Short, powerful statements are priceless…
They can turn big concepts into a few memorable words.
Let me show you what I mean. This is the best statement I’ve heard about trading (and I know some good ones). Here it is…
‘If you don’t bet, you can’t win…if you lose all your chips, you can’t bet.’
Larry Hite, system trading pioneer
Think about this for a moment.
Short, simple, and to the point. I believe this captures the essence of successful trading like few others. If you can understand this, you’re on the way to trading profitably.
There are two parts to Larry’s statement…
First, there’s the act of taking a trade. This is about stepping up and having a go. You can’t win anything if you don’t put yourself in the game.
Sure, I know this sounds easy. But many people find opening a trade overwhelming. This is when you put your money on the line. You’re taking a risk. And this can be uncomfortable.
I told you five strategies to help with this problem a few weeks back. You can read about them here.
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 update is about managing risk. I’m going to show you how trade size — and the number of stocks in your portfolio — can affect performance.
But first, let me tell you about Larry Hite’s impact on me…
A game changer
Larry is a pioneer of systems 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 inviting trouble. I wasn’t focusing enough on the potential for loss. My strategy was too reliant on being right — something had to change.
Larry 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 game 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 relatively small bets were better than a few big ones. My risk was now smaller and more 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 placing 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 they stay in the game. Controlling risk is critical.
Which strategy is like yours?
OK, let me show you the difference trade size can make.
I have three back-tests for you. They all use Quant Trader’s entry and exit triggers. The only difference is trade size, and the corresponding number of stocks in the portfolio.
The tests cover the period from 1 January 2009 (near the GFC lows) through to 16 February 2017. Each strategy starts with $50,000. There is no allowance for costs or dividends.
Here’s how the tests work…
First up is the ‘all or nothing’ strategy. The system bets 100% of capital on each trade.
The second is typical of many small portfolios. Each trade receives 20% of capital.
Finally, there’s the ‘many small bets’ approach. This strategy puts down 5% of capital per trade. This allows for a portfolio of up to 20 stocks.
Now, just pause for a moment. What do you think is going happen? This will help you understand why many people struggle to make money from stocks.
Source: Quant Trader
[Click to enlarge]
‘All or nothing’ is a volatile way to trade. Everything hinges on backing the right companies. You’re always just one bad call away from disaster.
The stocks in this back-test underperform. 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.
You could make a lot of money with this method. But it only takes one mistake to bring it crashing down. This strategy is like playing the lottery — it requires loads of luck.
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.
Now, let me show you a five-stock portfolio…
Source: Quant Trader
[Click to enlarge]
Many traders like this type of approach. Again, a key reason for using this strategy is to score a big win. Some also say a small portfolio is easier to manage.
But there’s a problem.
You see, there is still a lot riding on each trade. The downside of this is volatility. Have a close look at the graph above — this approach can be unnerving.
Five stocks are certainly better than one. But there’s still a lot of risk. It only takes a handful of bad trades to ruin your returns.
OK, it’s time for the final strategy.
Here’s the 20-stock portfolio…
Source: Quant Trader
[Click to enlarge]
You can see the difference immediately. Volatility drops away, while profitability increases.
And remember, this is the same strategy as before. The only difference is trade size. There are no big positions — just a lot of relatively small ones.
The small bet approach is a natural risk-limiter. It allows for more trades, which in turn lowers the impact of any one stock. The result of this is a smoother performance chart.
I believe spreading risk is the key to reducing volatility. Your portfolio will still have down periods — that’s unavoidable. But a few bad trades won’t wipe you out.
People who bet big are often after fast dollars. Sure, it may pay off at times. But risk has a habit of catching up with bold traders. Sooner or later, they lose all their chips.
Until next week,
Editor, Quant Trader
Editor’s Note: Many relatively small trades are a natural risk limiter. They can also increase the odds of buying into some of the best stocks. But do you know how to identify lots of high potential companies?
Don’t worry if you don’t — I have a suggestion.
Check out Jason’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. It then tells you when to buy and sell.