I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Monday, August 13, 2007

Why Being Right In Your Trading Does Not Necessarily Mean Making Money

I like the discussion in Corey’s Afraid To Trade blog some time ago on the topic of “Should I trade to be right or should I trade to make money?”

"Being right" does not necessarily mean "making money". In that post, Corey also gives some examples why it is so. But what interests me more is the discussion in the comments of that post, in conjunction with the post from Chris Perruna on “Position Sizing and Expectancy”.

The discussion in that post has triggered me to refer back to one of the favorite books of mine, which is also a popular book among many traders: Trade Your Way to Financial Freedom, by Dr. Van K. Tharp. A “must read” book if you want to create or improve your trading system.

And in that book, I found the following sentences with regards to “being right” that I’d like to quote here:

“There is a strong psychological bias to be right about we do with our investment. In most people, this bias greatly oversides the desire to make a profit overall in our approach, or it inhibits us from reaching our true profit potential. Most people have overwhelming needs to control the market. As a result, they end up with the market controlling them.”

To illustrate that being right does not necessarily mean making money, the book shows one simple & extreme example:
Say, there is a system with 90% winning trades (i.e. you get it right) with the average winning trade of $275, and 10% losing trade (i.e. you get it wrong) with the average losing trade of $2700.
Can you make money with such system that is 90% accurate, and only 10% of time you’ll be wrong?
Let’s count the Expectancy of this system:

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)
Expectancy = (0.9 * 275) – (0.1 *2700) = -22.5

The expectancy is negative. This example shows us how a system which can get you to be right most of time (90% of the time) may eventually lead you to lose money trading it.

A quote from one article in turtletrader.com summarizes this very nicely:

The irrelevance of winning percentage is nicely summed up by another legend named George (Soros): it doesn't matter how often you are right or wrong - it only matters how much you make when you are right, versus how much you lose when you are wrong.

Corey himself has recently written a great article about “Frequency vs Magnitude in the markets & in life”, as highlighted in my post "Links Of Reflections".

Therefore, what is more important in a profitable trading system is not the frequency of “being right” (which is normally linked to entry & exit strategy), but whether the system has a positive expectancy and how many opportunities (i.e. number of trades) the system presents, as well as how much to trade on each position (i.e. position sizing / money management), as discussed by Chris Perruna in the abovementioned article.

Entry & exit are important, but they are actually only small parts of the trading system. Hence, we shouldn’t focus too much on entry & exit strategies only, but rather should concentrate more on risk management (i.e. how much to risk per trade), money management / position sizing (i.e. how much to trade or how many shares / contracts per position) and positive expectancy (i.e. average gains higher than average losses).
And many professionals say that those are actually the holy grails of trading.

Related Posts:
* The Psychological Need To Be Right vs. Making Money
* The Real Purpose Of Trading
* Why Trading Psychology Is Very Important
* The Fear Of Losing Money

2 comments:

Oskar said...

I totally agree with you since most of my winning trade usually come from 1 or 2 stocks (options that is).

And being right in the stock doesn't mean your options will profit too :)

OPTIONS TRADING BEGINNER said...

Hi Oskar,

Yes, you're right.
Playing options is more complex than stocks.
In stocks, we only need to be right in the "direction" of the price movement.
In options, we have to be right not only in the "direction", but also in the "magnitude" of the movement and "the time" needed for the movement to happen.
However, options provide a great leverage & more flexible strategies. That's why we use options.

Thanks for your comment. :)

Regards,
OTB