Most people new to the financial markets are too focused on the upside. In fact, seasoned traders and investors may also fall foul of this tendency. It is nearly always more important to focus on the downside of your trade or investment.
“The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.” – Ed Seykota.
Ed Seykota is quite a famous commodity trader in the US and pioneered systems in trading. He worked with Richard Donchian in creating mechanical trend based systems. His message above is clear- for both mechanical and discretionary traders or investors, you must manage risk and cut losses quickly.
It losses are not cut efficiently, then you cannot build a solid Risk to Reward Ratio (RRR) average or expectancy over time. The RRR, also known as R Numbers are the corner-stone of an ‘edge’. An edge is often calculated using a Mathematical Expectancy (ME) formula. If your trading or investing strategy does not have a proven edge you will fail over time.
In both our trading and investing systems, we quantify risk and calculate the RRR very early. Knowing your risk first can then allow you to determine if the trade or investment is worth taking. As an example, if you are trading short term the S&P500 index and say, your risk is 20 points, then for a trend based system you should at least have a RRR of 2.0 (2.0R). That is, you hope to make at least 40 points on the trade. If you cannot probably do this, for instance there is an intervening support/resistance line, then do not enter.
For Reversion to Mean (RTM) based systems that uses pivots or Bollinger Bands for example, your Success Rate (SR) will usually be higher than trend based systems. This means your minimum RRR can be a little less, often a minimum of 1.5R or sometimes 1.2R.
This leads us to distilled elements of good trading-
I remember reading many years ago- if your expectancy is sound than little else matters. This may be a bit of an oversimplification, but if you are entering the markets without these basic calculations, then you are indeed trading or investing ‘blind’.
Lee Spano, Founder & CEO
Creatness International, www.creatness.com
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