The business of trading is based on the ability of the trader to manage their risk and maximise their returns. Treat your investing as a business activity by changing the way you think about approaching your investments.
Many people believe that trading successfully is similar to gambling. There is a huge difference between a gambler and a trader. A gambler will risk everything to achieve a given result, whereas a trader will take a calculated risk for a return. Betting on red or black at the roulette table means either you double your money, or you lose everything, with the green slot ensuring that over the long term you will lose. There are professional card players that go to the casino and play to a simple strategy which gives them an edge over the casino. They know the number of cards that are being used and the probability that a certain card will come up. Using this knowledge they improve their returns by betting accordingly. If they are very good the casino will throw them out. Fortunately this does not happen in the stock market.
Trading on the Toss of a Coin
Consider a simple game of chance, where you toss a coin 100 times. If it is heads you will lose your $1 bet and if it is tails you will win $1. On average this game should result in neither a gain nor a loss. But take a look at this chart made from one set of random outcomes.
There are times when this strategy is profitable and times when this strategy loses money. The worst case situation is a loss of -$5 and the best case for this series of throws is +$4. It is possible to make money playing this game; provided that you have a large enough amount of capital to trade through the down times. In this case you must have at least $6 to keep playing as you need to have enough to continue playing even after a loss of $5. A trading strategy like the one above will only benefit the broker long term as it does not have a consistent edge. As a trader you would like to skew the odds in your favour.
A simple way to do this is to practice a money management strategy. This time with the same results you could allocate your capital differently. Start with a $1 bet and if you lose, bet $1 again. If you win double up and bet $2. If you lose bet $1 and if you win again double up and bet $4. One more time, if you lose bet $1 and if you win double up and bet $8. Then start again betting $1 a time. Your capital must be at least 20 times your bet size, in this case $20, and when you have doubled your capital, take your profits and stop playing. The chart below shows the outcome of this strategy.
The drawdown in capital is larger than in the first game, but within the limits of your capital. During the 100 throws you do meet your profit objective and double your money. This uses a money management strategy to ensure firstly that you can survive the inevitable downturn in your results and secondly to take advantage of a winning streak and exit with your profits. Risk management is an important part of your trading strategy.
By Jeff Cartridge