Good day, All! We are back for another round of discussion on the topic of systems. This blog is less about the development of systems and more about the concepts behind finding a system that works for you and your trading personality. If you are looking for help in creating your own system that works for you then I would recommend gaining a working knowledge of the concepts we go over in this blog and then heading over to Tackletrading.com and checking out Systems Development 101. This can help round out your knowledge and help you to ensure that whatever system you decide to use that it will give you the best opportunity to be successful.

To quickly recap last week’s blog, we talked about how some high probability systems can be problematic if the trader’s skill doesn’t match the system requirements and also that if the inner workings of the systems are not understood well enough for flawless execution then we can run the risk of ruin. It is this risk of ruin that we must fight against with furious vigor! Risk is going to be the focus of this week’s blog.

It is very common for folks who dive into trading to look at two things right away when they are introduced to a new system or just being brand new to trading. Those two things are how often am I right and how much money do I make if I am right? This is only natural because really that’s why people trade, they want to make money. Let’s explore how this can work out for us if this is all that we focus on.

First, let’s say we are right 90% of the time. That puts a warm fuzzy feeling in the mind of the trader. This satisfies the human need to be right. We are taught at a very early age that being right is a good thing and then throughout the vast majority of our lives this concept is drilled into us. Let’s take our school system, for example, we go to school and we learn subjects and then we are tested to see if we know these things. Furthermore, we are graded on how much knowledge we retained or to put it another way we are rewarded for how many correct answers we get. To further ingrain this need to be right into us we are usually praised or chastized according to how right we are. If you take a good report card home you are usually given some form of acknowledgment or encouragement and this recognition gives us a little boost of endorphins and everyone strives for more of that. If you need further proof of one’s reward for being right, take a look at the process of going to college or university? If you are not right enough then you are not admitted or perhaps those who were right more, or achieved higher grades, would get placed first. This double reinforces the need to be right. As I said, if you get into the college of your choice then you get a nice boost of endorphins and if you are not admitted then you are essentially being punished by not getting admitted. So, as you can probably now understand the need to be right runs very deep.

So now that we have satisfied the need to be right we need to go the second place that folks look at and that is how much money can be made when they are right? Another common practice for people who are starting out in trading is to set some goals on how much money they wish to make and this is also natural and can be very constructive in building a plan to be successful but this issue pops up when folks stop at this part of the process. I often see when people are setting goals that they talk about making $1000 per week or making a million dollars over some period of time. This only step one of putting together a solid trading plan. Once you have the number you want to shoot for then you must look at the other side of the equation and that is how much I am willing to lose to achieve the number I want? This is the hard part for the majority of people because they don’t come into the market place thinking they will lose? As we went over in the above paragraphs the need to be right is deeply ingrained and it does a very good job of clouding our thinking as traders. We need to guard against this tunnel vision and the best way to do that is to look at the risk first and then reward afterward.

If we are wise enough to assume that we will lose on a certain number of trades and then plan accordingly by looking at our total capital number and making sure that we are still able to stay in the game even if we have an extended period of losses then we can plan to achieve the results we desire.

So, let’s talk a little more about risk. If you take a deck of cards and pull one card and each time you pull a red card then you have a losing trade and each time put that card back in the deck, how many times in a row do you think you would pull a red card? Would that happen 3 times in a row? How about 5 times in a row? How about 10 times in a row? We don’t really know how many in a row may come up but what we do know is that the odds of pulling a red card vs a black card is 50/50 because there are an equal number of cards in the deck and that over time and many pulls the red cards vs black cards should get close to even. That is how odds and probabilities work out. So what does this have to do with trading and risk? Well, we need to figure out the worst-case scenario of how many times in a row that a red card may come up so that we can plan accordingly how much we are willing to risk on each trade so that we are still around to trade another day and that we don’t blow up our account which takes you out of the trading game.

Using the card analogy we assumed that we win 1 unit when we are right and we lose one unit when we are wrong. In this scenario, we realize that we need to be right more than 50% of the time to make money. This means we need to pull red cards more than half the time to make money but we know that over time because the odds are 50/50 that over a large enough sample size that we should pull close to the same number of red cards and black cards and that this system over time would be a losing system, especially after we factor in the costs of running the system. Here it appears that we need to be right more often than not to win, which is kind of the opposite of what I was saying, right? That’s not exactly true, let me explain. I spoke about risk and dealing with that first, let’s say we were able to reduce the risk of a red card by half, meaning that each time we pull a red card we lose only 1/2 unit and each time we pull a black card we win one unit? All of a sudden we now have a winning system even including costs!

I hope by this example above you can see that risk is the most important factor in the trading game. Over the next few weeks, I will delve into a few more examples and also talk about how we can determine what our own realistic winning percentage is and how we can manage risk around that number.

Until next tine, trade well.

Coach Holmes