Ask Colin

I can't see how I can win at trading unless I make more than 20% on each win and my wins are more than 50% of my trades. Please explain?

Your full question was:

I have recently read a lot about money management as a part of a trading plan. I did a bit of math and got confused. Let's consider following scenario:

Trading capital - $50000. 1% of capital I can lose in each trade - $500.

I agree that in this scenario I have to be wrong close to 100 times to lose the capital, but it doesn't look like a winning strategy either.

Let's assume that my positions sizes calculated based on stop loss are around $2500. Value of position falls down 20% to $2000 and I have to sell at the stop loss. To be even I need to have another $2500 position to go up more than 20% in value.

So I am 50% right and actually I have losses because of brokerage, etc.

In this scenario to have a profit from trading I need to be:
1. More than 50% right
2. Every winning position has to go up more that 20%.

I think my calculations are still correct with larger trading capital, larger position size, etc.
I believe (1) and (2) are pretty tough. How can you win this game ?

In short, yes, you can win:

1. If you cut all your losses at 1% of capital, you actually have to do more than 100 trades to lose all your capital, because your capital gets smaller as you lose. However, this is only a technical point.

2. Your trade size will also get smaller as you lose. This is also only a technical point. Of more importance is:

3. If your stock selection method is reasonably sound, and if you do a lot of trades across both bull and bear markets, they will tend towards 50% wins and 50% losses unless you are very good at it.

If you did not cut losses, you would tend to have lots of small losses and a smaller number of large losses. You will also tend to have lots of small wins and a few large wins. This means your distribution of results will form a normal bell curve.

Now, if you cut losses ruthlessly at 1% of capital, you should never have any large losses. If, in addition, you let your good investments run until the big gains accumulate, you should have the big gains OK. Now your distribution of wins and losses is not a normal bell curve. You have lopped off the big losses and that biasses it to the gain side.

Now, the Pareto principle holds that 80% of profits will tend to come from 20% of your investments. In fact, I have found that all the small losses are cancelled out by all the small gains and the end result is the total of the few large gains - about 20% of your investments at most.

So, the real secret is to cut losses quickly while they are small and let the winners run till the big profts build. That way, yes you can win.