Thinking like a trader

Are you a trader or an investor?

Trick question – the ‘correct’ answer is both (or neither). But underneath this flippancy lies an important distinction – ‘investing’ and ‘trading’ are not mutually exclusive but are different ways of thinking about buying and selling shares.

I’ve always thought of myself as an investor, but recently I’ve started to wonder whether if I want to make real money it would help to think a bit more ruthlessly about winning the game, like a trader.

Owning businesses or trading a system?

At the core of the distinction between ‘investing’ and ‘trading’ is the extent to which your focus is on the reality of owning businesses or on the reality of playing the stock market ‘game’.

At one extreme an investor imagines himself as the owner of the business and treats the ‘market’ as a black box which spits out prices, which are influenced by investor sentiment and can therefore be totally wrong. The focus is on the fundamental characteristics of a business and how they relate to the price. At the heart of success is recognising where the price undervalues the likely future of the business.

At the other extreme, a trader, like a gambler or player of a game, focuses on ‘playing the market’. The market is always ‘right’ – the game is to predict where it will go. A trader can implement a system that takes advantage of certain properties of the market to make money. Whether a system makes money is determined by the simple maths of the game – the bigger the probability of winning or the bigger the win loss ratio (size of a gain divided by size of a loss) the more money is made.

These two perspectives are not mutually exclusive and both are important. The investor way of thinking is very familiar to me. My main focus in writing this is particularly to see what can be gleaned from the trading way of thinking.

Committing to a strategy

Whether a trader or investor, it helps to commit to a strategy. The three questions that define a strategy are ‘what is bought? when is it bought? and when is it sold?’ Committing to how you answer these questions in advance allows you to avoid making inconsistent decisions or being swayed by emotion.

Like many investors, I’ve always tended to focus a lot more on ‘what is bought?’  but I’m now convinced of the importance of also having a good approach to the other two questions. A trading perspective focuses on how to time buying and selling decisions with greater clarity and detail.

Mechanics of a trading strategy

A trader recognises that at the end of the day there are only two things that matter. The probability of the price rising after you buy a share rather than falling (how often are you right) and the degree to which it rises compared to the degree to which it falls when you are wrong (the win loss ratio). A trader plans his purchase and sale decisions in advance contingent on what happens to the price to maximise these factors over several trades.

An insight of many traders is that it can pay to focus more on increasing the win loss ratio rather than on trying to be right more often. It is possible to mechanically create an asymmetry in payout by making sure the size of gains is always much bigger than the size of losses – by running winners for longer and cutting losers more quickly. A key aspect of the trading framework is to maximise the time spent holding when prices are going up! The reason this works is that prices trend – momentum. I’ve discussed why momentum works previously.

How does my strategy approach this? Primarily I’m trying to maximise the win loss ratio by looking for unlimited upside and tight downside, but without sacrificing too much winning probability. Broadly I think using fundamentals focused more on identifying high quality than cheap valuation help identify the potential for a lot of upside. Running winners and selling losers allows the upside potential to be realised while the downside is tightly limited. Picking shares with existing momentum and positive news flow keeps me from sacrificing too much winning probability.

Risk management

Risk management is about how to avoid or deal with mistakes. The investing approach to risk management is to manage risk ex ante by avoiding investing in businesses which are assessed in advance to be risky. The investor then hopes he is right and changes his opinion only when the facts change.

A trader’s ‘bet’ is that prices will rise – if they do not she is wrong. Risk management for a trader is about when to tolerate volatility and when to admit she is wrong and sell. In practice this means stopping any losses before they get too big. This approach to risk management acknowledges that there is a probability of making mistakes and that it is important to maintain an asymmetric payout between gains and losses. It takes advantage of momentum – a change in momentum means you were wrong and should sell to avoid further falls.

I try to incorporate this into my approach. I partly focus on quality when buying, but fundamentally my risk management is based on the trading perspective of allowing unlimited upside but ensuring very limited downside. This exploits momentum and removes from the equation the ongoing uncertainty of whether you are more right than the market.

Risk management should apply equally to protecting gains as well as to preventing losses. I can’t see any reason why they should be treated differently.

There is some discretion over how much volatility to allow before selling a share (or where to set a stop loss). The trade off is between minimising trading costs and minimising losses. How best to balance this trade off depends on the liquidity of the share and your confidence in it. While you don’t want to be buying and selling too frequently, I would err on the side of not allowing much volatility and keeping stop losses fairly tight. I take 10% as a rule of thumb but apply some flexibility depending on what the long term chart looks like. The key thing is that the trend is still up.

This can be difficult in bear markets if many shares are falling at the same time. I’ve tended to give a bit of leeway in these situations, but in general I expect it’s probably better discipline to continue to be strict in applying stop losses before deciding whether to buy new positions with the proceeds or hold onto cash. I’ve previously thought it was a good idea to always be fully invested but after some reflection, I think it is important to leave yourself the rare option of holding cash where shares in your portfolio are falling and there aren’t many good alternatives available. Holding cash must be the best way to outperform in big market crashes, which typically take place over a number of months. The key thing is that you make sure you are quick to reinvest when prices start rebounding afterwards. If you monitor a watchlist effectively I don’t think this is particularly difficult.

Another reason to have fairly strict risk management and not allow much volatility is the time factor…

The time factor

I previously said that the probability of winning and the win loss ratio are the only things that matter. That’s not quite true – equally important in determining overall return is the time factor. The time factor captures how much you trades within a given time period (measured as how many times you turnover your portfolio). If I have a slightly lower expected gain per trade but make many more trades within a given time frame then I can do a lot better overall. Especially when you consider that reinvested returns benefit from compounding.

This is kind of obvious but something that many investors don’t really take account of very explicitly. It turns on its head the notion held by many that the aim is to trade as little as possible to minimise trading costs. As long as the price goes up in the end and ‘they are right’ then many investors are happy, but how quickly the price takes to get there is actually just as important. This is because tying up money in one investment for a period of time has the ‘opportunity cost’ of all the other uses the money could be put to. When you take compounding into account the difference in return resulting can be massive.

This has the implication that it’s important to constantly be thinking about how to optimally allocate the portfolio across opportunities, not just whether the current allocation is good enough to get a positive return. I take this as another reason to be very strict on minimising losses, even in bull markets where they may not be so significant. In some cases it might seem prudent to be patient to see whether a loss of momentum is temporary, but the opportunity cost of doing so can be very high. This is especially the case when there are lots of apparent alternative investments with positive momentum and high expected returns. While it’s important to avoid losses in bear markets, in bull markets it becomes more important to be invested in the really best performing shares.

 

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