In Chapter 13 of the second edition of Trade Your Way to Financial Freedom, I discuss the snow fight metaphor in which each aspect of the snow fight represents some aspect of trading. In this tip, I'll give the meaning of the metaphor, the missing variable, and discuss how you can use all of the variables to evaluate your trading system.
The first variable in the snow fight metaphor was the wall of snow. If the wall is gone, you have no protection from the snowballs. Hopefully, all of you figured out that the wall stands for the equity in your account. And generally the bigger your equity, the safer you are from disaster.
The next variable was the two kinds of snowballs, black and white. Yes, I know black snowballs are stretching things a bit, but not that much, and it really allows you to see the impact of the various aspects of your trading from a different perspective. The black snowballs stand for losses and the white snowballs stand for gains.
The slight destructive force that all the snowballs have is the cost of trading. Most people don't realize how big this force actually is. When I bought my first stock over 40 years ago it cost me $65 to get in and another $65 to exit. And had I purchased an odd lot, the cost would have been bigger. This is almost equivalent to the costs of buying and selling real estate today. Now we have costs of about $10 each way, but it can still add up. Two years ago, I did some very active trading. I was up 30% on the year, but at the end of the year I discovered that my trading costs were about equal to my profit. Thus, I was really up about 60%, but gave the broker half. So what are your trading costs?
Everyone would love to only have white snowballs coming at the wall because they would increase the size of the wall. But some black snowballs do come. And the percentage total snowballs that are white is equivalent to your win rate. This is the variable that most people spend all of their time thinking about because they want to be right about their trades.
We'd like to have 90% white snowballs (winners) and 10% black ones (losers). But what would happen if the white snowballs were the size of marbles and the black snowballs were the size of six foot boulders? It wouldn't matter if there were 10 times more white snowballs, you'd still be crushed. So perhaps you can now see why the golden rule of trading is to cut your losses short and let your profits run.
What you really need to know is the relative volume of white versus black snow. Another way of putting it is “what is the relative impact of the average snowball hitting the wall.” This is equivalent to looking at all of your trades as a multiple of your initial risk (R), or R-multiples for short. And the average R value that you get over many trades is the expectancy of your system. And this would be equivalent to the average impact of a snowball on your wall. Perhaps now you can see the importance of the expectancy of your trading system.
So let's say you assess the average impact of a snowball and the results are good, it's equivalent to 50cc of white snow. Thus the white snow has, on the average, 50cc more impact that the black snow. But isn't there something else you need to know? Of course, there is - it's how often do the snowballs come? This is equivalent to how often do you get trading opportunities.
If you add 50cc of white snow every minute, it's a lot more interesting than if you add 50 cc of white snow every hour. In fact, it's 60 times more white snow. That's equivalent to expectancy time opportunity which is the variable that I like to call expectunity. Gaining 3000 cc per hour (equal to 50 cc per minute) is a lot more significant to your wall (i.e., equity) than gaining 50 cc per hour.
So what is the most important variable that I didn't mention? It's position sizing. This is equivalent to how many snowballs arrive at any given instant. Having 1000 snowballs arrive at one time is a lot more significant that having one snowball arrive. And if 1000 black snowballs arrived at one time, it could destroy you wall. And it wouldn't matter if the average snowball had a positive impact or not. This might be equivalent to risking it all on one trade. If you are wrong, you are bankrupt. It doesn't matter if you have a huge positive expectancy in your favor, risking too much can be dangerous.
Think about these variables now. Which ones have you been concentrating on in your trading? Have you neglected some important ones? And if you don't know about expectancy, then I'd suggest that you look at the rest of Chapter 13 or some of the past tips in which I've discussed R-multiples and expectancy.
Have a good weekend. I gave you a taste of the importance of position sizing this week. We'll talk about it in more detail in the next tip. Until then, this is Van Tharp.
Dr. Van K Tharp
TradingEducation.com
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