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Trading is basically speculating on the underlying asset’s price movement. Whether the asset is overvalued or not doesn’t matter. The traders don’t try to determine the value of an asset.
Usually, the traders initiate a trade only then if the reward/risk ratio is at least 1.5.
The more the margin a trader use the less time frame for the trade he has because the price movements get more unpredictable for the longer time frames.
Usually, finding a trade opportunity with a reasonable success possibility and with a reward/risk ratio above 2 is very difficult.
Not only rising stocks but also falling ones offer traders profit opportunities. But shorting and sideways trades are more difficult than long trades. If the trader is trained to short selling he can make money during bear markets when long-term investors “lose” capital.
Beating the benchmark is also expected from traders because traders consume a lot of energy and time for their trades and why should they bother with trading when the benchmark indexes provide the same results? But one thing should not be overlooked:
even if a trader cannot beat the index he can limit his downside risks when the bears suddenly massacre the market. This is usually one of the main reasons why the novice ones choose trading and not directly owning stocks. The recovery after a market crash can take several years, maybe more than 5 years. Nevertheless, the author is 98% long-term tech-growth investor and 2% trader.
What is the required minimum capital to make a living from trading?
Of course, it depends on your skills, strategy and also on how much time and energy you are willing to put into trading. To my experience (ca. 9 years) and opinion, I would not consider trading as a full-time job if I have not at least 100K to risk.
There are a lot of websites or social media post stating that you need at least 35K. I recommend being very careful when seeking online advice because they are usually not an advice but promotion for a product or service.
The novice trader who probably begins trading during a bull market should be mindful of following principles:
- it is easy to make money during bullish times, almost everyone can make profits
- The returns are high in a bull market.
- A bull market cannot last forever, sooner or later bears will wake up from their winter sleep. If the bear catches you with a high margin or a high-risk portfolio you will lose a lot of money you cannot recover for a long time.
- Making money during turbulent times is difficult and far more risky than in bull markets.
- In a bull market, If you increase your risk exposure you can also increase your return but when the bear market suddenly comes, as mentioned above, or your trades don’t go well as expected and you lost money, say 50%, you need make more return than your lost, 100% return for 50% lost, to come back to your initial point (which can take 10 years, in previous example).
- You can not make high returns every year. In some years, you will make low returns or even losses. Because your returns are not fully in your control. The market provides opportunities and you try to take them with high risks.
- To my experience and opinion, 15% return in 10 years average is a very good performance. If someone asserts he makes above 20% ( 20% makes 234x capital increase after 30 years) ask him why he is wasting his time with social media, youtube videos etc.? Goldman Sachs would invite him with red carpet.
- In retrospect, Technical Analysis’ can appear more predictable and this is a trap many novice traders fall into. They think the market is very predictable, take very high risks and ruin their capital at the beginning. Technical analysis without a sound risk management is like trying to make money in a casino, nobody can get rich in gambling besides the owners of the game, pardon the casinos.
And the golden rule:
DON’T RISK THE MONEY YOU CAN’T LOSE!
You will not only lose your hard earned money but also experience some psychological pain and maybe a family drama.
The traders can be successful in the long term only then if they are consistent with a trading discipline. In short term, in a bull market, everyone can make money but only the traders with discipline can survive the turbulent times.
As mentioned above, you should keep a minimum Reward/Risk ratio of 1.5. Therefore you have to determine your entry point, stop-loss and target price before you open a position.
How to use stop-loss?
Traders have to use stop-loss to limit their loss from failed trades. Suppose you buy a stock at a price of $100 and you put the stop-loss at $90, then your loss would be limited to $10 if the stop-loss is executed.
Using the stop-loss is the first step to implement a sound risk management which is an absolute necessity for the success in trading. Without stop-loss, you cannot control your risks.
The first goal of trading is protecting capital, the second one is making a profit. You can make profits by taking high risks, but only in short-term, and sooner or later you will lose your all capital. If you can protect your capital you can always take opportunities the market provides and you will increase your earning when your experience and skills grow.
After determining the stop-loss and deciding to trade, you can use stop-loss orders to make an automated execution. The execution orders: buy, sell etc. can protect your trading from your emotions and help you to keep the discipline. But you should be careful and mind the fact that stop-loss orders don’t have the 100% guarantee to execute selling when the price hits the limit – the risk of “trading through”. An another risk is that the stock makes a gap under the stop-loss, for example, the opening price is $80 while your execution limit is at $90, in this case, you will make an additional loss of $10 per share.
Best part of trading is
— Centhrone Trading 💵 (@StockswithValue) October 8, 2017
Where should I set the stop-loss?
Usually, the stop-loss limits are placed just below support levels because a stock can experience a temporary pull back even if there is no reason, just because of a random noise and in such an event, the support level can prevent that the price hits the limit and selling order gets executed.
If you look at the table of the trade history above you can notice that the failed trades rarely wiped out the complete risked position, i. g.: only 0.3R and in two trades, almost all R is rescued because the support levels between the entry price and stop-loss limit have given the stock a re-bounce and us a time to exit before the price hits the order limit. The more stronger the support level the more the trade protected.
Some traders use percentages as execution limit, i. g.: 6%, with trailing stop-loss orders to protect the gains. Higher percentages will be less risky but they also need higher targets to remain a minimum Reward/Risk ratio, i. g.: 1.5, which means the trading time frame would be longer. But the technical analysis’ ability to predict the price movements weakens when the trader extends the time frame. In theory, you can apply technical analysis even for a ten years time period but it is almost completely useless.
Your trading performance depends on your trading position size:
To limit your losses on a trade and to protect your capital, you have to determine your position size before entering in any trade. Limiting the position size of trades is crucial for every risk management strategy.
Usually, traders use 1%, but not more than 2%.
Your strategy to determine the position size will not only affect your return but also the volatility of your trading capital. As mentioned before, if you lose X% of your capital you have to earn more than X% to recover from the lost. For example, suppose you lost 30% and 70% remains, in this case, you need to have a return of (30/ 70)% = 43% to recover from the 30% loss or have the same capital before 30% loss.
If you have a high volatility in your trading account you will experience more stress (and/or greed in a bull market) and it would be more difficult to protect yourself from emotions.
When the market changes its direction, for example from bull to sideways or directly to bear, you will experience the pain of string losses which means you will lose more than one trade at the same time.
When I writing this paragraph, there were only 3 open long trades: Nasdaq, Nvidia and Visa. Their price movements correlate to each other and if the bear market suddenly shows up we can lose all of them. But our loss would be limited to 3R or 3% and we can easily recover.
Even if the market doesn’t change its direction, statistically, you have the risk to lose all your trades. Suppose you have 5 trades with a probability of 60% and they are statistically independent to each other (that is unrealistic) the probability that you lose all of them is 0.40^5 = 0.01 or %1. In reality, it is much more than 1% because the price movements of financial assets correlate. Suppose, it is 10%, this would mean if your average trade in a month is 5 you can expect a loss of all your open trades every 10 months.
In short, 1% rule limits your maximum loss and enable you to easily recover. The logic of statistics is the hardest logic in math but it gives you a tremendous edge, not only in trading but also in whole life.
Advanced traders change their position sizes, usually between 0.5R to 2R. Suppose you have two trades, one has the possibility of 70% and the other 50%. If you apply 1R rule to both trades your expected return would be:
1Rx0.5 + 1Rx0.7 = 1.2R
If you use 0.5R for the trade with 50% probability which is lower and 1.5R for the trade with 70% probability you can expect:
0.5Rx0.5 + 1.5Rx0.7 = 1.3R!
You have risked the same amount of money in both scenarios but in the second case, you have 0.1R more profit. Therefore the advanced traders sometimes change their trade position but if you are new in trading you can stick with 1%, don’t bother with that.
The more random you change your position size, without any systematic approach, the more random your return will be.
Next: Determining the probability of a trade’s success, to be continued….
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