Monday, February 29, 2016

A few more things I've learned about trading

Here are some other lessons I've learned the hard way from trading. My conclusions might be wrong, but this represents how I see things at this point.

You might not have read my original article about my learning experience in trading. Read it here!

... Anyway, let's mention a few things before we start:
- I assume you trade using "leverage" (you magnify your trade size by taking up a loan, this way you can make higher profits - but you will also lose quicker. You will not end up in debt, because the broker will not allow you to lose more money than you've invested out of your own pocket - read up on leverage and make sure you understand how it works)
- You know what stop loss (SL) / take profit (TP) is (you set up a trade to automatically close if you've lost a certain amount of your trade position. Take profit is the opposite, where you close the trade once you've reached a certain profit)

1) Don't risk your whole account.
Let's say you start with $1000. You make 10 trades using $100 on each. You want don't want to be stopped out too early so you have a stop loss at 100% of each trade. That means that the markets can go against you until you lost your whole trade size ($100 for each trade). It seems highly unlikely that it will come to that. Let's say you have set take profit at 50% (that means your trade will be closed if/when you reach a $50 profit). It seems much more likely that your trades will reach a 50% profit than a 100% loss - cause you have an edge - judging by your information you could very well be making a good trade. Let's say you close all the trades at the same time and you end up with a $500 total profit. Your balance is now $1500. Now let's say you make another 10 trades, but now you use $150 on each trade. You do good again and you make a profit of $750 (50%, remember?). Your balance is now $2500. You feel good, so you decide to do the whole thing over again, and this time - you guessed it - you spend $250 on each trade. However, this time the markets go against you and you lose all your money. So much for those nice winnings in the beginning. Let's say that instead of trading with your whole balance on the third trade, you limited yourself to your previous trade: spending $1500 on trades. In this case you'd still have $1000 left after losing with all your trades. It's an easy mistake to keep making bigger trades once your account starts growing.

Let's pretend to make a rule: Only spend 20% of your account.
Round 1: 10 trades, $20 per trade. $100 profit.
Round 2: 10 trades, $22 per trade. $110 profit.
Round 3: 10 trades, $24 per trade. $240 loss.
Balance in the end: $970. $30 loss. Not your whole account.

What if we trade with 50% of our account?
Round 1: 10 trades, $50 per trade. $250 profit.
Round 2: 10 trades, $62 per trade. $310 profit.
Round 3: 10 trades, $78 per trade. $780 loss.
Balance in the end: $780. $220 loss. Not your whole account.

What if we always make 10 x $50 trades?
Round 1: 10 trades, $50 per trade. $250 profit.
Round 2: 10 trades, $50 per trade. $250 profit.
Round 3: 10 trades, $50 per trade. $500 loss.
Balance in the end: $1000. 0 profit/loss. Not your whole account.

Not spending your whole account just makes trading more pleasant and it gives you more do-overs. It might feel like you can make money faster by putting it all on the line, but suddenly you've lost it all.

2) Be careful trading the same thing
Instruments (stocks, indexes, currencies etc.) are connected. If the EUR gets weaker, it will affect all currency pairs that involve EUR. But if the EUR gets weaker, it could also mean that the CHF is getting weaker. If you trade USDCHF and EURUSD, you are - in my experience - pretty much trading the same thing. So if you find a good opportunity on the USDCHF you might also find a good opportunity on EURUSD, thinking these are two separate, good opportunities. If you have a rule to not spend more than e.g. 10% on a single instrument, you might as well avoid spending more than 10% on EURUSD and USDCHF together, the way I see it. Sure, you could do 5% on each if you want.

Indexes are very often strongly connected. If the US indexes are going up, chances are that the European and Asian markets are going up as well. Be careful trading many of these indexes at the same time, thinking they all look like great opportunities. If one of them turns around, chances are that other ones will do it as well.

3) Accept losses
Above I mentioned having a stop loss at 100%. This can work if you also take profits that are high enough. If you have a 100% SL and lose 1 out of 3 trades, then you need to make sure that you - on average - makes a profit of more than 50% of the other 2 trades to at least break even (taking for granted that the trades are of equal size). It's so easy to let losers go and to close winners too early. You need to let the winners go to be able to justify a 100% SL.

2 / 3 winners is just an example. Maybe losing 100% of your trade size is highly unlikely and that you can make 25% profits on the instrument multiple times before losing (100%). If you have 10 25% winners before you have your 1 100% loser, your profit from the instrument would still be 150% of the trade size. It's a numbers game.

Anyway, there are other ways to trade successfully. You can have a tight SL. The problem with tight SL's is that you can easily be stopped out by a "false breakout" against you. And sometimes if your broker is a "market maker" you can get stopped out easily by a sudden 1-minute drop-and-rebounce. If the instrument doesn't test your SL limit, then you have a good trade going with little risk.

You could have a not-so-tight SL. Let's say you set it to be 25% of your position size (trade amount). If you find good opportunities, this could work out well. But if you lose 1 of 3 trades, you need to make sure that the 2 winners are at least 12.5% profit each (average) to break even. However, should the market test your SL limit you might be tempted to move the SL further away. This is often a slippery slope. Sure, sometimes it will work out; the instrument will turn and you will get a profit. But what if it doesn't? What if you keep moving the SL all the way down to 100% loss? Or even further? You can inject more money into the position to accept a even higher loss; 150% or 200%. Let's say you lose 200% on the trade. Now your two other trades needs to make 100% profit each to help you break even. There's no shame in a having a 25% loss on your record.

4) Take my own advice.
Despite all the things I said above, I still trade poorly. It's psychology. It's a mind game. The markets still make me insecure enough to trade inconsistently.

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