|
|
 NEWS |
|
|
|
|
Markets
Learn from the Barings Bank rogue trader's mistakes
Jeff Cartridge - October 22, 2007
 When trading CFDs there are a number of times when being wrong is being right. To avoid making large losses admitting that you have made a mistake early is vital to your success. The Barings Bank collapse was caused by a “rogue trader” Nick Leeson who did not cut his losses, instead continually adding to a losing position until the losses totalled close to $1 billion. Exiting the trades when they were down $1 million or $10 million or even $100 million would have been a great move now that we have the hindsight to see what unfolded. Cutting losses before they grow to a substantial size will ensure the longevity of your account and ultimately your success in the markets.
To cut your losses it becomes vital to set stops to control your risk. Setting a stop loss order in the market determines the loss you are likely to experience. You will not be right every time you enter a trade so prepare to be wrong. For beginner traders stop loss orders should always be placed into the market. More experienced traders may keep these orders in their head or written next to their computer, but the temptation to alter these orders is very strong. When you are wrong admit it, quickly. From studies I have completed the best trades will move in the chosen direction from the very start and your profits will increase over a period of time. It is unusual, and certainly statistically unlikely that a trade that moves significantly against the direction you have chosen will be profitable. When you are wrong cut your losses.
The golden rule of trading is to cut your losses and let your profits run, but being wrong goes beyond this simple idea, it has psychological implications as well.
Consider two games. You must choose between the two and you must play one of them.
1) You have 50 percent chance of winning $150 and 50 percent chance of losing $10.
2) You have 100 percent chance of winning $50 and 0 percent chance of losing.
Which game would you choose?
For all those that chose the certain win it is time to withdraw all of your money from the stock market and put it into a bank term deposit. Bank term deposits are the closest thing to a certain win that is available, but due to the low risk the returns tend to be low as well.
Take a look at the game above from a statistical point of view. If you were to play the game enough times on average you would win $150 one time and lose $10 in the next turn. On average the game would deliver $140 for every two times you played the game or $70 per game. The profit from the first choice is higher than the profit from the certain win, but the profit is not guaranteed. This is the whole concept behind trading successfully. I have not yet met a trader that is right every time, but I have met many profitable traders. Unfortunately in the stock market your risk and reward are not spelled out as clearly as they are in this game.
Back testing your strategy, or studying your historical results can allow more clarity around these numbers as they apply to your trading. The key measures required to assess your trading are how often you are right, how right you are and how many trades you make.
The hit rate is a measure of the percentage of times you win. The calculation is simple: Count your wins, count your total trades and then divide the wins by the total trades and multiply by 100 to get a percentage. In August one of the strategies I trade had a total of 22 trades. Of these trades 11 were profitable. The calculation of the hit rate is 11/22*100 = 50%, meaning half the time I was right and half the time I was wrong. On average the strategy is right 60% of the time, but August wasn’t such a strong month.
There are different ways to measure the average profit, but the simplest way to do this is to total the profit from all the trades and divide by the number of trades. If the average win is positive then you have been making money and if the average win is negative then you have not been. Taking another look at the 22 trades in August the average gain was 1.31% per trade. This does not mean that every trade made a positive return, only 50% were profitable, but the average of all trades was profitable. The overall results for the strategy deliver an average profit of 2.33% per trade, so again August was not one of the stronger months for the strategy.
Some people prefer to use the average win and average loss rather than the approach above. This gives a much better insight into the risk and reward in a trading strategy. In August the strategy above the average win was 5.50% and the average loss was -2.97%. Losses were contained with a stop loss set at 3% below the entry. This is often expressed as a risk reward ratio or edge ratio by dividing the average win by the average loss. In August this figure was 1.85 meaning that the strategy delivered $1.85 for every $1 placed at risk. A risk reward ratio of 1.85 is not particularly strong, but any ratio above 1 is profitable. The strategy, which is based around the breakout from patterns, overall delivers a risk reward ratio of 1.90.
Another important variable that is linked to the return that a trader makes is the number of opportunities that the strategy provides to trade. If on average the trader makes a gain of 1.31% on every trade the trader’s return will depend on the number of trading opportunities. One opportunity a year would lead to a total return of 1.31% per annum on the capital employed. One opportunity a month would lead to a total return of 15.72% per annum on the capital employed and one opportunity a week would lead to a return of 68.12% per annum. To achieve these returns on your overall capital, would require that you place all of your capital on every trade. This is unlikely to be possible as more than one trade may be running at one time and is certainly not advisable. In August there were a total of 22 trades so the possible return on capital employed would be 28.8%. Note this does not mean that the capital used for this strategy increased by 28.8% during August as the amount placed on each trade and the leverage employed determined the actual return. This figure also does not take into account the cost of interest, brokerage, or slippage that may be incurred entering and exiting the trades.
Being wrong is a part of trading, and it is vitally important that all traders grasp this concept. The first thing a new trader is required to learn is to admit mistakes quickly and cut the losses. Beyond this concept the trader moves on to understanding the statistics that support the strategy the trader is using. From this understanding it is possible to forecast the expected results of any given strategy. These results will only be delivered on average, with some months better and some months worse than others, but being wrong sometimes should ultimately lead to better results than being right all of the time.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
More articles from this week's CompareShares newsletter:
Analysis: Market crash signals
Markets: Local market to drop on memories of '87
Stock picks for the long haul: Mineral Resources (MIN) and The MAC Services Group (MSL)
Election: Who should win on November 24?
Smart Investing: Rewind 1987: the lessons 20 years on
Markets: US market plunges on crash anniversary
Resident Trader: How to profit from volatility - part 2
Trading: Learn from the Barings Bank rogue trader's mistakes
Stock of the week: Malachite Resources NL
Expert Panel: Trading international shares using CFDs
Commodities: Raging oil bull feeds euphoria
Superannuation: Buying your dream home in your DIY fund
Expert Panel: Why buy an instalment warrant instead of a share
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
 Email to a friend
 Print this article
|
|
