Tame Trading an easier way to trade

I could start by saying that the key to success is simply buying stocks that always go up. But we all know that is not going to happen. Stocks that go down are an unavoidable part of trading and investing. I could say it's more important to have more winners than losers, but we know this to is not the case as there are many approaches with win rates below 40% that are successful. Some folks think it is critical to have some very big winners, and there is some real truth to this. A big winner always helps a lot, and one big winner can erase a lot of small losses very quickly.

If you've read about highly successful investors, you know many of them have something in common, an underlying factor, despite a myriad of very different approaches to investing. Some discovered the key early in their careers; others learned the hard way, and some figured it out but refused to do it until they finally realized how important it is. Sometimes it just takes time to realize the obvious.

The best book on successful traders, in my opinion, is Jack D. Schwager's Market Wizards. In the book, Jack interviews several very successful stock market traders. What I like about the people he discusses is their stories all start out the same. Early in their careers, not long after they discovered they had a real knack for making big money trading, they proceeded to go broke. And many of them went broke several times.

It is important to understand they went broke after first making large sums of money. After a period of success, these super-traders would inevitably run into a dry spell. During these periods their systems, strategies, even their gut feelings, simply did not work. Suddenly they found themselves giving back tremendous sums of money in a relatively short period of time, eventually going broke. This does not mean they lost all their money, but they suffered a significant setback. It can be a very humbling experience, and for some, it happened more than once before our "market wizards" realized what the key is.

So simple

First they realized they were good at making money; then they lost their money. That was when they said to themselves, "If I could just stop losing all my money during the dry spells I would be an extremely successful trader. How can I avoid going broke when the market turns against me?"

The amazingly simple answer is: Don't ever let a trade move significantly against you. That is the key. That is all you have to do. Don't let losses get out of hand, no matter what. No excuses, no rationalizing, no "What if it comes back," and no whining. From time to time even the best trader makes a bad trade. If you trade long enough, sooner or later you will find yourself in the wrong place at the wrong time. There isn't much we can do about that. But if you structure you strategy so even if a disaster happens that it won't be devastating, and you don't permit poor positions to get out of hand, you will dramatically increase your chances for success.

There is one more thing we all have to understand. The market goes through times when it is generous and it goes through times when it will do everything it can to take money away from you. Simply understanding that these unfavorable come and go and knowing you need to anticipate and compensate for them will also prove highly beneficial.

How to do it

First, a bad trade is not a mistake. Bad, meaning unprofitable, trades are simply a part of trading. They happen. The important thing is to prevent unprofitable situations from getting out of hand. One of the simplest ways to prevent unproductive positions from getting out of hand is to set a loss-cut point, more commonly known as a stop order. Before you enter a trade, you should know at what level you are going to place the stop order. This way you know what your risk is going into a situation. Whether you use 8%, 10%, 12%, or even 20% of your investment in that trade, the important thing is to be aware of your downside risk. Using stop loss orders is virtually the only way ensure erroneous trades do not get out of hand.

I could write a book about where exactly to place a stop order. In fact, I think several have been written. While every trade is different, its is best to keep things as simple as possible. From a statistical stand point, the ideal range for a stop is somewhere between eight and twelve percent. If you put five to fifteen percent of your equity account into a single trade, your stop order should never be more than eight to 12 percent away from the entry price.

As an example, if you buy a stock at $100.00, then you should place a stop order between $88 and $92; that is a range of 8% to 12% below the entry price. Let's use 10%, or a stop of $90, for this example. If the stock falls to $90, you will be stopped out, assuming the market is orderly, and your shares are sold at $90. (Note: That example is for a long trade; for a short trade the stop order price is above the price at which you initiated the short sale.)

Once you place your stop order, the worst thing that can happen is that you lose 10% of the money you put into the trade, exclusive of the commission. It is so simple, yet for some people it is incredibly difficult to actually do. People always have a reason for not entering a stop: "I hate to lose that money...and it can come back...." "I'll wait one more day..." The market wizards generally went broke several times before they realized how important this single aspect of trading is.

We don't expect to be wrong, but we know we will be wrong as it is a part of trading. The important thing is we can't afford to let losses get out of hand when things move against us. I've made and studied thousands of trades, and I consider this to be one of the true keys to successful trading.

I'll prove it

To illustrate the importance of this simple aspect of trading, I put together a thorough random trading test. I used four years of data for this test. The time window from which the trades were selected at random is from 1998 through 2001. In 1998 and 1999 the market was in a big time bull market, and in 2000 and 2001 the market was in a big time bear market. This avoided the typical bullish bias that exists in the market. A random system that went long only in 1999 would do very well because everything went up big time in 1999. However, the same system applied in 2001 would show very poor results because 2001 was a devastating bear market. So the four year window is a good bull bear balance for this exercise.

Keep in mind that there are many factors involved in trading, including how volatile the security being purchased is, and how much money, or what percentage of an account, will be put into the trade. After resolving these issues, to keep things simple, we picked stocks from the combined components of the S&P 500 and the NDX 100, which is a total of 536 stocks. We also decided to carry 10 positions in the portfolio and that they would be equally weighted.

Now when I say random, I mean random. I let the computer pick a stock randomly from the list. Next it picked a number between 1 and 1,000 at random; this number determined the trade entry day. Finally the computer "flipped a coin" to go long or short. This was done for each trade until the portfolio contained 10 positions. Each stock was traded in its own time window. When a stock was stopped out we added another random trade.

The key is the system set a stop order for each trade at 10%. As time passed I used a parabolic stop to adjust the stop point higher. (I don't want to get into the details of a parabolic stop-adjustment formula, but basically as time passes and the stock moves higher the stop price is moved higher, lower for a short sale.) If we did not move the stop then we would lose 10% on all the trades.

It is also important to note that in this exercise, the stop order was the only thing that could get us out of the trade. There were no targets and no time limits; at no point did we say, "We have a good gain here; let's take it." All the effort was put into risk management.

Look at the results

I ran the program 10 times and the results are below. In each case we started with $1,000,000. We put 10%, rounded down to the nearest 100 shares, of the day's equity into each new trade. The program ran for 250 "fictitious" days, the equivalent of one trading year.

As you look at the results, remember that everything about the trade entry decision was random. The only thing we did was set the initial stop 10% away from the entry price.

It's hard to believe, but four of the 10 purely random trading runs produced positive gains. One was down less than 0.25%, with the worst down less than 10%. This is based on one year of active trading; and as you can see there were a lot of trades. The point is that even if your stock selection and timing are completely random, even if you pick your trades with a dartboard, keeping your losses under control keeps you out of trouble.

It's important to understand that the results above are based on random activity. Using a 10% parabolic stop will not ensure success. However, based on this exercise, using a 10% stop will ensure that no single trade gets out of hand.

An advantage smaller traders have relative to large institution is you can do this. You can place a stop eight to twelve percent stop order on every trade you make. A mutual fund that buys thousands or hundreds of thousands of shares does not have the ability to step in and step of a stock the way you can. There is a catch, though: There is no overhead associated with placing a stop order, but you have to remember to do it every time. The one time you don't do it could be that rare instance when a trade goes against you. The next thing you know, the loss has gotten out of hand and you are left hoping desperately that it will come back. Hope can be expensive in the stock market.

What do soldiers know that you don't?

I often hear stories about ex-military people becoming great traders. I always thought it was because the military teaches discipline. Then one day an old army sergeant offered an alternative explanation. Evidently, after you have been in the military for a while, you develop a sense of impending trouble; you just know when a situation is going bad. Whether it is an approaching officer looking for someone to do his dirty work, or someone or something thing telling them the enemy is near, these guys learn how to instinctively recognize an unfavorable situation.

The best way to live long and prosper is to avoid danger whenever possible. The point is these ex-military people can sense when a trade is going bad, and they have no problem whatsoever getting out of harm's way. If you walk off the battlefield then you will live to fight another day. And that is much more attractive than the alternative.

It is really that simple. The key to successful trading is having defined exit points and sticking to them. Our Tactical Trading System has a stop point for every trading idea we consider. Sometimes the stops are hit; that's all part of the process. The fact that some stops are hit reminds us that they are doing their job.

The Tactical Trading system is a good system. It is going to find its share of winning stocks to trade. With that we know we can make money trading stocks. But we have to make sure that when things go wrong we don't give back our hard-earned gains.

The market goes through phases. There are times when everything you do works. Then there are those dry spells, the times when it seems nothing works out the way it is supposed to. During the difficult times that you have to survive.

It does what it's supposed to do. And it's free.

The results from our random trading exercise confirm that even if your stock-picking and decision-making are no better then coin-flipping, if you put effort into managing your risk, you can be a successful trader. In my opinion the key to successful trading is risk management, which boils down to avoiding letting losses get out of hand.

We expect to make money more than 50% of the time. On average we make money more often than we lose money. We expect to make more on average than we lose on average. So we make more than we lose, and we win more often then we lose: This is a successful formula for any trading environment. And what makes this possible is a defined exit strategy. This enables us to build a defined risk model for every trade we make.

In conclusion . . .

Gains are easy. It's knowing what to do when things fail to work in your favor that makes the difference between long-term success and failure.

We have necessarily simplified the process for this report. Even if you devote all of your energy to risk management, we recommend that you do not make trades at random. It is also important to understand risk management alone will not ensure success. You have to take your gains, and you should have a plan to strategically move your stop price higher.

If people put as much effort into risk management as they put into their research and buy decisions, which Tactical Trading Outlook does, there would be a lot more happy and successful traders.