Trading is war

That is the most apt description of trading or speculation. Trading is about waging battles, more often over periods of minutes, hours and days than over weeks or months. When it comes to investing, there are not just Black and White but innumerable shades of Grey. In trading you are either a winner or a loser. Your gains are somebody else's losses and your losses are somebody else's gains. A trader believes in making absolute profits.

What makes life difficult for a trader is that trading is unpredictable. And in an unpredictable world things will go wrong. The beauty is that what is wrong for you is not necessarily wrong for the other. It's like a half-filled mug of beer. To you it may seem the end of the world because it's half-empty. To somebody else, the glass is half-full and life is beautiful, thank you.

When the Vajpayee government fell in April 1999 it seemed like the end of the world to many traders. The recent tech sell-off in our markets had a large number of traders diving for cover. To those who were long it must have seemed like the end of the world. Those who were short are still laughing all the way to the bank.

 

The crux of the problem

Remember Murphy's Law? 'If things can go wrong, they will.' Well, he must have been a trader. There's no way he could have come up with an insight of that nature if he was not. Governments may fall, Crises may occur, Scams may happen, The Dow Jones might crash, the Nasdaq might rally, or China may invade Taiwan. But as a trader you must realize that you will not be able to anticipate these events. Very often these will come as a surprise to you, even as somebody else out there will be gloating. Trading is a risky business because the focus is on the short term - hours and days. Hence, events that are but a blip on the scale of time can take on a larger than life dimension in the short term.

 

It can be stressful

Of course it is. Trading is a very glamorous profession, but it is accompanied by significant downsides. It is not an easy life. It can turn you into a night owl these days. It involves getting hooked on to CNBC or pulling up quotes at Yahoo all night. But it need not be that way. If you play the war by the rules, then you will be able to sleep peacefully at night.

'Peace comes not from the absence of conflict in life but from the ability to cope with it.' Nice but what's that got to do with trading? It can be related to almost anything in this less than perfect world. In the trading context, it reads thus - 'Success (in trading) comes not from the absence of uncertainty but from the ability to cope with it.' The important thing is to have a plan to combat the uncertainty.

 

The key to coping: discipline

To be a successful trader discipline is a must. It's the key ingredient that sets apart the winners from the losers. In fact, we would go to the extent of saying that trading is 99% discipline and only 1% about stocks and markets. The right view on the market does not help you make money. It is the ability to implement your view through a clear strategy that does.

 

The IT refund approach

How much money should you deploy in trading? Actually, this is a simple question to answer. The right amount of capital to invest in trading (particularly the leveraged type) is the amount of capital that you are willing to lose in entirety. Once you do this you will also ensure that you do not lose your sleep. Obviously the right amount of money differs from person to person, depending upon their net worth and their risk appetite. The right amount of money typically equals the amount of unexpected refund that you receive from the Income Tax department. Got it? You must be prepared to lose it.

 

You don't need the Man from Mars

The most common but misplaced objective that a trader can have is to hope to make money out of every trade he makes. We know of only one such person who has got every trade right and he is an alien, from Mars. So we are unable to translate the secret of his success for you. That's the truth.

The objective when trading must very obviously be to make money out of it. Enough money to make it worthwhile. But that does not mean that you have to make money out of every trade. You only have to ensure that the sum total of all your profits is higher than that of your losses. If you get nine out of 10 trades wrong but lose only one buck on every wrong trade and make 10 bucks on every losing trade, the arithmetic is still positive. Set yourself a realistic goal. Not the one that sets you up for failure.

Our thumb rule for money-making is as follows. We hope to make money 60-70% of the times that we initiate a trade. And every time that we go right, we hope to make 2-3 times what we are willing to lose when we go wrong. Convert that into numbers. Let us say you make 10 trades every month. And you make 6% (on your capital) every time you go right, and that you lose 2.5% every time you go wrong. Overall, you would have made 28.5% on your capital. The beauty of the arithmetic is that even when your success ratio drops to 30% (for the month) you are still breaking even!

 

Battle versus War?

The Stop Loss is the Holy Grail of trading. It is the point at which you must cut your losses and retreat from the battle. In trading, as in war, you are better off extricating yourself alive from a losing battle rather than becoming a martyr. 'Live to fight another day,' is the motto of a successful trader. To go into battle without the Stop Loss is the equivalent of going into battle without a retreat plan. Sure you'll die a martyr and they'll build a memorial, but that is hardly the objective.

You must be mentally prepared and must accept the fact that battles will be lost; what matters is that the war must be won. The Stop Loss is the point at which you must admit the failure of your strategy and retreat from the battle. It is nothing but the amount of capital that you are willing to lose on a trade.

 

Sibling rivalry

How do you fix a Stop Loss? You start with the win-fail ratio. To understand the concept of the win-fail ratio you must revert to your sibling days. Did you have a younger sibling who suddenly became mama's darling, displacing you? Now, you could pinch Junior once while mother wasn't looking, but by the third pinch Junior would wail and mother being all-knowing would respond to the crime with a tight slap. That's the win-fail ratio. 3:1.

Now, if Junior were to wail loudly at the first pinch and you're going to get your just desserts for just one infraction, would you take the risk? No way. That's hardly an attractive risk-reward ratio. Are you prepared to lose one buck just to gain one? It's the same when you buy or sell a stock. You do not risk Rs100 if you hope to make only Rs50 from that trade. You should risk Rs100 only when you hope to make Rs300. Vice versa, you should be prepared to lose Rs100 if you hope to make Rs300. And if you do lose Rs100, then it's time to call it quits.

Ever tried pinching Junior again - immediately after getting the sharp slap? We would not advise it.

If you have reached this far then you know exactly how much of capital to deploy in trading. You have also understood sibling rivalry, battles et al and are no longer in pursuit of the Man from Mars.

It's time to wrap it all up into what we call Sharekhan's Rules for trading.

 

Prepare for battle

You must have a plan of action before you reach the battlefield. You cannot decide on your strategy (on the fly) after you reach the battlefield. You must take stock (no pun intended) of what you are willing to lose before you trade. As obvious as this may seem, the same is difficult to do. The trading screen is evil personified. The flashes of red and blue, and the whispers and shouts, are nothing but the handiwork of the Devil. Do not allow the excitement of the moment overtake or change your plans.

 

Don't take more pain than you planned for...

The beauty of a plan lies in its implementation. Follow your strategy (as planned earlier) on the battlefield. If you lose the maximum that you were prepared to, then you must cut your losses and exit the battle. Not to do so would jeopardize your capital. It will ruin your sleep at night. As they say in Poker - 'To win, you need to be at the table.' You will not be able to keep your place at the table if you allow your capital to evaporate.

 

Do not over trade

Trading indiscriminately and in large quantities is a weakening process. You can fight a battle on one, two, or maybe, three or even four fronts, but beyond that you run the risk of spreading yourself too thin and letting the enemy get the better of you. Monitoring each trade puts pressure not just on your capital but also on your mind. Failure to recognize this can prove fatal. The mind can focus on only so many things at one point.

 

Let your profits run, cut your losses early

Let your profits run and cut your losses early. Put simply, go after the enemy who is already on the run, retreat from the battle when you are finding it difficult to hold your position. To do otherwise would be foolish. This is the rule that, in our experience, traders find most difficult to implement. The desire to parade our successes is so strong that it makes us close out the winning trade so that they may be celebrated. It also makes us leave our dirty little secrets in the cupboard.

Instead announce your little mistakes (don't allow them to grow) to rest of the world and see how forgiving the world can be. Not to forget how well you will sleep at night. As for the winning trades, stay with them and allow your profits to soar. You must have started with a Stop Loss, keep hiking the same, as the trade turns profitable. How does this work? Let us say you bought a stock at Rs10, expecting it to go to Rs20. Being a sensible trader with a powerful recollection of your sibling days, you set your Stop Loss at Rs7.

Let us assume that the stock goes to Rs15. You must now move your Stop Loss higher. After it has risen by Rs5 it hardly makes sense to leave your Stop Loss where it was and risk the possibility of losing Rs3. So you hike your Stop Loss to say Rs12. This way, even if the stock reverses its trend, you still get out with a small profit. Keep hiking your Stop Loss in the same direction as the price, and pretty soon the Stop Loss would work not as a 'Stop Loss' but as a 'Protect Minimum Profits'. Beautiful.

What do you do when the stock gets to Rs20? Then you re-evaluate it as a new trade and apply the time tested sibling rule to set a new Stop Loss and a fresh target. If you think that Junior now realises that he should wail at one, then it might be time to get off the gravy train. Never treat this as an old trade or a free trade. There is no such thing as free trade.

 

Focus on the price

Focus on the price and cut out the noise. What's the noise? The noise is nothing but the fundamentals of the stock, which may be, and are, very often irrelevant when you are trading short-term movements. So don't pull out the balance sheet of the company when your trade starts to go horribly wrong. When you are trading, the price on the screen tells you everything you need to know. Also, don't look for news to convince you that what you are doing is right. If you wish to be a trader then you must buy on the rumour and sell on the news. The news tells you when it is time to get out; it's not to be treated as a reinforcement.

If you have reached this far then you have been outfitted with the weaponry for battle. But the battle must be fought by you and you alone. Go forward.