An Edge + Position Sizing – Emotion = Trading Alchemy

trading alchemy

In this post I explore the magic of the part-time trader’s edge, the magic of position sizing and how traders can effectively take the emotion out of trading. This all adds up to trading alchemy!

Your edge in trading

“If you don’t know what your edge is, you don’t have one”

What is your edge?

There are so many old sayings when it comes to trading. Some wise, some less so. This saying falls into the former category.

An edge is “something” that puts the odds in your favour. That “something” could be the combination of a good trading system, good money management and strong discipline.

Conventional wisdom says that professional, full-time traders have the edge in markets. Their access to information is typically better, they spend more time trading and therefore can accumulate more experience and they have more time to optimize and tinker with their trading strategies.

In some ways it is the non-professionals that have the edge in trading.

Take me for example. Trading is how I earn my living. I get up every morning, check the markets, my filled orders and open positions and then look every day for high-probability, profitable trading opportunities. I often find that I will take trades that are less-than-perfect setups because I must do something to try to make a living. Ok, ok, maybe I do have a slightly itchy trigger finger…BUT…I can’t sit on cash earning 0.2% all year.

Non-professionals don’t have to trade every day. They have the luxury of being able to wait for “perfect” setups before putting money at risk. Non-professional traders can wait for the trades with the ridiculously high probability for success. Professional traders like me are going to be a little less selective.
Only a few times a year does the market gives us truly excellent, low-risk, opportunities to trade. These are virtual “no-brainer” setups that are so easy to make money from, traders can earn a year of returns in just a few weeks.

Let me give you an example. Back in early December of last year (that’s 2017 folks) tech stocks were getting thumped. Nothing fundamental had changed, it’s just the big players in the market were simply cashing in on some alpha and rotating to new sectors. This was a great opportunity for traders with a good trading method to place some low risk trades in tech names such as these:

Facebook FB rally
NVDIA rally
Adobe ADBE rally
Salesforce CRM rally

(for those of you following my trading methods, these were all bounce trades)

For traders, late last year was a terrific time to get long the tech sector.

You get an opportunity like this maybe a handful of times each year. Sometimes – as with this example – you have to act quickly. Other times you can have days or even weeks to get set and let the trades play out.

Non-professional traders can do very well by catching just a handful of these setups each year.
I think part-time traders ought to expect to make at least 2% on invested capital on average, every month. I know that may sound high – especially since the average hedge fund, mutual fund, and pension fund can’t make those returns, even in a very bullish market.

But think of it like this: If you were running this as your own business (which you should be), what’s the minimum return you’d expect to make for the risk and effort? Frankly, if you can’t make at least 20% on invested capital per year in your own business, it might be time to try something different?

The beauty of it is you don’t have to sit in front of a computer screen all day to make those kinds of returns. But you must have a robust trading method that gives you an edge and you must take an active role in your trading.

The trend trading methods I teach all use daily charts and all orders are placed outside of market hours. I can generally get my trading done in 30 minutes per day or less, for each market that I trade. Personally, if I don’t make at least 5% per month on my trading account, I consider it a bad month. A good month is 8% or more.

Trading is unemotional

trading is unemotional

Good traders have to be unemotional about their trading. The dominant emotions when it comes to trading are – you guessed it – greed and gear.

Both of these emotions are kept in check with strong money management and discipline.

Let’s check in with fear first. Fear can lead to panic and our cognitive ability declines considerably when we panic. We humans are really pretty hopeless when we start panicking. (I had the opportunity to ponder this as I got stuck in a huge rip while swimming in the Indian Ocean last week!)

So managing fear and avoiding panic is crucial as a trader. How do we achieve this?

The secret sauce is position sizing.

The magic of position sizing

I can’t have so much money invested in a trade that I start reacting emotionally to it – watching every uptick and downtick – and second-guessing every little move in the market. Over the years I have learned that I have an (unpleasant) emotional reaction if I lose more than a certain dollar amount on any one trade. This I call my pain threshold.

Everyone’s pain threshold will be different. It will be a function of account size, experience and individual risk preference.

So what I have to do is limit the size of every trade I place to an amount that I can be unemotional about. If I’m trading with 100% of my trading account, I’m going to be nervous. I’m going to react emotionally, and it’s going to affect the outcome of my trades to the point where my returns would suffer greatly.

Let’s just say that your pain threshold is $100. In other words, if you risk more than $100 on a trade, it’s going to cause you one or more of the following symptoms:

  • Trouble sleeping
  • A knot in your chest
  • Sweaty palms
  • Irritability and grumpiness
  • Anxiety
  • Your thoughts keep on going back to that particular trade

Now when I talk about risk, I’m not talking about how much money you put into a trade. I’m talking about how much money you are prepared to LOSE on a trade.

For a long trade, risk is defined as:

Risk = (Entry Price – Stop Loss) * Number of shares

Continuing with this example, our risk/pain threshold is $100. Now lets assume the  entry price on a trade setup is $27 and our stop loss is $25.50. In order to determine how many shares we can buy and remain within our pain threshold, we can re-arrange the equation above as follows:

Number of shares = Risk / (Entry Price – Stop Loss)

Number of shares = $100 / ($27 – $25.50) = 66 shares (always round down when managing risk)

Therefore, in order to keep the trade at a comfortable, unemotional risk level, we would buy 66 shares, knowing that our maximum expected loss* is $100.

*this does not account for slippage or unexpected gaps down in the stock price.

Managing greed

managing the emotion of greed

In order to effectively manage greed, you need to overcome a different type of fear: The fear of selling a position.

I’ve seen this fear paralyze traders, and it’s one of the biggest mistakes you can make. A trader can have a solid profit on a position, it’s hit her target, but she’s afraid to take the gain because she thinks it might run even higher. Ultimately, she ends up holding on too long and giving back most, if not all, of her profit.

I am a massive advocate of traders paying themselves (by taking profit on part of the position) and reducing their risk (by trailing their stop-loss) as a position moves into their favour. This is something I teach all of my traders. Not only is it great for your bottom line, it’s also great for your emotional health. It’s a wonderful feeling to take a bit of profit on a trade and move your stop-loss to breakeven, knowing that this position is now very unlikely to lose you any money!

Good traders consistently take profits on their positions, and they stop out of trades quickly when they’re go the wrong way.

This way, your losses are always small (i.e. within your pain threshold) but your profits can occasionally be huge!

In this post I have explained:

  • the importance of having an edge in trading
  • the magic of position sizing
  • how traders can take the emotion out of trading

Good trading!