Recently I have been reading Dr. Alexander Elder’s “Trading for a Living”. This all started when the market changed a year or so ago, and the techniques I had been using to trade stocks (buy and hold, technical analysis) really had quit working. In fact, if you were a “buy and hold” investor, that strategy hasn’t really worked well for about 10 years.
I had a few spot successes, in one instance making a 10x gain in a little over a year, and a few 2x and 3x gains — but these events were not sustainable. More recently I got into a trade and then got out, and had I stayed in one more week I would have made another 10x in less than a month.
(You are reading these numbers right, not 10%, but 10 times — one was 3 to 30 and one was 0.33 to $3.45).
What I have come to realize, though, is that this has been about 75% luck and 25% maybe I sort of know what I am doing. I want to change that ratio dramatically, so it is more like 75% knowing what to do and 25% luck. And, I want to improve my winning trades ratio so I win at least 60% of the time. In the past I have won about 40% of the time, but when I won it was often big, and these were all multi-year holds, not short term trades. My short term trades have pretty much all been losers except for rare occasions when I got lucky.
So Dr. Elder’s book talks about trading being similar to alcoholism. He says the best thing a starting trader can do is go to an AA meeting and substitute “loss” for the word “alcohol”. Because trading is like drinking, I suppose, in that you can get a huge thrill from it and then it is hard to stop. I never had this problem — when I start losing, I quit trading.
Maybe it is because at the DMAS class taught by SRI coaching, Steve Linder asks a bunch of hypothetical questions, and in particular, once you have decided to buy something and the price starts to drop, he asks when you would sell. In this exercise you have a partner, and each time the price drops and you don’t sell, your partner slaps your hand, a little harder each time.
Eventually most people get the idea. If the market is slapping your hand, get out! Some people stay in thinking it will come back. OK for value investing if the reasons you bought in are still valid — not so good for technical trading.
The more important things I have learned from this book (so far) involve risk management. Some really simple steps can dramatically improve your performance. In my buy and hold strategy, I always used market orders, and generally risked a similar dollar amount on any given stock. Unless the fundamentals changed, I held the stock for the long term. And I watched as many of my holdings went between being down 50% and up 100% — over a period of 5-10 years. Ultimately I sold most of them for substantial gains, so I’m not complaining.
Today, I almost never sell or buy without using a limit order. And most of the time, I exit a position because I was stopped out — I don’t mind being stopped out, because I move my protective stops regularly. These things, though, are tactics — my trading has improved because I am careful to employ good tactics. It is even more important, though, to implement a great strategy. My strategy is one of risk management.
Many people talk about managing your risk in investments, whether they are real estate or equities or anything else. It can be straightforward to quantify your risk in the stock market. Here’s how:
First, identify a situation in which you think you can profit.
Second, identify these things:
1) Entry point
What exactly has to happen for you to decide this is the time to buy?
2) Initial risk
Where will you put your initial stop compared to your buy point?
3) Potential gain
If this trade works, what is the most likely profitable outcome?
4) Risk management strategy
As the trade starts to work, how will you move your stop to protect gains?
Now it is time to analyze the risk: What is the risk/reward ratio? If you don’t stand to make at least 3x (I like 5x) whatever it is you are risking, then look for a different trade.
Here’s an example: Let’s say stock XYZ has been trading in a channel (oscillating up and down between two relatively parallel lines). At some point, you think the stock will either break above the channel or fall below the channel. For some reason you think that, if it falls below the channel, it will continue down below the bottom of the channel the same distance as the channel height. So maybe the stock was trading between $30 and $38 in the channel, and this morning it opened at $29.
You “sell short” the stock at $29, and place a “stop” at $31, above the bottom of the channel. Your potential loss is $2. If you think it might fall below the channel as much as $8 (the height of the channel) then you could make up to $7 per share (if it falls to $22). So your risk is $2, and your potential reward is $7; your reward to risk ratio is 7:2 or 3.5. This is better than 3, so this is an acceptable trade.
[I apologize to those of you who are confused about a stock short sale, if you email me I will send you a description of that process].
If you have a strategy in which at least 50% of your trades are winners, and you keep your risk/reward ratio at 3:1 or better, then you will consistently win in the market.
There are lots of other rules to follow. You never want to risk more than a certain percentage of your entire portfolio. So for example, if you have a $10,000 trading account, maybe you establish a rule where you never want to risk more than 2%; so your risk amount should be no more than $200. In my buy and hold strategy, this would mean I would only buy $200 of any position. Here, though, since we are risking $2 a share, we can buy 100 shares and maintain this strategy. So for 100 shares which cost us $2900, we are risking $200 for a potential gain of $700. In terms of the invested capital, we are risking 7% for a potential 24% return. Those are pretty good odds. If we consistently win only 1 out of every 3 trades (a horrible track record), we still make 3%. [This does not include commissions or taxes which affect the returns].
So let me leave you with a big question:
How do you manage risk in a Real Estate investment? Pretty hard to set a “stop”!