Mind, Money, Method - Which One is More Important?

I was looking at my blog this morning and noticed the label cloud at the sidebar. It was no surprise that the 3M (Mind, Money, Method) are ones of the popular labels read. What surprised me is that the cloud size of Method is bigger that Mind and Money.

One certain thing is that the label Method is the most popular label in the blog, but does it necessary the most important aspects of the 3M?

People may have different opinions about this. Though all three aspects are important and I have written so many articles about 3M in this blog, one aspect should be prioritized among others.

To me, the Money aspect is the easiest to take care (though the accumulating money part is not easy at all). Understand the theory of positing sizing, and follow the concept with discipline. Mind is the hardest really, while for new traders Method is the most exciting.

I used to spend hours in a day just to find all sort of combination of technical analysis to find the Holy Grails. I tried to find the best Method, spending most of my energy and time to Method, ignoring Mind and Money. However, as I learn from Mr Market along the way, I have done it the wrong way. The 80/20 rules apply here.

MIND comes first. METHOD last.

What is your sequence?

The Rule of 72

Over the weekend, I read another great book, The Four Pillars of Investing by William Bernstein. I am not going to give a review this time around, but I am going to discuss on one of the concepts mentioned in the book: The Rule of 72. Honestly, it was the first time I knew it and I thought I would like to share it here in my blog.

According to Wikipedia, it is a method for estimating an investment's doubling time. The rule number (e.g., 72) is divided by the interest percentage per period to obtain the approximate number of periods (usually years) required for doubling. Although scientific calculators and spreadsheet programs have functions to find the accurate doubling time, the rules are useful for mental calculations and when only a basic calculator is available.

For example, if you want to know how long it will take to double your money at eight percent interest, divide 8 into 72 and get 9 years. Below is a table to shows how accurate the rule is.

As you can see from the above, the rule is remarkably accurate. So long the interest rate is less than about twenty percent, it is rather reliable formula. At higher rates the error starts to become significant.

You can also run it backwards such that if you want to double your money in six years, just divide 6 into 72 to find that it will require an interest rate of about 12 percent.

Watch this video from Investopedia to understand more about The Rule 72.

Relating 80/20 Rule and 3M (Mind, Money, Method) in Your Trading

I have just finished reading The 4-Hour Workweek, a bestseller book by Tim Ferris. One of his many interesting theories that struck me was the use of the 80/20 rule. This rule, also known as Pareto's Law  is applied in business studies, sales, economy and many other endeavors. Today, I am going to illustrate how the 80-20 rule can help optimize your trading and boost your trading profits.

Pareto's Law can be summarized as follow: 80% of the outputs result fro 20% of the inputs. To put it in different ways, Tim Ferris gives more examples in his book:

1. 80% of the consequences flow from 20% of the causes.
2. 80% of the results come from 20% of the effort and time.
3. 80% of the company profits come from 20% of the products and customers.
4. 80% of all stock market gains are realized by 20% of the investors and 20% of an individual portfolio.

One important thing to note is that the ratio is often skewed even more severely such as 90/10, 95/5, 99/1 are also common, bu the minimum ratio to seek is 80/20.

How this Law is related to trading?

Trading in general consists of the 3M - Mind, Money, Method. Mind is basically how you manage your emotions and understand the psychology of trading. Money is the position sizing system so that you can manage the risk and survive in the trading business. Method is the strategy to buy and sell stocks. 

For most traders out there, there is one thing that matters the most: the trading system. Trading system research and developing new strategies for trading are their main focus, but mostly this is about looking for that holy grail of trading systems. Their argument is that while I do like to apply money management and discipline/psychology, about 80% of what I do is test new trading systems and look for new methods. That leaves 20% for money management and trading psychology & discipline.

The truth is, to make profits in trading, one does not need to have the most accurate system in the world. What is needed is really a good system executed with discipline and using proper money management methods. I strongly believe that trading psychology + money management are the 20% which is responsible for 80% of trading success.

So, to relate the 80/20 rule, I would like to summarize this way..

1. Instead of researching and keep updating/changing your Method (I am not saying it is not important), spend more time in understanding the trading psychology and position sizing.
2. As 80% of your profits are coming from your top 20% trades, focus on the market movement and make sure you do not miss the boat when the market is uptrending.

Happy trading and happy holiday!

Build Your Capital for Stock Trading

I love system. Whatever I do, I want to see it happening in a systematic way. When you have a system, a good system, what you need to do is to strictly follow it. I made my own trading system. Before buying stocks, it has to go through a series of requirement before I am allowed to buy a stock.

I would like to introduce a money system on how you can build you capital for your stock trading.

If you have read my post of position sizing, it is clear that you need a rather big capital (C) in order to stay alive in the market. As you limit your risk (R), you can only be allowed to trade limited amount of shares (again, it is a position sizing system). So how can you build your capital?

Here is my money system.

#1. I strictly believe you should spend your earning AFTER saving! I mean when you get your salary every month, quickly distribute it (automatically) to a series of saving buckets. Do this religiously. When I started working, I have 4 criteria of savings: short term savings (to be used within one year - vacations), long term investment (retirement, kids educations, practically anything I need to spend my money more than five years from now), emergency fund (you wont know when you are out of job, or when your loved ones fall sick), and investment savings (this is for your stock trading and any investment-related).

My shares: 5% - short term, 5% - long term, 5% emergency and 10% investment. And do not get surprised, I have different bank accounts for each of them.

#2. Short term savings will be used in near future, so I don't really monitor it. However, for the other three, I create an excel sheet to monitor it monthly. If my "ideal" amount doesn't match my real savings, I will do re-balancing, QUICKLY.

#3. If you do it religiously, your investment savings will increase in no time! (Okay, it took me 6 months to be able to buy 1 lot of stocks).

So ask yourself, do you have a system for your savings? If the answer is no, make one now and share with me :)

Position Sizing - ATR Method

Average True Range (ATR) is a technical indicator to measure price volatility. This indicator is first indtroduced by Welles Wilder.

In simple words, when the market shows a trend (either up or downtrend), the ATR tends to be higher. The opposite works: when the market goes sideways, the ATR tends to be lower. It is indeed shows you price volatility.

So, how can you use it to calculate your position sizing or how many share you will buy?

Example:
Let assume:
Your initial capital (C) is $100,000.
Your risk (R) of losing in a single trade to your C is 0.5%.

Stock A has ATR of 75 cents over the last 20 days and that you are prepared to risk $500 on this particular trade (ie 0.5% of $100,000). By dividing 75 cents into $500, this would calculate the number of shares that you could buy, based on intrinsic volatility. Most traders using this method decide to use 2xATR ie 0.75 x 2 = $1.50 to position size. For example, $500/$1.50 = 333 shares can be purchased.

To read about another way to size you position.

Stock Trading Rules

Rules are made to be followed. I am a systematic person and I love creating system. In my trading days, I stand by my trading plan at all times. It is not easy initially, but I believe I am getting used to this. If you recall my post on my business plan for my stock trading, one of the important aspects is to have your beliefs and rules to follow. I created a checklist which is online on my Evernote - so that I can check on it occasionally. My room wall is too decorated with my trading rules :)

How do I define my trading rules? I read many books on real and successful traders and started to jot down their traits, quotes and advice. If you find these advice make sense, go ahead and adopt them in your trading rules. To categorize it in a systematic way, I split my rules into three main classes: MIND, METHOD and MONEY!

Take note of my rules below. Some are very conservative and sometimes causes me to be extra cautious in making decision to trade. Adopt what your think make sense to you. If they are not, ignore them.

MIND
[ ]When in doubt, get out. Only trade when you feel confident about your trading strategies.
[ ]Never get into the market because you are anxious from waiting, and never get out of the market just because you have lost your patience.
[ ]Never change your position in the market without a good reason. If you execute a trade, base it on a fundamental reason or technical rule.  And then do not get out without a definite indication of a change in trend
[ ]Do not guess where the top and bottom of the market is, but let the market prove its top and bottom
[ ]Perception is not reality. Only trade on "quality" advice.
[ ]Use self-discipline as your guide when the market goes against your position. Take your loss and wait for another opportunity.
[ ]Avoid taking small profits and big losses
[ ]Ignore the minor price fluctuations and place positions with the basic trend of the market. Remember, the odds are on your side when you trade with the trend rather than try to pick trend reversal points.
[ ]Guessing key reversal points can be risky. Therefore, let the market tell you when it is over by a patterned reverse in direction.
[ ]Always remain true to your trading plan, and follow the trading style that works best for you.
[ ]Put your trust in the markets, and do not be afraid when they reach historic highs or lows
[ ]Never let greed or fear take control over your winning positions

METHOD
[ ]Use stop-loss orders and always protect a trade when you use a stop-loss order by using reasonable price limits
[ ]Never over-trade and adhere to your risk management rules.
[ ]Remember, "the trend is your friend," and never buy and sell if you are not sure of the trend according to the fundamentals and technicals.
[ ]Trade "at the market" whenever possible and try to avoid using orders with a fixed buying and selling price (except a stop-loss)
[ ]Never buy just because the price of the stock is "low", or sell just because the price is "high."
[ ]Never Average Down.
[ ]Never make a mistake without asking yourself why. Learn from your trading mistakes. If possible, keep a log of your trades - why you made them, what happened and why, etc
[ ]Remember, the key to any plan is how well it performs over time

MONEY
[ ]Only trade with genuine risk capital, and be aware of the risk of losing.
[ ]Do not treat all markets the same. Learn to adjust the size of your positions and the frequency of your trades for different markets.

One tips I find it useful is to run through all the list when you are about to buy or sell. If any of the rules is broken, simply do not trade.

Money Management in Trading: Position Sizing

The terms "Position Sizing" came across to my trading journey when I read van Tharp's book, Super Trader. In his book, he stresses the importance of knowing "how much stocks to buy" to stay alive in trading. This theory of position sizing really struck me hard! This is essentially the MONEY part of the famous 3M theory.

The theory is this: Assuming you have a very good EDGE (or strategy - be it an algorithm, some technical analysis or fundamental analysis, or any strategy) that will give you a positive return in the LONG run, you have to be careful with your money management. I mean, you are sure that your EDGE (METHOD - another M in the 3M) will give you WIN over time, BUT you do not know the SEQUENCE! For example, you can have a straight ten losses before getting a big win on the eleventh trade. You wont know when you win, you wont know when you lose. Moral of the story: you have to play SMALL to stay in the game for LONG!

Simple theory and very logical, eh?

So the question is how SMALL you should buy? In his book, van Tharp mentioned about several ways to position sizing, but in this article, I am going to tell you the formula I am using with a great discipline (well, I am still in the game!)

The elements you need to define first:

1. How much is you current base capital (C)? In my formula, this is my total capital including those open position in the market.
2. How many percent of this C you want to risk (R) in a single trade? It means that, if you R is 1% and you C is USD 10,000, your allowable loss in a single trade is USD 100.
3. How many percent is your cut-loss (L)? I use fix percentage as it is easier to compute. Depending on stock market I trade, I use between 8-10% cut loss.
4. What is your buying price (B)? 
5. The final piece of the equation is how many stocks - position sizing (P) - you are allowed to buy.

Hence, the full formula is as follow:

P = (C*R)/(B*L)

Example #1,

Stock XXX price is at USD 1.5, your capital in your broker account is USD 20,000. In you trading plan, your cut-loss is at a fixed percentage of 8% and you can only tolerate 1% loss of your capital in one trade.

P = (20,000*1)/(1.5*8) = 1,666 stocks (round it down, to the nearest lot)

Example #2,

Stock XXX is at SGD 1, your capital in broker account is SGD 5000, and your open position is SGD 200, your cut-loss is at 10% and you are very conservative and only willing to risk 0.5% of you total capital. You are in Singapore market where 1 lot is 1000 shares.

P = (5200*0.5)/(1*10) = 260 stocks (round it down, to the nearest lot). This does not meet 1000 share minimum to buy 1 lot, so stick to your trading plan, and DO NOT buy the stock.