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Lesson 9: Becoming Successful

In Lesson number eight, it was stated that your ability to control average losses (AL) would be the most important talent you will ever develop as a futures, options or stock investor. I want to spend a little more time examining this issue.

Money chasing Money: Suppose you had the opportunity to invest a nickel to earn a nickel. You might be willing to do so. The game could be a simple one. You and your friend each put up five cents. You flip a quarter. If the quarter comes up heads, you win her five cents. If it comes up tails, she wins your five cents. You are investing a nickel to earn a nickel; it is five cents chasing five cents. A reasonable bet if the odds are around 50/50 for each player.

Suppose that your friend wants to change the bet. Under the new rules, you will have to put up $3.00 to win her 5 cents. The game will be the same; only the amount of money bet will change. The same quarter is flipped; if it comes up heads you win the 5 cents. If it comes up tails, she wins your $3.00. Your $3.00 is chasing her 5 cents. If the quarter is flipped 60 times and you are lucky enough to win 59 of those 60 flips, you will still lose money. This is because you will have won $2.95 on your 59 winning flips and lost $3.00 on the 1 losing flip. Winning 99% of the time can't prevent you from losing money on the series when you have $3.00 chasing a 5-cent profit. The only way you would be willing to take this bet is if it is absolutely certainty that you will win on 100% of the flips. You will play if and only if the quarter you are flipping has a "head" on each side and you are allowed to bet on "heads".

Central High School: In lesson number five, we learned of Central High School, a fairly large school with an average graduating class of 800 students. You and your neighbor decided to make a wager on the number of students that will graduate in the year 2001. You are long. You are betting that more than 800 students will graduate that year and for each student above 800, your neighbor promises to pay you $1. Your neighbor is short. She believes that less than 800 students will graduate in 2001 and for each student below that number, you promise to pay her $1. Every $1 that you win will come out of your neighbor's pocket. Every $1 that your neighbor wins will come out of your pocket. You both expect the graduating class of 2001 to have between 780 and 820 students. If such is the case, you stand to win or lose up to $20 and the same applies to your neighbor. You each deposit $20 with a neutral party and sit back and monitor the class of 2001. The likelihood of either of you winning is 50/50. You have $20 chasing $20.

Troubles in Centreville: The winter was bad, real bad in 1999 and the temperature dipped to record lows. It was reported that over 90% of the fruit trees were killed. New trees would have to be planted with a crop of fruit not ready for harvest for ten years. It was shortly after the cold that the rains came. The planting of the spring vegetable crops was delayed. The delay stretched to three months. The government reported that agricultural production would decline by 80%. The processing plant had to be shut down; there was no fruit for juice and no jobs for those who worked in the packing. It was said that if the lumber mill had not burned down in April that two hundred and seventy-five jobs could have been saved. But the lightening struck at the wrong place at the wrong time and it would be four years before the mill would be back to full capacity. The camel's back was broken with the straw of the auto assembly factory making the decision to relocate itself, lock, stock and barrel, overseas. Everyone was disappointed. The move to Asia cost Centreville another four hundred and fifty-five jobs. The handwriting was on the wall. Would the last person-leaving town please turn out the lights?

The school superintendent announced in February that three hundred students had left school that month. "They had to go where the work is" pretty much summed up his announcement. In March, the town newspaper reported that an additional eighty-six students had left with their families. In April, with the burning of the lumber mill, another four hundred students left town. In May things got a little better, only seventy-five students moved from Centreville that month.

By June of 2000, the graduating class size had shrunk from 800 students to 585. How many would be in the class of 2001 was now "anybody's guess". The rumor was that no more than 400 students would graduate the following year, a decline of 50% from the ten-year average. Your neighbor begins to worry. Not about winning her bet with you, it appears that she obviously will, she is short and student numbers are going down. Short traders win when markets go down. She is beginning to worry about your $20 deposit being enough to cover your now estimated $400 loss. Your neighbor has even heard a rumor that you were thinking about leaving town to start fresh in an area where the economic outlook was more promising. Surely this is only gossip; she hasn't noticed any moving vans or packing crates at your house so far. The questions are really only three (1) will you be around when the class of 2001 graduates? (2) Will your $20 cover the losses from your bet? (3) If 400 students graduate next year, should you put up $400 now to cover what is expected to be a $400 loss on your $20 bet?

$400 chasing $20: If you ignore all the disasters that have happened in Centreville since you and your neighbor first made a bet, the "best case outcome" for you would probably be a profit of $20. If you consider all that has happened, "the current worst case scenario" has you losing $400. Things may actually get worse. It is possible now to believe any bad news story. Who is to say that the graduating class of 2001 won't number 300, or 200, or even 100 students? Can you guarantee that this won't happen? How much money are you willing to risk earning the profit of $20 that you were originally going for? $20? $100? $200? $300? $400? $500? $600? $700? $800? How much is winning $20 worth to you? Aren't you worried about betting $3.00 to win a nickel?

Trading in a Series: In lesson number eight, we worked with a series of trades, three in number, in which losses occur on the first two and there is a profit on the third. We used the number of $200 for your average losses (AL) and the figure $400 for the profit you would need to break even in such a series. The number three is not fixed in concrete.

It makes no difference if you set up your own program to trade in a series of three, four, five, ten or twenty trades. You can even have a series of sixty trades if you like such as our second coin flip example in this lesson. The important thing is not how many trades are in your series; the important thing to remember is that there is a direct relationship between what your average losses (AL) are in a series and what you will need to achieve success from that series.

When you work in a series of three trades and are correct 33% of the time, if your losses (AL) average $2,000, you will need a profit of $4,000 on the third trade just to break even. You will need a profit of $4,200 to make $200 from the series. It is not easy to make a profit of $4,000 or $4,200 in futures or options or stocks. It is relatively easy to make a profit of $400 or $500 or $600.

You don't have to keep your average losses (AL) at $200. I just picked that number in lesson number eight to give us a starting point. What I am saying, however, is that it is easier to make a net profit from a series of trades if your average loss (AL) is a small number. In general, the rule is "the smaller the better".

How do you keep your (AL) number small? You do it by monitoring your losses and by keeping them under control. If you do not keep your (AL) under control, and this is very important to remember, one day you will find yourself in a bet where your $3.00 is chasing a nickel of profit or where your $400 is chasing a profit of $20.

As long as you trade in futures, options or even stocks, you will be able to control, to some degree, your average losses. A single loss may be less or greater than you expected but in the long run you can pretty much control your average losses (AL).

By concentrating upon that which you can control and keeping that sum at a reasonable amount, you will make the net profit that you hope to achieve from any series more likely to be achieved. Isn't that what you want in your trading, small losses and an achievable net profit? If this is what your goal is, then your road to success will be the road of controlling your losses. You can travel this road by using many different methods or vehicles, such as the four I mentioned in lesson number eight or several others that you can learn from my Choppy Market Trading Method or other writings. Whatever method you select, you should always remember,

You must learn to control your average loss (AL) per contract traded. No talent you develop as an investor will ever be as important to you as this one.

 

Bruce Gould

 

Always remember that stock, options, and futures trading may involve substantial risks and that past performance is no guarantee of future performance.