Using “Magic” To Be A More Profitable Trader

This post originally appeared on TraderPlanet.

I have a real issue with magicians. I put them in the same category with clowns, mimes, and Canadian teen idol singing sensations; they just creep me out. I mean just look at David Copperfield and the late Doug Henning…do I need to say more?

However, just because I don’t like magicians doesn’t mean I don’t like magic. Today I am going to show you some trading magic that will make you profitable even if you lose on two thirds of your trades.

RECENT PICKS
In the last month I have done three posts on three separate stock trades. The first in was in Morgan Stanley ($MS) where I suggested risking 50 cents for a potential $3.00 gain.

Then next was in Chesapeake Energy ($CHK) where the risk was $1.00 for a $5.00 reward.

The last was in Vocaltech Communications ($CALL) which risked $1.00 but didn’t have a specified reward target.

MS did trigger and hit its target. CHK triggered, but failed for a possible $1.00 loss. And CALL didn’t trigger, but let’s just say it did and you lost a buck on it.

But where is the magic O’ Great Lundini?

POSITION SIZING
The magic is in how you size your positions. By taking a set percentage of your account equity, you end up with a fixed dollar amount of risk capital on each trade. You divide that dollar amount by the spread between your entry and stop on each trade ($.50 on $MS, $1.00 on $CHK, and $1.00 on $CALL). That gives you your position size on each individual trade.

You then are risking a standard fixed amount or “R” on each trade.

DO THE MATH
On the $CHK trade you then lost 1R. On the $CALL trade, 1R as well. But you made 6R on the $MS trade, for a net profit of 4R.

So even though you lost on 66% of the trades I suggested, you are net profitable.

Alakazam…..!

See related post The Most Important Concept For Successful Trading.

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  • Jake

    I guess I missed the second sentence on there: “You divide that dollar amount by the spread between your entry and stop on each trade”

    Let’s assume you start out with a $100,000 account. The first step is to determine the fixed amount you want to risk on each trade. For this hypothetical, lets say we want to risk 10% of the account or $10,000 on any one trade.

    For each trade, we would divide the fixed risk ($10k) by the maximum loss. For each instrument it would look like this:

    10k/.50 = 20k shares of $MS
    10k/$1 =
    10k shares each of $CHK and CALL

    So your risk of loss is equal across the board. If you are stopped out on any of the trades your loss is 1R or $10k. When you hit your profit target on $MS then your profit is $3 per share for a total profit of $3 X 20k or $60k. This is equal to 6 times your risk on the trade or 6R.

  • Jake

    Wouldn’t the trade on $MS have a reward equal to 3R rather than 6R and a risk equal to .5R? You said “taking a set percentage of your account equity, you end up with a fixed dollar amount of risk capital on each trade.” You defined R on the $CALL and $CHK as $1 so it would seem to make sense that the $MS was equal to .5R. Thanks for your help.

  • I’ve been preaching and practicing this for years, and it works. I call this magic trick a ‘secret’ because apparently most don’t understand it’s simplicity and effectiveness. It works best with Day Trading when it’s almost foolproof; With Swing or Investment positions there is always the risk of major news causing a price GAP against you obliterating your risk/reward ratio. Clear and concise explanation Brian. Well Done.