Lessons from the Pros

Being Right Versus Being Profitable

As human beings, we have certain built-in emotional characteristics. These have evolved – and rightly so- as survival mechanisms. Fear is one of these emotions. When we’re put in a situation in which harm may come to us, fear is what triggers us to recoil, or seek a safe harbor. It’s almost instinctual that we avoid, or quickly move away from any situation that might cause us to experience pain.

Conversely, we’re attracted (like moths to a bright light) to experiences that provide us with pleasure. Whether it’s great food, fabulous wine, or lengthy vacations to beautiful destinations, we all desire as much of these as possible. In fact, marketing agencies make millions of dollars (as do Presidential campaigns looking to win elections) by tapping into these feelings of pain, fear, and pleasure.

It’s also true, for the most part, that when people are faced with the choices of avoiding pain versus feeling pleasure, they opt clearly for the avoidance of pain. A clear illustration of this concept applied to trading or investing is one I often use in class. I pose a scenario in which an investor owns three stocks: one is profitable, the second is breakeven, and the last one is currently trading at a loss. I then ask, "If given the choice to sell one of the three, which one would you sell first?" Invariably, most choose to sell the winner, and hang on to the loser.

All this ties in with some of the questions I received from readers about my last newsletter. In particular, I was asked to expand on this paragraph: "In order to maintain favorable odds, and shift the focus away from being right most of the time, perhaps another rule might put emphasis on trading only with favorable risk-to-reward ratios (preferable 1-to-3 or more)."

First, let me start by sharing some observations of over 18 years in the trading business: Most people new to the trading business come by way of marketing campaigns. These marketers naturally appeal to people’s greed (pleasure) – usually glossing over the potential for loss (pain). The irony of course, is that to be successful in trading, we must first embrace risk. Translation: we must accept losses, and reconcile the fact that we will be wrong often.

It’s well known in the trading community that surgeons and lawyers make the worst traders because of their inability to accept when they’re wrong. This attribute is great for their respective professions; after all, I would want a lawyer working on my behalf, or a surgeon operating on me, to possess this "must get it right" type attitude. However, big egos have no place in the trading world. Ego impairs our judgment; it causes us to impose our will on the market, thus allowing what should have been small losses, to magnify until the pain becomes unbearable. It’s at this point that the suffering must be arrested, and the only way to do that is by closing out the position.

What I show students in class (in an effort to de-emphasize this notion that one has to have a high win-loss ratio in order to make money) is that they should spend most of their time looking for low risk entries. The most important focal point of any trader should be to identify price levels at which he/she can expose the least amount of capital, if proven incorrect, and reap the most profits if correct. What this does is re-enforces the trading maxim "cut your losses short, and let your winners run".

I find many new traders are content taking small profits, mainly because it FEELS GOOD to do so. However, if you only gain $1.00 for every $1.00 risked, you would have to have a higher than 80% win-to-loss ratio in order to be consistently profitable. This is a tall order for most professionals, let alone a novice. After commissions, taxes, and trading expenses the math just doesn’t add up. On the other hand, if you profited 3 to 5 dollars for every dollar you lost, you can see that even if you were only right 50% of the time you would still be profitable overall. Incidentally, some of the most profitable (audited) methodologies have about a 40% win-to-loss ratio.

The way to calculate risk-to-reward ratios is quite simple. Say you’re trading the ES (E-Mini S&P) with an 8-tick stop loss ($100). If you’re buying it at or near a support level, you should figure your first target would be the next prominent resistance point. That resistance should be at least 24-ticks ($300) away, if this is not the case, you should take a pass and wait for a better set-up. Only by being discerning, will you be on the path to a lengthy trading career, as opposed to those futures traders who blow out their accounts in six months.

All and all, if you exercise patience, aren’t bothered by taking small losses, and have the mental fortitude to let those winners run, you can move towards experiencing the pleasure of being a consistently profitable trader.

Until next time, I hope everyone has a profitable week.

If you have questions, comments or you’d like a specific topic covered, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez