Know Your Odds Before You Trade By Lawrence Chan Second Edition potx

Know Your Odds Before You Trade By Lawrence Chan Second Edition, April 2012 Copyright Lawrence Chan 2010-2012 Smashwords Edition License Notes: Permission is given to copy, distribute, repost, reprint, and share this free eBook provided it is presented in its entirety without alteration and the reader is not charged to access it. Also by Lawrence Chan, available now and soon at ebook retailers everywhere: Special Theory of Price Discovery Market Bias Detective: S&P 500 Daytrading Time Map Vol. 1 & 2 Market Bias Detective: ForexDaytrading Time Map Vol. 1 Market Bias Observer Newsletter ~~~~ Disclaimer Limit of Liability / Disclaimer of Warranty: While the author and the publisher have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN. ~~~~ Preface Second Edition Many readers who read the first edition of this book told me that they recommended this book to their friends and loved ones either troubled by trading, or interested in trying out their hands on trading. Many of these individuals have no clue of what they are getting into. Somehow my way in relating the subject gets the message through to these individuals even though prior attempts by others have not produced results. I am told that positive changes happened to many of them. If you find it difficult to discuss the issues raised by this book with someone you care about, you can recommend this book to them. Sometimes it is easier for a stranger to bring the bad news. Lawrence Chan Toronto, April 2012 First Edition I have been asked this question way too many times, "How do you beat the market?" Back in the 1990s when I first started out trading on the TSE floor, I was too young and green to give an answer because I was just learning how to trade myself. I wasn’t even qualified to answer the question. When I started trading off the floor, the stressful trading style had such a bad effect on my temper that I never gave the proper answers. Over the years, after having helped many struggling traders, I have come to understand why people ask the question, but the answer is not something that can be delivered in a sentence or two. This short eBook is my sincere answer to this big question. Hopefully, this eBook can help many traders find the answers they need to either stop trading for good or to form a comprehensive plan to overcome their obstacles in trading, and eventually turn the tides in favour of becoming consistently profitable. As opposed to using mathematical formulas or trading systems as the foundation for the arguments, I have chosen a common-sense approach to explain many of the concepts presented in this book. My intention is to help traders, including those who just starting out, to understand the subject better before it is too late. Lawrence Chan Toronto, August 2010 ~~~~ Table of Contents Preface Second Edition First Edition Introduction Odds in Trading What Kind of Odds Are We Talking About Here? Odds of Your Particular Trade Being Profitable Odds of Your Trading Account Being Ruined Odds of a Retail Trader Being Able to Self-Correct Odds of a Retail Trader Mastering the Art of Trading Beating the Odds Practical Success for Retail Traders Not Everyone Has an Equal Start Accepting the Fact That You are Fighting an Uphill Battle Have a Proper Battle Plan When You Fight a War Patience Is a Virtue Equip Yourself with Knowledge on All Aspects Related to Trading Understanding the Importance of Capital Preservation Searching for Your Own Trading Style There Is No Need to Trade Full Time There Are Times You Should Simply Stop Trading Too Much Positive Thinking Is Hazardous to Your Bottom Line Afterword Know Thyself Trading Skills Are Useful Outside of Trading Resources for Aspiring Traders Acknowledgements About Lawrence Chan ~~~~ Introduction To know your odds before you trade is one of the most (if not the most) important concepts that enables a retail trader to survive long enough to acquire the necessary elements needed to achieve trading success in the financial markets. The lesser known fact is that it is equally applicable to any form of risk taking, like buying or selling real estate or running a business. One of the major weaknesses we have as human beings is our inability to properly evaluate various kinds of risk. We may know that getting too close to a lion that is roaming around freely is dangerous. Yet most of us do not understand that the risk of putting our lifelong savings into various trading vehicles is so high that it can ruin our lives in ways we could never imagine. Many people think that they are not trading but are just investing for the long term. That is very much like telling people you are a vegetarian because you only eat chips and drink sodas. These people often call themselves retail investors, a term that makes them feel much better and that gives them an excuse to not learn how to trade properly. Hence, these individuals facie a similar (if not higher) risk of losing all their life savings just like the average person who gambles at the casino addictively. The intention of this book is to introduce retail traders (and investors alike) to the concept of risk and to help them understand their odds of being able to make money from the markets. When investors can recognize the risk involved and understand how the odds are in favour of their failure, only then can they be called an informed trader (or investor) who knows how to trade within the risk that he/she can tolerate. Many trading education books touch on this subject and what I have to say is not something totally new. But no one, in the hope of selling their books, would spend all their efforts on what I am doing here — attempting to convince people to take trading slowly and seriously, explaining in painful detail why they will fail if they don’t. Those who listen carefully and do what is necessary stand a better chance at developing into consistently profitable traders. Hidden in the odds against the traders are clear pathways to success once the traders realize what it takes to beat the odds. The road to consistent profitability is long and rocky, because we are humans and not machines. Whether we like it or not, we are going to be subjected to emotional influences from the outcomes of trading and other unpredictable events. I do believe, however, given time and proper guidance, most people can achieve a reasonable level of consistency in their trading success. Throughout this book I use the word trader interchangeably with the word investor. ~~~~ Odds in Trading Odds, by definition, is the likelihood of one thing occurring more so than another. For example, what do we mean when we say that the odds are that it will rain today? It implies that it is more likely going to rain than not rain today. Notice that we skip the other event (not raining) in the first sentence because there are two possible outcomes in this example: to rain or not to rain. This means that if the odds favour that it will rain, then it is implied that the odds of it not raining are less likely. In trading, however, there can be many outcomes to any given trading position. The trading position you are holding by the time you close out the trade can have many outcomes. It may make a big killing, make good profit, make a tiny profit, not make any money, lose some money, lose big money, or lose more than what is in your trading account. This is the first important fact to remember. As you can see, the odds in trading are complex. There are many factors that affect the outcome of each trade, and accumulatively, on the net profit or loss made by the person throughout his or her life time. Yet most people I encounter think of trading as a one-time event, and that one-time event has only two outcomes — they are either right or they are wrong. By oversimplifying the matter at hand, or, maybe being misled into believing that trading is such a simple thing, the odds of these folks making money from the markets over their lifetime are pretty low. What Kind of Odds Are We Talking About Here? There are many kinds of odds that we can use to describe trading. Here are four that I cover in this book: • Odds of your particular trade being profitable • Odds of your trading account being ruined • Odds of a retail trader being able to self-correct • Odds of a retail trader mastering the art of trading And don't forget that in life there are many other things that can affect the outcome of your trading. We will spend some time on how to minimize the impacts of events that can affect your trading adversely. Are you thinking that I am wasting your time already? Here is a good example of what I mean. You have just closed a trade that is potentially very profitable, and at the exact moment that you are entering your order on your computer, you are disconnected from your broker on the Internet. How does that sound to you? Now, I am going to explain each of the odds listed above in detail. Odds of Your Particular Trade Being Profitable There are many ways to identify a trading opportunity. There is absolutely no fixed rule on what or how a trade is entered. As long as you have done your homework in identifying a trading setup, and you are willing to pull the trigger, you will be sitting on a position. By the time you close your position, the trade is completed. Just how likely it is that you are going to be profitable on a particular trade depends on many factors. This is not something we can tell precisely. However, we can tell easily if the odds are reduced. With less than your ideal state of mind in making your trading decisions, odds of the trade being profitable is lowered. Before entering a trade, there are three elements that can hel p you trade calmly and free of stress. These are knowing exactly what type of risk you are getting into (e.g., using stop orders properly); having a full understanding of the winning probability of such a trade based on the reasoning that gets you into the trade in the first place (e.g., historically how the scenario is likely to unfold, tips you get from a secret source); and knowing that in the worst case scenario this one single trade would not affect your ability to carry on your life or your ability to take the next trade. Anything less than this will make you nervous as the trade develops, introduce mistakes into your decision making, and turn a perfectly good trade into a disaster. I am not talking about being completely numb to the risk that is being taken or not feeling any tension or excitement at all. I am talking about keeping your mind focused on the trade so that you can make sound judgments when they are needed the most. Here is an example. If you have a reasonably stable income and your household cash flow is positive, then buying a lottery ticket is not going to make you lose sleep over the fact that the money you paid for the ticket is very likely to be as good as burned into ashes already. But, if you throw in your life savings into buying all the tickets you can buy, then you are very likely going to feel extremely bad should the tickets not produce enough winnings to cover the cost. A confused plan, without proper preparation of your mind to handle the unavoidable losing streak, is another factor that can lower your odds of being profitable in a trade. A perfectly executed trade can be a losing trade. There is nothing wrong with that IF you already know the exact odds of the potential outcomes. Not accepting the losing side of the potential outcomes of your trades will encourage you to keep looking for the Holy Grail that will improve your trading. The reality is that you have nothing you can improve because you do not have the correct perspective that can help you improve. Trading in a market that is too risky for your tolerance level will lower the odds of your trade being profitable. Retail traders do not have the infrastructure of a trading firm to support them or the financial support that is much needed to develop their trading abilities. They do not have an advisor to talk to or a friend to talk to who can understand what they are going through. Most of the money that retail traders put into their trading accounts is hard-earned money, making it extra painful to see how easy and quickly the money can be burnt. Thus, the issue of a single trade going badly and having a negative outcome is especially problematic for retail traders. Most people do not understand their own risk tolerance level. Period. It is not a function that only depends on the person’s net worth or how much burnable money there is in the trading account. It is much more related to the personality and character of the trader. Some people think that if they have more money in their trading accounts they would do better. The truth is that a bigger bank roll does not change a person's risk tolerance overnight. If you are one of those people who have a very low risk tolerance, then even trading on the smallest possible size in some markets will paralyze you on the first losing trade, causing you to function badly when called on to make any sound judgments. There are also people who pretend that they have high risk tolerance. This is only good for showing off in front of their friends. Their trading accounts will suffer. Trading mostly for the excitement or pleasure of the trade will not end well. The other extreme in risk-taking behaviour is found in those people who take risk mostly for the purpose of getting excited (or high, depending on your demographic). The sense of fear, uncertainty, and insecurity felt at the time of waiting for the outcome of a trade (or the outcome of a game in the casino) is addictive for some people. In this situation, trading is their venue for seeking excitement, not a means to gaining financially. These people always violate the most basic money management rules and there is no training in the world that can make them better traders. Those who choose to go to a casino for this kind of excitement at the cost of ruining their lives are known as compulsive gamblers. The best solution for these individuals is to stop trading (and gambling) and seek medical and psychological help. Retail traders are not properly informed by any stretch of the imagination. Retail traders are lured to trading (well, mainstream media call that "investment") without knowing what they are getting into. (Contrary to the fine print on the very complex brokerage agreement they signed hastily to acknowledge that they know their risks and understand the consequences.) Many people will say that it is these people's fault for not reading the agreement and understanding the risk in the first place. But risk is such a complex thing when it is related to trading. It is so hard to understand that brokers are required to pass several exams before they can go out and solicit clients. Why, then, would anyone without prior knowledge in finance think they can learn enough about the risk that they are going to take by talking to these brokers for an hour or less? Odds of Your Trading Account Being Ruined Think of the game of roulette in a casino. It is well-known fact that, if a casino is operating legally in the United States and in other well-regulated countries, then the casino is running its business on a very small but well-defined edge over its gaming clients who play the game of roulette. For most of the gamblers, the longer they stay at the casino and the longer they play over their life time, the greater the likelihood that they are going to lose money at the roulette table. This is how a casino makes its money — the aggregated result from all gamblers will give the casino a net profit, by probability. In short, the odds favour the casino right from the beginning. So, if you like the excitement of uncertainty at the roulette table and play sensibly, meaning that you only bet a small amount per game, then you will have a good time of riding the roller coaster of winning some, losing some, and occasionally winning big. At the end of an exciting week, you would probably end up not losing too much money and having a good time. Using the word sensibly is old fashioned because it means that, if you do something that is not sensible, you are an idiot. Well, the politically correct term nowadays is gaming responsibly. I am not trying to be politically correct here, so if you do not like it, it is your problem. In trading, a retail trader is facing a similar problem because the odds are not in his or her favour right from the start. If the person trades sensibly, then the trading account would likely enjoy a roller-coaster ride of account balance changes. By the time the person stops trading, the account may end up with about the same amount of money that was put into the account over all those years, minus commissions, service charges, and margin interest. This is going to happen no matter how smart the retail trader thinks he or she is, how much trust was placed in whichever guru he or she was following, or whatever random techniques were being used. Now some readers will figure out why I talked about roulette at the beginning of this section. Gaming or trading sensibly is the keyword here that enables folks to keep most of their money at the end of the game. Any rush to bet in larger amounts, without proper consideration of risk, in the hope of a bigger return, will put the trading account into a hole. The losses will not likely be repairable [...]... once you have stabilized your trading performance over a period of time Patience comes from a deep understanding of the issues you are facing By understanding that acting irrationally or impatiently will not improve your situation and will likely reduce your odds in accomplishing whatever goal you have in mind, you will be able to improve your patience slowly every time you successfully overcome your. .. against your chances in trading successfully, does not ensure that you will become successful in trading Other factors often come into play before you can get to the point where your trading is stable and reasonably profitable A sudden crisis in your life that is out of your control can disrupt your schedule or take away from the time you need to put into trading For example, an accident that puts you. .. two, before even trying to place your first order should you choose to quit your job Trading is not about glory Trading is a means of earning a profit from a market You can pick any market that can give you an edge, or odds in favour of you to win The last thing you should do is to stick with markets that you are undercapitalized to trade in Back in the days when the original S&P 500 index future was traded... practice unless you are not sure what you are doing The ability to identify and feel something that is dangerous to you (such as knowing that fire can burn you) is necessary to avoid being harmed More importantly, you need to know what has to be done when such adverse events happen Intentionally thinking of yourself as being a successful trader will not transform you into one unless you put your mind and... and so on If you insist on continuing to trade, then adjust your plan to handle the situation accordingly There are other minor incidents that can disrupt your focus, like getting sick or having too much fun at a party the night before If you know your brain is not functioning properly, walk away from trading You can turn off the monitors of the trading computer to avoid being hooked by activity on... can help you to focus and really pay attention to learning as much as you can before entering the arena of trading Better yet, it will help you become very efficient — things or ideas that produce negative effects on your trading will be more easily discarded, as you know that these items will reduce your odds in surviving Have a Proper Battle Plan When You Fight a War Everyone who wants to trade starts... the risk you take on just because you doubled your account size by taking outrageous risks is no different from betting on the roulette table over and over again with all the winnings you have made so far Probability will catch up with you sooner than you think Searching for Your Own Trading Style Every trading methodology has its own weaknesses A trader who has very short patience can never trade successfully... single trade) that is too much to handle mentally by that person will wipe out all the profits this person ever made in his or her lifetime It is extremely important to fully understand the risk you are taking Think deeply of the consequence of losing all the money you have It could ruin your life and ruin your family, and you could be devastated by the results for a long time Odds of a Retail Trader... too Retail traders, however, do not have this luxury and all they have are their own accounts to blow up, plus they have to answer to every single consequence by themselves When you find yourself trading without a plan, without discipline, and letting your trades affect you emotionally outside of trading, it is a very bad sign If you failed to break out of this downward spiral many times, you could... totally piling up against you has many advantages Being able to visualize and feel in your mind just how dangerous this trading business can be is even better, because that feeling of having a knife (or a gun) pressed into your back will make sure you focus on the very basic survival techniques before your fancy thoughts of success can even start to take shape This acceptance changes the attitude of . Know Your Odds Before You Trade By Lawrence Chan Second Edition, April 2012 Copyright Lawrence Chan 2010-2012 Smashwords Edition License Notes: Permission is. Edition First Edition Introduction Odds in Trading What Kind of Odds Are We Talking About Here? Odds of Your Particular Trade Being Profitable Odds of Your Trading Account Being Ruined Odds of a Retail Trader. Aspiring Traders Acknowledgements About Lawrence Chan ~~~~ Introduction To know your odds before you trade is one of the most (if not the most) important concepts that enables a retail trader