Month: May 2015

I am currently listening to “The Virgin Way” audiobook by Richard Branson. One of the more interesting stories so far covers the subjects of good luck and good judgement.

And then there are those other serendipitous situations that come along once in a life time, where being in the right place at the right time can present an opportunity that doesn’t require a preparation to take an advantage of it. When that happens, it falls to the individual’s ability to recognize a situation for what it is and seize the moment.

My friend, let’s call him Antonio, was raised in Santiago, Chile and eventually attended California’s prestigious Stanford University, where he would earn a post-graduate degree in business administration and behavioral sciences. One day, while he was attending Stanford, Antonio was waiting on a long line outside of a movie theater, when he and the stranger next to him were told that the show was sold out and they’ll have to come back another day. The two of them struck a conversation and with some unanticipated free time on their hands, ended up going for a cup of coffee together. Over coffee, Antonio asked what the stranger, who was also attending Stanford, was up to. Antonio was told that he and a fellow student were working on a research project that has something to do with search engines. As they parted company, the stranger handed a copy of his research paper and suggested he read it over so they could talk more the next day. Antonio said he tried reading the highly technical document at night, but the bulk of it was all about algorithms and way over his head. He was however highly intrigued with the object of the exercise, which was to organize a vast amount of information on the web according to the popularity of the pages. In short, it struck his as an idea that had a lot of market potential. When Antonio met up with his new friend the next day, he asked how he could get involved. He was told they were in the early stages of raising capital to launch their business, that it was valued at a million dollars and they’d love to have him as an investor. In what was to become the watershed moment in his life, Antonio responded by saying – “Well, I have $10,000 that was intended for a second-hand car, but I might consider putting it into your company instead. What could that get me?” He was told it would give him a 1% ownership stake. And so they agreed that they had a deal. If you haven’t guessed by now, the student Antonio was speaking to was Sergey Brin…

A counter-point to my friend Antonio’s story is that of Ronald Wayne. Wayne had worked alongside Steve Jobs at Atari and became of the co-founders of Apple, along with Jobs and Wozniak. At 40-years of age, Wayne was almost twice older than his co-founders, so he agreed to essentially add as the venture’s adult supervisor, in return of which he was given a 10% stake in the company. Among other things, Wayne drew the partnership agreement between the three, drafted the company logo and wrote the Apple I manual. For a variety of reasons however, Wayne didn’t just feel comfortable that things are going to work out. He also didn’t particularly enjoyed working with Jobs. And so, after only a couple of months, Wayne called it quits and relinquished his stock in the company for a one-time payout of eight hundred dollars…Was it bad luck or bad judgement? Maybe a bit of both, but I’ll let you make up your own mind on this one.

My Chilean friend was no Ronald Wayne and has been astute enough never to sell a single Google share. He never got the used car, but that $10,000 is now worth billions. Suffice it to say that luckiest thing to ever happened to him is that Antonio went to see a popular movie in a small theater. Had there been just two more sits left, his life would have been very different. But in terms of making the luck work for him, he had to have the smarts to recognize an opportunity when it came along and greater, still the gut to risk his $10,000 (about all he had at the time) on a couple of young fellow students with a dream. This one I’d certainly put down to a combination of good luck and good judgement – two elements that the sum of which will always be greater than the whole.

When an event repeats frequently, it becomes a pattern. A pattern, in which a lot of people wholeheartedly believe in and act upon. Buying oversold dips in the major indexes has been very lucrative in the past few quarters. Even more so, in the past few months, which have been a poster child of range-bound markets. Will the current dip be any different? No one really knows. There are some good reasons to believe so:

– seasonality;

– poor reaction to decent earnings reports;

– lack of great long setups;

When in doubt, stay out. When there are both good bullish and bearish arguments, it is better to give priority to capital preservation. If we flatline our equity curve during choppy periods by minimizing our drawdown, we could grow our capital a lot faster. Here’s a chart from a book I published last year – The 5 Secrets To Highly Profitable Swing Trading.

I truly believe that knowing when to be out of the market is the single most valuable trading skill anyone could develop. Why do I think so? Because, when markets are trending most setups work, most breakouts work and have a decent follow-through, it is a lot easier to make money. When markets are choppy, everything turns upside down and it is becomes difficult not to lose money. Be aggressive when it pays to be aggressive. Make sure you don’t give back most of your gains when the market environment worsens for your approach. For better of for worse, financial markets are one of those business fields, where working smart always trumps working hard.

What does it take to achieve 20% return in a year?

Let’s make a few assumptions first. Then we are going to elaborate on why and how.

Initial assumptions:

60% win rate; therefore loss rate is 40%
average winner: 10%
average loser 5%
average position size (capital allocation) = 7%
average holding period = 5 days

What is the average contribution of each trade taken under this approach:

Capital allocation * [(win rate*average winner)-(loss rate*average loser)]

7%*[(0.6*10%)-(0.4*5%)] = 0.28%

The average contribution per trade is 0.28% of total capital.

This means that in order to achieve 20% annual return, we need to take 20%/0.28% = 71 trades per year

Or about 1.4 trades per week

There are 5 Major Ways To Improve Our Performance:

1) Improve our win ratio – some might say that at 60% it is already too high and there is not a lot of room left for improvement. The win ratio is not static. It could change substantially over the year, depending on the market environment. If you know that under certain circumstances your win ratio drops below 50% and your average winner becomes smaller than your average loser, with other words your system loses its edge – then it makes sense not to trade at all during such environment.

For arguments sake, let’s assume that you could drive your win ration to 70%, while keeping all other factors the same:

The average contribution per trade becomes: 7% [(0.7*10%)-(0.3*5%)] = 0.39%

To achieve the same 20% return, you will need to take about 51 trades or about 1 per week.

If you take 71 trades under the same system, your annual return should be about 27.7%

2) Increase the average size of our winners – it depends on market environment and holding period. Increasing the size of winners might requires using wider stops and therefore increase the average size of our losers. Holding longer might decrease the overall number of trades we could take.

For arguments sake, let’s assume that your average winner become 12% and everything else remains the same.

The average contribution per trade becomes: 7% [(0.6*12%)-(0.4*5%)] = 0.36%

To achieve the same 20% return, you will need to take about 55 trades per year.

If you take 71 trades under the same system, your annual return should be about 25.5%

3) Decrease the average size of our losers – it is already pretty low. Using tighter stops might hurt our win ratio and take us out during normal market fluctuations.

4) Trade more – when you trade a system with positive expectancy, more trades equal higher overall profits.

For example, if we take 200 trades or about 4 per week under the original assumptions, the annual return would be 56%

This is derived from average contribution per trade of 0.28% * 200 trades

Of course, trading more might lead to a decline in our win rate and in our average winner. Also, our system might not produce as many trade signals. Also, trading more has very steep opportunity cost – the time you spend trading actively is a time you could spend doing something else, which could be another source of income.

5) Allocate more per idea: the original assumption was for 7% capital allocation per idea. With the average loser at 5%, this means that our average loser is eating 0.35% or 35 basis points of the total capital.

If we bump the average allocation to 15% and everything else remains the same, then

the average contribution per trade becomes: 15% [(0.6*10%)-(0.4*5%)] = 0.6%

To achieve the same 20% return, you will need to take about 33 trades per year.

If you take 71 trades under the same system, your annual return should be about 42.6%

Capital allocation doesn’t need to be the same – it could vary depending on the asset, the market environment and the overall risk you would like to take. As a general rule, using tighter stop losses increases your position size, but it is also likely to decrease our win ratio. You have to find the best system for your life style and experience.