The Hidden Trade that is the Key To Long Term Success

Boris Schlossberg

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Ask most traders what are the possible outcomes of a trade and they will inevitably give you a binary answer.

You either win or lose.

But if we think about it for a second, there is actually a third choice. You can neither win nor lose. In short, you can basically not lose and close the trade out for even. If we go over our many trades, there are countless examples of trades that may have started out badly only to rally to breakeven and then ultimately fall apart.

The art of NOT losing is perhaps the most underappreciated skill in day trading. It is, in fact, the foundational strategy of high probability businesses like insurance and casinos. Insurance companies are of course notorious for eliminating any possibility of large payouts. They are in the business of collecting premiums but the moment a client presents any type of collectible risk they move swiftly to cancel the policy. The insurance companies much like casinos will make sure to rig the rules so that customer has virtually no chance at collecting a payout.

So in Las Vegas, they will stop you from counting cards in blackjack and in Hartford they will make sure to exclude all coverage of any malady you may already have. Indeed, the current debate on pre-existing conditions in Trump-care is simply an attempt by insurance companies to collect as much premium as possible while providing the absolute minimum coverage necessary to satisfy the contract. Indeed, as my wife just pointed out to me under Trump-care pregnancy will be considered a pre-existing condition and could cost insurance buyers as much as $17,000 in out of pocket expenses even if the woman has full coverage.

Now we can all lament the evils of the insurance business, but it has a lot to teach us about trading. The more I trade the more I realize that there are really only two viable models of making money. The low frequency, high-profit model where your wins are very few but are massively larger than your losses and the high-frequency high probability model where the losses are very rare.

We are all familiar with the fact that throughout the whole history of the stock market all of the gains have come from only 20% of all publicly traded companies. Fully 80% of stocks are long term losers. And even amongst the 20% of winners, it is only a handful of equities that are responsible for almost all the stock market returns.

That’s why index investing is so hard to beat. When you buy the index you are essentially buying the whole lottery pot and betting that you will capture the few jackpots that will pay for all the losing tickets. Little wonder then that the hedge funds have been getting killed looking for the diamonds in the ruff amidst a pile of garbage.

But there are other actors in the market that actually play a very different game. HFT (High-Frequency Trading) funds have gotten a bad rap for being nothing more that digital “front runners”, but in reality, they employ a wide array of strategies almost all of them focused on mitigating risk. In fact, HFTs are the kings of the “not lose” trade as they break even on as much as 50% of their positions per day and yet make money almost every single day. Big firms like Virtu have lost money only on one day in six years.

If we are day-trading, the insurance model is the way to go and the “not lose” trade should be studied much more seriously. It is the hidden key to long-term trading success.

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Hidden Leverage That Will Kill Every Day Trader

Boris Schlossberg

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The more I trade the more I am convinced that the vast majority of problems arise not from faulty strategy ideas but from poor money management behavior -- mainly because most traders confuse speculation with investment -- an often fatal mistake when it comes your capital.

Investment is essentially the art of buying assets. The simplest and surest way to make money as an investor is to simply diversify your portfolio and dollar cost average into your positions over a very long period of time (decades). Investing works because real assets tend to appreciate as economy grows and wealth becomes a simple function of compounding that economic growth.

Speculation on the other hand has nothing to do with investing. It is the art of trading sentiment and by its very nature is bidirectional in form. Speculation also tends to revolve around assets that are price bounded such as commodities and currencies. The simplest, sharpest way to understand the difference between speculation and investing is to consider the chart of the Dow versus the chart of the GBP/USD going back to 1980. Since that time the Dow has appreciated by a factor of 16 (from 1000 to 16,000). Meanwhile sterling has basically range traded from approximately 1.0000 to 2.0000. Unless we face and end of the world scenario currencies and commodities will always range trade and will therefore be instruments for trading sentiment rather than investable assets.

So once you understand that speculation is nothing more than riding the rollercoaster of sentiment on a leveraged basis you can appreciate why trading has nothing to do with investing. First and foremost speculation requires stops because it is a bidirectional game. Even if you don’t use leverage, but find yourself on the wrong side of the carry trade and decide to hold on to your position for years, you will no doubt lose all your money through capital losses and interest payments. In investing its just opposite. You will collect dividends and bonds payments regardless of the underlying price.

So if you need stops to speculate that means you will inevitably incur losses and that means that money management is a much more important skill to master than trade entry.

This becomes even more crucial to remember when you daytrade. The more you trade the more losses you will incur. That means the only way to survive and prosper is to reduce your trade size in direct proportion to your frequency. So if you trade 10 times per day you should not risk more than 20 basis point per trade which generally means that you should be trading MAXIMUM 1 times leverage of your account per trade ( assuming you are using 20 pip stop. At 40 pip stop your max allowable leverage is .5 times you capital per trade)

The reason for such low numbers is because when you day trade, you are actually using 2 types of leverage -- the normal credit that you broker gives you (up to 100 to 200 times your capital in some jurisdictions) and the leverage of turnover that you generate through multiple trades. Suppose you have 10,000 in your account and you make 10 trades per day at 10,000 units each. You have just turned over 100,000 units of currency or 10 times your capital amount in one single day. Its this hidden leverage that most retail traders completely ignore -- and as with most hidden things in life -- it is the one thing that can kill you.