Trading to Win

Trading to Win in Volatile Markets with One Simple Rule
There’s nothing more mind twisting for a trader than getting whipped around in circles during a volatile market. It doesn’t matter whether it’s a raging bull or bear, volatility will kill a trader, unless ...
One of the biggest things you’ll hear traders talk about is that following a set of rules can be the key between winning and losing in the market. I’ve got a saying that I think everyone will agree with, “traders hate missing opportunities more than they hate booking losses.” That is, an investor or trader will curse the fact that they weren’t in a stock that ran up 20 percent more than they will a trade that cost them 20 percent. The important thing is staying solvent so that you can take the opportunities that pay off.
As you may know, we publish a series of reports that recommend option positions ahead of earnings reports (IDE Earnings Alert). Nothing can be more exciting and opportunity-laden than earnings season, which is why we provide this service.
Now, due to the volatility that is inherent with earnings season, we can have some losses that are larger than average. As a matter of fact, last quarter’s (Q3) trading results produced more losers than winners, and we still made money during the quarter by averaging a 15-percent profit for each trade. How? We try to follow stringent loss/control guidelines whenever possible to enhance our chances of winning over time.
It all comes down to one simple rule. Cut losses short and let your winners run.
Now I know you’ve heard this one before. If you haven’t, then write it down. Applying this rule to your trading, whether it be in options, stocks, or whatever, will enhance your overall success rate over time.
There are three main components that contribute to profits – the size of your average loss, the size of your average win, and your win rate. The key factor is the interrelationship among these three variables. A smaller average win is fine as long as the win rate is higher. A lower win rate (such as you find in aggressive option buying strategies) is fine as long as your average win size exceeds the average loss. The goal is to achieve an overall positive return for each dollar played over a large number of trades.
We’ve found that successful options traders (we’re talking about option buying here) can have a very nice bottom line with a win rate of around 40 percent. That’s a difficult concept for many to grasp. Winning fewer trades than you lose and still be profitable?
Let’s look at an example. Say our win rate is 40 percent, our average winner is 100 percent, and our average loser is –50 percent. Multiplying the win rate by the average win (0.4 x 100) and the loss rate by the average loss (0.6 x -50) yields an overall return of 10.0, or 10 cents for each dollar invested. This positive result comes despite losing 60 percent of the time. So don’t just concentrate on the win rate, but the average win and loss percentages as well.
Let’s stick with this lower winning percentage to explore a related, and very important, concept. Something that often comes as a surprise to many options traders is the experience of coping with an extended losing streak. Because the objective in options trading is to stay in the game and take advantage of the big winners, great care is required to control the amount of capital allocated to each position. Even the best trader is not immune to a string of losing positions. In short, you must weather the inevitable storms of losing trades and stay in the game.
A successful options buyer who has a 40-percent win rate runs a 97.6-percent chance of having a string of five consecutive losing positions over a 50-trade period. What’s more, this trader stands a better-than-50/50 chance of seeing eight consecutive losses over that same period, based on the laws of mathematical probability.
The take-home message is that given the high probability (and in some cases, certainty) of losing streaks within a given period, it is critical to realize that investors who place too much capital into successive trades run the risk of decimating their trading account during a perfectly normal trading cycle. In other words, they will be unable to stay in the game.
Those who are able to stay in the game and reap the rewards of the hot streaks and higher returns of winning trades stand a better chance of ultimate profitability over the longer haul. It’s in your best interest to have the long-term staying power to reap the full benefits of short-term options trading. And that’s especially true during earnings season.
Have a great trading week.