This is not a Casino
Most of the people I talk to refer to the market as
one big Casino. The unfortunate fact of the matter is that somewhere
between 75% and 95% of people who become involved with the sharemarket as
traders lose some or all of their capital. So who can blame them for
coming to that conclusion?
I can!
You see most people get involved with the
sharemarket because they see all their friends making money out of it, the
newspapers are talking about it, heck, even your hairdresser is waffling
on about nickel stocks! So they think to themselves, "Hey this looks
easy, I'll have a go!" The public has become excited about a bull run
in the market and for a while, everyone is making money despite
themselves. Genius is a rising market!
Unfortunately, bull runs don't last forever. Our
brand new sharemarket traders also leaped in without learning the rules of
the game.....a recipe for disaster! This phenomenon always occurs at tops
in the market because that is when the most excitement is generated. Exactly
the time when the professionals are SELLING!
What happens next is ugly. The market starts going
down, it may even crash as it did in 1987. Our brand new traders never
learnt how to preserve profits and they watch their profits quickly
disappear, hoping that prices go back up again. Can't sell now because
they've been bragging to their mates how well this sharemarket thing is
going!
So they hold on, and prices continue right on down
until eventually the pain becomes too great and they then sell all of
their holdings at a substantial loss. This usually occurs right at the market bottom. To add
insult to injury, this is when the market starts going back up again! This
is when the conclusion is reached; "The sharemarket is nothing more
than a hyped up casino!!!!!" They swear to never, ever go near the
sharemarket ever again!
What has just happened, is that they went to the
market with "Casino Mentality". Attracted by the bright lights
and the excitement and the stories of big winnings, they placed their
chips on the table.....and got fleeced by the professionals!
That would never have happened if our new trader had
learnt the rules of the game first. No! I don't even like the word
"game"! It's a business, and should be treated as such! Even if
you are starting out with a small amount of money! If you were going to
start a cafe' business, wouldn't you learn how to run one, where to buy
the coffee wholesale, where's the best place to situate it, how to hire
staff, how much to pay them etc. etc. etc.?
You bet you would!
Well I'm not going to teach you how to trade in this
article, but I am going to show you the principle the professionals use to
turn a profit. But first lets have some fun and take a trip to the casino
to see how they make money out of you. It involves a little bit of
mathematics, but bear with me.
A Trip to the Casino
OK, we've been sucked in by the bright lights and
Harry down the pub just told us how he cleaned up at the roulette table,
so that's what we'll play, roulette. After the household treasurer has
commandeered the bulk of our pay for groceries and paying bills, we have
$100 left. So this is what we have brought along with us, this is our capital.
Here's the rules, we're going to place a $10 chip on
either red or black every spin of the wheel. This gives us 18 chances out
of 37 to win, for which the casino will pay us even money. So if we lose
we lose $10, this is our risk. If we win we make $10, this is our reward.
Now we can work out some ratios and see how they
might impact on our capital.
Our generous hosts have given us 18 chances out of
37 to win, so our win/loss ratio is 18/37 or 48.65%. We've already
worked out our risk and reward but we need to put that into a ratio as
well. We have one unit risk verses one unit reward and it is expressed as
such- 1:1. This is our risk/reward ratio. ( Actually it is more
correct to express this as reward/risk, but for some reason we traders say
it the other way round).
OK one more calculation for now: Expectancy
Expectancy=((1 + reward/risk ratio) * win/loss
ratio)-1
=((1 + 1) * 0.4865)-1
= -0.027
In other words for every dollar you risk, on
average, you will lose 2.7 cents...straight into the casinos coffers. This
is what we call negative expectancy. That's not too bad you say, I
can have fun gambling $1000 over the course of the evening and only lose
$27...a cheap evening out!
It gets worse though. because in the real world it
doesn't happen that way does it? Depending on your luck you may come out
ahead or you may lose all of your capital very quickly. I tested this
scenario a hundred times using an excel random number generator and guess
what? Six times out of 10 the entire capital was lost before 100 bets and
that's no fun at all!
This brings up a whole new subject and that is money
management, which will discuss this when the time comes, OK.?
Now think about this! It's one thing taking $100 out
on a Friday night and blowing the lot; but it's entirely another thing to
take your life savings into the sharemarket with casino mentality and
blowing the lot!
It's no wonder that casinos......and sharemarket
professionals, make so much money!
OK how do the pro's do it then?
This part is a little bit contradictory because a
lot of the features of trading somewhat resembles gambling. We have
winners and losers just the same as a gambler, but we still do not
approach the sharemarket with casino mentality!
The difference is that the successful sharemarket
trader uses strategies to ensure a positive expectancy. We won't go
into that in detail now, but briefly it goes something like this; we cut
our losses short and let our winners run. Therefore our winners will
always be greater than our losers on average. This is of paramount
importance. Remember in my last article, I told you to remember the phrase
"risk/ reward ratio", well this is where it applies.
Ok then, lets go ahead and make some assumptions.
Lets say that we risk the same $10, but when we win, our reward
is $20. This gives us a risk/reward ratio of 2:1. ( or reward/risk
ratio if we're being pedantic.)
Lets say though, that we are not that accurate at
picking winners and our win/loss ratio is 37% .......hmmmmmm lets
go ahead and do our expectancy equation:
Expectancy=((1 + reward/risk ratio) * win/loss
ratio)-1
=((1 + 2) * 0.37)-1
= 0.11
AHAH! There's our positive expectancy! For every
dollar risked we will make 11 cents on average.
Here's a question for you. Would you take your life
savings and risk it in the market on the above scenario....I wouldn't!
You still have about a 15% chance of losing all of your capital. Run the
numbers through excel and you will see what I mean.
You must add in money management, but you guessed
it! I have to write a whole new article for that one!
There are a few ways; one is to examine your
historical trading performance.
If you become a
good trader, your risk/reward ratio and your win/loss ratio will be a lot
better than the figures above. To give you an idea, at the time of writing,
with my swing trades, my win/loss ratio is running at 57% and my
risk/reward ratio is 3.4:1. So based on those figures my expectancy
works out to be 1.508. So that means that for every dollar I placed at
risk in the market, I made about $1.51 profit. That's a pretty good
figure. It gives me every confidence to go right on trading exactly the
way I have been. It lets me know that every further dollar I place t risk
in the market, I can expect to make around $1.50....and that is a great
psychological advantage to have that in my mind.
It has a further use in that it helps me to optimise
my money management....and if there is one thing that can improve profitability,
it's proper money management.
The second way that expectancy can be used is to
compare trading systems.
The technical trader can create computer trading
models and backtest these with his/her charting software. This is where
the trading system is tested with historical price data. There are even
specialized software packages specifically for this purpose. We can devise
a new trading format, backtest it, and come up with an expectancy figure
for that system.
This is useful as we can compare the expectancy of
one system over another and select which one(s) we are prepared to use in
our trading. We can compare our new models against our current
system in use also.
Here is an example:
Suppose I have thought of two new trading
systems. After doing my backtests I have found that one system has a
win/loss ratio of 90% and a risk/reward ratio of 1.2:1. The second system
has a win/loss ratio of 35% and a risk/ reward ratio of 5.5:1.
How am I going to decide which one is better and how
am I going to decide if these new systems are better than my current one?
You guessed it right first time didn't you......expectancy! Let go ahead
and do the calcs:
Expectancy=((1 + reward/risk ratio) * win/loss
ratio)-1
System 1 =((1 + 1.2) * 0.9)-1
= 0.98
System 2 =((1 + 5.5) * 0.35)-1
= 1.275
Interesting! The second system has a higher
expectancy than the first system even though it wins only a third as
often. On the face of it, I would prefer to trade the second system, obviously. Hang on a
minute! my current system is running at 1.508! Hey I'll just stick with
what I'm doing.
There is a third way to use expectancy. Suppose that
six months ago I created a trading model with an expectancy of 1.5 and
decided to trade it. After six months trading, I can now compare the
actual results against my expectancy figures to see if it is performing as
anticipated.
This is why the sharemarket is not a casino. There
is no way that you can change the negative expectancy at the casino into a
positive expectancy; and if you do they'll ban you from ever coming
back!!!!! Not so in the sharemarket.
In the share market one can truly play to win!
Well I hope I have written that well enough that it
makes sense. Please send your comments/questions wayne@tradingforaliving.info
P.S. If you would like a copy of the random number
generator just ask. It's very basic and if you are good at programming you
can tidy it up a bit yourself :-)
Cheers
Wayne Lawrence
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