Lesson 14: Building a Plan - Part 3
Suppose you were to walk into a physician's office and ask for a
medical examination. Whatever age you were at currently, you would
like to be able to live a long and healthy life thereafter. In
response to your request, the physician would probably call for a
complete medical - to see what sort of condition you were in. If your
diet consisted of too many fatty foods and too little in the way of
vegetables or whole grains, the physician would probably recommend that
you change the ratio of the foods you consume. The physician
would explain to you the reasoning behind the suggestions and if you
did want to live a long and healthy life, you would probably go along
with at least part of the plan.
When it comes to stocks, futures and options trading, the first thing
you should do is to give yourself an examination of your own history
of trading. You should do this whether you have been successful or
whether you have not been successful. The best starting point in such
a self-examination would be to take all your trades for as long as
you have been trading or for the past two years or the past year or
the past six months, for whatever time frame you have the present
time to organize and analyze. Once you have all these trades
collected, you should then divide the trades into those that made a
profit and those that resulted in a loss. It is unlikely that you had
many trades that were exactly 'break-even' trades, but if you did you
can create a third category.
To find out how well you have been doing (although you know the
answer to this question before you even ask it) you will have to look
closely at the trades that returned you a profit and the trades that
returned you a loss. Set up a worksheet by which for each of these
trades you list date entered, date exited, number of days in the
trade and the resulting net profit or loss when the trade was closed.
When you have done all this you will be able to establish the following,
- How many profitable trades you have made.
- The average profit per profitable trade.
- The length of time you remained in each profitable trade.
- The average length of time that you remained in each profitable trade.
- How many losing trades you have made?
- The average loss per losing trade.
- The length of time you remained in each losing trade.
- The average length of time that you remained in each losing trade.
You now have some information on which to make a diagnosis of your
investment experience during the past six months or two years or for
however long you have been trading. To use some imaginary figures,
let's look at the above table and simply fill in some numbers just to
give us something to work with,
- 17 profitable trades made. (Hypothetical)
- Average profit per trade $325.00
- There were several trades that lasted 2 days and a couple that lasted
4 days and three that lasted 1 day.
- Average length of time in profitable trades was 5.2 days.
- 17 unprofitable trades made. (Hypothetical)
- Average loss per trade $848.00.
- There were two trades that lasted 14 days, two trades that lasted 19
days, and two trades that lasted 45 days. One trade lasted 185 days.
- Average length of time in unprofitable trades was 38.7 days.
The end result was 17 hypothetical trades yielding a net profit of
$5,525 dollars and 17 hypothetical trades resulting in a loss of
$14,416 for a net overall loss of $8,891. This analysis is very
similar to the physician's examination of your diet. The physician
might ask you, "what do you eat at your meals each day".
You might ask yourself, "How many winning trades and how many
losing trades did I have". The physician might then calculate
the ratio of healthy foods to non-healthy foods and give you a
number. In your self-examination you would ask yourself how long you
were holding onto your winning positions (5.2 days) and how long were
you holding onto your losing positions (38.7 days) and you also would
have a number.
A good rule of thumb is that the average length of your winning
trades should be two-times to ten-times the average length of your
losing trades. If your analysis of your own trading
experience does not show such a pattern and you have suffered losses
from your stock, futures or options investing, then you should
probably consider changing your pattern of trading. You are staying
with losing trades too long and you are cutting your winning trades
off too quickly.
What does all this have to do with "building a plan"? It
can have everything to do with it. You should build a financial plan
in the same manner that you might build a health plan. You develop a
health plan by improving the ratio of the consumption of grains,
proteins, fruits and vegetables to the consumption of milkshakes,
corn dogs and chocolate pie. You develop a financial plan by laying
out a program that allows you to cut your losses off rather quickly
but to remain with your profits for a longer period of time.
Let' look at the wheat market we were discussing in lesson 13. The
idea was tossed out that we should examine buying December wheat
futures on July 1 and selling December wheat futures on December 1 to
see what happens when this is done. But we need not look into
the past to immediately spot one primary benefit from such a trading program.
The immediate benefit that jumps out at us as we consider such a
program is that for every profitable trade in this program, the
trader remains with his position for five months. That
is an average trade of 150 days per profitable trade. This amount of
time is almost unheard of as an average time period for holding a
winning futures position. I read somewhere that the average futures
trader holds his position an average of one week. No wonder it
is difficult to achieve a significant profit if one is only remaining
in the market with a winning trade for an average of 5 days.
It is difficult to achieve long term success if the average trader
doesn't remain with his winning positions long enough to allow them
to turn into major profit centers.
Let's look at wheat again. Assume that we had only one method of
trading with three rules. Buy December wheat on July 1 and sell
on December 1 with a stop/loss order entered $500 below the purchase price.
Let's pretend we do this trade in the year 2000 and the year 2001 and
we don't even look into the past to see whether we want to take this
trade or not. We simply do it, on July 1 of 2000 and again on July 1
of 2001. Now, in this make-believe hypothetical world we are working
in, let's assume that in the year 2000 we suffer a loss of $500 and
that this loss occurs on July 31st. Let's assume that in the year
2001 we earn a profit of $1,500 and the profit naturally comes on
December 1. What has our one sentence plan for trading December wheat
futures achieved in this hypothetical example?
- We have 1 winning trade.
- We were in our position 150 days.
- Our average profit was $1,500.
- We have 1 losing trade.
- We were in our position 30 days.
- Our average loss was $500.
We have "cut our losses short" and "let our profits
run". The length of time we remained in our profitable
trade was five times the length of time we remained in our losing
trade. We ended up with a 5-1 ratio in favor of the winning trade.
Isn't that what we all want to do, to remain with our winning
positions while quickly getting out of our losing trades? Always
remember this as you formulate whatever plan it is you are developing
to use for the balance of your trading career and to leave for your
children in your will. If you have had a great deal of success in the
past calculate the ratio between the lengths of time you held winning
trades and the lengths of time you held losing trades. Calculate this
ratio especially if you do not have a successful record to work from.
These numbers will tell you much. They will tell you the personal
ratio you have for the lengths of time you hold winners as
compared to the lengths of time you hold losers and to be successful
that ratio should be 2-1 to 10-1.
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