Editor's Note: Gary B. Smith will be back with his regular column on Tuesday morning. Today and Monday, he'll revisit past columns that strike to the core of his trading style. This column originally ran on RealMoney Jan. 27, 2001.
Two weeks ago, I had the pleasure of speaking to Georgetown MBA students about technical analysis and trading. They seemed to enjoy it, and I know I had a great time. (Even better was the fact that a number of them took me out for a drink or two afterward. It has been a long time since this guy had the company of a pitcher of beer, and a population composed solidly of folks in their 20s!)
In any event, during my two hours of rambling, I believe I made a few good points I'd like to share with you. Consider them the "greatest hits" of any seminar I'd give. They're the essence of how and why I trade like I do. You've been exposed to many of these thoughts before. Nevertheless, here's a quick review to whet your appetite:
1. The most efficient way to turn a small amount of money into a large amount is through constant compounding. Even small percentage gains per day add up to big gains over time. I asked one of the students if he started with $5,000 and every trading day increased it only 0.5%, how much he'd have after five years. He guessed about $50,000. The answer is $3 million.
2. Fundamental analysis is fine, but the problem is threefold: One, you are never going to be on a level playing field with insiders and fund managers. No, you'll always be getting information third- or fourth-hand. Two, even if you
an insider, the link between knowledge and future prices is suspect at best. I often tell the story of my wife, who has been at or near the top at both
She is as smart as they come about business, but consistently clueless about future stock prices. So my thinking is that if she doesn't know where Digex will be a few days or even months from now, what chance do you think the person off the street will have?
Finally, even if you are smarter than the insiders, and have access to all the important information, how much background work can you possibly do in any one day? Can you investigate two, three or five companies? Maybe if you're good, you can scour through 100 companies a year. And of those, how many are worth trading or investing in? Very few, right? So the real problem becomes the lack of opportunities. And a lack of opportunities means you have to hold each opportunity longer, and hope that turns into a winner.
Given all this, can you see how even the best fundy has to take an approach that is the opposite of consistent compounding?
3. Ah, but what approach provides plenty of opportunities every day? Technical analysis, of course, and, even better, you're on the same playing field as everyone else. Bells starting to ring?
4. I asked another student how many times he thought you had to be "right" as a chart reader in order to make money. I'll bet his answer was the same as yours: 51%. But, of course, that's wrong. The correct answer is that there is no correct answer. You could be right 1% of the time and be filthy rich. How? Let's say I did 100 trades last year, and won once. However, that winner netted me a 200% gain. The 99 losers? I cashed out each for a 1% loss. See the interplay between win rate and gain per trade?
5. Chart reading is all about patterns. And I guess, in the end, you either believe that patterns repeat or you don't. I, of course, think they do, and can't understand those who believe the opposite. Ever drive down a freeway and sense when there was trouble around you? Sure you have. That's pattern recognition. There was something about the way you and the other cars were moving that you found alarming, because you've seen that set of circumstances before.
Ever walk into a party, meet someone new and get an immediate sense that you like or dislike that person? Sure you have, because your brain matched up certain characteristics it has seen before. Pattern recognition. That's all it is.
6. But, assuming you buy the notion that charts are nothing but patterns, why should they repeat? Because buy and sell decisions are made by fallible humans. Humans who are alternatively greedy and fearful. Why is the
straight up this year? Did things improve dramatically starting on Jan. 1? No, but psychology has changed. Now people are greedy. (Soon, they'll be fearful again.)
7. If charts are nothing more than patterns that repeat, how do you become a good chart reader? You look at a lot of charts. For example, who are generally the best drivers? Professional truck drivers. Why? Are they smarter than the average person? Or stronger? No, they just drive a ton more than most of us.
In the same vein, want to read charts like I do? Then look at 500 charts every day. I guarantee many of you will be better than I am.
8. Back to No. 4: There is a golden equation of trading. This is it:
(The win rate multiplied by profit percentage per win) -- (the loss rate multiplied by loss percentage per loss) = expectancy
. Learn this equation. Learn that there is an infinite set of numbers that could yield a positive result. And an infinite set of numbers that could yield a negative result.
9. People are far too caught up in having the correct entry and far too unconcerned in having the correct exit. In fact, you could come up with almost any half-baked scheme to buy a stock and still be profitable if you focused on making the "golden equation" positive. Instead, too many people focus on the win rate and stop at that point.
10. Trading is a brutal profession because you have to control your emotions. As humans, we generally stink at that. Therefore, most people make lousy traders.
11. As my wife told me a long time ago: I am nothing but a gambler. I countered that she may be right, but at least give me the benefit of being the "house." That is, if my "golden rule" equation is positive, then all I ask is that people keep coming through the front door and betting at my tables.
In trading terms, all I want to do is get a fair number of at-bats each day. If I have enough at-bats, I should make a decent buck over time. In other words, think like a casino, not like the rube who throws down a $100 bill and expects to walk away a big winner.
And there you have it. Stuff I'd talk about in a two- or three-hour seminar. Or maybe a book.
I'll be appearing at
Technical Analysis Seminar on Saturday, Nov. 6. Come hear me discuss the pitfalls of using anything other than technical analysis to do your trading; the tools every successful trader should have; and the 10 errors all traders make -- and how to avoid them. Please click
for more information.
Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
Smith writes a daily technical analysis column for RealMoney.com and also produces a daily premium product for TheStreet.com called The Chartman's Top Stocks --
click here for a free two-week trial. While Gary cannot provide investment advice or recommendations, he invites you to send your feedback to