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Warren Buffett speaking to a group of students...

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When I wrote my first book, The Mind of a Trader, I interviewed some of the world’s leading traders. Over the past 13 years since then I have met thousands of traders including spreadbetters from around the world – from my talks in Beijing and Guatemala to San Francisco and India.

If I had to write down what professional traders do that retail investors should do then they would be these:

If you know how much money to put into each trade you will make more money than those focussed on just making profits.

Spread trading is about making money of course. But to make money, you need to know how much money to put into each trade. That will, as much as calling the market right or wrong, determine how much money you make and keep.

One such rule is that if you know the stock could drop by an amount X before you exit, then that amount you could lose should be 2% of your total capital. I keep it that simple. In fact all professionals keep it that simple! The reason is if I have a string of five losing trades, then I am down 10%. Not too bad. Most people after 5 losing trades are down 50%!

Look at the table below. If your portfolio loses 20%, then you need to achieve a 25% gain to break-even. 25% is more than even Warren Buffett’s long-term average. The point is, make sure you do not even make a paltry 20% loss. It is easily lost.

So the point is look at the figures. It is why the world’s best traders cut their losses short and quickly. Phone in to any TV programme and ask any stock-picking analyst who appears on TV ‘if my portfolio drops 30% as a result of your stock-pick, how much does it need to rise to break-even?’

I guarantee they will not know.

Loss of capital (%) Gain to recover (%)
5 5.3
10 11.1
15 17.6
20 25.0
25 33.3
30 42.9
35 53.8
40 66.7
45 81.8
50 100.0
55 122.0
60 150.0

An experiment was conducted involving forty people with Doctorate Degrees. The doctorates were asked to trade on a computer. They started with $10,000 and were given 100 trials playing a game in which they would win 60% of the time. When they won, they won the amount of money they risked in that trial. When they lost, they lost the amount of money they risked in that trial.

How many Ph.D.s made money at the end of the experiment?

Two! The other 38 lost money. 95% of these very academically smart people lost money playing a game in which the odds of winning were better than any odds in Las Vegas. Why did they lose?

My own analysis has found winning spread betters mimicked successful professional traders in their win/loss profiles. Of course professional traders would be trading with much more money, but spreadbetting winners returns distributions looked the same.

The point to note with winners was that they had a few big winning months, very few big losing months. And most of their trades won a little and lost a little. Whereas losers had a few big losing months, very few big winning months and most of their trades also lost a little and won a little. So what is the difference between winners and losers? Winners had a way of ensuring no big losing months. They also had a way of ensuring big winning months. Losers didn’t.

How did winners do this? For some, they added to winning positions. Others never let a winning trade become a losing trade once it was up 10% for instance. Others had tight stop-losses at which they exited. They would not wait on a loser. They would never add to losing trades. Some winners had the attitude that each trade at the start is a 50-50 gamble and so you bet small. Once you know it is moving in your direction, you add more money. If it is not, you exit quick. Losers did the opposite. They exited their winning trades to pay for their losing trades, to which they added even more money in an attempt to lower their average break-even point.

By Alpesh Patel, founder, www.tradermindmarkets.com and www.investingbetter.com – free education, videos, newsletters, tips, webinars: training traders since 1997.