Trading / Investing to make (reasonable) money / returns

 

1. Get the trend right (up, down, sideways) and identify it early
2. Find a spot to enter with objectively defined risk point
3. Exit for a reasonable profit

Most often people lose money because they size too big and hold on to losing trades. How do you size - depends on the objective. Some may fancy maximizing wealth, while others minimizing the risk of ruin, and anywhere in between. There are mathematical approaches like Kelly criterion to position size. Here are some rough formula:

1. For equal size bets (win size = loss size), Kelly would suggest betting % win rate - % loss rate as the optimal bet size. So if the win-rate is 55%, the optimal bet size would be 0.55 - 0.45 = 0.1 or 10% of bank roll
2. For complex strategies, calculate the % return and standard deviation of returns - optimal bet size in % return over risk free rate / square of standard deviation -- For e.g. a strategy with expected return of 7%, risk free rate at 4% and standard deviation of returns at 20%, the optimal bet size is 75%

The issue with above approaches that size to bet with the objective to maximize wealth, can also result in ruin. Have you have saved up a stash that went up in smoke and would not bother you? Then, Kelly waits you!

For conservative souls, a reasonable return (say 10 - 15% per year) on their hard earned savings is possible. We can turn the required return into an objective function and can solve for the rest. Lets start with Sally (a conservative soul) who wants a steady return of 10 - 15% per year. She has done some research and identified a strategy with the following statistics:

• Frequency (how many occurrences per year): 50
• % Win rate: 60%
• Average win: 25%
• Average loss: -25%

Kelly would say bet 20% (0.6 - 0.4) on each trade. This would result in an expected return of 50%. This is amazing as long as Sally does not hit a bad streak that results in losing 50% of her account. For her reasonable 15% expected return, she can risk 6% of her account on each bet. This significantly reduces the likelihood of losing 50% of her account.

Now that we know how to size up correctly, we can turn to 1, 2, 3 above:

1. Get the trend right: Keep it simple, go with a simple combination of moving averages 20 / 40. Find a stock that is going down (price is below 20 day moving average, 20 day moving average is below 40 day moving average). Wait for some catalyst (earnings release, analyst upgrades, some major positive development). Following this development, wait till 20 crosses above 40. This could mark the start of a new uptrend.
2. Find a spot to enter - use some indicator to tell you price has pulled back enough. I prefer 4 period RSI. Just wait for it to go below 30 and buy
3. For a reasonable exit, target anything that gets you a 25% annualized return (or 2% for each 30 day holding period) or trend ends (20 period moving average crosses below 40 period moving average)

Assuming you can find 50 such opportunities, risk 6% of your account on each one and your average win is 25% (by design). If you average losing trade is ~25% annualized return, you can expect to hit 15% overall return. The advantage with setting things in this way allows you to diagnose the problem area when you miss your goal. If you identify the trend correctly and early, that should offer you significant number of opportunities. The main Achilles heel will be lack of stocks that are trending up or down. This will happen as markets will cycle between trending and choppy periods. We can look at other return sources to take advantage of choppy periods next time.