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Hi,
Many on this forum seem to trade stocks.
Many of my clients trade stocks, but some had reward to risk ratios that
were lousy and they were often unaware that they were lousy.
It seems that the kind of person who tends to be attracted to trading
individual stocks is less likely than other traders to steadily increase
their reward to risk ratio.
So how does a stock trader increase their reward to risk ratio? Many ways
- this is just one story of one trader.
This is a case study. For reasons of confidentiality, the trader name,
family history and even the particular stocks traded have been changed.
Tom was a very successful stock trader. He has built his trading to the
point where he can live on the profits easily. It was not always this
way.
He first asked for coaching assistance because he did not like the run of
three losing months he had one autumn.
His personal history was one we are all thankful is not our personal history.
His parents died together in a car crash and Tom lost his wife to cancer
two years later. Fortunately, the rental income from his parents
property allowed him to retire early and look after his two daughters (then
aged 6 and 9) full-time at home.
It also gave him the capital and opportunity to trade from home - trading
had been a passion that had been on hold when building a family and in a
full-time selling job that saw him in hotels 60 nights a year.
Tom had found that he had good skills at timing purchases of stocks,
eventually honing his skills in two stocks in particular.
He always traded from the long side and had built up his skills to the
point that he rarely had a losing month. So when three losing months in
a row occurred in 1997, he looked for help.
We will call the two stocks Tom traded Intel and IBM for this helps smooth
the discussion. In reality they were stocks in the Nasdaq and DOW but not
Intel and IBM.
Tom had traded Intel for years. Most of his profits came from
Intel. It was quite a shock to lose money at Intel 4 months in a row (IBM
came to the rescue in the first month).
He had never had even two losing months in a row before.
Using a very simple starter spreadsheet, I got Tom to use his trading log
to compare his history of Intel trades with the performance of the Nasdaq
100 index for each period of his open trades.
The results were amazing. He out-performed the index in 56 out of 63
trades.
The further analysis was even more amazing - his out-performance was 0.8%
per trading day over and above any movement in the benchmark index.
This might not sound much, but over his average two week holding period,
this meant if his stock was priced at 100 when he bought it, he would sell
it at 108 plus or minus any percentage change in the Nasdaq.
So what? An opportunity to increase the reward to risk ratio - that is
what. Over half of the periods that Tom held Intel, the Nasdaq was
falling, eating into his profits. Most of the 7 losing trades were in
periods of big market falls - in all but one of his trades Intel
out-performed the index.
I suggested that he had impressive out-performance skills for Intel trading
- he was was not just riding on the back of a rising market. So if he
had traded Intel and sold an equivalent amount of the index, his results
would have been:
- slightly lower overall profits,
- only one losing trade out of 63 trades,
- dramatic increase in reward to risk ratio,
- no period of three losing months.
He could slowly and steadily leverage his improved reward to risk ratio and
the accumulating profits to increase his trading size to make his profits
higher than before with lower risk. His broker turned out to be
supportive and he has trebled his average monthly profit in Intel.
But what about IBM? Another story completely. The same analysis
showed that his IBM purchases, although profitable rarely out-performed the
DOW. In fact, if he had bought an equivalent value in the DOW for each
holding period of IBM, he would have made more money.
For reasons that will become apparent, I asked Tom to compare his IBM
results with the Nasdaq 100. The results were similar (surprising to me)
- buying the Nasdaq instead of IBM would have yielded twice the profit overall.
So I then asked Tom how often he held positions in Intel and IBM at the
same time - the answer was about 20% the time he bought Intel, he also
bought IBM and typically held them for the same time.
So I suggested he could increase his reward to risk ratio further by:
- buying the Nasdaq whenever he would have bought IBM,
- using this, 20% of the time to partly offset his short Nasdaq
position taken when trading Intel. (His IBM trades had been smaller)
When he back-tested this approach, his reward to risk ratio nearly doubled
again.
In practice, Tom found that his actual results were 15% better than the
back-tested results, but he could not imagine going back to just trading
stocks.
Some time later, now that his IBM profits were higher (using Nasdaq
instead), I suggested he could slightly increase his reward to risk ratio
by increasing the offset he used (equivalent to increasing trade size in IBM).
I was most pleased to discover that Tom had not only thought of this, he
had implemented this and two other techniques to improve his reward to risk
ratio to the point where he was making 7 times his original profits, while
his risk of ruin (an idea he just loved) had actually fallen.
His comment summed it all up "I cannot believe I was dumb enough to trade
the way I did."
Unconditional regards, Ric.
www.traderscalm.com
P.S.
Still think your time is well spent talking about individual planned or
actual trades?
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