in the anticipated direction. If that were the case, would you rather be Guy 1 or
Guy 2? I don’t know about you, but with the stock moving favorably, I’d rather own
300 shares bought at $25.10, than 200 shares bought at $25.05. Why? Because, if
the stock moves in the anticipated direction, the profit from the 300 shares will
soon—very soon—outweigh the profit made from the 200 shares. How soon?
Only 10 cents later, at $25.20!
Now, because a TV commercial is a make-believe world in the first place,
let’s add another few make-believe assumptions to it. First, let’s pretend that both
guys had $25,000 on their trading accounts going into the trades, that XYZ
continues to trend higher, and that both guys got out at 30. How much money did
each guy make? Guy 1 made $1,470 [(30 25.10)*300], while Guy 2 made $990
[(30 25.05)*200].
Further, what if both guys were able to make 10 such trades in a row? How
much money would each one of them have in his trading account after such a run?
Guy 1 would have $39,700 (25,000 [1,470*10]), while Guy 2 would have
$34,900 (25,000 [990*10]). Thus, over this 10-trade sequence, Guy 1 would
have made $4,800 more than Guy 2.
As a final assumption in this make-believe world, let’s back up to the first
trade and assume that Guy 1, instead of always buying 300 shares, had continued
to invest 30 percent [(25.10*300)/25,000] of his account balance in each trade,
while Guy 2, the smug nickel-and-dimer that he is, continued to buy 200 shares
per trade over the entire sequence of 10 trades. How much more would Guy 1 have
on his account, compared to Guy 2? Guy 1 would have a total of $44,149, which
would be $9,249 more than Guy 2.
So what have we learned from this? The answer is, while it is unrealistic to
assume 10 such winning trades in a row (it happens every so often, but it’s not a
particularly realistic assumption), managing your trade size is way more important
than chasing a nickel here and a dime there on your entry and exit levels. This is
one of two important points I hope to get across in this book.
However, to be able to “optisize” the amount to risk and invest in each trade,
you need to have a trading system you can trust and that allows you to do so. You
can’t do this without fully understanding the second most important point this
book tries to convey. To illustrate the second point, let’s change the topic com-
pletely:
Picture a cheetah on the African savannah. The cheetah is one of my favorite
animals. It’s a highly specialized, lean, mean, killing machine that can outrun just
about anything and anyone. Its limber and muscular body and graceful moves ooze
self-confidence. As a metaphor for a good trading system, however, the cheetah
sucks. The reason is that it’s simply too specialized in hunting and killing a certain
sized prey in a certain natural habitat.
If the prey were slower but larger, the cheetah could outrun and catch it more
easily, but waste time killing it and run a larger risk of being killed itself. If the2 PART 1 How to Evaluate a System