Table of Contents - Market · PDF fileTable of Contents Why Do You Invest Money? ... and its...

Table of Contents Why Do You Invest Money? ................................................................................. 3

Investment Choices .............................................................................................. 5

The Winning Edge ................................................................................................ 6

Definition ........................................................................................................... 6

Impact on Portfolio Value .................................................................................. 6

Impact on Risk ................................................................................................. 10

Conclusions ..................................................................................................... 14

Key Components ............................................................................................. 14

Money Management Guidelines ......................................................................... 15

Emotional Tolerance for Losses .................................................................. 15

Financial Capability ...................................................................................... 16

Sticking To Your Trading Methodology ........................................................ 16

Selection Criteria ................................................................................................. 17

Specific Entry and Exit Rules .............................................................................. 18

High Velocity Turnover ........................................................................................ 19

The Perils of Forecasting .................................................................................... 20

Summary ............................................................................................................. 20

Copyright © Profits Run, Inc. of 22 Rev #12-20080411

Introduction Dear Trader, Welcome to the “The Profit Button: The 4 Simple Steps Successful Traders Know That YOU DON’T”. Before you continue, I urge you to print out this report. I’ve found that it’s much easier to read and re-read these digital reports when they’re printed out… and you don’t want to miss a word of what I’m about to reveal? Why? Because the information contained in this report is profound. And I’m not just saying that because I wrote it. Seriously, I wish I had had the information in this report when I was a beginner at trading. It would have saved me years and years of study and mistakes. I’m excited for you that you’re reading this now. Are your ready to begin? Let’s get started…

Are There Really 4 Simple Steps? Most people are not successful when it comes to investing and trading their portfolio. At best, they’re gambling and hoping for that “big win” that will set them up for life. Sure, that can happen, but you may as well go and buy a lottery ticket. Seriously. But where most people fail at investing and trading, there are select groups of individuals who have figured it out. They discovered long ago that you don’t need to win every trade. They found out the hard way that it’s ludicrous to bet your entire portfolio on a few “blue chip” stocks. They realized that you could, indeed, maximize your chances of success in the markets and put the odds in your favor, much like a casino has an eternal edge over its hapless and hopeful customers. I’ve been trading the markets since 1974, and over the past three decades I’ve made just about every mistake you can make in the markets. I paid my dues and learned through experience – the hard way. And what I discovered was that most


successful traders followed a very specific set of rules when it came to trading or investing their portfolios. These rules gave them a “Winning Edge” that they could use over and over again to tilt the odds in their favor. And after much trial and error, I discovered how to apply this winning edge to my trading, too. Specifically, I found that there are 4 steps, or components, to a winning edge. And when they’re used together, synergistically, it’s almost like having a big red “Profit Button” that you can press again and again, for the rest of your life; hence the name of this report. Now, you might think the idea of a big red Profit Button is a bit far-fetched, and you’re right. However, applying the 4 steps you’ll discover in this report to your trading is about as close as you’ll ever come to that mythical button, in my experience. Oh, and by the way… these 4 steps don’t just apply to trading the markets. They can apply to any type of investment – real estate, businesses, even fine art. They’re universal by nature. So first, I’ll dive in to how most people attempt to “invest” their money, and why it’s a loser’s game. Then, I’ll reveal the 4 steps to creating a Winning Edge with your trading that can help you build your very own Profit Button.

Why Do You Invest Money? Why do you invest money? This may seem like an obvious question, but it’s very important to understand your motivation for investing money in order to be successful. For some people, it’s the thrill of the game, but for most, it’s to grow your portfolio value and eventually provide you passive income. What to do with this passive income is where most people differ. Some people are motivated to increase their portfolio values in order to acquire things, like a second home or a new boat; others might want to pay for a college education; and still others might want to grow passive income to the point where it covers all living expenses, which can lead to financial freedom and early retirement. Whatever your motivation is for investing money, it’s important to set clear, definable goals supported by a written plan of action with status updates on a regular basis. Having clearly focused goals and plans is a pre-requisite to choosing the investment vehicles that are appropriate for you. Once your plan is


in place, you can follow it through to achieve success.

Investment Choices There are many different investment vehicles to choose from. The key to making the right choice is to select an investment vehicle along with an investment methodology that has the potential to deliver the financial returns necessary to meet your goals. For example, if your goal requires a 20% per year rate of return, buying high grade bonds yielding 6% per year would not be appropriate. On the other hand, if low risk is more important to achieving your goal than high returns, high grade bonds may be just the thing for you. Real estate has proven to be an excellent long term investment capable of producing passive income along the way. Through rental properties, rehabbing, and land development, there are a variety of ways to invest in real estate, but these are only good choices if they align with your investment goals. And of course, there are down cycles as well, making real estate investing from being risk-free. Then there are stocks: small caps, mid caps, large caps, techs, etc. With stocks, you can tailor your investment strategy to align with your goals – a diversified portfolio of high to low risk stocks, a short-term oriented stock trading portfolio, or a buy and hold long-term mutual fund portfolio just to name a few. There are probably as many strategies to investing and trading the stock market as there are stocks to invest in. Whether your investment choices include bonds, real estate, or stocks, in order to be successful in the long run you must have a Winning Edge that you can leverage over and over again. In this report, you’ll learn in detail what it means to have a Winning Edge, including a comprehensive definition, the implications of returns versus risk, and its key components. The discussion will focus on the Winning Edge as it applies to stock trading, and hopefully will assist you in determining if you currently have a Winning Edge in your own personal stock trading strategy.


The Winning Edge Definition An investor that is able to follow an investment methodology that has the potential to produces net profits or positive returns over time can be said to have a Winning Edge. For example, a stock investor that has a Winning Edge can expect to achieve more winners than losers, or average winning trades that are higher than average losing trades, or both. In other words, the odds are in your favor, so the more trades that are made, the probability of being a net winner increases dramatically. Casinos use the concept of a Winning Edge to great effect – they know that while they will suffer losses on occasion, they will be net winners because they have a Winning Edge. As thousands of bets are placed, the probability of a casino being a net winner becomes a near certainty. That, of course, is why they are so happy to see you come to their establishment.

Impact on Portfolio Value Let’s look at the impact of a Winning Edge on portfolio value. Figure 1a shows an ideal graph of portfolio value increasing steadily over time through the consistent application of a Winning Edge. Figure 1b shows the same thing, except it reflects the reality that even with a Winning Edge, portfolio value does not go straight up – there are occasional drawdowns. Figure 1c is a variant of 1b. Instead of several small drawdowns, Figure 1c depicts one significant long-lasting drawdown followed by the portfolio value recovering to new highs. While the portfolio values fluctuated differently, all three charts show net positive gains that you would expect through the consistent application of a Winning Edge. Figure 1


Now let’s examine a chart of the S&P500 from 1950 to 2001 (Figure 2). As you can see, if your strategy was to buy and hold the basket of S&P500 stocks from 1950, your portfolio could show a net gain of about 9% per year. Therefore, this strategy exhibits characteristics of a Winning Edge.

$

S&P500

1950 2002

Average Return = 9% / year

Figure 2

Likewise, if you look at a chart of the Dow Jones Industrial Average from 1900 to 2001 (Figure 3), you see again that if your strategy was to buy and hold the Dow Jones stocks from 1900, your portfolio could show a net gain of about 6% per year. This, too, exhibits Winning Edge characteristics.


$

Dow Jones Industrial Average

1900 2001


Figure 3

Here is a look at the NASDAQ composite from 1978 to 2001 (Figure 4). Again, a buy and hold strategy exhibits Winning Edge characteristics.

$

NASDAQ

1978 2002


Figure 4


While a buy and hold strategy could have produced approximately 6 to 13% per year return in the previous examples, this strategy requires that you never sell while somehow replicating the index performance in your portfolio. Neither of those factors is very likely to occur in the real world, which calls into question the robustness of a buy and hold strategy. It becomes apparent that some level of stock or mutual fund trading may be required in the real world if you are to attempt to increase the value of your stock portfolio over time. Let’s look at a few scenarios. Figure 5a shows the portfolio value over time of a short-term stock trader who has occasional successes, but ends up giving back profits in subsequent trades with no net profit when all is said and done. This tends to be the experience of traders who trade without discipline and without rules – in other words, without a Winning Edge. Of course, such a trader could do even worse by consistently losing money over time as shown in Figure 5b. Figure 1, on the other hand, shows the kind of results you would expect from a trader using a strategy with a Winning Edge.

Short-‐Term Trading:No Discipline -‐ No Rules

$

Time

$

Time

0% / yr

-‐xx% / yr

a.

b.

Figure 5


Impact on Risk There are many ways to define risk from highly technical statistics to very simplistic statements. I prefer to define risk in terms of what happens to my trading position that I don’t like. For example, I don’t like it when my portfolio suffers a drawdown (loses money), and I don’t like waiting to recover my losses so I can break even. Both of those occurrences represent risk to me and my portfolio. So it should not be surprising that my definition of risk includes both of those elements (Figure 6).

$

Time

time to breakeven

% drawdown

Risk

Figure 6

Percent drawdown: The amount lost from the previous peak portfolio

value.

Time to break even: The opportunity cost of lost trading opportunities. With this straightforward definition, it becomes easy to evaluate the level of risk inherent in various strategies. Take a look at Figure 7, which shows the S&P500 from 1950 to 2001. What would be the level of risk for the buy and hold strategy discussed earlier? By simply examining the graph, you can see that the ‘time to break even’ took 7 years from 1973 to 1980, and during that period, the ‘percent drawdown’ was 48%. Since 1956, there were five other drawdown periods ranging from one and half to four years. While not as severe as 1973 to 1980, the ‘percent drawdown’ was still very significant, from a low of 16% to a high of 39%.


$

S&P500

1950 2002


f.

e.

d.

c.b.

a.

Figure 7

S&P 500 Risk Assessment

Period Time to Break Even

Percent Drawdown

a. 1956 – 1958 2 years 16%

b. 1969 – 1973 4 years 35%

c. 1973 – 1980 7 years 48%

d. 1981 – 1982 1.5 years 29%

e. 1987 – 1989 2 years 36%

f. 2000 – 2007 7 years 51%

g. 2007 – ? 1 year & counting 20% so far

A key question you should ask is how long will it take the most recent bear market to break even? As of this writing, the ‘time to break even’ is one year and counting. The answer will only be known over time – it could be within the next year or could be as long as 7 years as was the case from 1973 to 1980, and again from 2000 to 2007. Reviewing Figure 8 for the Dow Jones Industrial Average, from 1900 to 2001 the following risk assessment for a buy and hold strategy can be made:


$

Dow Jones Industrial Average

1900 2001


e.

d.

c.b.

a.

Figure 8

DJIA Risk Assessment


Percent Drawdown

a. 1904 – 1919 15 years 48%

b. 1920 – 1925 5 years 36%

c. 1929 – 1954 25 years 89%

d. 1965 – 1983 18 years 37%

e. 2000 - 2006 5 years 39%

f. 2007 – ?

As you can see from this data, ‘time to break even’ was extensive in the first half of the Twentieth Century. Likewise, a review of Figure 9 for the NASDAQ index from 1978 to 2001 indicates the following risk levels for a buy and hold strategy:


$

NASDAQ

1978 2002


d.

c.b.

a.

Figure 9

NASDAQ Risk Assessment


Percent Drawdown

a. 1981 – 1982 1.5 years 29%

b. 1983 – 1985 2 years 32%

c. 1987 – 1991 4.5 years 37%

d. 2000 - ?

While the buy and hold strategy technically has a Winning Edge, the preceding analysis shows that adhering to this strategy would have required uncommon resolve and patience to endure years, sometimes decades, of ‘time to break even’ and near-catastrophic ‘percent drawdowns’. The stock trader who trades without a Winning Edge fairs even worse, as you can see from Figure 5a where the ‘time to break even’ and ‘percent drawdown’ are in a repetitive pattern that lead nowhere. Worse still is Figure 5b, where the ‘time to break even’ is infinite with ‘percent drawdowns’ approaching 100%.


Contrast that level of risk with a stock trader who trades with a Winning Edge methodology. As Figure 1 shows, ideally he experiences relatively short ‘time to break even’ periods with modest drawdowns. This trader is obviously the one to emulate!

Conclusions

The conclusion from reviewing this information suggests that in order to be successful, your strategy must indeed have a Winning Edge. Furthermore, your strategy must exhibit risk levels within your risk tolerance and be consistent with your goals, and why you are investing money.

Key Components

You should now have a good understanding of how a Winning Edge impacts returns and risk. It’s now time to dive deeper into how to potentially achieve a Winning Edge. Remember, I defined a Winning Edge as an investment methodology that has the potential to produce net profits or positive returns over time. Here are the four key steps that are required: 1. Money Management Guidelines 2. Selection Criteria 3. Specific Entry and Exit Rules 4. High Velocity Turnover The absence of any one of these components will dramatically reduce, or even eliminate, your chances of achieving a Winning Edge. Now that you see what steps make up our Profit Button, let’s have a look at each one of these components in detail.


Money Management Guidelines Money management is about balancing risk with reward. Given the risk inherent in any investment methodology, you need to have sufficient funds and personal resolve to cover that risk so you can continue to enjoy the rewards without being knocked out of the game. The number one rule of money management and the most effective thing you can do is to reduce your methodology’s risk in the first place. For stock traders, you do this by only trading with the predominant trend. That is, you take mostly long positions in bull markets and mostly short positions in bear markets. The reason being is that three out of four stocks will follow the predominant trend. The second rule is to ensure that the risk (drawdown percentage and ‘time to break even’) does not exceed: Your emotional tolerance for losses Your financial capability to live through those losses Your ability to stick to your trading methodology

Emotional Tolerance for Losses For example, if your methodology is to buy and hold an index basket of stocks, then you must be comfortable with the multi-year ‘time to break even’ and drawdowns of 20% to 50% or higher that are inherent with this methodology. Otherwise, you may fall victim to selling at precisely the wrong time. On the other hand, if your methodology produces minimal drawdowns and ‘time to break even’ as is potentially the case for the trader with a Winning Edge, it is much easier emotionally to stay committed to your plan.


Financial Capability Financial capability is simply about assuring that given the funds you have available for trading purposes that you do not over-commit to any one transaction or position where an adverse outcome would impair or eliminate your ability to continue trading the methodology.* Suppose your methodology has a Winning Edge which produces three out of four winners and an average gain and loss per trade of 8%. Suppose further that the maximum loss per trade is 30%, only happens infrequently, but it does happen. This is a great methodology, but only if you use sound money management rules. If you had the misfortune of investing all your funds in one stock trade that lost 30%, you would require an almost 43% gain in your portfolio value just to get back to break even.

A far better approach is to allocate your funds equally among five to ten positions where a 30% loser has only a 6% to 3% impact on your portfolio. Or, the simplest and possibly most effective approach is to never risk more than 2% of your account size on any one position. Risk here means the maximum amount you would lose on the position.

Sticking To Your Trading Methodology Given a methodology with a Winning Edge, you can only succeed by sticking to the methodology. That means having the discipline to follow the rules and to keep trading even when losses occur, which they inevitably will with even the best methodology (remember, there is no Holy Grail in stock trading). It is much easier to adhere to this discipline if you have only committed funds to your trading program within your comfort zone (your Financial Capability).* There are several methods that can be used to mitigate risk to accomplish rule number two of money management. Here are a few: Diversify your money among non-correlated investments. For stock

traders, diversify among several stocks.

Limit the percentage of portfolio funds committed to any one trade. For example, invest only 10% to 20% of your entire portfolio to one trade. And/or never risk more than 2% of your account size on any one position.

Estimate the expected maximum drawdown and ‘time to break even’ (based on historical data), and be prepared to cover such a drawdown in the future without abandoning your investment plan.


Selection Criteria The second component to a Winning Edge system is to develop a set of criteria that must be met in order to consider taking a position in any given investment vehicle. For stock trading, this would be your criteria for selecting which stocks to consider for long or short positions. If the criteria are not met in any way, you should simply pass on that stock and go on to the next. Stock selection criteria can typically be based on fundamental analysis (earnings performance, industry group strength, etc.), technical analysis (price patterns, support and resistance levels, etc.), or both. Whatever the basis, the criteria should be very demanding so that only the best trading opportunities emerge. For example, for every 2000 stocks, 100 could be selected by using fundamental criteria. Then, by applying technical analysis, orders for two stock trades could actually placed, expecting only one of those to following through with market action that triggers the order. The ratios look like this:

Stocks Scanned

Stocks Selected

Orders Placed

Orders Filled

2000 100 2 1 By using a very demanding set of criteria, you could potentially increase the odds of having a winning trade. For fundamental criteria, I highly recommend Investors Business Daily’s fundamental data which is available for every stock traded on the major exchanges. Remember, just because a stock meets demanding fundamental criteria doesn’t mean it’s a good stock to trade. Rather, you must be patient and wait for market conditions to align consistent with your trading system rules before pulling the trigger.


Specific Entry and Exit Rules A good trading system will utilize specific entry and exit rules that have proven to work effectively in the past under varying market conditions. These rules are essential to ensuring that the odds of winning are high, and are also essential to having a Winning Edge. Good entry rules will typically demand a low-risk entry point and also require short term confirming market action to trigger the order. Good exit rules will typically include both a profit target point and a stop loss point, with adjustments along the way. In the absence of these rules, you’re more than likely to find trouble and be unable to achieve a Winning Edge (see Figure 5). The most common example of a stock trader that trades without specific entry and exit rules is one who trades on the basis of the news networks, the commentary of the day, analyst reports, and other hot tips. This type of investor trades stocks based on free advice available to the unwary public. The assumption here is that somehow you can profit from this hodgepodge of recommendations. (Where were they in March of 2000 when the bear market began, generally recommending buys all the way down, as those that followed this advice saw their portfolios lose significantly?) Most of the time they will issue buy recommendations, but seldom do they issue sell recommendations. This approach offers no Winning Edge at all and illustrates the importance of having specific entry and exit rules.


High Velocity Turnover Velocity is the rate of travel in a particular direction. Another way to think of velocity is to ask how long it will take to get your money back with a reasonable rate of return once you place a trade. With this general definition in mind, remember that the object of investing is to make money on your money consistent with your goals within strict risk control parameters. More specifically, the objective is to profit over time. The rate at which you profit depends on the percent return and the time it takes to achieve that return.

For example, a 10% return that takes one year will yield a 10% annualized rate of return. On the other hand, a 10% return that takes one month will yield a 120% annualized rate of return. In the first case, it takes one year to get your money back, whereas in the second case it only takes a month. Both cases return your money with a 10% return, but the second case has a dramatically higher velocity (120% annualized rate of return).

This is why high velocity and

short-term trading can be such important components of a Winning Edge and why significantly higher rates of return can potentially be achieved compared to traditional buy and hold strategies. Figure 10 shows the power of high velocity trading.*

Time

Short-‐Term Gains vs. Long-‐Term Gains

80

70

60

50

40

30

20

10

1 year

10%

46%

77%

10% every 12 months10% ever

y 6 months

10% ever

y 3 month

s

10% every

2 mont

hs

Figure 10


The Perils of Forecasting It is important to note that forecasting market direction is not a key component of a Winning Edge. There are two reasons for this. First, it is impossible to accurately forecast market moves on a consistent basis. Second, thankfully, it is not necessary to be able to do so. But what do most people do? They listen to the forecasters for a clue on what strategy they should follow and how their investments will perform in the coming year. I believe this is potentially a losing strategy and inconsistent with a Winning Edge method. This should be a great relief to all who have struggled with this issue. Instead, stick to the key components of the Winning Edge, and leave forecasting to the forecasters.

Summary Let’s do a brief review of what was discussed. I talked about the importance of understanding why you invest money and what your goals are in that regard. I noted that there are several investment vehicles to choose from such as stocks, bonds, and real estate. Then, a powerful concept called the Winning Edge was introduced. The performance of a buy and hold approach was looked at by analyzing the historical stock index charts in terms of rate of return and risk as defined by ‘time to break even’ and ‘percent drawdown’. And finally you saw how I believe the short-term stock trader with a Winning Edge had the potential to outperform the buy and hold strategy in both rate of return and assumed risk. Most trading methods do NOT have a Winning Edge. However, all of the trading methods I teach my students DO have a Winning Edge, and a whole lot more. So now you should have a basic understanding of how to construct your own Profit Button, made up of the 4 key steps or components of a Winning Edge. You can do what I did, and spend the better part of your life trying invent your own… or, you can test drive a step-by-step home study course that already has all the components discussed in this report built-in and practically set to auto-pilot once you master the method

Copyright © Profits Run, Inc. Page 22 of 22 Rev #12-20080411

Disclaimer: Stock, forex, Futures, and options trading is not appropriate for everyone. There is a substantial risk of loss associated with trading these markets. Losses can and will occur. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the information in this special report will generate profits or ensure freedom from losses.

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