If you are like me and don’t trade full time for a living, your goal is different. Your objective is to make more than the riskless rate of return (i.e., the amount you could earn, say, from a savings bond or bank certificate of deposit) after expenses. In that case, you allocate a portion of your savings to your trading account and use that portion of your money to improve returns from other investments and savings vehicles. This process means that you will be particularly sensitive to risk-adjusted returns, as you won’t want to place your savings at undue risk. Trading, in that context, is part of diversification of your capital and is part of a larger financial plan.
Your business plan will look different if you’re trading as an avocation rather than as your vocation.
If you’re trading for a living, then you’re truly in the mode in which your trading is your business. A retail business needs to know how it will make money: what products they will sell, how they will sell them, how much it will cost them to sell them, and how much they can charge for them in order to make an acceptable return on investment. In your trading business, the questions become:• What will you trade and how will you trade it? What simulated and live trading experience tells you that this will be successful?
• What will your overhead be? This includes software, hardware, commissions, and other expenses related to full-time trading, from the cost of data to your electronic connections and educational materials.
• How much can you expect to make per trade? Per month? Per year? What is the likely variability of your income? Will this be manageable?
These questions require hard data based on experience, not guesses or hopes.
Before you attempt to trade for a living, you should have a sufficient base of experience to tell you four things:• What is the average size of my winning trade?
• What is the average ratio of my winning trades to losing trades?
• What is my average percentage of winning versus losing trades?
• What is my average variability (volatility) of returns per day, week, and month?
The answers to these questions will determine the likely path of your returns: the income generated from your trading business. These questions lead you to ask other questions:• What kind of trader am I: do I tend to make money by being right more often than wrong, by having larger winning trades than losers, or a combination of the two?
• How much variation in my winning percentage and in the ratio of the size of winners versus losers is normal for me?
• How large would my trading need to be to generate acceptable returns and how much capital would I need to support that trading without undergoing drastic swings?
It is surprising—and dismaying—how few traders really look under the hood of their trading to understand how they make money. Because traders don’t have a grasp on how they perform on average and how much variation from average can be expected, they are poorly equipped to distinguish normal drawdowns from troublesome slumps. They are also in a poor position to identify those occasions when the patterns of their returns shift due to changing markets.
If your trading experience does not extend to a variety of market cycles and conditions, your trading business will be ill prepared to weather shifts in volatility and trend.
Your assignment for this lesson is to go to Henry Carstens’ Vertical Solutions site (www.verticalsolutions.com/tools.html) and check out his two forecaster tools, using your own trading data as inputs. His first tool will show you how the path of your returns will vary as a function of changes in volatility. These volatility shifts could be attributable to market changes or to your taking more risk in each of your trades. You’ll see clearly how much drawdown is associated with a given level of volatility, which will help you gauge your own tolerance.
The second forecaster tool asks you to input the average size of your winning trade, your average ratio of winning to losing trades, and the ratio of the size of your average winners to losers. Run the forecaster many times with your data and you’ll see a variety of plausible sets of returns. This will give you a good sense for the expectable runs (to the upside and downside) in your trading, as well as the expectable returns over a 100-trade sequence.
Finally, tweak the parameters from the second forecaster to simulate the paths of possible returns if your average winning trade shrinks (maybe due to slow markets) or if your ratio of winning to losing trades declines (perhaps because of misreading markets). Tweak the ratio of the size of your average winners and losers to see what happens to your returns if you lose discipline and hold losers too long or cut losers short, creating poor risk/reward per trade.
All of these what-if scenarios will give you a good sense for what you can expect from your trading. It is much easier to deal with business adversity if you’ve planned for it in advance. When you’re coaching yourself, the more you know about your trading business, the better you’ll be able to make it grow.
COACHING CUE
An important element of success in building a trading career is being able to identify periods of underperformance as quickly as possible, before they create large drawdowns. The more you know about your trading—the average sizes and durations of drawdowns and the variability around those averages—the better prepared you’ll be to identify departures from those norms. Keep statistics on your trading so you can also highlight periods in which you’re trading particularly well and learn from these episodes. The single most important step you can take to further your trading performance is to keep detailed metrics on your trading. These steps will highlight what you’re doing right and wrong, informing your self-coaching efforts.
LESSON 73: DIVERSIFY YOUR TRADING BUSINESS
Suppose you have a passion for coffee and decide to start your own coffee-house as a business. You develop reliable sources for high quality beans, purchase a roaster, and rent space in a well-trafficked area. You furnish the cafe’ attractively and purchase all the cups, saucers, and utensils you will need. Altogether you sink $100,000 into your new enterprise, which is loaned from a bank with your home as collateral. Your average cost to serve a cup of coffee, just based on materials and labor expenses alone, is 50 cents. At $1.50 per cup, you’re making a dollar for each cup you sell. At 300 customers per day, that’s $300 per day or about $90,000 per year. That doesn’t leave you with much to take as a salary once you pay off your overhead.
In this scenario, you can only make a go of the business by increasing the number of customers coming to the cafe’, by increasing the average expenditure per customer, or both. So let’s say you try to increase the average check size per customer by adding something additional to the menu. In addition to coffee, you now also serve tea.
Unfortunately, this doesn’t help your business greatly. A few more customers enter the cafe’ who are tea drinkers, but few customers order both coffee and tea. As a result, you’ve increased your overhead (for tea equipment and supplies), but haven’t greatly added to the bottom line. Tea overlaps coffee too much to add much to the menu; it doesn’t really diversify the offerings of your cafe’.
Suppose, however, you add pastries to the menu, sourcing them from a local bakery. Now you find that many people interested in your coffee also like a pastry to go with their drinks; this increases the size of their checks and enables you to make profits from two sources instead of one: the beverage and the pastry. You also now attract people who are interested in a snack or who just want a bite to eat after a concert or theater. The increased traffic also adds to the bottom line.
What has happened is that you’ve made your business more diversified . You have multiple profit centers, not just one. If you offered evening entertainment, sandwiches, and breakfast items, you would be even more diversified. Instead of attracting 300 patrons per day at one dollar each, you might attract 800 a day at $2.50 each. With $2,000 a day of gross income after labor and materials costs, you now have the basis for a thriving business. Moreover, should a cafe’ open elsewhere in the neigh
borhood, your business will be protected because of its other unique offerings.
Diversification leverages talent.
The same business principles that impact the viability of the cafe’ apply to trading. When you trade different markets, time frames, and patterns, you generate multiple potential profit sources. This protects you when markets shift and place any single idea or pattern into drawdown mode. It also leverages your trading productivity, as you now can generate profits from many centers instead of a very few.
There are many ways of diversifying your trading business. If you are an intraday trader, you’ll be diversified by trading long and short and by allocating your trades to different stock names and/or sectors. You may also hold some positions overnight, creating a degree of diversification by time frame as well. If you are trading over a longer time frame, you may trade different markets or strategies, each with different holding periods.
The key, for the trader as well as the cafe’, is to make sure that diversification truly adds diversity. Adding tea to a coffee menu did not achieve adequate diversification for the cafe’. Adding a Dow trade to an S&P 500 trade similarly fails to add unique value. Your diversification should provide a truly independent and reliable income stream. When the coffee business is slow, for example, customers may come to the cafe’ for a bite to eat. This keeps the flow of customers strong through the day. Similarly, when one of your trading strategies is drawing down, other ones that are not correlated can sustain the flow of profits to your account.
Of course, when you diversify, you need to make sure you stay within your range of expertise. Adding fresh entre’es to a menu would make little sense for a cafe’ owner who lacked cooking skills. Similarly, it doesn’t help your profitability as a trader to add strategies that are not well tested and known to be successful. Diversification only makes sense when it adds unique value to what you’re already doing.
Many beginning traders think they’ll find a way of trading that is profitable and then trade that for a career. Rarely are markets so accommodating. If a cafe’ brings in a huge number of customers, you can be sure competitors will soon follow. If a trading strategy is successful, it will find wide interest. Successful businesses must always innovate, staying ahead of the competitive curve. Adding new sources of revenue to exploit changing markets is essential to long-term survival.
I cannot emphasize this strongly enough: markets change. Edges in markets disappear. Trends change. The participants in markets change. The themes that drive markets change. The levels of volatility and risk in markets change. I have heard many promoters hype trading methods that they claim are successful in all markets, but I have yet to see documentation of such success. Every trader I have known who has sustained a long, successful career has evolved over time, just as successful businesses evolve with changing consumer tastes and economic conditions. Quite a few traders I’ve known who have been successful with a single method have failed to sustain that success when that strategy no longer fit market conditions (momentum trading of tech stocks in the late 1990s) or when it became so overcrowded that the edge disappeared (scalping ticks on the S&P 500 index by reading and gaming order flow). It’s difficult to learn how to trade; even harder to unlearn old ways and cultivate new ones.
The successful trading business, like elite technology, pharmaceutical, consumer, and manufacturing firms, devote significant resources to research and development: staying ahead of their markets.
When you are your own trading coach, it’s not enough to learn markets. You’re an entrepreneur; you’re always developing new strategies, new ways of building upon your strengths. What products do you have in your pipeline? What markets, strategies, or time frames are you looking to expand to? You can adapt your current trading approaches to new markets or cultivate new strategies for familiar markets. Your challenge is to develop a pipeline: to always be innovating, always searching for new sources of profit that capitalize on what you do best.
Many traders sit down at their stations a little before markets open, trade through the day, and then go home, repeating the process day after day. That schedule is like coming to work at your cafe’, putting in your hours, and then going home until the next workday. That is what you do if you’re the employee of the business, not the owner. Your challenge, as your own coach, is to actively own and manage your trading business, not just put in hours in front of a screen. You need an edge to succeed at trading, but you need to develop fresh sources of edge to sustain your trading business.
COACHING CUE
I find there is value in learning trading skills at time frames different from your own. Short-term, intraday traders can benefit from looking at larger market themes that move the markets day to day, including intermarket relationships and correlations among stock sectors. If you identify those themes and relationships you can catch market trends as they emerge. Conversely, I find it helpful for longer-term traders, portfolio managers, and investors to learn the market timing perspectives of the short-term trader. This process aids execution, helping traders enter—and add to positions—at good prices. The views from different time frames can fertilize the search for new sources of edge: the perspectives of big-picture macro investors and laser-focused market makers can add value to one another.
LESSON 74: TRACK YOUR TRADING RESULTS
You cannot coach your trading to success if you do not keep score. Keeping score is more than tracking your profits and losses for the day, week, or year. It means knowing how you’re performing and how this compares with your normal performance.
Score keeping makes sense if you once again think of your trading as a business. A sophisticated retail clothing firm tracks sales closely every week. Retailers know not only how much they’ve sold in total, but how much of each product. Perhaps the economy is slow, so women’s accessories—which are lower-priced—are hot, but high-priced clothing is not. The company that tracks these trends regularly will be in the best position to shift their product mix and maximize profits. Similarly, if one store is dramatically underperforming its peers despite a favorable location, managers can use that information to see what might be going wrong at the store and make corrections.
Score keeping in the business world can be extremely detailed. There are good reasons for the investments in information systems that we observe among the world’s most successful corporations. Firms may track sales by hour of the day to help them determine when to open and close. Purchasing patterns based on gender and age are factored into advertising messages and promotional campaigns. Score keeping provides the business with knowledge; in the business world, knowledge utilized properly is power.
You can’t properly manage your business if you don’t understand what it is doing right and wrong.
Nowhere do we see this power more dramatically than in quality control. Firms such as Toyota collect reams of data on their manufacturing processes to help them identify lapses in quality, but also to make continuous improvements in manufacturing processes. If you don’t collect the data, you can’t establish the benchmarks that enable you to track progress. It’s not just about ensuring that you do well; the best businesses are driven to do better.
When you keep score in your trading business, a few metrics are absolutely essential. These include:• Your equity curve, tracking changes in portfolio value over time.
• Your number of winning versus losing trades.
• The average size of your winning trades and the average size of your losers.
• Your average win/loss per trade.
• The variability of your daily returns.
Let’s take a look at each metric in a bit of detail.
Equity Curve
Here you’re interested in the slope of your returns and changes in the slope. As we saw with Henry Carstens’ tools that simulate trading returns, a great deal of directional change in your portfolio can be attributed to chance. For that reason, you don’t want to overreact to every squiggle in your
equity curve, abandoning hard-won experience. Too many traders jump from one promised Holy Grail to another, shifting whenever they draw down. A far more promising framework for your self-coaching is to know the equity curve variation that is typical of your past trading, so that you can compare yourself against your own norms. If you have learned trading properly, you will have a historical curve of your returns from simulation trading and small-size trading before you begin trading as an income-generating business. When your current equity curve varies meaningfully from your historical performance, that’s when you know you may need to make adjustments. If the variation is in a positive, profitable direction, you’ll want to isolate what is working for you so that you can take full advantage. If the variation is creating outsized losses, you may need to cut your risk (reduce the size of your trades) and diagnose the problems.
Knowing your normal performance is invaluable in identifying those periods when returns are significantly subnormal.
Winning Versus Losing Trades
This is a basic metric of how well you’re reading markets. Again, the emphasis is not on hitting a particular number, but on comparing your current performance to your historical norms. Let’s say, for instance, you’re a trend follower. You tend to make money on only 40 percent of your trades, but you ride those winners for relatively large gains compared to your losers. If your win percentage suddenly drops to 25 percent, you’ll want to diagnose possible problems. Has your market turned choppy and directionless? Have you altered the way in which you’re entering trades or managing them? The more the drop to 25 percent is atypical of your historical trading, the more you’ll want to enter a diagnostic mode. If, however, you’ve had past periods of 25 percent winners just as a function of slow, directionless markets, you may choose to ride things out without making major changes in your trading simply by focusing on markets or times of day with greater opportunity.
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