Hello All,

Last week we talked about risks that are seen and known and some that, much like my cliff diving experience, are maybe not known or fully understood. I think it is easy to see that these unknown or misunderstood risks can lead to a great disaster in trading. We demonstrated these risks using a credit spread in AAPL just to give the discussion some context. This week I would like to give a little more context and have a gander at the different parts of a system and what we can do to prevent that disaster from happening. So let’s DIVE in! LOL

This next situation that I am about to describe was a pretty big source of embarrassment for me when I was a new trader. I think it shows what a lack of understanding that I truly had as a new trader. I would also bet that I am not alone when it comes to making these kinds of mistakes. As a matter of fact, the more traders I meet and the more great traders I come in contact with the more stories I hear that are quite similar to the one I am about to relay. You see…when I was a young trader I didn’t fully comprehend the business I was embarking on. I was able to jump right into investing and trading with little to no barriers and therefore I wrongly underestimated the dangers I was about to face. You see when I started off as a trader I was using one of those high probability systems that we have been talking about for the last few weeks. I had a friend of mine introduce me to a high probability credit spread trading system that he had learned from some other source that I was unaware of or cared to find out about. My friend had told me about all the money he was making selling credit spreads and I was fascinated by this because to this point in my trading/investing life I had just bought a bunch of dividend-paying stocks and sold them when I had made a nice profit. This wasn’t much of a system but I did pretty well at it. I later realized that my timing was much better than my overall skill and that when I had actually entered the market was a banner time for going long value stocks. Although I had made some money trading those value stocks, I really wasn’t killing it in the markets like I thought I should be or like my buddy said he was. So, after many conversations with my friend who had the credit spread system, this was a far out of the money credit spread system, by the way, I decided to sit down with him and learn how to implement this system. In reality, implementing the system was nothing more than the right buttons to push to get the trade into my brokerage account. At this time I didn’t understand much about risk and reward or position sizing or really much else. I essentially learned to copy what my friend was doing. I went on thinking that if I just copied what he did then I would have the same success he did.

Fast forward about six months…my buddy had moved away for work and I was on my own trying to copy what he did and be successful. This actually worked for quite a while. It was so successful that I was out on the golf course with another friend of mine that I had shown what I was doing and we were laughing at how easy it was to make money in the markets. I believe the term “taking candy from a baby” was thrown around. Well, I don’t know if karma was listening to our conversation that day or whether it was just good timing again to start using what I was using but that very next day the market turned. I wasn’t too concerned on the first day because it only clawed back some profits and I was still in the black. I figured I was fine because I still had a cushion and I had made a fair bit of money using this system already. The very next day again went against my positions, at this point I was underwater on a couple of positions but really close to breakeven. In hindsight, I should have done something right then and there and it would have saved me a tonne of heartbreak. Herein lies the problem, even if I wanted to do something that day to stop the pain, I hadn’t learned how? You see, mimicking a system is all fine and dandy until something goes wrong and then you need to know the rest of the parts of the system to be able to work out of the issue. I didn’t know the rest of the system and my buddy who showed me the original system wasn’t around to help me out. As it turns out, he didn’t really know the other parts of the system either because after speaking to him, later on, he suffered the same fate as me which was a total loss. All the positions I had on went against me and essentially destroyed that account. If you look at the example from last week’s blog you will see that the risk was over 4 times the reward and the spreads I had been doing were even worse than that!

I had said that this was a source of embarrassment for me at the start of this situation and it wasn’t until later when I really started to understand what trading was all about and I was able to look at the situation with a more objective and experienced point of view. It was actually this devastation to my account that spurred me on to learn more about what I was doing and pretty everything else I could find out about trading the markets. So, in hindsight, this knockdown was actually a blessing although at the time I didn’t think so and it would have been so much better if I could have learned this lesson without the massive beatdown that my account took. However, I am hopeful that this series of blogs may help prevent other traders from suffering that same fate and so that is why we are talking about systems and why I want to get further into the parts of a system and make sure that you all have a clear understanding of what it is that we are doing here.

The parts of a system as I see them are as follows, there may be different terms or different interpretations of a system but this is how I see it. I like to keep things as simple as possible because I believe in the old adage….the simplest solution is probably the right solution.

Part 1 of any system is the end game or the goal of that system. Some use the term objectives for what we are trying to accomplish. This part of the system is probably the most important part and the part that is often overlooked. I say that this part is often overlooked because most people think that “making money” is a goal or objective. I wholly disagree, this to me is merely a wish or a thought. For one to have a decent handle on part one of the system one must be ultimately clear of the stated goal! For example, I will make a 20% return annually with a drawdown of no more than 5%. This is very clear about what we are trying to accomplish.

Part 2 of any system is a framework of what processes are involved in running the system as well as what procedures that can achieve the results desired in part one of the system. This will include what markets are to be traded or what vehicles can present the opportunities necessary to achieve the desired results. This will also include contingency plans for the system should market conditions change or circumstances change while running the system.

Part 3 of any system is the mechanics of the system. We talked about the credit spread system that I used when I first started. That system had parameters and strategies as well as entry techniques and exit techniques. It is this part of the system that one must discover all ins and outs of the system and must become intimate with all the details of the system so that the pitfalls I spoke about above don’t befall the user of the system.

Finally, Part 4 of any system is the review process of the system. This part of the system takes a look at how the system performs and this is also the part where the system is controlled by keeping track of the mechanics mentioned in Part 3. This is also the part that allows a system to evolve as markets change or as the objectives in Part 1 change.

These are the four parts to a system as I see them and as we go along in this blog series we will discuss in more detail each part and shed some light on where our focus will make the most impact on our system and where we can tweak the parts of a system to produce the results we desire from Part one and possibly even increase the performance of the system overall.

So, be sure to look at your systems and see if you have all the parts we discussed and ask yourself what part do I focus on most and do the other parts deserve or require some more attention to prevent trouble in the system as well as optimizing the system we have.

Until next time….be well.

Coach Holmes