Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
How to Overcome Overtrading
08/04/2011 3:30 pm EST
Even good risk managers can fall victim to overtrading, and Travis McKenzie explains that by only choosing the highest-probability trades, profitability can dramatically increase.
Talking with Travis McKenzie about the bain of overtrading, and overtrading is a problem for a lot of traders. How do you solve that?
You’re right, it is a huge problem, especially for newer traders. I think the reason most people overtrade is they don’t understand or appreciate what you can achieve by going for the highest-probability trades; going for fewer trades, but higher-probability trades.
When I trade, I never risk more than 1% of my account in any one trade. So if I’ve got $20,000 in my account, I want to make sure I’m never risking more than $200 on a trade.
Most people say if you’re only risking 1% and you’re aiming for at least a risk/reward of one-to-one—so if I’m risking $200, I want to make at least $200 on a trade—they normally say you can’t get rich that way, so that’s why they risk 2%, 5%, 10%, so they can get rich quickly.
What you’ve got to realize is if you take that analogy and break it down to only doing one trade per week, and base that over, say, 48 weeks of the year (so you have four weeks holiday), if you do that one trade per week, aiming to make at least 1% per trade, and you compound that over the year, you’ll make 61% per annum.
I’m not saying that’s easy to do, but I’m just breaking it down to show people what is achievable.
Now Warren Buffett, he makes 23% per annum, and he’s I think the third-richest man in the world, and the most successful trader ever. If you could make 61% per annum for the rest of your life, you could make outstanding returns.
What I try and get people to think about is that you don’t need to overtrade to make exceptional returns. What you’ve got to focus on is finding those high-probability trades.
A lot of traders though are looking for that home run as opposed to the singles or the doubles that will get them there. What’s your advice to them?
That’s a very, very good point; exactly. One of the things I always say is that “Consistency is the key.” You don’t want to be a hero, you don’t want to pick the tops and the bottoms, you just want to take the little bite-sized chunks out of the market time and time again.
That’s where you can do that; by risking 1%, aiming for 1%, finding the highest-probability trades. So say the one or two best trades a week—and it can be more if you’re a daytrader, it could be the one or two best trades a day—but you’ve got to wait and be patient for those high-probability trades. Just do it over a large number of trades and it will come to you.
For those who are looking for a bit bigger risk/reward ratio or reward/risk ratio, is there a problem with that?
No, that’s a minimum. I should have said that, sorry. That’s a minimum of one-to-one. Ideally, you’re going to aim for more than that. If you achieve that, well then, your results are going to be that much better.
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