Today’s Trading Lesson: Foundation: The Secret To The Big Money In Trading
This probably isn’t where you thought we’d begin but it’s the most important trading lesson of them all...it has built multi billion dollar fortunes… not to mention many multi million dollar fortunes.
The way most people begin to trade is flat out silly. Why? Because the odds, just like in a casino, are stacked against them by the way they choose to trade. Most people have been lulled into thinking that there’s some magical tool that overcomes bad odds. They’re taught from an early age to be “investors.” That trading is all about the so called fundamentals and time.
They’re wrong.
Trading is about 1 thing…
Probability (well actually it's about expectancy which employs probability, but that's a lesson for a later day).
More specifically, trading is about you putting favorable odds to work for yourself… repeatedly. It’s about building a solid foundation for yourself wherein you exploit some favorable probability over and over… and over. The more times you’re able to exploit that favorable condition the more your money compounds… More on that awesome circumstance a bit later.
Bad (negative) probability can’t make you a winner. You can’t “make it up on volume” and trying harder will only make you more exhausted. There are tons of tools available that can help you trade profitably, but if you don't get the foundation built correctly, it doesn't matter what tool you use, you won’t succeed. Let's put that foundation in now.
Trend
Trend is the basis of all directional trading profits. You’ll hear a lot of people talking about this very thing. Trend is defined as a security’s general direction over some period of time. That direction is either up or down. A security can trade sideways for a time, but eventually it will resume moving in a general direction either up or down.
But trend is not the true foundation of your fortune. It’s a start, but it’s not what allows your money to grow from a small amount to a large amount… in fairly short order.
That distinction belongs to a concept called compounding. Let me explain.
Compounding
If you buy a share of stock and it trends higher over time, you will make money when you sell your position. If the stock’s price doubles over the course of a few years, you will make 100% on your money. Not bad as these things go.
The problem? Time.
If your portfolio is full of 100% gainers, but they all take on average 2 to 3 years to deliver that 100%, your wealth is growing. But it’s growing slowly.
And most portfolios don’t have names that deliver 100% in the first place… much less in 2 to 3 years. It’s actually 7 years if you believe the personal finance gurus.
Contrast that with a far more active portfolio that delivers on average 10 to 20% per stock, but in weeks versus years… As you might imagine the result is… better.
No matter what your process, if your winning results don’t have an opportunity to really compound, you won’t make real money.
Got that? Your money needs to grow in a compound fashion to really deliver the kind of results you want. This means we need to understand what compound growth really means.
I often tell students and mentees that a good short term trader beats a long term trader hands down. Why? Compounding.
Consider this: Trader Z is a “long term” trader. Last year he purchased a $25,000 position of a fast growing stock on January 1. The stock went on to double in price during the year which left Trader Z with $50,000 when he sold his position on December 31.
Trader Z was happy.
Now consider Trader X who happens to be the ultimate short term trader… i.e., he’s a day trader. Trader X started January of last year with $25,000 as well. But by day trading the same stock Trader X was able to average ½ of 1% (yes that’s a return of only $125 on day 1) per trading day for 200 trading days (essentially the equivalent of a calendar year assuming some days off). His result? He turned the same initial balance of $25,000 into a bit over $67,000 (that’s 68% better for you stat geeks like me).
How does he do so much more with the same base and on the same stock?
Compounding.
Remember how I said Trader X returned approximately $125 on day 1? Well on day 2 he started with a capital base of $25,125. Doesn’t seem like much of a difference I know, but if he’s able to do this consistently, by day 20 his account balance has risen to approximately $27,622.39… which means on day 21 he’s able to take a $27,000 dollar position.
In share terms that means if the stock is approximately $100, on day 1 Trader X could purchase 250 shares… on day 20? 270 shares all else equal.
That’s how compounding works.
It’s also why it delivers far better results. And that’s even if you could consistently find stocks that double each year.
Which do you think is more reasonable… consistently finding stocks that double over a year or extracting $.50 profit from a $100 stock on average?
Here’s a hint… they’re both difficult. But it’s a lot easier to find a process that extracts $.50 per share per day than it is to find a process that delivers consistent annual doubles.
Time
One of the biggest rationales I hear from the anti day trading crowd is some version of, “you need time to let a move develop… and day traders simply don’t have that time.”
It’s true… THEY do need time to allow a bigger move to develop… because that’s where their process gets most of its return. Thus the only way a long term trader can be profitable is to capture big moves over long periods of time.
My way around that is to have relatively small positions and catch reasonable profits using price action analysis… over short time frames (intraday)… repeatedly.
Even though the first day (FAF) result above of $100 might seem like a paltry drop in the bucket... when you think about it, it's also a 10% gain on my initial capital. In a relatively low risk way.
And my starting capital on Monday is $1,100.
I'll take it.
So There It Is...
The not so secret secret.
You need a solid foundation in good probability strategies (though you only need 1 strategy) that you can deploy on small time frames repeatedly to generate compound growth.
Simple right?
Start small… deploy a profitable, low risk strategy on a small time frame… rinse and repeat.
Wake up tomorrow and do it again.
Linear growth versus exponential growth.
This is the foundation of the multimillion (and sometimes, billion) dollar profit machines run by hedge funds like Renaissance Technologies (look it up) as well as some fairly astute (if immodest) individuals :).
And it can be your foundation as well.
KIS.
P.S. Bored yet? So what... keep going. You're taking info in and you don't even know it. In the next lesson I'll make you uncomfortable by telling you why I'm doing this... my manifesto if you will. |
