A full scholarship

After paying tuition for a time, I entered the next phase of my trading: utter chaos. First, a picture:

Phase 2

I was starting to have some good ideas, but had no rhythm or discipline in my trading. I was all over the place, with no sustainable system to follow. That first spike was rather heady, as it reflected a doubling of my account in a matter of weeks (without using any leverage). But the same practices that led to the spike also led to the subsequent downturn. Another lesson learned.

Toward the end of the phase you’ll see the graph settle down. The spikes and drops smoothed out. But it also settled down, as in pointing down, generating negative returns.

At the end of these tumultuous months, I was back where I started. Or was I? In hindsight, I had learned just as much during this second phase as I had during the first phase of my trading, and this time I had not lost additional money. So school was still in session, but now I had a scholarship.

Paying Tuition

Three years ago (pretty much to the day), I opened an account and began trading mechanical systems of my own design. Those early months are what I now refer to as a time of “paying tuition”. Since a picture is worth a thousand words, let me keep the entry brief:

Paying Tuition

Perhaps there is a different path to take… I don’t know. But if any of you become interested in system trading, be prepared to paint your own pretty picture like the one above.

If you want to be a doctor, or get an MBA, or go to law school, you know you’ll have to pay tuition. Trading really isn’t so different.

Expectancy

How can one describe a trading system and its potential to make money? Most folks use expectancy as a key metric. Expectancy is the amount of money you expect to make for each dollar risked on each trade. If you trade $1000 on a system with an expectancy of 0.05, then you would expect to make $50 per trade. You expect to make 5 cents per dollar risked and you are risking $1000 on the trade, so you expect to make $50.

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

In the case of a trade size of $1000, it might look like this:

Expectancy = (0.4 * 200) – (0.6 * 50) = $50

That is, you win on average 40% of the time, and your average win is $200. The probability of winning and losing have to add up to 1, so you lose on average 60% of the time with an average loss of $50. In this scenario, you expect to make $50 per trade with an expectancy of 0.05.

All of this assumes the word “average” is relevant, and that implies many, many trades, or, in the language of statistics, trials. Over many trials averages become relevant. Over very few trials, averages can be very misleading.

Etched onto Stone Tablets

One of the oddities of books on trading is how emphatically the authors tend to state their case. As a group, they are rarely satisfied to simply make observations and offer insights. No, axioms are where its at in the world of trading literature.

Which is why I highly recommend one begin reading such literature with any or all of the Market Wizards series by Jack Schwager. Schwager gets some fantastic interviews with many of the world’s best traders (across numerous financial instruments). It makes for interesting reading, but it is also very eye opening. These guys all disagree on what axioms govern the markets! Trader A uses Technique A and thinks anyone who uses Technique B is a bit daft, while Trader B uses Technique B quite successfully but heaps scorn on those who think Technique A is anything but a fool’s errand. And on and on.

My own approach to the market breaks at least 18 rules that govern the universe, according to this or that expert. Which is not to say these folks aren’t experts. Many of them probably are. It just seems many of them believe their trading rules got etched onto stone tablets somewhere along the way.

Losing my marbles

My efforts in developing trading systems stemmed from a chance encounter with an entry on the Jonsson’s blog. I was fascinated by Van Tharp’s claims and began reading quite voraciously on the topic toward the end of 2003 and was soon trading mechanical systems.

I had no idea at the time, but I had basically signed up to be schooled, and class was in session for a couple years…

Mad cows

One of the funniest trades I ever made was really prior to my effort to learn to be a trader. I had investigated trading methodologies just enough to be dangerous (to myself), had pored over the books of numerous companies, and finally settled on Wilsons The Leather Company as a good, safe investment. I bought a small stake in the company, and approximately 24 hour laters the hysteria in Europe over mad cow disease began. Interestingly, they burned the carcasses of the slaughtered animals, which apparently caused a spike in the cost of leather goods to the manufacturers, and Wilsons tanked.

I didn’t realize it at the time, but this experience may well have been extremely important in my developing a philosophy of trading. In the years since, I have always been biased toward trades that minimize the impact of sudden, surprising news.

Manville

I had my first crack at trading stocks sometime around 1981 or 1982, which would put me around 5th grade. My father was going to buy some Johns Manville stock, and I had recently come into some small amount of money, and so he offered to let me piggyback his order.

From the corporate history, we find the following entry:

1982

  • Manville Corporation files for Chapter 11.
  • Manville and certain of its subsidiaries file (individually) for protection under Chapter 11 of the Bankruptcy Reform Act of 1978 in U.S. Bankruptcy Court for the Southern District of New York.

Okay, that one didn’t turn out so well. However, if you look at their current front page, they have this to say: “Johns Manville, a Berkshire Hathaway company, is a leading manufacturer…” There’s almost no greater accolade than getting bought by Warren Buffet, so I guess it turned out well for the company in the long run.

Here’s the interesting thing. I don’t remember having any regret over the transaction. There were risks, I lost, life went on.

Trading Thoughts

No, I don’t want to swap brains. I’m referring to my thoughts on trading stocks. For those of you who don’t know it already, I’ve been knee deep in trading for several years, and have decided to open up a new category (aptly named “Trading”) to begin passing along my insights and stories on the topic… mostly failures, but also some successes.

Last year, my Schedule D (reporting sales of stocks for my federal income tax) was around 26 pages long. But I didn’t start there. No, my early forays into trading were quite discreet and targeted. However, I wasn’t what I consider a stock trader at the time, so I’m not going to emphasize that pre-history, other than to briefly cover it in a post or two. For those interested, what did I consider myself as I traded stocks but wasn’t a stock trader? A dabbler. But more on that later.