How to win the trading game by adjusting your position sizes

The only way to win at trading is have larger position sizes when you are right and smaller position sizes when you are wrong.

You can adjust your position sizes when trading with multiple units

• Enter 3 units into the market (one unit could be 100 shares, or 50 shares, or 1000 shares, or 1 unit count be 1 option contract, or 10 contracts, etc.,you determine the unit size per your money management rules)

• Pre-determine 3 levels of stops and the minimum profit target (for example, if you enter the market at price of 50, you stop 1 could be 49, stop 2 at 48 and stop 3 at 47, and the minimum profit target at 53). Make sure your profit goal is larger than your stop loss point.

• Stagger out of your trades when wrong by reducing your positions. If the market reaches your stop 1, you exit 1 unit. If the market still against you, at stop 2, you exit another unit…if market rebounds, you still have 1 unit. If market continues against you, you are out of all units. Wait for next trade.

• If the market moves in your direction, hold on to all your positions until it reaches the minimum target price. STAY with ALL your positions until they meet the minimum profit objective.

• Once the price reaches your minimum profit target, you can exit 1 unit of your position for profit. Now with the use of trailing stops for the other 2 units, you are going to sit back and try to go catch a big move. Use a breakeven stop to never let a winner become a loser. You will never know when it will happen, but it is critical that you are there when it happens. Adjust your stops as the market moves with you

“Fear and greed are emotions felt when you don't have specific rules in place. Follow your rules, and the only way to have confidence in them is to test them.”

You can only do the above steps with MULTIPLE units, i.e., trading with multiple units
“…trading 1 unit size is a fool's game…” why?,

Ok, you entered the market. Now your positions show a small profit. Here is where the true test of your nerve will be played out. The natural tendency will be to take it. Will you be right? Sure, sometimes you will catch the top before it retraces, but when you get into a habit of doing that, you will miss the big trenders and you will curse and stomp around and there is nothing you can do.


80% of your Profits will come from 20% of your trades (Pareto Principle).

What is an Edge (How to engineer an Edge)

I believe Edge makes people successful, but what is the Edge?

We have defined “Edge” in the Note “The Holy Grail Formula”,

Edge =(1+ Reward/Risk)*P(w) -1

P(w) is the probability to win, or Win%.

We also said that Edge must be positive if you want to be successful. If your Edge is negative, don’t waste your time.
.
Do we have an Edge if we go to a Casino and play Roulette?

Let’s calculate, Roulette has 38 numbers, and if you bet the number correct, you win 36 times of your bet. So,

P(w) =1/38
Reward/Risk = 36/1

Edge = (1 + 36/1) * (1/38) -1 =37/38 -1 = -1/38

The Edge is NEGATIVE !, that means we don’t have an Edge in playing Roulette.

I like play stock option vertical spread. Play options allows me to easily calculate Reward, Risk, and Probability. For example, if you play a $5 spread vertical, currently is selling for $4. That means you risk $4 to make $1, and at the moment I purchase the spread, I assume my Edge is zero, so

Edge =(1+1/4) * P(w) -1 =0, thus

P(w)=1/(1+1/4) =80%

What is saying is that you have 80% chance to be right when you risk $4 dollar to win $1 dollar.

Now, if you are a good chart reader, and you don’t have to risk the full $4 before you think the position is wrong, if the chart turns sour, you want to get out before you lost the full $4 dollar.
Let’s see, so, you are only willing to risk $2 dollar to win $1, and if the estimation of P(w) is correct. Then,

The real Edge=(1+ ½) *80% -1 =1.2 -1 =0.2
Booya!, we got a positive Edge. We are engineering a positive Edge by adjusting the Reward/Risk ratio.

That’s my main strategy to play option with Edge. I will provide more details in the later date.

The "Holy Grail" Formula for Trading

Let’s develop the “holy grail” formula for trading.

Collect all the trades you did last year, separate them into two groups: winners and losers. Now calculate the following:

AverageWin=(Sum of all winners in dollar amount)/(total number of winners)
AverageLoss=(Sum of all losers in dollar amount)/(total number of losers)

Total numbers of trades= (Total number of winners) + (Total number of losers)

Win% = (Total number of winners)/ (Total numbers of trades)
Loss% = (Total number of losers)/( Total numbers of trades)


Total Profit = (Sum of all winners in dollar amount) – (Sum of all losers in dollar amount)

Divided by (Total number of trades) on both sides of the above equation,

(Total Profit)/(Total number of trades) = (Sum of all winners in dollar amount)/ (Total number of trades) – (Sum of all losers in dollar amount)/ (Total number of trades)

Now let’s study the first term of right side of the equation: (Sum of all winners in dollar amount)/ (Total number of trades)

(Sum of all winners in dollar amount)/ (Total number of trades) = AverageWin * Win%

Similarly,

(Sum of all losers in dollar amount)/ (Total number of trades) = AverageLoss * Loss%

Now let’s define:

Average Profit per trade =(Total Profit)/(Total number of trades),

Now we have:

Average Profit per trade= AverageWin * Win% - AverageLoss * Loss%

Since Loss%=1-Win%, so the above equation becomes,

Average Profit per trade= AverageWin * Win% - AverageLoss * (1-Win%)

Average Profit per trade= (AverageWin + AverageLoss )* Win% - AverageLoss

Now if divided both sides by AverageLoss,

(Average Profit per trade)/(AverageLoss)=(1 + AverageWin/AverageLoss) *Win%– 1

Before we continue to make conclusions from the equation, let’s use some actual numbers. Let’s say your collect all your trades last year, the numbers are as follows:

Total Trades=100;
Total number of winners=60
Total number of losers=40
Sum of all winners = $12,000
Sum of all losers = $4,000
Total Profit=$12000 - $4000 = $8000
Average Profit per trade=$8000/100=$80

AverageWin = $12000/60 = $200
AverageLoss = $4000/40 = $100
Win%=60/100

Now let’s calculate the right side of our final equation:

(1 + AverageWin/AverageLoss) *Win%– 1 = (1+ 200/100) * 60% -1 = 1.8 -1 = 0.8

So,
(Average Profit per trade)/(AverageLoss)=0.8 =80%
Or,

(Average Profit per trade)=80% * (AverageLoss) =0.8*100=$80.


Now let’s again look at more details about this equation

(Average Profit per trade)/(AverageLoss)=(1 + AverageWin/AverageLoss) *Win%– 1
We can make the following conclusions:

If the right side (1 + AverageWin/AverageLoss) *Win%– 1 is equal to 0, then Average profit per trade is zero

If the right side (1 + AverageWin/AverageLoss) *Win%– 1 is less than 0, then Average profit per trade is less than zero, i.e., we will lose

If the right side (1 + AverageWin/AverageLoss) *Win%– 1 is greater than 0, then Average profit per trade is always positive, i.e., we will win.

In summary, if we want to win, all we have to do is to make
"(1 + AverageWin/AverageLoss) *Win%– 1" great than zero.

We can call the term as “expected gain” or I’d like call it “Edge”

"Expected Gain" or Edge = (1 + AverageWin/AverageLoss) *Win%– 1
To be winners in the market, all we have to do it is to make “Edge” positive.

There are two factors determine the Edge:

1.The ratio of AverageWin/AverageLoss
2.The win%

Engineers are usually smart people, they always try to be perfect. That’s why they always try to get a higher Win%.

“…engineers and accountants are usually bad traders” -claimed by many trading experts, especially people with psychology backgrounds in books or internet articles.

Let’s say your Win% is 80%, but AverageWin=100, AverageLoss=1000,

Your Edge or expected gain is

(1+ 100/1000)*0.8 -1 = -0.12, Which is NEGATIVE, that means you will lose money.

So, Win% is 80% means nothing if your AverageWin/AverageLoss is small.

Now, if your Win% is only 50%, but your Win/Loss ration is 2, then your edge is

(1+2)*0.5 – 1 =0.5

That means you will win.

“My percentage of winners is only about 50/50, because I cut my losers very quickly. The maximum loss I allow is 7 percent, and usually I am out of a losing stock a lot quicker. I make my money on the few stocks a year that double and triple in price. The profits in those trades easily makes up for all the small losers. “ - David Ryan
Next time, if you see some advertisements such as this one, "Join us, Trade Stocks, Futures, And Forex With Up To 80% Accuracy …",you know what to ask them.



“Human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.
Two of the cardinal sins of trading - giving losses too much rope and taking profits prematurely - are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance.”- William Eckhardt