I would like to launch the blog with a simple yet very powerful concept. I am sure that over time we will elaborate much further on this simple concept but it seems appropriate to start here.
It all starts with the 4 possibilities. Once you put on a trade only four things can happen:
1- You can win big
2- You can win a little
3- You can lose big
4- You can lose a little
The goal is to eliminate number 3. What do we do?
Number #1- First form a hypothesis.
Your hypothesis can be as simple as this.
1- You (or your system) think the stock or future is going up.
2- You (or your system) think the stock or future is going down.
How you arrive at this conclusion may be based on your analysis of fundamental indicators, technical indicators or a trading system. You might even be in agreement with someone else’s analysis. For example, you might agree with Morgan Stanley’s opinion that crude oil is going much higher.
However, what you do next is extremely important.
You need to determine how much money you are going to risk on this particular trade. The easiest way to do this is to use a percentage of your account value. For example, if your account value is $100,000 and you are going to risk 1% of this value, you are going to risk $1000. You do this because your hypothesis might be wrong or you might be just early. By defining and accepting your risk, you hopefully eliminate the possibility of the big loss.
Number #2-The trend should confirm your hypothesis
This is done for two reasons:
1- If you are trading against the trend, you may not be in sync with your hypothesis and you either going to get stopped out often or suffer a big loss.
2- If you are trading with the trend, you know anything can happen. You are positioning yourself for the possibility of winning big.
Winning big is what will eventually make you a successful trader.
Number #3-You think in probabilities for two reasons:
1- It is unreasonable to believe that every individual trade is going to be profitable. It is equally unreasonable to believe that you will be able to identify only the successful trades. However, each trade has a probability of being profitable. The way to determine how your trading is doing is by evaluating a series of trades over time.
2- Evaluating your trading over a series of trades will also confirm or not confirm your hypothesis. If after a series of trades you are losing money it might be time to review your hypothesis.
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