Updated: Jul 20
13th September 2022
I'm going back to the first principles to illustrate that trading is simple but not easy. I'll leave you with a challenge at the end of this article too.
In this game of trading, we know that you can't win on every trade. We also know that what's important for success is that you need to win more on your winning trades than you lose on your losing trades, and keeping your losses small is critical. If you can get that right, then even a win rate below 50% will allow you to be profitable over a sufficiently large number of trades. This is simple stuff and most of you here already know these basic concepts.
To illustrate the point, I have compiled a theoretical spreadsheet that shows how you could generate a 40% annual return using very simple, conservative assumptions. These are the assumptions:
100 trades taken in a year, based on a strategy with an edge
$100,000 starting capital
Risk per trade is 2% or $2,000
Win rate is 40%, Loss rate is 60%
Risk to reward ratio is 1 : 2 ($2000 losses, vs $4000 winners)
Distribution of wins to losses is random
Clusters included, with up to 5 losses in a row twice in the data series
Max winning cluster is 3 winners in a row
No compounding of returns
Take a look at the data in the table. You'll see that these assumptions generate a 40% return over 100 trades, with relatively low volatility. I've also shown a theoretical chart of return distribution.
Is this a simple approach to trading? I believe it is. Is it easy to achieve? Experience says no.
If it's such a simple approach and very simple to achieve in theory, then why is it not easy to achieve in reality?
I'd say the answer boils down to psychology.
What would it take to achieve this type of return in reality?
1. A strategy with a reasonable edge
2. Trust in the process
3. Discipline to stick to the process
4. Patience to allow the process to play out, even through drawdowns
5. Blocking out noise
6. Not allowing your emotions to get in the way of the process
Points 2,3,4,5,6 above (Trust, Discipline, Patience, Noise, Emotions) all have one common thread running through them. They are all aspects that require a very solid grip over your psychology. And that's why it's difficult. Trading is simple, but we make it complicated because trading is psychologically very demanding.
I look at this theoretical example and feel excited and yet foolish at the same time. I have not managed to achieve this type of consistency myself - not over 100 trades. Over a smaller sample yes. But not over 100 trades. At some point along the way, I've always found something gets in the way. Greed, Fear, Noise or some other distraction that derails the process. Yet I know it is possible to achieve this. It's simple, but not easy.
So here's the challenge to you: TRY IT! Commit to two or three trading setups that have an edge and taking the trades when they present. Commit to 100 trades. Commit to cutting losses at 2% of capital. Commit to banking profits at 4%. Commit to not breaking the rules for 100 trades. Commit to being patient for your setups to present. Commit to blocking out noise. Commit to seeing through the entire process for 100 trades and not getting derailed. Commit to persistence and discipline to make this into reality.
Am I being too simplistic here? Am I selling dreams? I'd be interested to hear your feedback on this.
I am firm that this is possible. I'm firm that somebody with a strong commitment to the process could achieve this. Could that somebody be YOU?