Maybe MATH can explain some of it to you in my absence.
Now that's opening a huge can of worms! To be fair, we all have our own criteria for choosing specific entry and exit points. That's black magic. :) If you mean the risk/reward criteria that must be satisfied by those entry and exit points then I would be happy to attempt to explain my "system". It is based on the system laid out in Trader Vic's books. (We will have to proceed in a series of posts since I am at a trade show and don't really have as much time as I'd like. Also, I am long-winded. Or, PM your address and I will send you a couple of books.)
Note: The risk management system exists independently of any stock picking, TA, market analysis, turnips, gorilla gaming, etc. that you might use. It is a framework based on three goals in order of importance:
1. Capital preservation
2. Consistent profitability
3. Pursuit of superior returns
In other words, treat your investing activities as though you were running a business. (Another implication of that is to ALWAYS include the effects of taxes and transactions on your trades.)
To accomplish the first goal, you must set hard limits on how much you are willing to lose on a trade and never overcommit. For example, if you had decided that it was acceptable to lose 5% of your total available trading capital on each trade, then you can be wrong 10 times in a row and still 'only' be down 40% overall. If you choose 3%, you can be wrong 17 consecutive times and be down 40%. Since there are losses, I am assuming tax benefits and transaction costs cancel. This point is critical in maintaining a level head amid a series of bad calls, which is an inevitable occurrence.
For the second, it means adjusting your goals from beating the market to being profitable whether the market is up or down.
For the third, it means letting your profits run while cutting your losses short. (You never know when that nice little trade will turn into a monster!) It also means increasing the size of a bet when you are particularly confident in a trade (i.e. good risk/reward ratio) AND profitable. That means increasing the size of your position by risking part of your profits if you have them and under the right circumstances, but never risking additional original capital. It DOES NOT mean changing your risk/reward criteria, which will likely be the subject of the next post.
M |
