Thursday, November 28, 2013
Success in trading (or investing or gambling or any kind of speculation for that matter) is primarily the mastery of balancing risk versus reward against probability of win. A buyer of a lottery ticket makes a rational choice of wagering a nearly zero-impact amount on a potential windfall of low probability. A casino gambler is essentially in it for the thrill and may choose to do something similar (bet on number 6 on roulette or bet on red) to maximize gains on a low probability but much more realistic than the lottery buyer.
A trader should aim to only trade when a win far outperforms the losing trade by probability. This means that if on an average if you have a 50% win rate, your wins have to be at least larger than your losses by just a bit. The larger your wins compared to your losses, the steeper your account growth. You should typically only trade when your wins are expected to be twice as large as your losses. This will enable you to be a break-even trader with 33% win rate.
Your win rate depends on your skill of course, but more importantly, it depends on how the price action is unfolding. In a very strong trend, taking with-trend trades is a good win/loss ratio regardless of the probability of success. This is why sometimes in a strong trend, its ok to re-enter right after you were stopped out (as long as the trade was in the direction of the trend).
The worst time to trade is when your win/loss ratio is poor even with high probability of success. Today's price action reflects such a day. When the bars are small and doji-ish and the swings are small, its unlikely you will make huge profits on runaway trends. Even your scalps may fail despite the patterns you expected playing out as predicted.
Therefore the first lesson in profitability is to be able to simply recognize chop and sit out.