This is the second part of a series of articles discussing the application of the Karate foundation precepts in trading and portfolio management. Whether you focus on trading the PowerShares Nasdaq 100 ETF (NASDAQ:QQQ), the SPDR S&P500 fund (NYSEARCA:SPY), Apple (NASDAQ:AAPL), Ford (NYSE:F) or gold through the SPDR Gold Trust (NYSEARCA:GLD), or you are hedging your U.S. dollar exposure by trading the DB USD Index Bullish (NYSEARCA:UUP) or DB USD Index Bearish (NYSEARCA:UDN) funds, the principles presented in the articles will be beneficial to you.
However, they do not appear in Karate only. They seem to be universal ones which lay the basis of success in many areas of life. People familiar with other sports or activities could come close to the same basic tenets derived from their own experience. Nevertheless, Karate or not, such a strong foundation seems to be an important factor for a continuous success in trading and investing.
The first part of our "Karate Principles in Trading and Portfolio Management" series discussed the following seven principles:
- Never forget: karate begins with rei and ends with rei (Rei means courtesy or respect, and is represented in karate by bowing).
- There is no first attack in karate.
- Karate supports righteousness.
- First understand yourself, then understand others.
- The art of developing the mind is more important than the art of applying technique.
- The mind needs to be freed.
- Trouble is born of negligence.
Some of them might seem to be unrelated to trading and portfolio management, at first. If this is the case, please read the first article of the series. I would love if you then share your comments as we all know that in discussions the truth is often born.
Now the time for the second part of the Karate precepts has come. Their importance lies in the fact that many of them concern the money management and risk controlling which happen to be of an utmost importance for a healthy and profitable portfolio.
The Karate precepts
- Karate training requires a lifetime
This maxim when applied to trading and investment management implies the ever evolving nature of financial markets. In the foreword of a recent publication of the CFA Research Foundation named "Fund Management: An Emotional Finance Perspective", Arnie Wood writes:
"Despite our sophisticated storytelling, what has and always will characterize the "investment game" is uncertainty. Uncertainty is not so much mathematical risk but is rather part of the unknown that we cannot estimate numerically."
This uncertainty is what creates a potential for profit and development. It has been present in the markets since their beginning and is expected to continue. Changes are part of uncertainty and recently we have witnessed a lot of them. There has been an increased volatility in the markets. Certain trading or investment models found it hard, if not impossible, to deliver their expected returns. For instance, a recent article in Business Insider point to the saving and pension schemes in a continuous low rates environment as being among the most hardly hit models.
The liquidity and debt crisis in the U.S. and Europe just add to the events that question the achievement of expected returns and they even try to challenge some economic theories. Assets that were previously perceived as being a relatively risk-free ones are not longer considered as such.
All those changes that happened during the relatively short time of about only five years come to show us that financial markets evolve. Having this in mind, we should be aware that what has worked yesterday could not always work tomorrow. We should always be ready to recognize the changes and adapt our trading to the new conditions, the "new normal". To some extent this is connected with the flexibility of the mind which was discussed in the previous article.
Of course, the basics of investing and portfolio management could stay the same. What this principle tells us however is that we should not rule out the opportunity to learn as long as we are in the markets as there will always be new things that could cross our way.
- Genuine karate is like hot water; it cools down if you do not keep on heating it
Like the previous one, this is another behavioral tenet. Applied to trading and investing it would translate into the principle that we could lose our expertise if we do not continuously practice what we know. We have heard the "good physical shape" phrase and we know that such a shape has to be continuously worked for. The same is true for investing. In general the more time one is submerged into portfolio management strategies, trading or any other type of investing activity, the better he or she becomes. This skill however could be lost if it were not regularly tested against the market.
- Do not think of winning; you must think of not losing
This principle is at the heart of risk and money management. Numerous successful traders have repeated that focusing only on the profit is a dangerous strategy. The main practical reason for this is the simple fact that a profit would not hurt your portfolio while a loss certainly would. Thus it is much more reasonable that investors take precautions against their losses and let their profits run.
There are also behavioral explanations why traders and investors must focus and think more about not losing rather than simply winning. They concern the fact that not accounting for what one could lose on a deal and eventually winning that deal reinforces a bad habit in this particular market participant. By a pure chance if such a behavior continues, at the end there will be an event that could wipe that participant's investment account simply because there would not be any protection put in place.
Paul Tudor Jones II, the founder and manager of Tudor Investment Corp., who already successfully navigates his funds for more than 30 years, has expressed the same attitude in his words:
"I'm always thinking about losing money as opposed to making money. Don't focus on making money, focus on protecting what you have"
Jesse Livermore, an American stock and commodity trader from the Great Depression years, also known as the "Great Bear of Wall Street" expands the idea:
"When you know what not to do in order not to lose money, you begin to learn what to do in order to win. You begin to learn!"
Among the things one should learn to avoid doing in the financial markets is "falling in love" with a particular investment, be it a stock, commodity or an index. Investors should always take a critical approach to their investments even if they have held them for a long time. Thus they would increase their chances of not decreasing their capital one day, simply because they missed to notice a change in the underlying fundamental or technical conditions of the stock's price.
As the uncertainty is always present in the market and changes happen regularly, the risk of loss is inevitable. If the investors think more of not losing than of winning they will be able to control for this risk and minimize its effect on their portfolios. This could be done by using options, other types of hedging strategies or simply by exiting the position that threatens the capital preservation.
These more detailed ways of protecting the investments are covered by the next principle.
- The outcome of the fight depends on one's control
This is a continuation of the previous more general principle of protecting one's capital. This one further emphasizes the need for investors to control for the deals they make as opposed to acting on a pure hope or other emotional motives.
Paul Tudor Jones II is known to have said:
"Where you want to be is always in control - never wishing, always trading."
The fight in the investments field is between the individual investor and the collective will of other participants which together form the market. In order to not be unpleasantly surprised by the market the investors have to control for the risks they take when entering positions. They should also control for the profit potential of their deals. Practical issues include determining how much of the available capital will be invested in a single deal, setting proper stop loss orders and choosing an entry level so that the risk-reward ratio of the deal suits the investor's preferences, among others.
The maximum loss investors could take on a single deal depends on their risk attitude. Often FOREX traders speak about a loss of 1-3% of their capital. This is so because of the various amount of deals they usually make. Risking a small part of their capital gives the investors the ability to continue to trade even after taking a loss on some positions. The value at risk often determines the size of the positions and the risk-reward ratio affects the entry and exit levels.
Below is a simple example which serves to show some part of the various parameters a trader should control for in a deal. We will use the daily graph of Ford .
Let us say the date is near the end of October 2009 and a trader sees an upside potential in Ford shares. We would not discuss the reasons for such a view as those are not the main point here. Her preferred risk-reward ratio is 1:3 so in general she risks $1 to make $3. The stock has been in an upside trend till August 2009 but since then it traded mostly downward. It went several (three) times to around the 23.6% Fibonacci level ($6.97), broke it but bounced back. Now the stock is headed again to that level so the options are that it will either break its lowest point at $6.60 and continue to around $5.80-$5.20 levels or it could bounce back and go to its previous high at $8.8. The trader enters at $7 with a stop loss order at $6.50. If the first goal of profit taking is around $8.70-80 this would mean a reward of $1.80 for a risk of $0.50. This is better than the traders general desired risk-reward ratio of 1:3 so she takes the deal.
If the trader operates with $100,000 and is willing to risk 2% of that capital on a single deal this would mean that the value at risk would be $2000. According to the stop loss order which is set $0.50 below the entry level, that trader should buy no more than 4000 (4000 x $0.50 = $2000) shares of Ford in order to stay inside her limits.
- Always be good at the application of everything that you have learned
We close the review of the application of Karate principles in trading and portfolio management with this beautiful last one of the precepts.
Among the main characteristics of the market is that it attracts some of the brightest minds on the Planet together with some of the fastest and newest technologies. In such a highly competitive environment mistakes are usually costly. In order to continue to be profitable the traders and investors should apply by the best way possible what they have learned. This best way is learned by practice. As Jesse Livermore has said:
"The game taught me the game. And it didn't spare the rod while teaching."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.