' you will feel more
confident the second time around' and youEll also start to
realise the power of capturing a sustained trend
/yramid the position
When doing something right' do more of it When doing something
wrong' do less of it
26
The abo%e is one of my fa%ourite mantras' and this is exactly the
process that pyramiding follows )y definition' pyramiding is simply
the process of adding to an existing position as the market mo%es in
your fa%our "yramiding will expand the winLloss ratio because
when a loss is incurred' it is on a smaller positionF when an
extended trend occurs' the position is added to so the trend is
ridden with a larger position
2ay you place an order to buy $)8 stock at G1200 and the
protecti%e stop' according to your rules' is to be placed at G1160
&ou would normally trade 1000 shares 1n this situation' there can be
only two outcomes3
R 2cenario one D you get stopped out at the protecti%e stop le%el at
G1160
R 2cenario two D you were able to exit the position using your trailing
stop at a profit
1n order to analyse these two scenarios' weEll assume that in
scenario two the trade was exited at G1>00
-etEs first re%iew the outcome with normal trading D that is' without
any pyramiding applied3
R 2cenario one D if you were stopped out in normal
circumstances' your loss would be G/00 61000 x 0/07
R 2cenario two D exiting the trade using the trailing stop allows a profit
of
G1000 61000 x 107
R Resultant winLloss ratio M >*0
Now letEs re%iew the outcome if pyramiding is used When we
pyramid' we buy a smaller initial position and only add to it when
prices mo%e in our fa%our -etEs assume that weEll di%ide the
position into four parts' where we buy 200 shares at 10T
increments as the price mo%es up3
2*
R 2cenario one D buy 200 at G1200F stopped out at G1160 for G100
loss
R 2cenario two D buy 200 at G1200F buy 200 at G1210 and mo%e
initial stop to G11*0F buy 200 at G1220 and mo%e initial stop to
G1150F buy 200 at G12>0 and mo%e initial stop to G1140
R !xit position at G1>00' as per trailing stop' for profit of G1>00
R Resultant winLloss ratio M 1>00
&ou can clearly see how pyramiding can skew the numbers in your
fa%our
D in the example abo%e' the winLloss ratio mo%es from >*0 out to
1>00 +owe%er' this is the best?case scenario' where the market
mo%es in your fa%our without retracing &ou should be prepared for
the worst?case scenario
1n the abo%e example' each time the position was added to' the
initial stop was also mo%ed up This is imperati%e in order to keep
the total risk aligned The worst?case scenario will occur when we
add the last position' in this case at G12>0' and then the market
re%erses and stops us out The problem is that the stop is still at
G1140' which would result in a loss of
G200 &ou may be fine with this' but looking deeper the initial
position siHing was aimed at losing G100' not G200' so the winLloss
ratio is reduced to 0/
$lso to be taken into account is the extra brokerage incurred
through multiple transactions when pyramiding D although' when a
strong trend is ridden the resultant profitability' because of the
winLloss ratio' will ensure brokerage looks after itself
There are %arious ways to skew the numbers in your fa%our
=ltimately' itEs a matter of decreasing the amount of each loss
and increasing the amount of each win D and nothing more
complex than that When you place a trade' it is important to think
about the way you can reduce the risk &ou cannot control the
profits D only the market can do that
25
+owe%er' you can control your losses and' therefore' you can
control your a%erage loss )e pro?acti%e in your trade management
1f you can get the a%erage winLloss ratio out beyond /31' you will be
a %ery' %ery successful trader D regardless of the tools you use
24
CHAPTER 3 - ENTRIES, FREQUENC AND MIND-
SET!
8hapter 2 discussed the primary ingredient of profitable trading D
getting that a%erage winLloss ratio as large as possible To do this'
the first step is to limit the initial losses as much as possible The
initial loss is like a business expense 1tEs a necessary risk D you
cannot trade without some type of initial risk (ne way to get the
winLloss ratio out as far as possible is to ;ust trade lowDrisk entries
This concept is the cornerstone of my discretionary trading
(electing the lowBrisk trades
2e%eral years ago' 1 tried a straightforward computer test using a
basic break?out model 6$s you may ha%e gathered' 1 like to test my
theories using an unbiased tool such as a computer 1 ha%e learnt
ne%er to make assumptions when it comes to risking money7 The
<uestion 1 had on this occasion was' E2hould 1 take e%ery entry that
comes along' or wait ;ust for lower risk entriesJE 1 initially told the
computer to take e%ery buy signal between the entry point and
protecti%e stop' regardless of risk siHe 1f this distance created too
much risk' though' 1 told the computer to still take
the trade but o%erride the technical protecti%e stop with a hard dollar
stop
6that is' a stop deri%ed by a dollar amount rather than some other
criterion such as a chart le%el7 The results are recorded in table
>1 and labelled ERawE
Next 1 told the computer to take the same signals but only if the
distance between the entry point and protecti%e stop was within my
specified risk tolerance 1n other words' if the distance from the
entry point to the protecti%e stop wasnEt within my risk tolerance
6and therefore could not be considered a low?risk trade7' donEt ;ust
use a hard dollar stop' donEt e%en take the trade at all The results
from applying this filter are also shown in table >1
>0
Table :.7: all trades CD#awDE versus lowBrisk trades CD%ilteredDE
#aw %iltered ,hange
*et /rofit and .oss
CFE
20415 245*5 U10S
+a. drawdown ?>052 ?2440 ?>S
/rofit factor >04 /*1 U02S
*o. of trades 01 /1 ?14S
< win /4S 04S U20S
Average win 005 *25 U/>S
$s can be seen from table >1' it was better' in e%ery category' to be
more selecti%e with trades D that is' to only take the low?risk trades
and stand aside from the higher risk trades altogether Net
profitability went up by
10 per cent The losing e<uity streak or maximum drawdown
decreased by
> per cent The profit factor 6dollars won di%ided by dollars lost7
increased by a whopping 02 per cent Remember that this statistic
measures
EcomfortE le%el' so we can also assume that taking lower risk trades
results in a more comfortable trading experience
The actual number of trades 1 had to make declined by 14 per cent
6less money paid to the broker is always good7 and the amount of
times 1 was profitable also increased by 20 per cent D not that this
is important The a%erage win increased by /> per cent' which can
only mean the a%erage loss must ha%e decreased
Tightening the protective stop
What exactly does a low?risk entry look likeJ Take a look at figure >1
>1
%igure :.7: large range and ascending triangle in 3$G ,orp
:igure >1 shows a clear sideways trading range between G14/* and
G2040 "rior to this' the trend was conclusi%ely up' so usually the
safest trade is to buy the breakout if prices pass through the high D
in this case' at G2040' marked as 617 D and assume the trend
should continue $fter entering' there are two ob%ious technical
points to place the protecti%e stop
The first point is below the bottom of the range D in this case' at
G14/*' marked as 627 The risk here is G1/5 6G2040 ? G14/*7 1f
you were to risk
G2000 of your capital to buy C&9 8orp at this price' you could buy
1>01 shares 6G2000 V G1/57 Therefore' if you bought the
breakout and then got stopped out at G14/*' youEd lose G2000
The next possibility for the protecti%e stop is the minor pi%ot point D
in this case' at G2011' marked as 6>7 The trend here could be seen
as an ascending triangle pattern instead of the sideways range
=sing this stop
>2
would make the risk G05/ 6G2040 ? G20117 should you be stopped
out =sing the same risk allocation of G2000 of capital' you could
now buy 2>50 shares
This is textbook stuff' so letEs ;ust stop for a moment and assess the
ob%ious $fter entry we will ha%e absolutely no idea whether this
trade will turn out to be a winner or a loser Regardless of how
smart you think you are' itEs impossible to know the outcome $ll we
can be certain of is that if we follow our plan and get stopped out
weWll lose G2000' hence the
importance of protecti%e stop loss orders and executing them without
fail
The amount of dollars risked is the same in both scenarios D what
is different is the siHe of each position 1f this trade is a winner'
which position do you think will make more moneyJ (f course'
position two' with the larger holding of2>50 shares' will generate
more profits D e%en though the risk for the two positions was the
same $ll weE%e done is tighten the stop to allow a larger position
siHe 62>50 shares %ersus 1>017 to be placed
-etEs assume we exit the trade at G2>*0 "osition one will make a
profit of
G>*52 6G250 x 1>01 shares7 The riskLreward or the winLloss ratio
in this case would be 154 6G>*52 V G20007 "osition two will show
a profit of
G666/ 6G250 x 2>507 and therefore will ha%e a winL loss ratio of
>>> 6G666/ V G20007
&ou can see that we ha%e effecti%ely skewed the numbers in our
fa%our by simply tightening the stop 1magine if we could ha%e cut
the risk on
position two by 00 per cent again 1tEs basic maths' basic
expectancy' and it is that simple 6and remo%es the psychological
impact7 Remember' though' that the tighter the stop' the greater the
chances of getting stopped out &our immediate reaction here might
be to focus more on reducing the chances of being stopped out This
means you are more focused on trying to be right rather than
concentrating on the potential outcome if the trade is a winner
>>
1tEs essential to remo%e this ingrained urge 6in fact' remo%e any
urge that pops immediately into your head D theyEre usually wrong7
$s already discussed' o%er time the higher winLloss ratio will result
in greater profitability and this is more important than trying to %ie
for a higher win percentage -etEs look at the same trend shown in
figure >1' but in a different light
%igure :.A: small range and ascending triangle in 3$G ,orp
:igure >2 shows the exact same pattern' yet on a smaller scale
What will be the outcome here using the same scenariosJ
(b%iously' the position siHes here will be e%en larger and therefore
the winLloss ratio will also be larger' all for the exact same risk of
G2000 -etEs run through the numbers ;ust to make sure
WeE%e bought on the breakout at point 617 at G2050 We can
place the protecti%e stop loss at G2011' and therefore buy 2*02
shares 6G2000 V
>/
G0*/7' or we can trade the smaller ascending triangle and place a
tighter stop at G20>4 This would enable us to buy />/* shares
6G2000 V G0/67
$ssume again we are able to exit at G2>*0 The first scenario abo%e
shows a profit ofG*5>0 with a winLloss ratio of >4 6G*5>0 V G20007
The second scenario shows a profit of G12606 with a winLloss ratio of
6> 6G12606 V
G20007
Now we ha%e four different scenarios with ;ust two things in
common The first commonality is we could ne%er ha%e known
ahead of time that the trade was going to be successful or that weEd
be able to exit at G2>*0 ThatEs in the hands of the gods 6although
not in the G20000?course %endorEs opinion7' but we did ignore the
ErightLwrongE factor 2econdly'
the loss was always going to be the same on each of the four
trades D we were going to lose G2000 regardless of whether any of
the set?ups were wrong These are the only two similar
characteristics in all four scenarios
The differences lie in the tightness of the protecti%e stop' which in
turn leads to a larger position siHe 1f' and only if' the trade is a
winner' weEll always be better off with a larger position siHe on the
trade Bo back to figure 11 and see where these winLloss ratios lie
on the expectancy cur%e and note how weE%e managed to mo%e
deeper into the profitable Hone $ winLloss ratio of 6> doesnEt e%en
register on that cur%e With this ratio' youEd still be a winner if you
;ust won 1/ per cent of the timeK 1Ed like to think that 1Em a little better
than 1/ per cent
0etting closer to the riskBfree trade
1t doesnEt matter what we do' as long as the initial risk is as low as
we can make it To ha%e no risk would be ideal' but that ;ust cannot
be the case when trading or in%esting We can certainly help our
cause' howe%er' by starting the trade with a low?risk entry and then
<uickly following up by mo%ing the stop to breake%en or at least
reducing the initial risk by 00 per cent That is the closest scenario
we can ha%e to a risk?free trade' and this
>0
is exactly how 1 operate 1tEs a remarkably simple concept and one
that will work anytime' anywhere
Would it ha%e mattered to the bottom line if weEd used a slow
stochastic to enter these tradesJ No Would it ha%e mattered to the
bottom line if weEd used %olume as a filterJ No Would it ha%e
mattered to the bottom line if weEd used six different indicatorsJ
No Nothing matters more than understanding the winLloss ratio
mentality
$ll these things' including the patterns 1 ha%e used in the examples
abo%e' are merely tools to achie%e our goal of making profits The
patterns themsel%es donEt make you a successful trader The mo%ing
a%erage crosso%er doesnEt make you a successful trader The R21'
stochastic' $TR double?hitched backflip twist doesnEt make you a
successful trader $ll these tools are ;ust for your comfort D a way for
you to feel in control and as such allow you to participate in the
market ThatEs okay We all need comfort when placing a trade' but
is it really worth spending G20000 6or some other ridiculous amount
of money7 to buy a trading course or attend a secret seminarJ 1W%e
gi%en you the XsecretY here for free3
What makes you a successful trader is how much you win when you
win and how much you lose when you lose 1t wonEt matter what
instrument you decide to use to trade The same basic trading
principle can be used in e%ery market in the world D stocks' futures'
commodities' !T:Es and foreign exchange D and on e%ery time
frame from three?minute charts right through to weekly and monthly
charts The same expectancy will be re<uired anywhere in order to
be profitable $ lot of people use my
consulting ser%ices They approach me to specifically learn how to
trade :C
or stocks or another type of instrument They seem to think that
there is a fundamental difference between trading one instrument
and trading another 1 can see no differences' except in terms of
le%erage' across markets They all work the same They all create
the same opportunities of trend and consolidation and will therefore
always present low?risk opportunities
>6
1f you disagree' thatEs okay )ut 1 challenge you to pro%e me wrong
Trade freHuency
1f the abo%e discussion on risk?free entries can be found to be true'
profitability can be further impro%ed by trading with higher risk or
simply trading more fre<uently There are some ca%eats to this
concept' howe%er' which 1Ell outline shortly
:irstly' letEs start with trade fre<uency 1f being profitable is about
increasing the winLloss ratio and you now know how to do this' the
next step is to increase profitability by increasing the number of
trades we do
in any gi%en period of time 1f you can achie%e an a%erage winLloss
ratio of
/31 and do 100 trades per year' you can then increase your o%erall
profitability further by doing more trades per year "retty simple'
although most people will attempt to increase profitability through the
frustrating exercise of trying to increase the win rate Iust do more
tradingK
There are %arious' including some extreme' ways of doing this :or
example' an extreme trade fre<uency would be a scalper who
trades >0 times a day in one market 6Refer to my first book ! % er y ?
day Tra d ers D Wrightbo o ks' 200> D for real?life examples of this7
2calpers find a %ery small edge and then exploit it as often as they
can They usually trade one %olatile market that has high li<uidity
(ne step down from this extreme would be to look at short?term
mo%es D
say' two to fi%e days in length D and trade' say' fi%e to 10 different
stocks
at once 6more if you ha%e the time7 2tepping down e%en further
would be to trade out to 20 to >0 days' as 1 attempt to do' and track
more stocks to increase trade fre<uency -astly' you could capture
much longer term trends and follow up to >00 stocks
The ad%ent of margin lending and' more recently' 8:.s means you
are no longer restricted by capital outlay $s such' trade fre<uency
can be
>*
increased <uite dramatically (b%iously the use of le%erage is a
double? edged sword so one needs to practise sound risk
management
,aveats on increasing trade freHuency
Trade fre<uency is important' but the ca%eats are3
R The higher the trade fre<uency' the higher the associated costs
such as brokerage' data collection and time (f course' the larger
your winLloss ratio' the better your net profitability will become after
these costs are deducted
R The shorter the time frame' the less instruments you can physically
monitor 8on%ersely' the longer the time frame' the more
instruments you need to watch
1ncreasing trade fre<uency helps increase profitability if you ha%e a
positi%e expectancy method for extracting profits from the market
Throwing darts or tossing a coin may theoretically achie%e the
same goal but they certainly arenEt psychologically appropriate for
most people While 1 ha%e made my arguments in the last section
seem rather simplistic' what canEt be o%ersimplified is the
importance of ha%ing the right psychological mind?set to trade
profitably and consistently
+y thoughts on mindBset
While an in?depth analysis of the psychology of a top trader is
beyond the scope of this e)ook' it is another factor that is
paramount to success' so you should take the time to study it more
While the concepts of the winLloss ratio and expectancy co%ered so
far are all?important' it is possible that you wonEt be able to
implement these concepts if you donEt ha%e the correct mind?set
Too many people come into trading with preconcei%ed ideas of
what is actually in%ol%ed and one of the most destructi%e forces on
a new trader is the emotional baggage brought to
the table 1t is' howe%er' extremely difficult to teach the correct mind?
set D
/0
which is why 1 am only highlighting its importance here While 1 ha%e
used a psychologist to help me with my own trading' it is not a <uick?
fix way to make you a more profitable trader The correct mind?set
de%elops o%er time through experience and is certainly not
something that can be taught in a book' during a 60?minute
consultation or through an expensi%e weekend retreat
1 realised a few years ago that my line of thinking is %astly different
to that of many people 1 came into contact with "re%iously' 1 had
;ust assumed e%eryone thought of risk and expectancy in the same
way 1 did While my concern for risk or ha%ing a losing trade was
completely non?existent' or perhaps unconscious' it appeared to be
a ma;or dilemma for most people 1tEs not that it had ne%er occurred
to me that a trade could be a loser 1
was %ery aware of the possibility of loss and also knew all too well
my ability to string many losers together +owe%er' 1 donEt
consciously get concerned about losing money in the same way
most people do "erhaps after 26 years of trading and seeing
e%erything from the 145* crash to the implosion of the B:8' it has
become so second nature that now the thought of losing money sits
deep inside my unconscious and has no bearing on my day?to?day
decision making
1 %iew trading as simply entering a position and then defending
the risk in%ol%ed with that position .efending the risk is about
finding low?risk set?ups' mo%ing the protecti%e stop to breake%en
as soon as it is
appropriate and trailing the stop as the trend de%elops 1n that mind?
set' 1 simply donEt think about the potential of a loss and 1 am
completely free to accept what the market gi%es me each day
=nfortunately' this is %ery different to what passes through the minds
of most people when they get into a trade They tend to look for
confirmation by reading a public
bulletin board or e%en by unconsciously only accepting
information that agrees with their position and re;ecting
information that conflicts with their position
/1
The market is not the enemy
(ther people approach trading as if they are in battle and the
market is the opposition The market is not the enemy 1t cannot hurt
you &ou can hurt you' but the market simply facilitates the buying
and selling of shares and as such pro%ides feedback %ia its prices
What you do with that feedback is up to you 1f you donEt use a
protecti%e stop' if you use too much le%erage' if you do not allow the
trends to be ridden' if you bog yourself down in too much analysis'
you will lose money
@ore often than not' most people blame the market for their losses
and so create a Eme %ersus themE scenario @any people ha%e
attempted to explain to me how the market is EriggedE or how big
players make it unfair for smaller players or how the broker issued
bad ad%ice =ltimately' it is your decision to play the game and
therefore your responsibility to ensure that you know what youEre
doing &ou wouldnEt attempt to fly an aeroplane without first
recei%ing instruction and extensi%e training &et people who ha%e no
idea about how to be profitable in the market in%est their hard?
earned money in an arena that contains professionals who dedicate
their li%es to making a li%ing from it
Trading is not a hobby
Trading is a serious occupationF it is not a hobby 1 do endless
research on anything that might add to my trading andLor in%esting
repertoire 1n this day and age of le%erage' we ha%e the ability to
extend funds across %arious strategies and we donEt ha%e to be
o%erly exposed to risk in order to do so Too many traders stick to
one single strategy or one instrument While there is nothing
inherently wrong with this' it limits their understanding of the markets
and therefore their growth as traders
-earn to be open to anything that comes along 1 readily tinker
with strategies or suggestions that 1 read about on forums'
:ace)ook or in books (n most occasions' the theory gets
dispelled rather <uicklyF
/2
howe%er' 1 ha%e also found some gems )ecause of this openness
to ideas' 1 ha%e been able to build on existing strategies and add
new ones This not only adds to my bottom line but also to my
confidence in my ability to understand what is %alid and what is
garbage 1 am able to %ery <uickly decipher the difference between a
good trader and an amateur ;ust by listening to the way each talks
and what they talk about
To get you started on the road to de%eloping the correct mind?set' 1
would recommend Trading in th e 9one by @ark . o ugla s W hile it
may take a few reads to comprehend' it should help explain the
angle from which 1 approach trading &our psychological fortitude
plays an important role in all aspects of your trading and in%esting'
so ensure you work on it &our emotions will do e%erything they can
to keep you in a losing position and get you out of a winning
position
&ou are your worst own enemy and' generally' what you feel is the
correct thing to do' is the wrong thing to do Taking a <uick profit
may feel right but it skews your ability to be a solid long?term winner
,uite simply' you need to run a trend' not cut it short &ou need to
cut a loss as <uickly as possible' not hope it will come good 1
accept that you must find a style that suits you' that is comfortable
and that you can replicate in the future )ut going around and
around will only add to your inability to make a decision and be a
detriment to your bottom line
/>
CHAPTER " - RISK MANAGEMENT
No trading text would be complete without discussing risk
management 1t ne%er ceases to amaHe me how many people still do
not practise appropriate risk management The topic of risk
management' or position siHing as itEs sometimes known' is
paramount to your longe%ity as a trader The bottom line really
comes down to this ? the more you bet on a single trade' the more
%olatile your returns will become The more %olatile your account
balance is' the greater the emotional roller?coaster you will ride
!xperiencing too many ups and downs' especially large ups and
downs' is not really appropriate for a career trader 1t will create an
unsettling en%ironment in both your professional and personal life'
and it may also ad%ersely affect your health 1t is therefore important
to manage your exposure to risk and so create some trading and
health longe%ity for yourself
(ne of the simplest ways of managing risk is to di%ide your trading
capital into e<ual parts While this may not be the best way' it is
certainly better than no way 1Ell get onto what 1 think is the best way
shortly' but for now letEs ;ust use the following simple analogy
1magine you are a professional golfer and compete on the pro tour
The tour e%ents are made up of four days of golf and on each of
those days you play 15 holes 1n total you will play *2 holes $s
much as youEd like to play e%ery hole perfectly' you know that is
impossible Therefore' while you simply attempt to play as best you
can' the goal that is really in the back of your mind is not to ha%e
an extremely bad hole that destroys the entire round or
tournament 1n essence' you are managing your score by not doing
anything completely stupid' like hitting bold shots or taking on
too many risky shots &ou attempt to a%oid bunkers' play away from
water haHards and out?of?bounds areas' and do your best to control
the ball and
//
keep it on the fairway at all times &ou realise that if you fail to
keep the ball on the fairway' you will be penalised harshly for the
o%ersight
When playing the tournaments you are also aware of external
factors that may play a part in your decisions :actors such as the
wind' recent rain or dryness' angle of the fairways' speed of the
greens and e%en the competition can ha%e an ad%erse impact on
your game There are also external factors such as sports critics
who may influence your line of thinking
When faced with all these factors good golfers will simply take one
shot at a time They micro?manage their game by not thinking about
the absolute end result They simply play the shot they ha%e in front
of them They play for safety and to stay in the game for the long
haul They play each shot so as to be in some type of contention at
the end of the tournament' as you canEt win if youEre not in
contention
1f we apply this analogy to trading' hitting a bad shot into a water
haHard and being penalised is like taking a much larger loss than
a%erage We know that not e%ery trade will be a winner' ;ust like a
pro golfer will know that not e%ery shot will be perfect )ut we trade
to stay in play and by that 1 mean we only allow a small amount of
risk on each trade When we do ha%e some bad trades' and they are
bound to occur' they will not disrupt the end game' which is to ha%e
enough capital to keep on trading
2o think like a pro golfer and di%ide your capital into *2 e<ual parts D
as if each trade you make is similar to each hole a pro golfer plays
in a four?day tournament $ single hole cannot be responsible for
winning the tournament' but a %ery bad hole can certainly make it
impossible to win Bood traders understand that some trades will be
losers' some trades will be winners and some will be great wins' but
they do their best to ensure that a single trade or e%en a string of
losing trades will not destroy their account balances
/0
The probable length of a losing streak
$s long as you ha%e di%ided your capital into *2 e<ual parts and
placed a protecti%e stop' a single trade on its own is rarely
destructi%e +owe%er' when a string of losing trades occurs it can be
a cause for concern ? both financially and emotionally &ou might
think that if you win about 00 per cent of the time' a winning trade
would surely follow each losing trade Nothing could be further from
the truth 1 remember waiting for a plane in +ong Aong se%eral years
ago and being bored 1 started tossing a coin and counting how often
a streak of heads or tails would occur ? after all' a coin only has two
sides and so there is a fifty?fifty chance of a head or a tail coming
up @athematically 1 knew the outcome' but 1 wanted to see it for
myself 2ure enough' on <uite a few occasions 1 was able to toss a
run of nine heads or tails Runs of fi%e were extremely common
1f you were able to mathematically ascertain the probable length of
a losing streak you could better prepare yourself for its potential
impact D financially and emotionally ? when it does occur =sing an
!xcel spread sheet and our win percentage we can make some
assumptions as to what is possible
:or the purposes of the exercise' 1Ell use my humble pie example'
where 1 expect to win around 00 per cent of the time 1n cell $1 of the
!xcel spread sheet' enter that 00 per cent expectancy as 00 1n cell
$2' enter how many trades you would like to test the theory on 1tEs
best to be conser%ati%e' so a large number such as 10000 is better
than 100 !nter 10000 into cell $2 1n cell $>' enter the following
formula3
MR(=N.6-N6$27L?-N661?6$1L100777'07
(nce you ha%e entered this formula' E1>E automatically appears in
cell $> What this means is that after 10000 trades with an a%erage
win rate of 00 per cent' there is a chance that you could sustain 1>
consecuti%e losers in
/6
a row 1tEs always best to err further on the side of caution and
expect that perhaps e%en worse than this could occur
This gi%es us some %aluable information' both mentally and
financially 1 say mentally because most people go looking for
another method after about fi%e consecuti%e losers 1f you
intimately understand what is possible in trading' both good and
bad' you will be more inclined to see a losing streak through
Anowing what is possible also allows you to consider the emotional
conse<uences that can pop up when your capital starts being
depleted by a string of losing trades What will your spouse sayJ
Will you tell your friendsJ +ow will your mood be at work the next
dayJ Will you ha%e a few extra drinks at the pub that nightJ 1f you
prepare yourself for 1> 6or more7 losses in a row' when the
ine%itable losing streak does come along' youEll be ready and know
that it is ;ust part and parcel of trading
)ut this chapter is about risk not psychology' so letEs concentrate
on the financial side of the e<uation
,apital allocation
There is a well?known trading course sold globally that has been
around for 20 or more years The operators of this course suggest
you should risk
10 per cent of your initial account e<uity on each trade 1s this wiseJ 1
say
no What happens if the first fi%e trades are lossesJ They' ob%iously'
will tell you that it wonEt happen' but what if youE%e ;ust paid G1000
for this great trading course and you lose 00 per cent of your capital
in ;ust fi%e tradesJ &ouEd be de%astated 1 say 1 am no better than
random' or a 00 per cent win rate Therefore' according to our
spread sheet calculations' there is a possibility 1 could ha%e 1>
losses in a row 1n light of this' 1 cannot bet
10 per cent of my account on each trade because there is a
chance 1 will lose more than what is in my account !%en if 1 bet 0
per cent on each trade' after 1> losing trades my account balance
would ha%e declined by
60 per cent 1s that acceptable to youJ 1tEs not to me The students of
the
/*
abo%e course would ha%e to achie%e a minimum win rate of 60 per
cent D which could still potentially produce 10 losers in a row'
meaning there was still a chance of losing 100 per cent of the
account 1 ne%er want to be in that position or e%en close to that
position 1f you are risking 10 per cent of your initial e<uity with e%ery
trade' an account decline of less than 00 per cent will only occur if
your win rate exceeds 52 per cent
There are not too many traders in the world that can do that 1f we
use our golfing analogy and di%ide our capital into *2 e<ual parts'
weEre risking ;ust
1>4 per cent of our e<uity on each trade 6Remember D the amount
risked
is the amount lost if you are stopped out of a trade' not the total
amount in%ested7 This means that 1> consecuti%e losers would
cause a total loss of ;ust 15 per cent 1s that acceptable to youJ 1t
certainly is to me $fter making this basic calculation' we can ad;ust
our risk on each trade to suit our own risk profile !ach person has
a different risk appetite 2ome people are more than happy to lose
00 per cent of their account balance (thers shudder at the thought
of losing 20 per cent 2ome of you may think that such a losing
streak will not happen to you @aybe not' but do you want to put
yourself in that positionJ 1Ed like to be a fly on the wall as you
explain to your spouse why youE%e lost 60 per cent of your capital in
the first few weeks of your new trading career &our friends and
family will
call you a gambler D and' unfortunately' if you bet too much on a
single trade' thatEs exactly what you are
Advanced asset allocation
This basic concept of splitting your capital into e<ual parts is
ade<uate for a beginner or intermediate trader 1f you wish to take
the next step or you are <uite conser%ati%e' the best method 1 ha%e
used is fixed fractional position siHing
:ixed fractional 6::7 also uses the concept of percentage risk per
position but is calculated from the account balance on an on?going
basis rather than the initial trading account balance 1t is also %ery
useful because it
/5
naturally compounds your account when youEre profitable' yet
defends it when you are ha%ing a losing streak When using this
method' a percentage risk of your account is chosen for each trade
$s shown abo%e'
the higher the risk' the more youEll lose 6or win7 and the more %olatile
your account will become
$ssume your starting account balance is G10000 and you risk 0 per
cent on each trade The first trade will ha%e a risk of G000 610000 x
0007 1f this trade is a loser' the second trade will ha%e a risk of
G/*0 6G4000 x 0007 1f that trade is also a loser' the third trade will
ha%e a risk of G/01 !ach successi%e loss will make the capital go
lower and therefore the
percentage risk of that capital will also decrease
Table /1 shows the e<uity decline for %arious risk percentages
after 20 losers in a row
Table @.7: varying account balances after A= consecutive losers
)alance 0S )alance /S )alance >S )alance 2S )alance 1S
10000 10000 10000 10000 10000
4000 000 4600 /00 4*00 >00 4500 200 440 100
4020 /*0 4216 >5/ 4/04 241 460/ 146 4501 44
50*/ /01 55/* >64 412* 252 4/12 142 4*0> 45
51/0 /24 5/4> >0/ 550> 2*/ 422/ 155 4606 4*
**>5 /0* 510/ >/0 505* 266 40>4 15/ 4010 46
*>01 >5* *525 /26 5>>0 205 5505 151 4/10 40
645> >65 *01/ >1> 5050 200 5651 1** 4>21 4/
66>/ >/4 *21/ >01 *5>* 2/2 5005 1*/ 422* 4>
/4
6>02 >>2 6420 254 *602 2>0 5>>* 1*0 41>0 42
045* >10 66/5 2** *>*/ 225 51*1 16* 40// 41
0655 244 6>52 266 *10> 221 500* 16> 540> 40
0/0/ 25/ 612* 200 64>5 210 *5/* 160 556/ 40
01>> 2*0 0552 2/0 6*>0 205 *640 10* 5**0 54
/5** 20* 06/* 2>0 6025 202 *0>6 10/ 565* 55
/6>> 2// 0/21 226 6>>> 146 *>56 101 5601 5*
//01 2>2 020/ 21* 61/> 140 *2>5 1/5 5010 56
/151 220 /446 205 0405 15/ *04> 1/0 5/24 50
>4*2 204 /*46 200 0*50 1*4 6401 1/2 5>/0 5/
>**/ 144 /60/ 142 0606 1*> 6512 1>4 5262 5>
>050 154 //20 15/ 0/>5 165 66*6 1>6 51*4 5>
>250 D //20 D 0/>5 D 66*> D 51*4 D
$s can be seen from table /1' se%eral things occur when fixed
fractional position siHing is used :irstly' the ending balances after
20 consecuti%e losing trades differ considerably depending on how
much is risked on each trade While the opposite is also true' my
concern here is one of risk management and creating longe%ity and
this should not be confused with trading for maximum profit The
next factor is that the actual dollar amount risked per trade
decreases and will continue to do so to the point that it becomes so
small you may not be able to place a trade
00
Natural compounding will also occur' as shown in table /2 +ere
the results are shown for 20 consecuti%e winners with %arying risk
percentages :or the purposes of the table' 1 ha%e assumed that
only as much as was risked was won in each trade (f course' in
reality' profits for a winning trade are potentially limitless
Table @.A: varying account balances after A= consecutive
winners
)alance 0S )alance /S )alance >S )alance 2S )alance 1S
10000 10000 10000 10000 10000
10000 000 10/00 /00 10>00 >00 10200 200 10100 100
11020 020 10516 /16 10604 >04 10/0/ 20/ 10201 101
110*6 001 112/4 />> 1042* >15 10612 205 10>0> 102
12100 0*4 11644 /00 11200 >25 1052/ 212 10/06 10>
12*6> 605 1216* /65 1104> >>5 110/1 216 10010 10/
1>/01 6>5 1260> /5* 114/1 >/5 11262 221 10610 100
1/0*1 6*0 1>104 006 12244 >05 11/5* 220 10*21 106
1/**0 *0/ 1>656 026 12665 >64 11*1* 2>0 10524 10*
1001> *>4 1/2>> 0/* 1>0/5 >50 11401 2>/ 104>* 105
16254 **6 1/502 064 1>/>4 >41 12140 2>4 110/6 104
1*10> 51/ 10>40 042 1>5/2 /0> 12/>/ 2// 1110* 110
1*404 500 16010 616 1/205 /10 12652 2/4 11265 112
15506 545 16601 6/0 1/650 /25 124>6 20/ 11>51 11>
14*44 4/> 1*>1* 666 10126 //1 1>140 204 11/40 11/
20*54 440 15004 64> 10050 /0/ 1>/04 26/ 11610 110
01
21524 10>4 15*>0 *20 160/* /6* 1>*25 264 11*26 116
22420 1041 14/*4 */4 16025 /51 1/002 2*0 115/> 11*
2/066 11/6 20205 **4 1*02/ /46 1/252 250 11461 115
202*0 120> 21065 510 1*0>0 011 1/065 256 12051 120
260>> 126> 21411 5/> 15061 026 1/504 241 12202 121
260>> 21411 15061 1/504 12202
8learly' there are two sides to the risk e<uation but the following
three factors must be considered3
7 1f you lose all your capital you will not be able to trade
A The more you lose' the harder is becomes mentally to continue to
trade
: The only thing you can control is how much you lose
Table /> shows how many consecuti%e trades it will take to lose 00
per cent of the account balance' which seems to be a common
benchmark for new traders' based on percentage risked per trade
Table @.:: number of losing trades before a 9= per cent eHuity
decline
#isk per trade *o. of trades for a 9=< eHuity
decline
1S 64
2S >0
>S 2>
/S 1*
02
0S 1/
0>
!ach person will ha%e a different risk profile' so itEs now ;ust a
balancing act to find your own riskLreward point and stick to that as
part of your trading plan 1 use 2 per cent risk per trade as a guide
but a pri%ate trader could go to around > per cent $s a rule of
thumb' if you start to mo%e toward 0 per cent' youEre looking for
trouble and possibly being too aggressi%e with the risk
#isk management using leverage
1n the past' the use of le%erage was confined to exchange traded
options 6!T(s7' warrants or futures contracts howe%er 8:.s are
now a popular product 8:.s are highly le%eraged products and
must be traded and managed differently to normal shares With
normal shares' the amount that may be lost is usually restricted to
the capital outlaid With 8:.s' though' the capital outlay re<uired is
minimal in comparison to the total %alue of the in%estment This
tends to make people think they should use all the capital a%ailable
to them' ;ust like when they trade normal shares This is plain
wrong and can be fraught with danger
-etEs highlight this point using a simple example that shows how
le%erage actually works 2ay you ha%e G20000 to trade with and you
feel that the price C&9 2tock is trading at has potential to mo%e
higher &ou wish to buy at G550 and place a protecti%e stop at
G500' or a risk of G0>0 1n terms of your account' you do not wish to
lose more than G000' so you can buy
1/25 shares 6000 V 0>07' which will mean an outlay of G126>* 61/25
x
G5507 The problem is that G126>* represents o%er 6> per cent of
your a%ailable funds and in%esting this amount will mean you wonEt
be able to take any more trades until this one has been completed
This can be construed as being EriskierE than using le%erage 1t
doesnEt allow di%ersification' a prime ingredient in successful
trading' especially during strong trending markets
With 8:.s' howe%er' we only need to place a small amount of that
G126>* with the broker D indeedF the amount re<uired may be as
small as 0 to 10
0/
per cent' depending on your pro%ider 1f it is 0 per cent' we need
only place G6>2 6G126>* x 0007 toward the trade' yet are still able
to purchase the 1/25 shares we need 1f the trade is a loss' we will
still lose G000 of the
G20000 but we only needed to use G6>2 to do it' rather than
G126>* Therefore' we ha%e a lot more money a%ailable to us to
take other trades and better apply our trading skills and reduce our
risk through di%ersification
+owe%er' itEs this last point that can get people into trouble with
le%erage )ecause they ha%e only outlaid G6>2' many people turn
the e<uation inside out and do one of two things :irstly' they may
say that their account balance is really G/00000 6G20000 V 0007
because thatEs how
much they can control with the le%erage 2econdly' they may buy
G/00000
worth of shares with their G20000 When using le%erage you should
not concern yourself with the underlying %alue of the stock you can
control $fter trading futures for the last 26 years' 1 can comfortably
say that 1 ha%e ne%er known how much the underlying commodity 1
held was worth
WhyJ $part from the fact that it is not rele%ant to you as a
trader' it misconstrues your attitude to risk
The only rele%ant point is how much your loss will be if you get
stopped out and what percentage of your account balance it
represents This is the key 1n other words' work backwards from the
risk to the underlying %alue' not the re%erse 1 calculate the entry
point' then the protecti%e stop point That is my risk 1n the C&9
2tock example abo%e' it was G0>0 Then 1 di%ide that into the
account risk D in my example' G000 Then' and only then' will
1 know how many shares to buy and what outlay will be re<uired
The risk always determines the amount of shares purchased and
therefore the dollars outlaid 1f you can start to think along these
lines' you will be better placed to protect yourself from an extreme
e%ent that may destroy your capital and land you in serious financial
trouble
00
.evel of diversification
There is one more element to consider ? how many positions to
ha%e on $gain' using a risk management tool we can correctly
define this' rather than ha%ing to take a wild guess according to our
confidence le%els When the stock market is mo%ing along strongly'
as it was from 200> to 200*'
the inclination is to get onto anything that mo%es )ecause of the
le%erage
a%ailable from 8:.s' this can be a %ery dangerous proposition
and one that must be controlled The <uestion is how many
positions should you takeJ :i%eJ !ightJ @oreJ
The answer lies in the amount of margin being used 1n the pre%ious
C&9 2tock example' we put up G6>2 in margin to co%er the position
The G6>2 represented >16 per cent of our G20000 account This
percentage is known as the margin to e<uity ratio and' ideally' it
should not exceed >0 per cent to >0 per cent to remain on the safe
side $s prices mo%e around and your protecti%e stops are ad;usted'
this ratio will also mo%e' so you should keep monitoring it in case it
starts to creep beyond the >0 per cent le%el 1f it starts to get toward
00 per cent' the exposure to the market should a nasty price
re%ersal occur is starting to become dangerous
2ome 8:. pro%iders offer a guaranteed stop loss 6B2-7 facility that
enables the margin to be lowered e%en further and again helps you
reduce your risk The B2- facility is a great idea when you are going
against the ma;or trend or shorting a %ery low?priced stock that may
be a takeo%er target
,apital restrictions with nonBleveraged trading
)efore the days of 8:.s' when the market was extremely bullish
on the coat?tails of the =2 technology boom in the late 1440s' 1
came across the problem of ha%ing too many trading signals and
not enough capital to trade them all 1 needed some type of filter
that allowed me to make an educated guess as to which of two
stocks might be a better performer should they both be winners 1
named the filter E)ang for )uckE and it
06
e%entually found its way into the @etastock user guide as well as
se%eral trading books
2tock selection without le%erage has one serious drawback D it
means buying G10000 of a G50 stock is %ery different to buying
G10000 of a sub?
G10 stock' as capital usage in higher priced stocks is inefficient
compared with lower priced stocks $ good exercise to pro%e this is
to compare the a%erage price range of a stock o%er the last 200
days with its current price
:or example' C&9 8orp has a 200?day a%erage price range of
G0>2 with a current underlying price of approximately G2100
=sing G10000' you
could buy /*6 shares with an expected profit of G102 per day 60>2 x
/*67
8ompare this to $)8 8orp' which has a 200?day a%erage price range
of
G00>0 with a current underlying price of G0// This enables us to
buy
22*2* shares with the G10000 +ere the expected daily profit would
be
G*40 600>0 x 22*2*7 1n this example' weEd get more Ebang for our
buckE by buying $)8 8orp and not C&9 8orp 2o if 1 recei%ed a
buy signal in $)8 8orp and one in C&9 8orp' in theory 1 should be
better off taking the $)8 8orp trade and forgoing the C&9 8orp
The )ang for )uck simply filters the relati%e %olatility of the
stock in comparison to its price
To calculate the )ang for )uck filter' simply di%ide the amount in
your trading account 6say' G100007 by the closing price of the stock
on any gi%en day This number is then multiplied by the a%erage
range of the stock for the last 200 days 6The a%erage range is the
a%erage distance the stock has mo%ed from its high to low point
each day o%er the last 200
days7 .i%ide this number by 100 to con%ert the result to dollars and
cents'
which in turn indicates the possible dollar return on any gi%en day
0*
The higher the expected profit %ersus re<uired in%estment' the
higher the profit potential meaning selecting higher ratios will enable
stock selection with potential for mo%ement and this is what we
want
05
CONC#USION AND
FURTHER READING
1 hope this e)ook has pro%ided you with
the light?bulb information you need to
take you trading to a higher and
hopefully profitable le%el
1f you now re<uire a decisi%e' pro%en and
repeatable strategy 1 strongly recommend
Un h oly G ra il s 1n this new release 1 outline
the foundations and philosophies of acti%e
momentum in%esting' 1 fully disclosure eight strategies as well as
pro%ide proof?of?concept from real time trading results and
inter%iews with successful traders
Unholy Grails has sold globally and is now a%ailable on Ki n dle or
iBook s
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).
Z1 am ;ust totally amaHed at thisZ B (teve A.
Z%ery powerfulZ ? #ichard ).
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60
APPENDI, A - STOPS AND #ONG TRADING
The table below outlines the impact that different protecti%e stop will
ha%e on results The number of points used as the protecti%e stop
was tested between one and 00 and no other risk management
factors were used The computer was told to buy at e%ery open and
close at the end of each day D or get stopped out at the %arious
protecti%e stop?loss le%els The exercise shows that a tighter stop
may ha%e a smaller win percentage and profitability' but the
associated risk declines at an e%en faster rate D making a tighter
stop a better alternati%e than a wider stop
(top
points
*et
/rofit
/rofit
C<E
Avg.
win6loss
Avg.
trade
+a.
Drawdown
/rofit
%actor
7 4/400 6 2>26 >*5* ?1/000 100
A 42/00 10 1044 >65* ?16520 125
: 1001*0 10 652 >44* ?26020 122
@ 11/0*0 14 /42 /0*2 ?24/20 120
9 1>0120 2/ >** 0>42 ?2*5*0 120
; 1/*>*0 2* >04 0551 ?>0220 114
? 1255*0 >1 206 01/> ?>0020 110
J 1160*0 >/ 216 /6>2 ?>*520 112
> 45/00 >6 141 >424 ?/2020 110
7= 10/100 >5 1*/ /106 ?/1200 110
77 106100 /0 104 /2>6 ?/2>00 110
7A 5>000 /2 1/6 >>12 ?01600 10*
7: *16*0 /> 1>* 256 ?/6000 106
7@ *41*0 /0 124 >104 ?/>>20 10*
79 *1/00 /6 12/ 2501 ?/0>20 106
7; 012*0 /6 114 20/6 ?/2**0 10/
7? /1/20 /* 110 160> ?00>20 10>
7J >/0*0 /* 112 1>5 ?/*120 10>
7> /*020 /5 110 15*6 ?01600 10/
A= 60500 /4 104 2/25 ?0>520 100
A7 025*0 /4 105 211 ?0/600 10/
AA 01600 /4 10* 2004 ?0//00 10/
A: /6500 /4 106 1565 ?0/*20 10/
A@ /1**0 /4 100 166* ?006*0 10>
A9 />220 /4 10/ 1*20 ?0*1*0 10>
A; 02200 /4 10/ 205> ?0>500 10/
A? /1200 /4 10/ 16// ?06000 10>
AJ /0400 00 10> 15>/ ?/4020 10>
A> 02400 00 10/ 211> ?/*/00 10/
:= 00020 00 10/ 2146 ?/*6*0 10/
:7 60020 00 10/ 2/10 ?/*0*0 100
04
:A 66200 00 10/ 26/2 ?/*620 100
:: 6/000 00 10/ 2006 ?/5*20 100
:@ 04600 00 10/ 2>*5 ?/50*0 100
:9 00**0 00 10> 2226 ?/4>20 10/
:; 02**0 00 10> 2106 ?/46*0 10/
:? 016*0 00 10> 2062 ?/4*00 10/
:J /04*0 00 102 141/ ?/4500 10/
:> /5520 00 102 14/5 ?00**0 10/
@= /*>*0 00 102 1540 ?/44*0 10/
@7 016*0 00 10> 2062 ?00>*0 10/
@A 0>200 00 10> 2120 ?/4220 10/
@: 00000 00 10> 2210 ?/4600 10/
@@ 00/20 00 10> 2212 ?/44*0 10/
@9 0>400 00 10> 2101 ?/4520 10/
@; /4600 00 102 14*4 ?/4400 10/
@? 0/400 00 10> 2141 ?00120 10/
@J 0/000 00 10> 210* ?/4>*0 10/
@> 0/1*0 00 10> 2162 ?/4020 10/
9= 00500 00 102 2024 ?/46*0 10/
60
APPENDI, B - STOPS AND SHORT TRADING
The following table is the in%erse of appendix $ D that is' short
selling on e%ery open' closing the trade at the end of each day' or
getting stopped out at the %arious protecti%e stop?loss le%els The
results from this short selling strategy show %ery similar
characteristics to those in appendix $ &ou can see' howe%er' that
as the stop is widened the profitability drops dramatically' which
suggests the upward bias of the stock market o%er the longer term
@y research suggests that short selling strategies for stock markets
are only profitable o%er %ery short time inter%als and ha%e poor
results when longer time frames are used
(top
points
*o. of
trades
*et
/rofit
/rofit
C<E
Avg.
win6loss
Avg.
trade
+a.
Drawdown
/rofit
%actor
7 2006 6*000 6 1442 264/ ?1>/20 1/0
A 2006 /4>00 11 4>0 146* ?25420 110
: 2006 101*00 16 60* /060 ?>0200 122
@ 2006 5/120 20 /// >>0* ?24/*0 110
9 2006 50/20 2/ >/2 >204 ?25600 112
; 2006 62600 25 2*5 2/45 ?20*20 105
? 2006 6*420 >1 2>/ 2*10 ?26600 105
J 2006 6*/20 >/ 201 2641 ?20000 10*
> 2006 **1*0 >* 1*5 >050 ?255*0 105
7= 2006 5*>00 /0 162 >/5/ ?>0>00 104
77 2006 4*2*0 /2 1/5 >552 ?>1000 104
61
7A 2006 4/020 // 1>5 >*02 ?>1400 104
7: 2006 52100 /0 124 >2*6 ?>10*0 10*
7@ 2006 *0*00 /6 122 2521 ?>>000 106
79 2006 600*0 /* 11* 2/1* ?>0220 100
7; 2006 /0000 /* 11> 1046 ?/0/20 10>
7? 2006 2*500 /5 104 1111 ?/0200 102
7J 2006 10/00 /5 106 /10 ?60100 101
7> 2006 15220 /4 10/ *2* ?6>000 101
A= 2006 146*0 /4 10> *50 ?62420 102
A7 2006 142*0 00 101 *64 ?6>400 102
AA 2006 4120 00 044 >6/ ?66500 101
A: 2006 10400 00 044 />* ?6>200 101
A@ 2006 ?100 00 04* ?006 ?*2100 100
A9 2006 ?12200 00 046 ?/54 ?526*0 044
A; 2006 ?22*00 00 040 ?405 ?40/20 045
A? 2006 ?25200 00 04/ ?112* ?42400 045
AJ 2006 ?>2020 01 04/ ?1245 ?4/2*0 045
A> 2006 ?25*00 01 04/ ?11/0 ?40100 045
:= 2006 ?2>2*0 01 04> ?424 ?40020 045
:7 2006 ?>2220 01 04> ?1256 ?45500 045
62
:A 2006 ?>0/00 01 042 ?1/1> ?10>/20 04*
:: 2006 ?>/100 01 042 ?1>61 ?100020 04*
:@ 2006 ?/1100 01 042 ?16/2 ?100400 04*
:9 2006 ?002*0 01 041 ?2006 ?11>120 046
:; 2006 ?0>5*0 01 041 ?210 ?11*/00 046
:? 2006 ?06>20 01 041 ?22/5 ?12>>00 046
:J 2006 ?61000 01 040 ?2/0/ ?126/20 040
:> 2006 ?04420 01 040 ?2>41 ?12/>*0 046
@= 2006 ?05100 01 040 ?2>2 ?122000 046
@7 2006 ?61020 01 040 ?2/>0 ?12>420 046
@A 2006 ?06*00 01 040 ?2260 ?114/00 046
@: 2006 ?0*>20 01 040 ?2255 ?115600 046
@@ 2006 ?621*0 01 040 ?2/51 ?122>20 040
@9 2006 ?6*/00 01 054 ?2642 ?126*20 040
@; 2006 ?600*0 01 040 ?204* ?12/220 040
@? 2006 ?6*2*0 01 054 ?2650 ?120/*0 040
@J 2006 ?05600 01 040 ?2>/ ?1104*0 046
@> 2006 ?61/*0 01 054 ?2/0> ?1150*0 046
9= 2006 ?0*500 01 040 ?2>06 ?110400 046
Pisit us at w wwth e chart i stcomau
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