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,
- How many profitable trades you have made.
- The average profit per profitable trade.
- The length of time you remained in each profitable
trade.
- The average length of time that you remained in each
profitable trade.
- How many losing trades you have made?
- The average loss per losing trade.
- The length of time you remained in each losing
trade.
- 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,
- 17 profitable trades made. (Hypothetical)
- Average profit per trade $325.00
- There were several trades that lasted 2 days and a couple
that lasted 4 days and three that lasted 1 day.
- Average length of time in profitable trades was 5.2
days.
- 17 unprofitable trades made. (Hypothetical)
- Average loss per trade $848.00.
- 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.
- 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?
- We have 1 winning trade.
- We were in our position 150 days.
- Our average profit was $1,500.
- We have 1 losing trade.
- We were in our position 30 days.
- 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.