Large part of effort is spent on getting direction of market right...little is spent on how to play that direction right....
O Ashuji...
Most in financial markets (I refer to traders not brokers...brokers are as their name implies BROKERS) spend most of their time getting the direction right on markets. It may based on studying macros, price movement, inter market relationship, volatility, cycles, etc. But most of the time results are very different even though one may be right on the direction of markets. This is due to SIZING OF TRADES. In this blog, I will not get into how to size but why sizing of trades is important.
Being Right Is Not Enough In Markets....(Why Sizing of Trades Matter)
Stock Price Moves are Compressed
Stock market returns are compressed (Price Moves are compressed, Large part of moves occur in very brief period of time). Since moves are compressed, wrong sizing of trades and frequent trades can drain you out before large moves set in. Trading is boring and Investing is even more boring because moves are compressed. If trading becomes exciting then its largely broker who is enjoying. Leverage should differ across times. If its kept constant then basic principle of price move (compression of price) is not respected and results will be very poor. One has to be active only during 20% of time (because 80% of price move occurs in 20% of time) and its only during this time sizing of trade matters. If sizing is poor during this time then at worst of the time sizing will be increased to compensate for the missed move.
Extent of Volatility is Difficult to Know
Call on market direction may be right but extent of volatility could be very different which can drain out mental capital in the market. "I got the general direction of the market right, but I did not allow for volatility. As a consequence, I took on positions that were too big to withstand the swings caused by volatility, and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done better if I had taken smaller positions and stuck with them." - George Soros (Book - The Soros Lecture). Basically with reduced size of trade volatility can be played much better.
Mental Capital is More Important Than Economic Capital
Wrong sizing of trade kills not only economic capital but also mental capital. Mental capital is far more important than economic capital. Being right on trend/trade and not making money or making very little money is very painful. One might not lose economic capital here but mental capital will be exhausted to capture future opportunities.
Most of the biggest traders made largest part of their fortune in the smallest amount of time in their career. Trading is very different (compared to other businesses) and should be treated differently. Its not annuity game, its a barbell game.
