Everyone has heard of it, everyone has been warned about it, and everyone feels reluctantly curious as to the daily life of a successful Day Trader. The thought of making quick, fast, and ‘easy’ money from home by reading the markets is strongly appealing. So appealing, in fact, many people use this as the basis in arguing that can’t be profitable. The expression “if it’s too good to be true, it probably is” is a cliché that guides our life choices. We’d rather risk missing out on a large opportunity then look like suckers. Luckily in day trading, there’s a time-proven method of avoiding becoming just another ‘sucker’. Developing a fundamental understand of the market, creating a system that matches this system, trading within its rules, and using sound money management to ensure this works into the distant future. A combination of aptitude, hard work, discipline, and strict capital management are the key ingredients to a successful Day Trader.
I’ve heard it’s impossible to be profitable Day Trading. Who is right?
This is a common argument against Day Trading – it’s impossible to make a profit because the market is efficient, and even if it wasn’t, you’re competing against people who are much smarter then you. Some, however, should be heeding the advice, as the skill set and mental attitude they possess is not high enough to be able to trade profitably. Just because something is extremely difficult, and takes a huge degree of understanding, doesn’t mean Day Trading is some sort of scam. Although it may be advertised like a scam, it’s really no different to poker. Poker promises great riches to the talented player prepared to take risks. If you think about how a layman views and rationalises poker, and ask them for how they ‘beat’ the game, you’ll hear baseless theory, often built on results orientated finds from anecdotal experience. Day Trading is no different; the theory and skill gap between the top traders and the rest is startling (but not unexpected).
The myth that Day Trading can’t be profitable is one which usually leads back to the gospel perpetuated by academics. Academics have a vested interest in keeping Day Trading as a ‘gambling’ venture, theoretically unprofitable; most economic and financial models are based on theories which were written under the assumption that the market is ‘perfectly efficient’. They have half a point, but it’s not the full story. A better way to think of the markets is them being ‘effective’ rather then ‘efficient’. The price rarely ever sits at its mean, its rational value, all factors considering. Instead, it’s like a rubber band, which bounces around the mean like a pinball. Much like a rubber band, the further price moves away from its true mean (or value), tension grows, and using certain systems we can devise the strength of that tension, and what the short or long term expectancy is for that price.
This is of course, my opinion. You’re entitled to your own. What I do ask, is instead of pointing fingers using second hand evidence, take a step back and look at the whole picture. Read both sides; think about the rationality each exhibit. If you’re convinced of a side of thinking, stick to it. Buy and hold is a viable strategy, not the strategy I would choose, but some great thinkers have turned it into great money, so I respect that. At the same time, there are undoubtedly traders that have turned great fortunes using a different strategy, but still with the idea of exploiting pricing differences. Day Traders, Market Makers, Swing Traders, Arbitragers, Value Buyers, there’s a rich guy behind every level.
Is our job as a Day Trader to predict the market?
NO! Prediction is for CNBC analysts and ivory tower banking macro economic think tanks. Seldom is either on target and even if they were, the advice they give is to obscure and based on too many variables to be profited off in a realistic sense. The goal of an astute Day Trader is to develop theories about his chosen market(s) through observation and testing, and using risk managements strategies, in order to show a long term profit. This is not prediction. We’re exploiting statistics in order to create a competitive advantage in the market place.
How does one profit from Day Trading?
By constructing two facets; build a dynamic system, and tailoring a risk strategy to that system. A risk strategy is using your capital, or ‘bankroll’, and optimally allocating it for each trade you make. Obviously, risking too much on a single trade can be disastrous, and increases our risk of ruin. Allocate too little, and we may see sub optimal profits. A balance must be struck. TraderMike has a fantastic article on the types of position allocation and the conventional thinking among traders:
Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it’s rarely covered in trading books. A position sizing model simply tells you ‘how much’ or ‘how big’ of a position to take. Position sizing can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.
Dr. Van K. Tharp did an experiment which shows the importance position sizing. In his book “Trade Your Way to Financial Freedom” Van gives the results of his testing of four different position sizing models. He tested the models on the same trading system, so the only variable was the position sizing. The simulations were run with an initial equity of $1,000,000 and took 595 trades over a 5.5 year period. The models produced drastically different results:
* The worst was the baseline model which just bought 100 shares of stock whenever a signal was given. That model returned $32,567 or 0.58% annualized.
* Fixed-amount model: This method traded 100 shares per $100,000 in equity. It returned $237,457 or 5.75% annualized.
* Equal leverage model: Each position in this model was 3% of the account equity. So at the start of the trial each position was $30,000. This method returned $231,121.
* Percent risk model: According to this model positions were sized such that the initial risk exposure was 1% of the account equity. So with $1,000,000 equity the initial risk would be $10,000. So if the initial stop on a trade was $1 the system would trade 10,000 shares. For an initial stop of 50 cents the system would trade 20,000 shares, etc. This model returned $1,840,493 or 20.92% annualized.
* Percent Volatility model: Positions were sized based on each stock’s volatility — the more volatile the stock the fewer shares are traded. For this trial positions were pegged at 0.5% volatility (initially $5,000 per position) — so if a stock’s average true range was $5 the system would trade 1,000 shares. This model returned $2,109,266 or 22.93% annualized.
You can see how important position sizing is by that simple experiment. Remember that’s the same trading system with the only difference being the size of the positions.
In the past when I was swing trading I used to simply divide my equity by 5 and that would determine my position size. I wanted my maximum risk per trade to be 1% of my equity so that dictated that my maximum loss per position was 5%. I still do that with my long term account but I’m seriously considering changing that.
Now that I’m daytrading it makes a lot more sense to me to use the percent risk model. I always liked that model but I never felt comfortable using it when I was holding stocks overnight. Now that I don’t have to worry about overnight gaps I feel much better about using this method. It allows me to put a lot of money to work when I have an entry with a tight stop. But despite the fact that I could have 2 or 3 times as much money in play versus my old position sizing model I can still keep my risk per trade very small. It’s also kept me out of trades that were just too risky because it forces me to really look at where my initial stop will be. Often the stop will be so wide that I can only buy a handful of shares so it becomes clear that the trade isn’t worth the effort. This method also allows me to equalize my 1R risk across all trades which help in my expectancy calculations.
Here is some position sizing resources:
* Van Tharp’s books are by far the best work I’ve seen on position sizing, expectancy and money management. I’ve read “Trade Your Way to Financial Freedom” and “Financial Freedom Through Electronic Day Trading” and recommend both highly.
* Money Management or Position Sizing or Bet Size… No Matter What You Call It, Better Know It
* Michael Taylor on his position sizing trials.
* Stephen Vita on his position sizing model.
* Jon Tait’s argument for trading many small positions. (I don’t necessarily agree with Jon’s conclusion but he covers some important topics in this post.)
* Position Sizing: Why Size Matters to All Investing Greats
* TradersCALM - Introduction to Position Sizing
* Position Sizing - The Most Powerful Investment Concept
* Size Really Does Matter! Position-Sizing Management Can Make a Difference Between Profit and Loss - (Free subscription required)
* T.I.P.S. - Trading is Position Sizing
* My position sizing spreadsheet
* TradeStars’ position sizing calculator
* Dave Laplander’s position sizing calulators