Monday, May 19, 2014

Cutting Losses and Letting Profits Ride

Hundreds of trading books throughout the ages have repeated the phrase "cut losses and let profits ride".  Interviews with top traders bear witness to the fact that trading is about cutting your losses short and allowing your profitable trades to remain open.  Rather than simply trusting these individuals, we should seek to understand the rationale behind this rule of trading.

The markets are essentially random.  A trend will occasionally emerge from market noise, but on average, most trading signals are false.  This does not mean that it is impossible to make money in the markets, however.

Think about this.  Let's say that you are trading a strategy in which you are able to, at most lose 1%, but are able to keep winning trades open indefinitely.  In other words, when you're wrong, you lose 1%, but when you are right, you can win magnitudes more.  A trader using this type of strategy will only need to win a handful of trades to more than pay for his losing trades.  For example, if 70% of your trades result in a 1% loss but 30% of your trades result in an average gain of 6%, after several hundred trades, you would be very successful.

Here is a graphic representation of this trader (70% of trades result in 1% loss, 30% of trades result in 6% gain).  This is a random simulation of 100 trades under this strategy.

This is why we should cut our losses short and allow our profitable trades to ride.  The mathematics of trading are simple:

1.  The market is essentially random (most of the time)
2.  You must protect capital by tightly controlling risk because your attempt to predict randomness will fail (most of the time)
3.  You must allow the times that you are correct to more than pay for the times that you are incorrect
4.  Repeat this formula through time

The application is simple - set stop-losses and don't cap your profit potential.

Monday, May 12, 2014

What is the Difference between Investing and Trading?

Over the past several years, I have engaged in multiple conversations (and debates) about the definition and role of investors and traders.  I have encountered several strong opinions on the topic and in this post I will seek to concisely describe the difference between investing and trading.

In The Intelligent Investor by Benjamin Graham (Warren Buffet's professor), Mr. Graham clearly expresses the difference between investing and speculation. "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

These words, from perhaps the most qualified individual to define investment, seem to indicate that anything that does not promise safety of initial investment and satisfactory return is speculation.  There are very few true investments in that I cannot think of a single instrument that promises both safety and return, not even government bonds.  Essentially, if you are in the arena of actively managing your portfolio, you are speculating.

Graham understands this and adds that "outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook".  In other words, if you are a speculator, there is no need to experience illicit feelings, but understand that most people fail in this endeavor.

Trading is a form of speculation.  Trading is the willingness to trade a market on either side without ideological attachment.  In other words, if you are willing to buy, sell, and short a market, you are a trader.  Traders dispassionately examine risk and seek to earn a profit regardless of market conditions.

The Fine Line
According to Benjamin Graham, the "father of value investing", the vast majority of market participants are speculators.  Trading is simply speculation with a willingness to buy or sell either side of the market.  In light of these definitions, much of the dialog and debate between "investors" and "traders" as to the best and most profitable course of action is irrelevant.  Perhaps we should focus on common ground rather than trying to stir up conflict in nuanced definitions.  We are pretty much all speculators in some form or fashion - let's help either other speculate better.

The Role of a Trader

The role of a trader can be reduced to two basic tasks:

1) Manage risk
2) Earn a return

First and foremost, a trader must protect precious capital.  A trader accomplishes this several ways.  First, a trader must know when she or he is "wrong".  In other words, prior to entering a trade, one must decide beforehand where to exit the market in the event of adverse price movement.  Secondly, a trader must establish a criteria for "slowing down".  After a string of losses, no matter how small, one should seriously consider verifying that he or she is trading according to the plan.

It is only after managing risk that a trader is able to focus on earning a return.  The allure of the markets is deceptive.  Many flock to trading seeking profit, but the vast majority of individuals fail.  In my opinion, the primary reason for this failure is a lack of proper risk management and an inability to plan and reassess one's edge.