Transcription
Okay everyone, today I want to talk about the holy grail in trading, and I'll do an illustration to, uh, bring home a point of what trading is about, what speculation is about. Um, so we're going to start off with this graph here, assuming that this, this point right here, this is representing your buy point, okay? And the upside is infinity. Of course, a stock can go up, uh, you know, if there is no cap on how much a stock can go up. And of course, downside is to zero. A stock can go to zero, right? So you have infinity on the upside, zero on the downside, losing all your investment from the buy point, of course.
So now, let's assume that from that buy point, whatever it is, whatever, whether you, it's from a specific technical setup, whatever that buy point represents, let's assume that fifty percent of the time the stock is on the positive side and fifty percent of the time it's on the negative side. Now, there are times where it's going to be on the negative side, maybe a lot less than the positive side, and it'll go negative and then positive, right, and vice versa. So, but just let's assume that 50 percent of the time the stock spends its time on a positive side and a negative side, right? So this just represents what the price did after the buy point, right? Just think of that as representing what the price did after the buy point.
Now, your goal is not to try to come up with some type of strategy that figures out where these peaks are going to be, how much the stock's going to go up, or even end up with, you know, maybe a stock that keeps going up for a lifetime, right? You can buy a stock maybe at a certain price and hold it for the next 20 or 30 years, and it never goes below your buy price, okay? That's, that's obviously some type of long-term investment idea. But we're talking about trading on a regular basis and optimizing your trading so you're getting the biggest return in the shortest amount of time, and, and you're able to do it consistently. That's the main thing is to do it consistently.
And to do that, what you have to do is figure out what you can capture when the stock is on that positive side. And now these numbers could be 80/20, you know, it could be any numbers. I'm using 50/50 as, you know, basically the flip of a coin that you're right half the time, you're wrong half the time. That's been my about my average between about 45 and 50 percent, uh, profitable trades over, um, you know, a long period of time, my career. And if you can, if you can be right 50 percent of the time, you should do very well if you follow the formula of capturing the gain, right? Figuring out what gain that you can capture while the stock is on that positive side versus what cost, as far as cutting your loss and keeping your risk contained. What cost is it going to take to be able to capture that upside and have a relationship that is profitable, that you have an edge?
I want to have a two to one profit to a risk relationship, but let's even look at, let's start with a three to one, all right? That's what I really prefer is to have a three to one. So let's say you're able to capture 15 gains on the upside on average, okay? This is all on average, not every trade is going to be 15, but on average your winners are 15 profits. And, and to do that, you're able to keep your losses contained at 5 and not choke off that other half of this, the equation to get that 15 percent, right? So now you have a three to one. So for every dollar that you're risking, you're making three dollars. So if you're right 50 percent of the time, you obviously would want to be able to make this, uh, a bet as often as possible and roll this over as many times as possible.
So imagine if you had a, you had a coin, and it, of course, it's 50/50, a coin flip is 50/50. Um, and let's say when you hit your heads, you got paid three dollars, and when the coin landed on tails, uh, you lost a dollar. When you want to flip that coin as much as possible, right? You'd want to be, you'd want to flip that coin as much as you possibly could because you have an edge. And if you were able to flip that coin 100 times, you're going to make a heck of a lot more money than if you flipped it 10 times. And if you flip it a thousand times, you're going to make a whole lot more money than you flip it 100 times. And the more you flip it, the more likely that that scenario is going to come to fruition because now the probabilities are going to distribute, right?
So let's say that you're only right 40 percent of the time, right? You're right 40 percent of the time, and 60 percent of the time you're on the losing side, okay? So now that's a, that's a three to one reward to risk ratio, but when you adjust it for your batting average, and to do that, you simply take your, your percentage, right? Your, your percentage gain times your percentage of winning trades divided by your percentage loss times the percentage of losing trades. So this now, that would come out to two to one, right? This would, you'd still be a two to one trader. So if you were capturing 15 percent gains and you were losing 5 percent, and you were only right four out of ten trades, 40 out of 100 trades, you'd still be making two dollars for every dollar that you, that you risk. And again, you'd be making a fortune if you can do that and turn that edge over.
So now, what trading is not about is trying to figure out to get the biggest gain and to capture these peaks or to buy at the lows. That's virtually impossible, and it's unnecessary, and it also, it may not be optimal. Here's the key: you're not looking for the biggest gain, right? You're not looking for necessarily the largest gain. That may sound counterintuitive. Why would I want to have the largest gain? Well, because the largest gain may cost you an opportunity cost. So let's just take a look at, um, that should actually, should actually say one times 100. So if you were to have one stock that went up a hundred percent, obviously that would be a hundred percent return, correct? If you were to buy four stocks that went up twenty percent, you compounded that. You bought a stock, it went up 20 percent, you bought another stock, you took that money, went up, uh, 20 percent, or whatever trades, four trades, you'd be up 107, just about the same as the 100. So if you found eight stocks or eight trades that went up ten percent and you compounded those, you'd be up 114 percent.
So the question is, first of all, which one is easier to find? Is it easier to find a stock that goes up a hundred percent or 20? Obviously, 20 would be easier than 100, and 10 percent would be easier than 20 because almost every stock goes up 10 percent many times per year. So now, how many opportunities are you going to have in a specific, in a period of time? And that is where we go back to figuring out the optimal level versus the risk versus the maximum level. Maximum level is not what you're looking for. You're looking for the optimum level so you can turn that edge over as many times as possible, and that is the holy grail.