There is an overwhelming number of different trading and investing methods out there.
The question is: how do you find the best one?
I’ve learned quite a few different strategies in my trading career, ranging from pure fundamentals, to pure technicals, from day trading to buy & hold…
I was basically looking for the best strategy, the strategy that would fit my vision of the world, a strategy that would fit my personality, my schedule, a strategy that wasn’t too difficult to learn, a strategy to could turn me into a millionaire…
However, it is only when I looked at from a different angle that it all made sense and I finally was able to come up with the strategy I’m using today.
The Casino Analogy
Let me ask you a question. How can you make money consistently in a casino?
Well, you have to own it, you have to be the house.
How do casinos make money? They make money because they have the odds on their side.
Does that mean they win every single hands? Not at all. They lose many hands. But given their probability of winning, losing a single hand is not important. Since they have the odds, the more and the longer the customers play, the more the casino will make money. It follows the law of large numbers (LLN). According to the LLN, the average of the results tends to become closer to the expected value as more trials are performed. That means that if the casino has an average winning probability of 60% over the player, over time, the casino will win 60% more times than the players.
In trading, it works the same way. The outcome of a single trade does not really matter. You have to find a strategy that puts the odds on your side, and as the number of trades you take grows, so do your profits.
The Difference With a Casino
The big difference between a casino and trading, is what type of probabilities you’re playing with.
This point is often unknown, misunderstood or even disregarded by unprofitable traders.
A casino makes money on their win/loss ratio which is the number of winning hands to the number of losing hands.
Profitable traders make money on their profit/loss ratio, which is the average profit on winning trades to the average loss on losing trades.
So basically, although both the casino and the profitable trader lose many hands/trades and play the odds, a casino makes money because they win more often, whereas a profitable trader makes money because he makes much more money on winning trades, than lose money on losing trades.
What Really Matters
So 2 things are now obvious when it comes to finding a winning strategy:
1- Losses are unavoidable but you must keep them as small as possible
2- You need to find situations where the potential amount of money you can make on a trade is much higher than the potential amount of money you can lose on a trade, i.e. a large reward to risk ratio.
Stop thinking like everybody else, categorizing yourself and your strategy as being purely technical or short term or whatever else. Quit looking for the strategy that is said to hit winners 80% of the time (which doesn’t exist by the way).
The only thing that matters is that your strategy must make a lot more money when you’re right than lose money when you’re wrong
“5-to-1 Rule: Five to one means I’m risking one dollar to make five. What five to one does is allow you to have a hit rate of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose— assuming my risk control is good” – Paul Tudor Jones