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To: OZ who wrote (104)	10/3/2001 7:19:50 PM
From: Mathemagician	Respond to of 248

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

To: OZ who wrote (104)	10/6/2001 6:10:52 PM
From: Mathemagician	Read Replies (1) \| Respond to of 248

Maybe MATH can explain some of it to you in my absence. Appropriately identifying risk and reward is an important process to complete before entering any trade. You should note the current price and use whatever techniques you favor to determine the direction and extent of the move you're hoping to trade. You should also determine the point at which the market proves you wrong. Once you've done that, your risk is defined to be the difference between the current price and the point at which the market proves you wrong. Similarly, reward is your target price. For example, last week SEBL was at 13 and had double-bottomed. I thought that it was due for a bounce to about 20. I would be proven wrong at 12. Thus, my risk was 1, reward was 7, and risk/reward ratio was 1:7. This fit my criteria of at least 1:3 and so I initiated the trade. Calculating a risk/reward ratio is that simple, but it must be done as objectively as possible. In other words, don't let your risk/reward criteria influence your choice of either the risk or reward. Now, why is my risk/reward criteria 1:3? It's because I figure I will be right about 1 in 3 times I make a trade. Here is what I can expect, assuming 1 trade per month, 5% of my capital at risk on each trade, and wins limited to 3 times risk. I started with $100 to keep percentages easy... Trade Capital P/L Win? 1 $100 $(5) 0 2 $95 $(5) 0 3 $90 $14 1 4 $104 $(5) 0 5 $99 $(5) 0 6 $94 $14 1 7 $108 $(5) 0 8 $102 $(5) 0 9 $97 $15 1 10 $112 $(6) 0 11 $106 $(5) 0 12 $101 $15 1 Balance $116 Actual results will be different because of the order of wins and losses, but on average, my performance should look similar. I was never down more than 10% and at the end I'm up 16%. Also, in reality losses will never be more than 5% of available capital, but the wins will often be more than 3 times the risk, because I let gains run and cut losses short. This significantly improves performance. Getting one additional trade right results in a better than 40% performance. However, changing one of the wins above to a loss only results in a -4% performance. Getting all 12 wrong in a row with no wins yields a -46% result. Not great, but I will still have 54% of my capital left to work with. This is one way to implement the idea of preserving capital, consistently making money, and still giving myself the opportunity for superior returns as explained in the previous post on this topic. M