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Below is an excerpt from Trade Your Way to Financial Freedom2nd ed 2007 McGraw Hill, Van Tharp
How active do you want to be in the market? What is your time frame for trading? Do you want to have a very long-term outlook, probably making a change in your portfolio only once a quarter? Do you want to be a stock trader who holds positions for a year or longer? Do you want to be a long-term futures trader whose positions last one to six months? Do you want to be a swing trader who might make several trades each day with none lasting more than a few days? Or do you want the ultimate in action—being a day trader who makes 3 to 10 trades each day that are closed by the end of the day so that you have no overnight risk?
Table 4.1 shows the advantages and disadvantages of long-term trading. Long-term trading or investing is simple. It requires little time each day and has minimal psychological pressures each day — especially if you take advantage of your free time to work or spend time with your hobbies. You can typically use a fairly simple system and still make a lot of money if you adequately size your positions.
I think the primary advantage of long-term trading or investing is that you have an infinite profit opportunity (theoretically at least) on each position in the market. When you study many of the people who’have gotten rich through investments, you’ll find that in many instances wealth builds up because people have bought many stocks and just held on to them.4 One of the stocks turns out to be a gold mine — turning an investment of a few thousand dollars into millions over a 10- to 20-year period.
The Advantages and Disadvantages of Long-Term Trading
|No need to watch the market all day—you can use stops or options to protect yourself.
|You can be whipsawed by intraday market moves each day.
|Psychological pressure of the market is lowest in this type of system.
|You can have large equity swings on a single position.
|Transaction costs are low.
|You must be patient.
|It only takes one or two trades to make your whole year profitable.
|It usually has a reliability (number of winning trades) of less than 50 percent.
|You could have an expectancy (see Chapter 7) well over a dollar per dollar risked.
|Trades tend to be infrequent, so you must capitalize by trading many markets.
|You can use a simple methodology to make a lot of money.
|It requires a lot of money to participate if you want to trade big liquid markets.
|You theoretically have an infinite profit opportunity with each trade or investment.
|If you miss one good trading opportunity, it can turn a winning year into a losing year.
|Costs of data and equipment are minimal.
The primary disadvantage of long-term trading or investing is that you must be patient. For example, you might not get a lot of opportunities, so you must wait for them to come along. In addition, once you’re in a position, you must go through fairly extensive equity swings (although you can design something that minimizes them) and have the patience to wait them out. Another disadvantage of longer-term trading is that you generally need more money to participate. If you don’t have enough money, then you cannot adequately size your positions in a portfolio. In fact, many people lose money in the markets simply because they don’t have enough money to practice the type of trading or investing that they are doing.
Shorter-term trading (which might be anything from day trading to swing trading of one to five days) has different advantages and disadvantages. These are illustrated in Table 4.2. Read through the list and then compare it with the long-term table. Once you’ve done so, you can then decide for yourself what best fits your personality.
The Advantages and Disadvantages of Short-Term Trading
|Most day traders get many opportunities each day.
|Transaction costs are still high and can add up each day. For example, in my own active account, transaction costs for last year amounted to about 20 percent of the initial value of the account.
|This type of trading is very exciting and stimulating.
|Excitement usually has nothing to do with making money — it’s a psychological need!
|If you have a methodology with an expectancy of 50 cents or more per dollar risked, you may never have a losing month—or even week.
|Profits are limited by time, so you may need to have a reliability well over 50 percent to make money. However, I’ve seen some notable exceptions to this rule of thumb.
|You don’t have overnight risk in day trading, so there is little or no margin required even in big markets.
|Data costs are very high because most short-term traders need live quotes.
|High-probability entry systems, which most people want, work with short-term trading.
|Many high-probability entries can have losses that are bigger than the gains.
|There’s always another opportunity to make money.
|Short-term systems are subject to the random noise of the markets.
|Transaction costs have come down so significantly that they are no longer prohibitive.
|The short-term psychological pressures are intense.
I once met a short-term foreign-exchange trader who made about six trades a day. No trade would last more than a day or two. However, the fascinating thing about what he was doing was that his gains and losses were about equal and he made money on 75 percent of his trades. This is a fantastic trading methodology. He had $500,000 to trade with and a $10 million credit line with a bank. When you understand position sizing, as discussed later in this book, you’ll realize that this system comes as close to the Holy Grail as anything in existence. He could easily make a hundred million each year with that system and the capital he has.5
However, that’s not the case with most short-term systems. Most of them seldom have a reliability much higher than 60 percent, and their gains are usually smaller than their losses — sometimes even leading to a negative expectancy.6 Sometimes one big loss can ruin the whole system and psychologically devastate the trader. In addition, the psychological pressures of short-term trading are intense. I’ve had people call me who say something like this:
I make money almost every day, and I haven’t had a losing week in almost two years. At least until now. Yesterday, I gave back all the profits I had made over the last two years.
Keep that in mind before you decide that short-term trading is for you. Your profits are limited. Your transaction costs are high. Most importantly, the psychological pressures could destroy you. Nevertheless, my belief is that the largest profit percentages are made by active short-term traders who really have their psychology together. I’ve seen short-term traders who could make as much as 50 percent or more per month (on small amounts of money such as a $50,000 account) when they were very in tune with the market and themselves.
- These people may have purchased a dozen low-capitalization stocks. Eleven may turn out to be worthless, while one turns into a new giant. Because the stocks were largely ignored, the owner neither gets rid of the losers before they become worthless nor finds out about the winner until it is worth a lot of money.
- Somehow fate is often cruel to people with such a great system. In this person’s case, he could not trade size. Nor was it possible for him to fix his problem psychologically because he did not believe that he had anything to do with the problem. In fact, at this point, he cannot trade at all because he’s nervous and he believes that his stomach is stopping him from trading. Thus, in my opinion, he doesn’t understand the real meaning behind a Holy Grail system — finding yourself in the market.
- One of my clients has developed a day-trading system based on gains being significantly larger than losses. His system has a reliability rate of less than 50 percent, yet it nets him tremendous rates of return. This shows that there are other ways to conceive of short-term systems.