In­vest DIY: A sim­ple rule for trad­ing

Be­fore you start trad­ing, make sure that you un­der­stand the fun­da­men­tals. Here are a few ba­sic rules to keep in mind to en­sure that you make a profit.

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­

iwant to talk about trad­ing this week. Not trad­ing strate­gies or where to put the sto­ploss or what de­riv­a­tive prod­uct to trade or time frame to use – rather, I want to start with a sim­ple anal­ogy that will hope­fully help you un­der­stand the sim­ple prob­a­bil­ity in­volved in trad­ing. By im­ple­ment­ing some ba­sic rules, we can use this to our ad­van­tage.

Let’s start by toss­ing a coin, and let­ting it land on the ground. Ev­ery time it lands on heads we make 100c and ev­ery time it lands on tails we lose 100c. Af­ter enough coin tosses we’ll end up with an equal num­ber of heads and tails, and we would have made zero profit. Equally, we would have made zero loss. We’ll be ex­actly where we were when we started.

Now let’s add a coloured square on the ground, cov­er­ing about a fifth of the to­tal area where the coin is land­ing. If the coin lands in that square af­ter we toss it, our profit or loss will be tripled.

So, we’ll make 300c when it lands on heads and lose 300c when it lands on tails. If the coin lands out­side the square the nor­mal rules ap­ply – a profit of 100c for heads and a 100c loss for tails.

Again, af­ter enough coin tosses we’d have made no profit with the losses off­set­ting the win­ners.

What if we change the sce­nario? So ev­ery time the coin landed on tails in the square, in­stead of los­ing 300c, we only lost 100c. Now we have two ways to lose 100c, one way to make 100c and another in which we make 300c. Af­ter enough coin tosses we would have made a profit as the coin would have landed on heads and tails within the square an equal num­ber of times, but on tails we only lost 100c and on heads we made 300c.

Now we sub­sti­tute in­di­vid­ual trades for coin tosses. Trad­ing is about prob­a­bil­ity; it is very im­por­tant that we ac­cept we can­not know the out­come of a trade be­fore it is com­pleted and in fact we do not need to do so if we have a plan and risk man­age­ment. The ques­tion is how we turn those 300c tails into only a 100c loss. The an­swer is sim­ple. We use a stop-loss. In­di­vid­ual trades are ran­domly dis­persed and we never know which will make us a profit or a loss. But if we al­ways limit our losses to 100c, then the win­ner at 300c sud­denly makes all the dif­fer­ence. Of course, this as­sumes two things. First, that we have a trad­ing strat­egy with a 50/50 win-loss ra­tio. Yours may be slightly bet­ter, or like my All Share In­dex (Alsi) sys­tem, you may have a slightly worse win-loss ra­tio. (My 7/21 Alsi sys­tem has a win rate of around 42% af­ter costs. See for more in­for­ma­tion.) But even with a 42% win rate, by lim­it­ing my losers and find­ing the oc­ca­sional large win­ner, it makes a profit. The sec­ond point is about costs. This is in the form of bro­ker­age fees, in­ter­est if de­riv­a­tives are be­ing traded, and the spread (dif­fer­ence be­tween the buy and sell price). Th­ese costs have the ef­fect of re­duc­ing the profit in win­ning trades and in­creas­ing the loss in los­ing trades. But again, if we limit the losers to just 100c, we’ll come out ahead. So back to the be­gin­ning. Trad­ing is about prob­a­bil­ity and we trade when our sys­tem says that prob­a­bil­ity may be in our favour. As long as we con­trol how much we lose in the los­ing trades, we’ll come out ahead. No rocket sci­ence is re­quired, just a plan and dis­ci­pline.

Trad­ing is about prob­a­bil­ity; it is very im­por­tant that we ac­cept we can­not know the out­come of a trade be­fore it is com­pleted.

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