‘If you don’t bet, you can’t win…if you lose all your chips, you can’t bet.’
Larry Hite, system trading pioneer
Short powerful statements are priceless. And this is one of the best. It captures the essence of successful trading with a simple analogy.
There are two parts to Larry Hite’s statement…
First up is the act of taking the trade. This sounds easy enough. But many people find it the hardest part of trading. The stress of committing to a trade can be overwhelming.
You see, this is when you put your money on the line. You swap the safety of an account for the uncertainty of the market. You’re taking a risk. And this makes many uncomfortable.
Managing this discomfort is essential. You can’t make money watching the game…you have to be in it. No one ever made a fortune by paper trading.
Now read the second half of the quote again ‘…if you lose all your chips, you can’t bet.’
Managing risk is vital to trading success. It is the single most important thing I can tell you. Yet many people give this little attention. Some even overlook it completely.
Today’s report will take a closer look at managing risk. The part I’m going to focus on is position sizing. I’ll show you the difference that the size of the trade can make to your results.
But first, let me tell you about Larry Hite’s impact on me…
My lesson from a market wizard
Larry is a pioneer of system trading. He was one of the first to use computers to test trading strategies. He also co-founded one of the world’s biggest trend following funds.
I first read about Larry in a book — Market Wizards, by Jack Schwager. It was 1993, and I was a junior currency trader at Bankers Trust.
Starting out as a trader at a bank is tough. It’s a case of sink or swim…and you don’t get much time. I remember a few trading careers only lasting months.
My main focus in those days was on a trade’s upside potential. I thought a few big wins was the best way to keep my job. And I was lucky. This got me through my first year.
But my approach was trouble waiting to happen. I wasn’t thinking enough about the potential for loss. My strategy was too reliant on being right.
Larry Hite got me thinking differently. I began to see trading in terms of odds. Gone was the dumb luck of the roulette wheel. I was now using probability like a pro poker player.
This was a career changer. I stopped taking marginal trades — that was gambling. Instead, I would look for situations where the potential gain would justify the risk.
I also reduced my trade size. It became clear that many small bets were better than a few big ones. My risk was now small and consistent.
This had a duel effect. It reduced the risk of any single trade becoming a disaster. Spreading risk also increased the odds of getting the outliers — the trades that run a long way.
Quant Trader uses the same principles. It buys into strength and sells into weakness — probability favours the trend. The system then spreads risk across many stocks.
Have a read of the following email. This member is discovering the difference position sizing makes. It’s the same lesson I learnt from Larry Hite when I was starting out:
‘Having used several of PPP’s trading services in the past, this is certainly different to previous approaches. I see Quant Trader as a system which relies on placing multiple small bets and letting the position run, thereby limiting individual losses to a manageable level.
‘Whilst it is still early days, the previous systems used by PPP have relied on a small number of larger bets (relatively speaking) to achieve the same desired profit outcome — this consequently involves a higher level of risk and leaves one prone to larger losses.
‘I like the risk minimisation approach of making multiple small trades with an average 25% stop loss. This means a $10k portfolio has a much lower probability of hitting all its exit stops than a single trade of $10k with a 25% stop.’
Many people make the mistake of a few big bets. The problem comes when something goes wrong. It can take years to recover from a setback.
Professional traders typically only risk a relatively small amount of capital per trade. It’s all about ensuring you stay in the game. Controlling risk is critical.
Swing for the fences or take the single?
Now let me show you the difference position sizing can make. I have three back-tests for you. They all use the same entry/exit triggers. The only difference is the trade size.
The tests cover the last five years. Each strategy starts with $50,000. There is no allowance for costs or dividends.
Here’s how the tests work…
First up is the big hitter’s strategy. The system bets 100% of capital on each trade.
The second is typical of many small portfolios. Each trade receives 25% of capital.
Finally, there’s the many small bets approach. This strategy puts down $1,000 per trade.
What do you think is going happen? This will help you understand why many people struggle to make money from stocks.
Okay, here’s our first test…
This is a volatile strategy. It all hinges on backing the right companies.
The stocks in this particular test perform poorly. That’s not to say this would always happen. But it did on this occasion. The system selects the first stock to signal on the start date.
It’s possible to make a lot of money with this method. But it only takes a few mistakes to bring it undone. This strategy requires luck — and loads of it.
Putting all your capital in one stock is a risk maximising strategy. There is nowhere to hide when something goes wrong. Your portfolio takes the full hit.
So let’s move to a four stock portfolio…
Many traders like concentrating their capital in a few stocks. They believe this gives them the best chance for a big win. The problem is they are still vulnerable to a large loss.
Look at the volatility in the graph. This is what can happen when a portfolio only holds a few stocks. There is a lot riding on getting every trade right.
Four stocks are certainly better than one…but there’s still plenty of risk. It only takes a handful of bad trades to ruin your returns.
Okay, it’s time for the $1,000 per trade strategy…
Remember, this test uses the exact same entry/exit methods. The only difference is the trade size. There are no big positions…just a lot of small ones.
The small bet strategy is a risk limiter. It lessens the impact of any one trade. This results in a smoother performance chart.
Spreading risk is the key to reducing volatility. Your portfolio will still have down periods — there is no getting around that. But a few bad trades won’t wipe you out.
People who bet big are often looking for fast dollars. Sure, it may payoff at times. But risk has a habit of catching up with bold traders. Sooner or later it takes them out.
Until next week,
Editor, Quant Trader
Editor’s note: Did any of your stocks hit an all-time high this week? Chances are the answer is no. And that’s understandable…the All Ordinaries is still showing a loss for the year. But some stocks are surging. They could make a big difference to your portfolio.
Take Blackmores [ASX:BKL] for instance. This week it hit $200 per share. And that’s good for Quant Trader’s members. You see, Quant Trader signalled this stock three times — at $33.93, $39.00, and $44.00. The first entry is up over 400%.
Anyone can get gains like these. It’s all about having the right strategies. You can learn more about these here. Look for Jason’s article. The title is ‘It’s an Eagle’s World’.