CALIBRATE YOUR RISK AND REWARD
What we see is that small edges over time add up. When the small edge is negative, as in the case of Trader A, the average portfolio loss over 100 days is around 3 percent. When the edge is positive, we see that Trader B averages a 100-day gain of about 3 percent.
Clearly, it doesnt take much to turn a modest positive edge into a modest negative one: the distance between 52 percent and 48 percent winners and the difference between a win size that is 10 percent smaller versus larger than the average loss size are not so great. Just a relatively small change in how markets move, how we execute our trades, or how well we concentrate and follow our ideas can turn a modest winning edge into a consistent loser.
You dont need to have a large edge to run a successful trading business; you do need to have a consistent edge.
Had we tracked results every single day, we would have found that Trader A had some winning days and Trader B had some losers. Over a series of 100 days, however, the edge manifests itself boldly. There are no scenarios in which Trader A is profitable and none where Trader B loses money. Just as the edge per bet in a casino leads to reliable earnings for the house over time, the edge per trade can create a reliable profit stream when sustained over the long run. Once you have your edge, your greatest challenge as your own trading coach is to ensure your consistency in exploiting that edge, every day, every trade.
But lets take the analysis a step further and explore risk and reward. Our Traders A and B are not great risk takers: they are only trading one ES contract for their $20,000 account. This provides them with average daily volatility of returns approximating 50 basis points, which is not so unusual in the money management world. We can see, however, that the 3 percent return for Trader B over 100 days would amount to about 7.5 percent per year (250 trading days). While thats not a terrible return, it is before commissions and other expenses are deducted. The consistent small edge does not produce a large return when risk-taking is modest.
So how could our Trader B juice his returns? A simple way would be to trade 3 contracts instead of 1. Assuming that this does not change how Trader B trades, the average daily variability of returns would now be 1.5 percent, with an average win size of $300. The return of over 20 percent per year would now look superior. If you take more risk when you have a consistent edge, this certainly makes sense, just as betting more makes sense at a casino makes sense if the odds are in your favor. You simply need to have deep enough pockets to weather series of losses that are expectable even when you do have the edge. When I ran the scenarios for Trader B, peak to trough drawdowns of $700 to $800 were evident. Multiply that by the factor of 3 and now Trader B incurs drawdowns of 12 percent.
But what if Trader B took pedal to the metal and traded 10 contracts with a small edge? The potential annual return of 75 percent looks fantastic. The potential drawdowns of more than 40 percent now seem onerous. That small, consistent edge suddenly generates large losses when risk is ramped to an extreme.
The variability of your returns will tend to be correlated with the variability of your emotions.
In that aggressive scenario, Trader B would ramp the variability of daily returns to 5 percent. Average daily swings of that magnitude, particularly during a slump, are bound to affect the traders psyche. Once the trader becomes rattled, that small positive edge can turn into a small negative one. Amplified by leverage, the trader could easily blow up and lose everything, all the while possessing sound trading methods.
The size of your edge and the variability of your daily returns (which is a function of position sizing) will determine the path of your P/L curve. Management of that path is crucial to emotional self-management. Your assignment is to utilize Henrys forecaster in the manner illustrated above, using your historical information regarding your edge and average win size to generate likely paths of your returns. Then play with the average win size to find the level of risk, reward, and drawdown that makes trading worth your while financially, but that doesnt overwhelm you with swings in your portfolio.
Few traders truly understand the implications of their trading size, given their degree of edge. If you know what youre likely to make and lose in your trading business, youll be best able to cope with the lean times and not become overconfident when things are good. Match your level of portfolio risk to your level of personal risk tolerance for a huge step toward trading success.
Doubling your position sizing will have the same effect on the path of your returns as keeping a constant trading size when market volatility doubles. This process is a dilemma for traders who hold positions over many days and weeks, but is also a challenge for day traders, who experience different patterns of volatility at different parts of the trading day. It is common for traders to identify volatility with opportunity and even raise their trading size/risk as markets become more volatile. This greatly amplifies the swings of a trading account, and it plays havoc with traders emotions. Adjusting your risk for the volatility of the market is a good way to control your bet size so that a few losses wont wipe out the profits from many days and weeks.
THE IMPORTANCE OF EXECUTION IN TRADING
You can have the greatest ideas in the business world, but if theyre not executed properly, they wont be worth much. A great product marketed poorly wont sell. A phenomenal game plan by a top coach wont work on the basketball court if the players dont pass well and cant establish position underneath the basket for rebounds. The quarterback can call a great play, but if the line doesnt block, the pass will never get off.
So it is with trading: execution is a much larger part of success than most traders realize. The average trader spends a great deal of attention on getting into a market, but its the management of that trade idea that often determines its fate. When you are the manager of your trading business, you want to focus on day-in and day-out execution, just as you would if you were running your own store.
A trade idea begins with the perception that an index, commodity, or stock is likely to be repriced. For example, we may perceive that a stock index is trading at one level of value, but is likely to be trading at a different level. Our rationale for believing this may be grounded in fundamentals: at our forecasted levels of interest rates and earnings growth, the index should be trading at X price rather than Y. Our rationale might be purely statistical: the spread between March and January options contracts on the index is historically high and we anticipate a return to normal levels. Too, we may use technical criteria for our inference: the market could not break above its long-term range, so we expect it to probe value levels at the lower end of the range. In each case, the trade idea takes the form: Were trading here at this price, but I hypothesize well be trading there at that price.
What this suggests is that a fully formed trade idea includes not just an entry setup, but also a profit target. Too often that target is not made clear and explicit, but still it lies at the heart of any trade idea. A trade only makes sense if we expect prices to move in an anticipated way to an extent that is meaningful relative to the risk we are taking.
Just as businesses set target returns on their investments, traders target returns on their trade ideas.
It is in this context that every trade is a hypothesis: our belief regarding the proper pricing of the asset represents our hypothesis, and our trade can be thought of as a test of that hypothesis. As markets move, they provide incremental support for or disconfirmation of the hypothesis. That means that, as trades unfold, we either gain or lose confidence in our hypothesis.
Any good scientist not only knows when a hypothesis is supported, but also when it is not finding support. A hypothesis is only meaningful if it can be objectively tested and falsified. The outcome that would falsify our trade hypothesis is what we set as a stop-loss level. It is the counterpart to the target; if the target defines the possible movement in our favor, the stop-loss point captures the amount of adverse movement were willing to incur prior to exiting the trade and declaring our hypothesis wrong.
The trader who lacks clearly defined targets and stop-losses is like the scientist who lacks a clear hypothesis. You can trade to see what happens, and scientists can play around in the laboratory, but neither is science and neither is likely to prove profitable over the long run. A firm hypothesis and objective criteria for accepting or rejecting the hypothesis advances knowledge. Similarly, a clear trading idea and explicit criteria for validating or rejecting the idea can guide our market understanding. Frequently, if you get stopped out of a seemingly good trade idea you can reframe your understanding of what is going on in the market. After all, scientists learn from hypotheses that are not confirmed as well as those that are.
With the target and stop-loss firmly in mind, we now have the basis for executing our idea. Good execution mandates that we enter the trade at a price in which the amount of money we would lose if we were wrong (if were stopped out) is less than the amount of money that we would make if we were right (if we reach our target). When traders talk about getting a good price, this is what they mean: they are entering an idea with relatively little risk and a good deal more potential reward. A good way to think about this is to think of each trade as a hand of poker: where we place our stoploss level reflects how much were willing to bet on a particular idea.
Many traders make the mistake of placing stops at a particular dollar loss level. Rather, you want to place stops at levels that clearly tell you that your trade idea is wrong.
Lets say my research tells me that we have an excellent chance of breaking above the prior days high price of $51 per share. We are currently trading a bit below $49 after two bouts of morning selling took the stock down to $48, which is above the prior days low of $47.50. A news item favorable to the sector hits the tape and I immediately buy the stock at $49, with $51 as my immediate target. My hypothesis is that this news will be a catalyst for propelling the stock higher, given that earlier selling could not take out yesterdays low. Im willing to lose a point on the trade (stop myself out at $48) to make two points on the idea (target of $51).
Suppose, however, that the stock was trading at $50, rather than $49 when the news came out. Now my risk/reward is not weighted in my favor. If Im willing to accept a move back to $48 before concluding Im wrong, I now have two points of potential loss for a single point of targeted profit. While the idea is the same, the execution is quite different. It is difficult to make money over the long haul if youre consistently risking two dollars to make one. If, however, youre risking a dollar to make two or more, you can be right less than half the time and still wind up in the plus column.
Good execution means that you calibrate risk as a function of anticipated reward.
Execution provides proactive risk management. If you control how much you can win and lose based on your price of entry, you keep your risk known and lower than your potential reward. You can track the quality of your execution if you calculate the amount of heat you take on your average trades. Heat is the amount of adverse price movement that occurs while youre in the trade. If youre taking a great deal of heat to make a small amount of money, youre obviously courting disaster. When your execution is good, you should take relatively little heat compared to the size of your gains. Your assignment for this lesson is to calculate heat for each of your recent trades and track that over time. This assignment will tell you how successful you are at executing your ideas, and it will provide a sensitive measure of changing risk/reward in your trading. Good execution, psychologically, is all about patience. To get a good price, you will have to lay off some trade ideas that end up being profitable. Like the poker player, you want to bet when the odds are clearly in your favor. That means mucking a lot of hands. Similarly, a business doesnt try to be all things to all people. A business owner passes up certain opportunities to sell products in order to focus on what she does best. When youre running your trading business well, you dont take every conceivable opportunity to make money; you wait for your highest probability opportuni
ties. The clearer you are about risk and reward, the easier it will be to stick to trades that offer favorable expected returns.
A simple rule that has greatly aided my executions has been to wait for buyers to take their turn if Im selling the market and wait for sellers to take their turn before Im buying the market. Thus, I can only buy if the NYSE TICK has gone negative and if the last X price bars are down. Similarly, I can only sell if the NYSE TICK has gone positive and the most recent X price bars have been up. This reduces the heat I take on trades by entering after short squeezes and program trades juke the market up or down. Once in a while youll miss a trade if you wait patiently for the other side to take their turn, but the extra ticks you make on the trades you do get into more than make up for that.