Know Your Odds Before You Trade By Lawrence Chan Second Edition potx

Odds of Your Particular Trade Being Profitable Odds of Your Trading Account Being Ruined Odds of a Retail Trader Being Able to Self-Correct Odds of a Retail Trader Mastering the Art of T

Know Your Odds Before You Trade

By Lawrence Chan Second Edition, April 2012 Copyright Lawrence Chan 2010-2012

Smashwords Edition License Notes:

Permission is given to copy, distribute, repost, reprint, and share this free eBook provided it

is presented in its entirety without alteration and the reader is not charged to access it.Also by Lawrence Chan, available now and soon at ebook retailers everywhere:

Special Theory of Price Discovery Market Bias Detective: S&P 500 Daytrading Time Map Vol 1 & 2 Market Bias Detective: ForexDaytrading Time Map Vol 1

Market Bias Observer Newsletter

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CFTC RULE 4.41 – HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN

LIMITATIONS UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT

REPRESENT ACTUAL TRADING ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT

NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN

Lawrence Chan

Toronto, April 2012

presented in this book My intention is to help traders, including those who just starting out,

to understand the subject better before it is too late

First Edition

Introduction

Odds in Trading

What Kind of Odds Are We Talking About Here?

Odds of Your Particular Trade Being Profitable

Odds of Your Trading Account Being Ruined

Odds of a Retail Trader Being Able to Self-Correct

Odds of a Retail Trader Mastering the Art of Trading

Beating the Odds

Practical Success for Retail Traders

Not Everyone Has an Equal Start

Accepting the Fact That You are Fighting an Uphill Battle

Have a Proper Battle Plan When You Fight a War

Patience Is a Virtue

Equip Yourself with Knowledge on All Aspects Related to TradingUnderstanding the Importance of Capital Preservation

Searching for Your Own Trading Style

There Is No Need to Trade Full Time

There Are Times You Should Simply Stop Trading

Too Much Positive Thinking Is Hazardous to Your Bottom LineAfterword

Know Thyself

Trading Skills Are Useful Outside of Trading

Resources for Aspiring Traders

Many people think that they are not trading but are just investing for the long term That is very much like telling people you are a vegetarian because you only eat chips and drink sodas These people often call themselves retail investors, a term that makes them feel much better and that gives them an excuse to not learn how to trade properly Hence, these individuals facie a similar (if not higher) risk of losing all their life savings just like the average person who gambles at the casino addictively.

The intention of this book is to introduce retail traders (and investors alike) to the concept of risk and to help them understand their odds of being able to make money from the markets When investors can recognize the risk involved and understand how the odds are in favour of their failure, only then can they be called an informed trader (or investor) who knows how to trade within the risk that he/she can tolerate

Many trading education books touch on this subject and what I have to say is not something totally new But no one, in the hope of selling their books, would spend all their efforts on what I am doing here — attempting to convince people to take trading slowly and seriously, explaining in painful detail why they will fail if they don’t Those who listen carefully and do what is necessary stand a better chance at developing into consistently profitable traders.Hidden in the odds against the traders are clear pathways to success once the traders realize what it takes to beat the odds The road to consistent profitability is long and rocky, because

we are humans and not machines Whether we like it or not, we are going to be subjected to emotional influences from the outcomes of trading and other unpredictable events

I do believe, however, given time and proper guidance, most people can achieve a reasonable level of consistency in their trading success

Throughout this book I use the word trader interchangeably with the word investor

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Odds in Trading

Odds, by definition, is the likelihood of one thing occurring more so than another

For example, what do we mean when we say that the odds are that it will rain today? It implies that it is more likely going to rain than not rain today Notice that we skip the other event (not raining) in the first sentence because there are two possible outcomes in this example: to rain or not to rain This means that if the odds favour that it will rain, then it is implied that the odds of it not raining are less likely

In trading, however, there can be many outcomes to any given trading position The trading position you are holding by the time you close out the trade can have many outcomes It may make a big killing, make good profit, make a tiny profit, not make any money, lose some money, lose big money, or lose more than what is in your trading account This is the first important fact to remember

As you can see, the odds in trading are complex There are many factors that affect the outcome of each trade, and accumulatively, on the net profit or loss made by the person throughout his or her life time Yet most people I encounter think of trading as a one-time event, and that one-time event has only two outcomes — they are either right or they are wrong By oversimplifying the matter at hand, or, maybe being misled into believing that trading is such a simple thing, the odds of these folks making money from the markets over their lifetime are pretty low.

What Kind of Odds Are We Talking About Here?

There are many kinds of odds that we can use to describe trading Here are four that I cover

in this book:

• Odds of your particular trade being profitable

• Odds of your trading account being ruined

• Odds of a retail trader being able to self-correct

• Odds of a retail trader mastering the art of trading

And don't forget that in life there are many other things that can affect the outcome of your trading We will spend some time on how to minimize the impacts of events that can affect your trading adversely Are you thinking that I am wasting your time already?

Here is a good example of what I mean You have just closed a trade that is potentially very profitable, and at the exact moment that you are entering your order on your computer, you are disconnected from your broker on the Internet How does that sound to you?

Now, I am going to explain each of the odds listed above in detail

Odds of Your Particular Trade Being Profitable

There are many ways to identify a trading opportunity There is absolutely no fixed rule on what or how a trade is entered As long as you have done your homework in identifying a trading setup, and you are willing to pull the trigger, you will be sitting on a position By the time you close your position, the trade is completed

Just how likely it is that you are going to be profitable on a particular trade depends on many factors This is not something we can tell precisely However, we can tell easily if the odds are reduced

With less than your ideal state of mind in making your trading decisions, odds of the trade being profitable is lowered.

Before entering a trade, there are three elements that can hel p you trade calmly and free of stress These are knowing exactly what type of risk you are getting into (e.g., using stop orders properly); having a full understanding of the winning probability of such a trade based

on the reasoning that gets you into the trade in the first place (e.g., historically how the scenario is likely to unfold, tips you get from a secret source); and knowing that in the worst case scenario this one single trade would not affect your ability to carry on your life or your ability to take the next trade

Anything less than this will make you nervous as the trade develops, introduce mistakes into your decision making, and turn a perfectly good trade into a disaster I am not talking about being completely numb to the risk that is being taken or not feeling any tension or

excitement at all I am talking about keeping your mind focused on the trade so that you can make sound judgments when they are needed the most

Here is an example If you have a reasonably stable income and your household cash flow is positive, then buying a lottery ticket is not going to make you lose sleep over the fact that the money you paid for the ticket is very likely to be as good as burned into ashes already But, if you throw in your life savings into buying all the tickets you can buy, then you are very likely going to feel extremely bad should the tickets not produce enough winnings to cover the cost

A confused plan, without proper preparation of your mind to handle the unavoidable losing streak, is another factor that can lower your odds of being profitable in a trade

A perfectly executed trade can be a losing trade There is nothing wrong with that IF you already know the exact odds of the potential outcomes Not accepting the losing side of the potential outcomes of your trades will encourage you to keep looking for the Holy Grail that will improve your trading The reality is that you have nothing you can improve because you

do not have the correct perspective that can help you improve

Trading in a market that is too risky for your tolerance level will lower the odds of your trade being profitable

Retail traders do not have the infrastructure of a trading firm to support them or the financial support that is much needed to develop their trading abilities They do not have an advisor to

talk to or a friend to talk to who can understand what they are going through Most of the money that retail traders put into their trading accounts is hard-earned money, making it extra painful to see how easy and quickly the money can be burnt Thus, the issue of a single trade going badly and having a negative outcome is especially problematic for retail traders Most people do not understand their own risk tolerance level Period It is not a function that only depends on the person’s net worth or how much burnable money there is in the trading account It is much more related to the personality and character of the trader Some people think that if they have more money in their trading accounts they would do better The truth

is that a bigger bank roll does not change a person's risk tolerance overnight If you are one of those people who have a very low risk tolerance, then even trading on the smallest possible size in some markets will paralyze you on the first losing trade, causing you to function badly when called on to make any sound judgments There are also people who pretend that they have high risk tolerance This is only good for showing off in front of their friends Their trading accounts will suffer

Trading mostly for the excitement or pleasure of the trade will not end well.

The other extreme in risk-taking behaviour is found in those people who take risk mostly for the purpose of getting excited (or high, depending on your demographic) The sense of fear, uncertainty, and insecurity felt at the time of waiting for the outcome of a trade (or the outcome of a game in the casino) is addictive for some people In this situation, trading is their venue for seeking excitement, not a means to gaining financially These people always violate the most basic money management rules and there is no training in the world that can make them better traders Those who choose to go to a casino for this kind of excitement

at the cost of ruining their lives are known as compulsive gamblers The best solution for these individuals is to stop trading (and gambling) and seek medical and psychological help

Retail traders are not properly informed by any stretch of the imagination.

Retail traders are lured to trading (well, mainstream media call that "investment") without knowing what they are getting into (Contrary to the fine print on the very complex brokerage agreement they signed hastily to acknowledge that they know their risks and understand the consequences.) Many people will say that it is these people's fault for not reading the

agreement and understanding the risk in the first place But risk is such a complex thing when

it is related to trading It is so hard to understand that brokers are required to pass several exams before they can go out and solicit clients Why, then, would anyone without prior

knowledge in finance think they can learn enough about the risk that they are going to take

by talking to these brokers for an hour or less?

Odds of Your Trading Account Being Ruined

Think of the game of roulette in a casino It is well-known fact that, if a casino is operating legally in the United States and in other well-regulated countries, then the casino is running its business on a very small but well-defined edge over its gaming clients who play the game

of roulette For most of the gamblers, the longer they stay at the casino and the longer they play over their life time, the greater the likelihood that they are going to lose money at the roulette table This is how a casino makes its money — the aggregated result from all

gamblers will give the casino a net profit, by probability In short, the odds favour the casino right from the beginning

So, if you like the excitement of uncertainty at the roulette table and play sensibly, meaning that you only bet a small amount per game, then you will have a good time of riding the roller coaster of winning some, losing some, and occasionally winning big At the end of an exciting week, you would probably end up not losing too much money and having a good time

Using the word sensibly is old fashioned because it means that, if you do something that is not sensible, you are an idiot Well, the politically correct term nowadays is gaming responsibly

I am not trying to be politically correct here, so if you do not like it, it is your problem

In trading, a retail trader is facing a similar problem because the odds are not in his or her favour right from the start If the person trades sensibly, then the trading account would likely enjoy a roller-coaster ride of account balance changes By the time the person stops trading, the account may end up with about the same amount of money that was put into the account over all those years, minus commissions, service charges, and margin interest This is going to happen no matter how smart the retail trader thinks he or she is, how much trust was placed in whichever guru he or she was following, or whatever random techniques were being used

Now some readers will figure out why I talked about roulette at the beginning of this section Gaming or trading sensibly is the keyword here that enables folks to keep most of their money

at the end of the game

Any rush to bet in larger amounts, without proper consideration of risk, in the hope of a bigger return, will put the trading account into a hole The losses will not likely be repairable

over a long period of time, if they can be recovered at all Doing something like that is

pushing your luck Some people do get lucky a few times, but just like the roulette analogy,

as long as these people continue to play the market, these lucky winnings will be lost over time

Remember the pain tolerance level I mentioned in the last chapter?

Here is the universal version for net worth and account balance Many people have a total pain tolerance level of around 20% of their account balance or amount in total life savings Some people may have a higher tolerance but mild symptoms will still show starting at around this 20% level What it means is that once a critical blow to an account balance has reached 20%, most people will stop acting with reason They will start to average down at all cost (even if their normal selves do not do that), act numb to cut losses, and bet all they have in the hope of a small gain

Their animal instincts to survival are triggered but the response is all wrong because we are not talking about a fight to the death situation here, and that financial matters do not work the same way as a fight to the death scenario

Unless the person fully develops a sense of capital preservation (or, well, is extremely lucky), eventually, just one mistake in taking on risk (read a single trade) that is too much to handle mentally by that person will wipe out all the profits this person ever made in his or her

lifetime

It is extremely important to fully understand the risk you are taking Think deeply of the consequence of losing all the money you have It could ruin your life and ruin your family, and you could be devastated by the results for a long time

Odds of a Retail Trader Being Able to Self-Correct

Most traders start out trading using charts, technical analysis, fundamental analysis, etc — whatever has been stuffed into their minds in the first place It could be an article from the Internet, reading books, or an introduction to an idea by friends Eventually, however, it will

be the concepts that fit their perceptions of what a market is that will dominate their

decision making

All these methods and tools give you a filtered view of the market This filtering process is like wearing a pair of coloured glasses You will see whatever is not filtered away, which helps you simplify the scenario so you can make a decision whether or not to enter a trade

But that is not scientific at all, because choosing a method to study the price behaviour of a market that has no objective quantification to determine its effectiveness is no different from believing the moon is made of blue cheese Retail traders are choosing a particular method to trade in a market because that method makes them feel most comfortable, not because it offers any form of profitability potential.

So how do traders advance beyond this stage of development in analytical skill? That depends heavily on the person’s ability to self-correct Self-correcting is the ability to sense problems

in the information gathered and proactively investigate the cause or origin of the problems, resulting in a correction of the knowledge acquired

For example, many avid readers are good at self-correcting when they read a line of text from a book that causes them immediate confusion about what the text really means They will reread the text again several times, more carefully, in order to sort out its meaning.Those who are able to apply their self-correcting ability to the information or knowledge gathered about trading at this point in time will not only review the information gathered but also will discard those materials that are irrelevant These individuals are the ones who will likely achieve some form of consistent success in trading

Those people who are not able to apply their self-correcting ability to their acquired

knowledge, on the other hand, will be stuck in their development As they seek more

information and techniques in trading to improve their poor performance, the pile up of these techniques will cause ongoing problems in their analysis There are two ways these individuals can overcome this obstacle

First, those who can make up their minds to completely discard the acquired knowledge and start over again on a clean slate can make a breakthrough in applying their self-correcting ability Slowly, they will be able to find their way towards better consistency in trading.Second, those who cannot see that the problem is nothing but themselves, yet understand that it makes no sense to keep losing money trading the way they do, would be wise to seek

a mentor, a coach, etc to help them correct their mistakes Provided that a good mentor is found and the mentor is compatible with the trader, the trader will have a good chance to purge his or her mind of the useless ideas or concepts that have blocked him or her from making better trading decisions

Most of the time, however, it is simply a function of capital depletion that finishes off the learning process Running out of money to trade, because all the money available with which

to trade has been lost, will stop these people from trading, if not permanently then at least for a long time At least until they choose to come back to try their hand at trading again

Odds of a Retail Trader Mastering the Art of Trading

Economics, which is the supposed study of economic activities, is not really a science It is at best a pseudo-science with no empirical significance Trading, being called the very minute details in the study of economics, are often labelled as a stochastic process (i.e., a fancy term for something random and unpredictable) That means, trading and trading techniques

in general remain a magical skill and art form that cannot be fully described or explained Most people who master the skill learned from first-hand experience or learned from

observing someone else

Like any other art form, trading skills take time to develop, and different people will require different levels of training to enable them to trade better Some people need a mentor, a coach, or a trainer to help them improve their trading skills Some people, who like a more hands-on approach to learning, require a lot of painful experience before they can stop their irrational decision-making behaviour from interfering their trading And then there are others who have difficulty understanding that trading is an art form, keep searching through the historical data in the hopes of finding some illusive edge they can comfortably lean on

Once traders can consistently profit from a market for a period of time, no matter if it is the result of a lucky streak or hardworking efforts, they will have to face a completely new set of challenges

At the early stage of success, many traders would

• increase their position size blindly without careful consideration

• ruthlessly trade everything they can put their bets on

• act on the instrument they trade even though they do not know if the odds are in their favour

All these actions indicate that traders have either run out of patience with the progress of trading or have simply developed a sense of invincibility This particular juncture in any trader’s career is the most likely time period that ends it once and for all