Lesson 14: Building a Plan - Part 3

Suppose you were to walk into a physician's office and ask for a medical examination. Whatever age you were at currently, you would like to be able to live a long and healthy life thereafter. In response to your request, the physician would probably call for a complete medical - to see what sort of condition you were in. If your diet consisted of too many fatty foods and too little in the way of vegetables or whole grains, the physician would probably recommend that you change the ratio of the foods you consume. The physician would explain to you the reasoning behind the suggestions and if you did want to live a long and healthy life, you would probably go along with at least part of the plan.

When it comes to stocks, futures and options trading, the first thing you should do is to give yourself an examination of your own history of trading. You should do this whether you have been successful or whether you have not been successful. The best starting point in such a self-examination would be to take all your trades for as long as you have been trading or for the past two years or the past year or the past six months, for whatever time frame you have the present time to organize and analyze. Once you have all these trades collected, you should then divide the trades into those that made a profit and those that resulted in a loss. It is unlikely that you had many trades that were exactly 'break-even' trades, but if you did you can create a third category.

To find out how well you have been doing (although you know the answer to this question before you even ask it) you will have to look closely at the trades that returned you a profit and the trades that returned you a loss. Set up a worksheet by which for each of these trades you list date entered, date exited, number of days in the trade and the resulting net profit or loss when the trade was closed. When you have done all this you will be able to establish the following,

1. How many profitable trades you have made.
   
2. The average profit per profitable trade.
   
3. The length of time you remained in each profitable trade.
   
4. The average length of time that you remained in each profitable trade.
   
5. How many losing trades you have made?
   
6. The average loss per losing trade.
   
7. The length of time you remained in each losing trade.
   
8. The average length of time that you remained in each losing trade.
   

You now have some information on which to make a diagnosis of your investment experience during the past six months or two years or for however long you have been trading. To use some imaginary figures, let's look at the above table and simply fill in some numbers just to give us something to work with,

1. 17 profitable trades made. (Hypothetical)
   
2. Average profit per trade $325.00
   
3. There were several trades that lasted 2 days and a couple that lasted 4 days and three that lasted 1 day.
   
4. Average length of time in profitable trades was 5.2 days.
   
5. 17 unprofitable trades made. (Hypothetical)
   
6. Average loss per trade $848.00.
   
7. There were two trades that lasted 14 days, two trades that lasted 19 days, and two trades that lasted 45 days. One trade lasted 185 days.
   
8. Average length of time in unprofitable trades was 38.7 days.
   

The end result was 17 hypothetical trades yielding a net profit of $5,525 dollars and 17 hypothetical trades resulting in a loss of $14,416 for a net overall loss of $8,891. This analysis is very similar to the physician's examination of your diet. The physician might ask you, "what do you eat at your meals each day". You might ask yourself, "How many winning trades and how many losing trades did I have". The physician might then calculate the ratio of healthy foods to non-healthy foods and give you a number. In your self-examination you would ask yourself how long you were holding onto your winning positions (5.2 days) and how long were you holding onto your losing positions (38.7 days) and you also would have a number.

A good rule of thumb is that the average length of your winning trades should be two-times to ten-times the average length of your losing trades. If your analysis of your own trading experience does not show such a pattern and you have suffered losses from your stock, futures or options investing, then you should probably consider changing your pattern of trading. You are staying with losing trades too long and you are cutting your winning trades off too quickly.

What does all this have to do with "building a plan"? It can have everything to do with it. You should build a financial plan in the same manner that you might build a health plan. You develop a health plan by improving the ratio of the consumption of grains, proteins, fruits and vegetables to the consumption of milkshakes, corn dogs and chocolate pie. You develop a financial plan by laying out a program that allows you to cut your losses off rather quickly but to remain with your profits for a longer period of time.

Let' look at the wheat market we were discussing in lesson 13. The idea was tossed out that we should examine buying December wheat futures on July 1 and selling December wheat futures on December 1 to see what happens when this is done. But we need not look into the past to immediately spot one primary benefit from such a trading program. The immediate benefit that jumps out at us as we consider such a program is that for every profitable trade in this program, the trader remains with his position for five months. That is an average trade of 150 days per profitable trade. This amount of time is almost unheard of as an average time period for holding a winning futures position. I read somewhere that the average futures trader holds his position an average of one week. No wonder it is difficult to achieve a significant profit if one is only remaining in the market with a winning trade for an average of 5 days. It is difficult to achieve long term success if the average trader doesn't remain with his winning positions long enough to allow them to turn into major profit centers.

Let's look at wheat again. Assume that we had only one method of trading with three rules. Buy December wheat on July 1 and sell on December 1 with a stop/loss order entered $500 below the purchase price. Let's pretend we do this trade in the year 2000 and the year 2001 and we don't even look into the past to see whether we want to take this trade or not. We simply do it, on July 1 of 2000 and again on July 1 of 2001. Now, in this make-believe hypothetical world we are working in, let's assume that in the year 2000 we suffer a loss of $500 and that this loss occurs on July 31st. Let's assume that in the year 2001 we earn a profit of $1,500 and the profit naturally comes on December 1. What has our one sentence plan for trading December wheat futures achieved in this hypothetical example?

1. We have 1 winning trade.
   
2. We were in our position 150 days.
   
3. Our average profit was $1,500.
   
4. We have 1 losing trade.
   
5. We were in our position 30 days.
   
6. Our average loss was $500.
   

We have "cut our losses short" and "let our profits run". The length of time we remained in our profitable trade was five times the length of time we remained in our losing trade. We ended up with a 5-1 ratio in favor of the winning trade. Isn't that what we all want to do, to remain with our winning positions while quickly getting out of our losing trades? Always remember this as you formulate whatever plan it is you are developing to use for the balance of your trading career and to leave for your children in your will. If you have had a great deal of success in the past calculate the ratio between the lengths of time you held winning trades and the lengths of time you held losing trades. Calculate this ratio especially if you do not have a successful record to work from. These numbers will tell you much. They will tell you the personal ratio you have for the lengths of time you hold winners as compared to the lengths of time you hold losers and to be successful that ratio should be 2-1 to 10-1.