Humungous Myth #1: You can't go broke taking a profit!

I was on an E-Mini day trading chat forum just now and happened to read a post from someone saying “ I have a sign over my monitors that says ‘You will never go broke taking a profit’”.

I’m sorry but that is utter horseshit. It's not only very easy to go broke taking a profit but it's one of the commoner ways people do go broke. In fact I’ve done it, several times - as have most traders that have been around the block. When I began trading I used to believe this nonsense too but came to realize that this commonly-held belief is actually an amateur’s rationalization of the flawed strategy of exiting one’s winners too soon.

The correct statement should read “You will never go broke taking a profit that is on average larger than your average loss”. In my experience all seasoned traders who have clawed their way to profitability have had to navigate their way through this trap. What’s the trap? It’s that if the profit you take isn't big enough it's quite easy to go broke taking it.

The trap consists of these 2 elements:
1) every trade has a risk of some amount or other, and
2) some trades will incur losses. (Although theoretically one could have a 100% win rate, it’s so unlikely as to be impracticable to consider it)
In theory the smallest possible stop loss is 1 tick but in actuality the minimum stop loss is almost always 2 ticks because entry on the E-Minis is almost always at the bid or the offer. So if you are going to have at least some losers, that means you will have to offset your losses with gains from your winners. So here’s how it becomes a trap: If you consistently exit with a profit that is smaller than your average loss you become a net loser and you will ultimately go broke!

This particular trap was for me by far the hardest one to beat! Like many E-Mini traders, my stop was the low or high of the preceding bar. I actually thought this was pretty good even though this generally meant a risk for each trade of about 5 or 6 ticks average stop loss. So I would enter the trade and sure enough price would generally move at least a point in my favor. I would take my point profit and feel delighted. But you can see the flaw, can’t you? My average loss was 6 ticks plus commission so about 6.5 ticks total. My average profit was about 4 ticks less commission so about 3.5 ticks. Yes, my win rate was higher than my loss rate but not enough to overcome the disparity between win and loss amounts. It was 1 step forward and 2 steps back!

And of course what makes things worse is that when one has just spent the whole morning and had say 4 winners and 2 losers, it is utterly demoralizing to realize that you’ve made perhaps $50 for 4 hours work. Heck, you think, I might as well be working at McDonalds for that kind of money. And even with consistent winners, while you could maybe say you’re not going broke, you’re probably not getting rich either.

So now we should actually amend the saying above to ”You will never go broke taking a profit that is on average larger than your average loss, and nor will you get rich either, until you make the win-loss ratio about 3:1” That’s the ratio of win amount to loss amount that is generally quoted as guaranteeing riches.

So now this introduces the next interesting piece of the puzzle. If you need your winners to be on average 3 times bigger than your average loss, and you know your average loss is going to about 6 ticks, then you see what this means?

It means two things: You need your average win to be 18 ticks, which means that… you need trades that are capable of generating 18 ticks. Wow! That’s a bit different from where we started, taking our 4 tick profit! But remember we’re talking about getting rich here, not just getting by.

OK, so now we’re getting closer! If we need trades that are capable of generating 18 ticks that means two things:
1) We have to use higher timeframe charts because the swings are larger, and
2) We have to hold our trades longer on the lower timeframes when we are in trending conditions.

...to be continued....(BY THE WAY, FEEL FREE TO ADD YOUR COMMENTS

Progress report

Progress report: OK, I have now got our 3 e-commerce websites to the point where they are generating the kind of consistent income that pays the bills and enables me to not worry about getting a real job, which is the point I was aiming for. It's a relief to have made it this far, although we have certainly earned it, putting in hundreds of hours over the last couple of years to create a series of websites that now they're up and functioning should generate a semi-residual income for years to come...

What this means is that I can now focus on trading again. I will be writing articles on some of the aspects of trading that I think are particularly clouded with misunderstanding out there in the trading world - a "debunking" style of writing shall we say....

The first article above was prompted by a comment on a day trader chat forum, and it's about debunking the myth of not going broke taking a profit! As always, your comments are welcome...just hit the comments button.

Paved with good intentions....

I have to confess to being a tad embarrassed at my lack of follow through on my initial intentions to keep a regular blog going. I have to conclude that I'm not ready to be a full time trader yet. And I'm certainly not a full time blogger!

What I discovered is that my other commitments have so far demanded too much time to allow me a consistent focus on the market during trading hours yet. I don't know about you but I've noticed that once my focus is broken and my attention is drawn elsewhere I find it hard to stay in tune with the 'feel' of the market. And somehow, even though I try and deny it, this 'feel' is actually extremely important to trading success.

I tell myself that the signals are the signals and I should just be able to turn back to the screen when the setups are showing up on my indicators and execute the trade. But too many times when the focus is broken I would try to execute and realize that having lost touch with the market I was on the wrong side of the trade. That's because some signal setups have to be ignored as the correct signal is actually setting up in the opposite direction on a different timeframe.

And after a few errors like this I begin to doubt the signals themselves which is far more dangerous to long term success. And all this happened because I took my fingers off the pulse of the market and tried to trade anyway. So it makes sense (for me at least) to only trade when I can sit down in front of the screen and remain focused all morning.

My wife and I run three e-commerce websites which has proved to be the main distraction from trading. I am still hoping to get these to the point where they don't demand my attention during trading hours, but I'm not quite there yet.

My thanks to these three fine traders

Like all of us traders I have learned enormous amounts from other traders encountered along the way. And I am grateful to them all for sharing their insight and ideas. But there are 3 traders in particular I would like to mention who have had an enormous influence over my trading and helped me get to the point where I am today. They are:

Linda Raschke: She is a great trader and extremely generous with her knowledge. I had the great good fortune to be introduced to her by my broker who was a friend of hers. I did a fantastic weekend trading course with her back in 1993 which set the overall course of my trading based on indicators, especially the MACD. Thank you Linda!

Buffy: Engaging and very savvy moderator of the E-mini trader's online chat forum and developer of the B-line. She is a warm and extremely helpful teacher who is also a dynamite trader. Thank you Buffy! Your presence has meant a lot to me as I have followed you over the years.

Jimmer: I came across Jimmer in the B-line room mentioned above. He is an older guy with a dry sense of humor who is not only a fantastic trader but who has also been extremely generous in sharing his excellent approach to trading. Jimmer, thank you from an unknown admirer! You have taught me a lot, all of it useful.

Chart example

Here is an example of my trading charts with indicators. I know it's got a lot on it - a friend of mine once commented that it was like looking through a screen door, there were so many lines on it!

But it works for me and over the years I've become very comfortable with this format.

What do I need to measure?

There are 6 important metrics I intend to keep on a daily basis:

1. No. of trades available (i.e. trades that fit my entry rules)
2. No. of trades taken
3. No. of winners
4. No. of losers
5. Dollar amount of winners
6. Dollar amount of losers

I would like to get to the point where I consistently take 80% or more of all the trades that fit my entry rules. One of the hardest things for me so far has been to take the next trade after taking a loss. I know that if I keep taking the trades I'll come out a winner overall.

My Trading Style

I am a short-term trader of the E-mini S&P. Over the last 16 years I have tried trading pretty much all commodities on pretty much all time frames - but it has all led me back to the firm idea that it is much easier to predict the weather over the next 15 minutes than the next 15 days. So I use short term volume charts of the ES to trade.

My primary charts are the 9500v. the 4750v and the 2375v. I also have up on my screen a 19000v and a 3-min ES chart and I use these to establish context, which they do excellently. I don't watch the Dow or the Nasdaq or the Russell or the advance-decline line or the Tick or the Tiki or anything else. I have tried them all over the years and found a diminishing level of return from the information. Reluctantly, and after many attempts, I was forced to conclude that more is not better, that there is a limitation to the amount of useful information my brain could process and still maintain clarity. It was getting to the point (I'm sure you have experienced something similar if you've been trading a while) where I would see a trade setting up on one chart and would look across at a Tick chart or a Nasdaq chart and see something there that would fail to confirm the trade, so I would pass on the trade. And of course we all know what happened to the trade, right?!

I remember one day I got rid of all the charts I had up and asked myself "If I had to trade just one chart, which one would it be?" I decided it was the 4750v. So I experimented just using that for a while and actually did much better. The only problem was it didn't generate enough trades and it became too boring waiting for the next trade so I found myself at risk from distraction. So I added the 2375v. That filled in the gaps nicely, generating enough signals but without trading too much noise (although with the 2375v you've gotta know what you're doing or you will end up just trading noise)

Now having said all that, I keep an eagle eye on the 9500v and 19k because that's where the best trades come from. The ideal setup is where a nice swing is happening on either of these and you can find a way to enter on the lower timeframe charts.

I did a lot of research at one point on the average number of trades I could expect each day on the 4750v and 2375v and it came out to about 8 on the 4750v and about 15 on the 2375v, for a total of roughly 20-25 trades a day. I'll miss some of those as they're setting up (because I'm thinking something else is setting up) and I'll be away from my desk for some of these, especially in mid-morning slower times. But my goal is to take 80% of all the trades that will be marked on my charts by the end of the day as being decent trades.

I use a color coded system for marking my charts:

1. a PINK arrow means I took the trade and made a profit (or break even)
2. a BLUE arrow means I took the trade and made a loss
3. a GREEN arrow means I didn't take the trade but it showed up after the fact as being a decent trade (so I can learn from them)

So I don't want to see too many green arrows! Because that will mean I'm either not following my rules or I'm not seeing the setups well enough - either way that's not OK.