Charted Territory: Good News for Bad Traders

Every Sunday morning, our family has an enjoyable routine: We all drive to downtown Bethesda, and while my wife goes to an early morning workout, the girls and I grab a bagel and some beverages and hang out at the local Barnes & Noble.

I suppose it's taken the place of the local library because I can catch up on my email, think about my next column and peruse the shelves for the latest offerings.

This past Sunday, I found myself in the investing section and was struck by two things. The first was just how large it had grown. For better or worse, "investing," in all its many incarnations, has truly become the national pastime. I guess no news there.

The second item, though, was more distressing: 99% of the books on trading are just plain awful. Oh, I don't mean awful in the sense of badly written. Or even in the sense of not thoroughly covering their subject matter.

No, I mean awful in the sense of focus. Just about every book I picked up talked in one way, shape or form about entry. That is, what signals, indicators, oscillators, chart patterns, moving average crossovers, etc., ad nauseum, one should use to enter a trade.

And why is that? Because entry signals are fun. Entry signals are neat. Entry signals are the magic elixir. And if you're fortunate enough to stumble upon the right one, well, by golly, you'll be rich!

To be fair, I've often been a carnival barker myself, focusing on my own blend of "magic" signals for both the long and short side. So, I guess there's a place for these discussions. Otherwise, I'd be out of business.

That said, let me make one concept crystal clear: Money management is everything. That's right. You can have the absolute worst entry signals in the world, but if you manage your trade correctly once it's off and running, you can make an excellent living.

Now read that paragraph again. Money management is everything. Really, it is, so let me give you an example using two extreme examples, Lotto and Ego.

Lotto stinks as a trader. When Lotto goes long, Ego goes short. Lotto's so bad, in fact, his success rate is no better than 10%. But every once in a while, he stumbles across a winner. A big winner, which he has the perseverance to ride home until he's up nearly 50%. Even better, while he gets a lot of losers, he's smart enough to fold as soon as his position is 4% or so into the red.

Ego, on the other hand, prides himself on having fantastic entry signals. If MACD is crossing the fast stochastic, while the ADX line is retreating to the north, then that's his signal! And he's almost never wrong. Want a winner? Come to him because 80% of the time that's what he has.

Unfortunately, to get those winners he needs to grab his profits and run. No, he doesn't wait around, but instead when his position is up 3%, he dashes. Of course, they don't all go up 3% immediately so he needs to give them some room. But he's not stupid, so he'll only let them fall 7% and then he's gone.

So, with all that, who's the better trader, Lotto or Ego? Ironically, over the course of thousands of trades, both will come out in a dead heat. That's right. On every trade their "expectancy" is exactly the same at 1% [The calculation for expectancy is (win rate x win percentage) - (loss rate x loss percentage).]

Furthermore, look at the chart below.

No matter how successful or unsuccessful your entry signals, if you use the right money stops and targets, you can perform pretty well. Of course, the real trick would be to have an extremely high win rate and an extremely high win percentage relative to your loss percentage. But those traders are a rarity if they even exist.

Now if I were really being exact, I'd add one more column called "average time to close each trade." This would give me the ability to figure out who was making the most profit per day. But, we'll save that discussion for another column.

For now, the thing I want you to take away is just how successful you can be with the right money management tools. Geez, you could pick 10% winners just by throwing darts. And in this type of market lately, that'd be a pretty good hit rate.

So, what's the mantra? Right -- Money Management is Everything! Now, clip, save and a year from now, remember to thank me.