Chart Based Stops: How Not To Lose A Million Dollars

Back in the 90’s, when internet stocks were going berserk, I had a friend who was just out of law school and had decided to dabble in the markets.  He had a small account, and he decided to put it all into AOL (America Online).   As he started making the rounds to interview for a job, he noticed that his stock was taking off, moving up almost every day.

His account started to grow, and he bought more and more AOL.  His account value hit $250,000, then $500,000, and then $750,000.  It seemed as if he could do no wrong with AOL, and he had stopped interviewing with law firms, and decided that he was just going to live off the profits in his trading account.

His account continued to climb higher, and one day I asked him when he was going to take his profits, to which he replied, “When it hits one million dollars, I am going to close it out, and travel the world.”  This was a young man in his mid-twenties and one million dollars was a ton of money to him.  His account value finally hit a high of $970,000 just before the long running internet bubble began to burst.

After the first substantial decline, he told me that if it just got back to $750,000 he would sell it.  Well you know the rest of the story.  He repeated that mantra with $600,000 and $500,000 and $400,000 and so on.  He took his position all the way back down to below his original account value, and thus began knocking on doors of law firms to try to get the job he never thought he would have to get.

The takeaway from this harrowing tale is that when setting stops and targets for trading, they have to be chart based, and not money based.  The market has no idea that you exist, and thus its movements have no relation to how much you are up or down on your position.

The movements of the market are related to areas where there is support and where there is resistance; that are based upon the number of buyers and sellers in those areas.  So if your $ target on your position puts the price above resistance, you many never get that price, thus not locking in your profits.  Likewise, if your $ stop is above support, you make get taken out, just before price turns and rallies.

support-resistance2The key to converting from $ based stops or targets to chart based ones is to start by “reverse” sizing your position.  This takes away the emotional aspect of the trade, and allows you to trade better, and off of what is happening in the market, instead of what is happening in your head.  Check this post for more info on reverse position sizing.

Billionaires I Have Known (and Do You Really Want to Be One?)

We’re fascinated with billionaires. They make the headlines every day. Forbes devotes an annual list that celebrates them and Bloomberg tracks their wealth in real-time.

Well, I have a confession to make.  I am not a billionaire.

Truth be told, I don’t even have 100 million dollars.  But for some reason, I always seem to be hanging with billionaires.

One day, when I was standing in front of a restaurant, waiting to meet my friend for lunch, I looked next to me and one appeared. Billionaires are sneaky like that.  It was George Argyos, former ambassador to Spain.

Contrary to popular belief, billionaires do not levitate nor do they give off an eerie Jesus-like glow, in fact they often look pretty normal.  George actually looks a lot like my high school Algebra teacher Mr. Ross, but with a better suit.

I thought about approaching him to say hello, but just like in my 20’s when I wanted to strike up a conversation with a beautiful girl, I couldn’t think of a good opening line.

I contemplated saying “Hello, Ambassador Argyos, my name is Brian Lund and I’m a big fan of your work on implementing the treaty of Talacaloco,” but it just seemed too forced.   Instead, I stood there in awkward silence for a few minutes until my friend arrived.

When we went inside to eat,  as fate would have it, George sat at the table next to us.  I gave him that knowing nod that only two people with a shared history can understand, but he pretended not to see me.  I am pretty sure he was eating a ham sandwich.  Possibly with mustard.

George is a nice guy but I probably won’t hang out with him again.  He is a little boring, and besides, he’s only worth $2 billion.

John Arnold, the former Enron trader, and wunderkind oil trader, is the youngest billionaire I have chilled with.

We were at a club in Houston, and I was with my brother-in-law and his friends, all former Enron traders as well.  John was in the VIP section, but had a round of drinks sent over to our table.

Later, when I was waiting in line for the restroom, he and his posse’ passed by me on the way to the exit.  I was a bit lit up at that point and yelled, “Johnny Baaaaby! The Grey Goose was the BOMB!  You the MAN!”  In retrospect, I probably should have asked where he thought natty gas was heading.

Some of the billionaires I have hung out with are more interesting than others.

Henri Samueli and Henry Nicholas are the co-founders of Broadcom, and when I hung with them they were each worth a cool 10 billion.  I owned a company that coordinated projects for interior designers, and we were hired by the firms working on each of their respective homes.

I was at Samueli’s house one day, standing on his driveway working on a quote when he drove right past me into his garage.  I waved to him, and I am pretty sure he waved back, although his windows were tinted so I am not quite sure.

Nicholas and I used to chat a lot.  I remember on one particularly hot summer day, I was walking his house with his designer, when he emerged from his workout room.  He had a couple of bottles of water in his hand.  “Would you like one”, he asked as he walked past me towards the front door.  “No thanks”, I said.  “Okay, suit yourself”.  He was always saying crazy things like that.

Even though they were partners at the same company, Henri and Henry had slightly different personalities.  For example, Samueli built a multi-lot, modern style house right on the water, whereas Nicholas erected a massive Tudor style home high on a hill with a sex dungeon under it.  Samueli used to host parties where the captains of industry would get together and raise money for charity.  Nicolas used to host orgies where he furnished strippers and prostitutes for guests.  Samueli bought the Anaheim Ducks and Nicholas bought a warehouse and filled it with cocaine and ecstasy.  Neither one of them ever invited me to one of their parties, but my guess is that the ones at Nicholas’ house were more fun.

Donald Bren is probably one of the wealthiest billionaires nobody outside of Southern California has heard of.  He made his money in real estate, and could buy and sell Donald Trump four times over.  We met at Bloomindales’s one day about 10 years ago, when we were both in the women’s section, where I was looking for a scarf for my mother’s birthday.

Donny (as I like to call him), was being waited on at the counter by a sales associate, while his assistants busily conducted business on their cell phones.  I was standing behind him, and noticed that he was purchasing a very nice lady’s handbag, probably for his wife.  When the sales associate took it away to wrap it, and there was a pause in the action, I leaned over and said, “Nice choice”.  He was about to engage me in conversation, but his associates were jealous and formed a semi-circle between him and me.  No big deal.  I didn’t really like the handbag anyway.

Billionaires fascinate me and when I was younger I assumed that eventually I would become one.  I was told from an early age that I was “very intelligent”, and in my young mind that and time seemed like a sure recipe for landing on the cover of Forbes.  However as I got older I started to realize that I was often doing things that probably were not conducive to becoming a billionaire.

When I was twenty-one I spent a whole week during Christmas break sitting on my couch, drinking beer, and playing Super Mario Bros with my roommates.  Chances are not many billionaires have done that.

Other times when I was closing down a bar with friends on a Thursday night, I would wonder if any billionaires out there were doing the same thing as me at that moment.  I doubt it.

Sleeping in on the weekends is something I used to loved to do, but as I would lay there wrapped underneath my comforter, it would dawn on me that billionaires were already hard at work.

As time went on it became clear to me that I did not have what it took to be a billionaire.  I resigned myself to that fact, and proceeded to get on with my life.  For many years I didn’t think about billionaires or what their lives were like.  I settled down, got married, and started having children. And then something funny happened.  I began to think about them again.

When there was thunder and lightning outside and my frightened kids jumped in bed with my wife and me, I thought about being a billionaire.  If I was a billionaire would I have been there to experience that moment with them?

How many times would I have been on my private plane in route to a high-powered negotiation or in five-star hotel suite far away, getting ready for an early morning board meeting while a school play was going on?

That lazy summer vacation spent with the family driving up the coast to see the redwoods and camping out under that stars…would I have been there for that?

Those are the things that are important to me, and although I am not a billionaire,  I like my life because I have the life that fits who I am.

Life has its own filtering process, and often we spend the majority of our time fighting that process, trying to be something we are not.  Chasing some illusion of who we are or what we should be, instead of starting the process of becoming who we are meant to be.

Let me be clear, I am not talking about “settling” or giving up on your dreams, but about exploring and discovering what and who is important in your life, and then creating a life that puts it/them at the center.

Looking in on a billionaire’s life we imagine what it would be like to have that wealth and project the life we currently have on top of it.  We rationalize killing ourselves so we can “make it”, and once we do we think then we will focus on more important things.  But that is an oxymoron that rarely exists in the real world. Very few people have the single-minded, unrelenting, laser focused drive that it takes to become a billionaire, and then just “turn it off”.

Perhaps it is best summed up in the by the follow story;

A reporter goes down to the floor of the exchange to interview a very successful trader.  He says, “I don’t get it?  You have been doing this for 20 years and you are worth 100 million dollars.  Yet every day, you get up at 4:30am, take the train into the city, fight among the traders in the pit, stay late to examine charts, and take the last train out of the city at night to go home.  If I was worth 100 million dollars, I would be retired, sitting on a beach somewhere, enjoying my life.”  The trader pauses, looks straight at the reporter and says, “That’s why you’ll never be worth a 100 million dollars.”

So perhaps I will never be a billionaire, or even a hundred millionaire, and that’s okay.  I have family and friends that I love.  I have my health, and I love what I do, and you can’t put a price on that.

The Most Important Concept for Successful Trading

What is R?

Any sound trading methodology has to incorporate risk management, and one of the easiest ways to do that is to use the “R” method.

“R” is a fixed dollar amount that stands for both risk and reward, and is best arrived at by using a percentage of your total trading capital.  It allows you to size your position in relation to your risk level instead of in an arbitrary way.

For example, if you have $50,000 available in trading capital (cash not including margin), you might use one-quarter of one percent (.0025), or $125.00, as your “R” factor.  This is the total amount you are willing to risk per trade and is expressed as 1R.

In the example below, A is a former support level that was broken and now is a potential resistance level.  Price has been trapped between B and C level, and you are looking to go long if it breaks back above B.  You know that a reasonable stop loss would be just below level C, so you determine the price distance between your entry just above B and your stop just below C.

Let’s say that this distance is 50 cents.  You now take that distance and divide it by your “R” factor, which gives you a position size of 250 shares ($125.00 / .50 = 250).

You now know that if your trade fails and hits your stop-loss, the most you can lose is $125.00 or 1R.  The goal then becomes to only take trades where you have the best potential reward for your 1R risk, ideally 1:3.

In this same example, the resistance level of A is a reasonable target for a successful trade, so you determine the distance between your entry just above B, to the target of A.  You then divide this number by your “R” factor to see if the trade is worth taking.

If the distance between A and B is $1.50 then you have a 1:3 risk/reward ratio and the trade is a good bet ($1.50 / .50 = 3).

The higher the risk/reward ratio you have on your trades, the fewer times you have to be right to still make money, as the chart below illustrates.

Risk Reward # of Trades 50% WT 40% WT 30% WT 20% WT
1 1 10 0R (-2R) (-4R) (-6R)
1 2 10 5R 2R (-1R) (-4R)
1 3 10 10R 6R 2R (-2R)
1 4 10 15R 10R 5R 0R
1 5 10 20R 14R 8R 2R
WT =Winning Trades

You can see that if you only take trades that have a 1:3 risk/reward ratio, and you are correct just 50% of the time, you will have a 10R profit on ten trades.

Understanding how to use risk/return and position sizing allows you to make sure you are never over extended on a trade and allows you to always return to fight another day.

Thoughts on Paper Trading (and What Sugar Tastes Like)

Because I’ve been involved in the market for so long, people often ask me about my trading style and how I feel about the market in general.  Occasionally, they will tell me about their own forays into trading and some will even say something like this…

“I have been paper trading for about six months now, and I am killing it!  I’m thinking about quitting my job and starting to trade full-time.  By the way, where is the local Ferrari dealership?”

Since I like to see people in terrible pain and suffering, I always encourage them to go for it! (Jk).

I am not a fan of paper trading because since you are not using real money, it gives you an artificial sense of detachment from your trades, both wins and losses.

Almost every person out there will change their paper trading methodology once they experience the euphoria of a winning trade or the depression of a losing one.

Sometimes I will find a person with a very rules-based background (think engineers, airline pilots, etc) who will actually trade real money the same way that they paper trade, but for vast majority of people, they just can’t.

I have a lot of issues with Alexander Elder, as well as any author whom I suspect makes more money from writing books about trading than actually trading. That being said, I remember reading his book, “Trading For a Living” and thinking that he spent too much time on the psychology of trading.

Being young and foolish, I also remember thinking, “what the hell does all this crap have to do with trading?  You buy a stock, if it goes up, you make money, and if it goes down, you lose.”

Needless to say, the point of that book was to try to save the novice trader from blowing their account out before they really began to understand how emotions, mindset, and pre-conceived perceptions about the market can affect their trading success.  Those who paper trade can never understand that.

It’s like trying to understand what sugar tastes like without actually tasting it.  You can read about it, you can talk to friends about it, you can study its molecular structure, but until you actually take some and put it on your tongue, you can never know what it really is all about.

So to those would-be traders, I suggest a better alternative, which is to trade with a very small amount of money.  Even if you are only risking $50 or $100 dollars on a trade I believe it will tell you more about your ability to trade than any amount of paper trading will.

It will give you “skin in the game” and focus your trading.  It will also give you time to build a methodology, which if proven sound over time, can be scaled up as your trading experience and account equity grow.

For more (and better) info on the psychology of trading, try Trading In The Zone and The Disciplined Trader by Mark Douglas.