In the first blog, we took a basic look at risk and reward and we concluded we need an Edge.
The Edge is essential if you are going to win.
However, you trade you want your profits to exceed your losses – I don’t think I need to elaborate on that point.
In fact, there are two “metrics” which govern whether you win or lose. These are…
- the frequency of your winners, and
- the ratio of the average amount you win against the average amount you lose.
As an example, many trading systems or trading approaches may win 50% of the time – so the frequency of winners would be 50%.
If the amount lost and the amount won each time was the same – in this case, the ratio of the average win against the average loss would be 1 – the trader would not make any money because his winners and his losers would be equal.
Plus you must bear in mind the costs involved with trading. These can be minimal but you will have a computer, maybe a PDA, software, and you may subscribe to newsletters or attend seminars.
These can add up.
Your edge also has to overcome disadvantages such as the spread you may be charged and any commissions you may pay. (Tweet this)
So to make money with an approach approximating to 50% winners and 50% losers you really want to aim for an average winner twice your average loss.
Of course if you win more often, say two winners for every loser, then the average profit ratio can be lower.
We will be looking at your edge throughout this course but here are some examples…
- a trading technician will have an edge if he finds an indicator or combination of indicators that give an expectation of profit
- a chartist will have an edge if he finds a chart pattern that does this
- a value investor will have an edge when he finds a stock offering good asset cover, including cash, for his investment
- an arbitrageur will have an edge when he finds two or more positions which either eliminate his risk or bring it down to very low levels.
In the next module, we will be looking at the first stage of trading – where we fixate on profits and need to learn to cut losses.
Imagine if in one fell swoop you could remove your losing trades?
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