Select a Strategic Approach

Select a Strategic Approach

As a person makes decisions about which asset classes to trade, they should also begin to think about which strategy they may want to employ. This is especially true for the option asset class. Options provide a great deal of opportunity for traders to use them in creative ways. This has resulted in a number of defined trading strategies that can be sorted into categories.

The following strategy matrix may be helpful as you contemplate the strategy you’ll use to engage the markets and implement your trading process.

Market prices are both unpredictable and uncontrollable. While the outcome of individual trades cannot be reliability predicted, if approached in the right way, the outcome of many trades can be. This approach is what we mean by a complete and trusted trading process.

A trading process is trusted because expectations have been verified by actual results. The first step to creating your own trading process is to determine your base winning percentage which is determined by your Natural Trading Style and where you set your exits relative to entries. Additional elements are layered in one after the other until the process is complete and the trader has confidence in both its reliability and its ability to predict results over many trades.

Many new and even seasoned traders don’t have a trusted trading process. This is a danger. Not having statistically relevant expectations or taking the time to create a rules based process of trading that includes a feedback loop for confirmation and improvement is what leads to frustration and loss. This is why traders often break whatever rules they have and assume unnecessary risk.

Everyone wants to have large gains on every trade and many traders spend a great deal of time, energy, and money looking for ways to achieve this desired result. The reality is that this pursuit of perfect entries is unrealistic and unhelpful in the pursuit of profits.

Real financial independence does not come as the result of a few lucky trades. It comes from a reliable and repeatable process that provides consistent results in any market condition. Everything we teach in our curriculum is designed to help you build out a specific, technique oriented trading process that provides constant feedback to help you both monitor its performance and to make continual improvements to its design. 

How to Determine the Probability of a Winning Trade

It’s said in real estate that profits are made on the buy. So buyers focus on the purchase price of the house and work diligently to find distressed sellers desperate to unload their home at below market rates. Most people who trade stocks or options mistakenly assume the entry price is just as important. But it’s not. What most people don’t know (or can hardly believe) is that the chosen exit tactic (not the entry price) actually sets the base winning percentage. 

Those who wish to improve their performance can if they learn four simple principles:

    1. Setting a profit target and a stock loss generates a condition that give the trader a reliable and measurable probability of a profit.
    2. Where the profit target and stop loss are set relative to the entry determines the expected percentage of winning trades.
    3. The base winning percentage is a statistical reliability and will produce expected results across asset classes, market types, and even when using random entries. 
    4. The choice of what asset classes to trade will in part be determined by the selected base winning percentage.

 

The idea that it’s possible to get statistical predictability and a reliable base winning percentage from the markets may seem unbelievable to some. Yet it’s true. This concept is one of the 7 Pillars that individuals control to help them gain predictable and reliable outcomes over many trades.

By internalizing this idea along with the rest of the Pillars, a trader will begin to be able to approach the market much like a professional trader would…with a clearly defined process, a clear understanding of probabilities, and the ability to focus on following your process despite the outcome of individual trades. 

Our hope is to help you begin to shift your focus and efforts on your trading process instead of the outcome of individual trades. Focusing too much on outcomes will whipsaw you into and out of trades at exactly the wrong time and for the wrong reasons. This sort of trading might also cause you to give up and go back to what wasn’t working in the past.

This lesson will lead you through four parts:

    1. What is a base winning percentage?
    2. How base winning percentages affect your trading
    3. The five Natural Trading Styles 
    4. The power of alignment

 

Wall Street has a saying that money flows where it is treated best. If you treat your money well by establishing and then following a well-considered and complete trading process, money will more likely flow into your accounts.

What Is a Base Winning Percentage?

The base winning percentage of your trades is determined by the ratio of how close your stop-loss order is to your profit-taking target. It’s possible to increase your base winning percentage by choosing profit taking targets closer to the entry while at the same time increasing the distance of your stop loss orders. The random nature of the markets daily price range will trigger the profit target, more frequently leading to a higher number of smaller profits and a few number of larger losses.

Setting a profit taking order further away from the entry than the stop loss order will result in a fewer number of trade reaching the profit taking order before they get stopped out. This results in a fewer number of larger gains compared to a more frequent stream of losing trades.

All base wining percentages simply measure the number of winning trades expected over the total number of trades. The relationship between profits and losses means that the base winning percentage will always be statistically breakeven unless it is combined with a trading edge which we’ll discuss in other lessons.

A desired base winning percentage can be selected simply by adjusting the relationship of the stop loss and profit taking orders relative to entries as shown in the graphic below.

 

The base winning percentage should always be expressed as a dollar amount risked to make a dollar amount of profit. It’s possible that a trader could design their process to win 90% of their trades. The tradeoff is that while losses are infrequent, they would be substantial relative to individual gains.

A good exercise at this point is to look at your past trades. If possible, average the gains and losses over the previous 30 trades. We use 30 trades throughout this course because that is the smallest group of trades that provides a statistically relevant sample size.

Assume that the average loss was the amount risked and the average profit was the amount gained. So if your average losses are $350 and your average gains are $700, your base winning percentage is 33% since you’ve gained twice as much as you risked on each trade (risk 1 to make 2).

Use the following calculator to help you discover the base winning percentage of your current strategic approach.

Average Trade Profit
Average Trade Loss
The Percentage of Trades needed to Breakeven %

Assume your past 30 trades have averaged a loss of $525 and a profit of $700. This would result in a breakeven win rate of 43%. What this means is that you would need to win at least 43% of your trades to just to breakeven. 

If your actual percentage of winning trades is less than the number you need to breakeven, stop trading immediately. If your actual winning percentage is higher than the breakeven number, you have a trading edge. The size of this trading edge is determined by subtracting your breakeven percentage from your actual percentage. So if your breakeven percentage is 43% and your actual percentage of winning trades is 48% the trading edge is 5% (48% – 43% = 5%). A trading edge does not need not be large to create consistent profits.

Below is a copy of the previous graphic showing the expected base winning percentage combined with a more visual representation of the size of loss compared to the size of gain at each level.

 
 

As seen, expected base winning percentages come with tradeoffs and limitations as they relate to size of profits relative to size of losses. They also come with tradeoffs in other areas as well. Understanding these tradeoffs and how they relate to your expected and actual trading results is a critical component of developing your own, unique, specific, and technique oriented approach to the markets.  

 

How Base Winning Percentages Affect Your Trading

A base winning percentage determines the size of individual losses compared to the size of individual gains. They also provide a trader with specific expectations related to the size and frequency of losing streaks. This knowledge, combined with the amount risked per trade, helps the trader understand and mentally prepare for the size and frequency of drawdowns, as well as the size of a potential maximum drawdown in a worst case scenario. 
 
A high winning percentage comes with the likelihood of longer and more frequent winning streaks and only a few losing trades or the possibility of just a few losses in a row. Conversely, a low winning percentage provides the expectation of a likely longer and more frequent number of losing streaks. 
While it might seem obvious upon reflection, it is important to reiterate that trading frequency also determines the size and frequency of losing streaks. A higher trade frequency will provide a greater number of trades both winners and losers. This means even a high base winning percentage will experience more losing trades which are likely to be grouped into larger and more frequent losing streaks.
 
 
The following table shows the likelihood of expected losing streaks given range of trade frequencies:
 
Losing streaks
 
If the selected winning percentage is above 50%, losing streaks will be less frequent and consist of fewer trades. If the winning percentage is below 50%, losing streaks will come more frequently and consist of more trades. 
 
While any part of the base winning percentage spectrum can be profitable, investors and traders are almost never profitable unless they know which side of the spectrum they operate in and know exactly how big their trading edge is. 
 
 
Warren Buffett’s partner, Charlie Munger once said: 
“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.”
 
 
Our research has shown that there is more than one kind of trading temperament. Each individual has a unique set of experiences, thought processes, and emotional responses to pressure. These an be measured and then sorted into 5 different market approaches. We call these market approaches Natural Trading Styles.
 
Knowing your natural trading style helps you understand where on this base winning percentage spectrum your natural strengths and life experience will give you the best results. This lesson has divided the spectrum into five probability profiles for greater clarification, though all future lessons will refer to only three.

 

The 5 Natural Trading Styles

 

The 5 Natural Trading Styles can be broadly grouped into three main approaches to the market. These broad groupings have a primary trading style which helps you understand the kind of trading or investing that operates best in each region of the probability spectrum. The five styles are grouped into three and can be designated as follows: (1) Win Big, (2) Just Win, and (3) Win Frequent.

Within these three regions we can identify five different profiles. These can be labeled as follows:

    • Win Big Extreme
    • Win Big
    • Just Win
    • Win Frequent
    • Win Frequent Extreme

 

We’ll talk about the extreme ends of the spectrum in this lesson, though in future lessons we’ll simply refer to Win Big, Just Win, and Win Frequent trading styles. By now you should have the results of your Natural Style Assessment. 

Having a clear understanding of your Natural Trading Style helps you select trading strategies and time horizons that best match your strengths. Once you’ve studied your assessment results, we encourage you to come back and carefully read through the profile that fits your style. As you do so, take some time to think about your past market experiences in light of this new information.

As always throughout this curriculum, we encourage you to journal your reactions to your assessment results and what insights you might have gained into your prior trading results. This is a great way for you to continue mapping your mental wiring as you learn those things that will support you and which things you’ll have to guard against as you start putting your money to work in a consistent way to hopefully achieve a higher rates of return like those guaranteed by Warren Buffett.

Profile 1 – Win Big Extreme

Counterintuitively, this trading style, which loses the highest number of trades, will actually be the most profitable (all else being equal). Use the calculator below to test this for yourself:

 

The 7 Pillars Calculator

Potential Profit Form
Trading Account Size $
Natural Trading Style
Base Win Rate %
Trading Edge %
Amount Risked per Trade %
Annual Trade Frequency
Potential Net Gain $
Expected Annual Return %
Starting Amount $
Years it can compound
Nest Egg $

7 Pillars of Control

  1. Entries and Edge Techniques
  2. Base Win Rate
  3. Amount Risked per Trade
  4. Annual Trade Frequency
  5. Allocation
  6. Asset Class
  7. Journaling

Believing that market approaches which lose most of the time and are still highly profitable is one of the biggest challenges traders new to our curriculum must battle. Most part time traders suffer a natural bias that mistakenly leads them to believe that they can only be profitable…or that they will be most profitable if they win a higher percentage of their trades.

This bias actually puts them under a heavier and unnecessary strain while trading. Play the chart game as many times as you need to begin believing the statistical truths of our unique approach to the markets.

This profile describes people who patiently endure many small losses as they mine the market for big wins to pay them for their efforts. It is reminiscent of the gold-rush prospectors who would patiently sift through dirt and mud to find highly valuable gold nuggets. The system of trading they prefer is to take a series of small positions which each have the possibility of turning into big gains, but which are only likely to win one out of four times or so.

They know they can’t allow fear to stop them or cause them to shift gears midstream. They must carefully and methodically carry out their strategy even though they know that most of the positions they take will lose. They know they may experience lengthy losing streaks at times, but they are patient and confident enough to keep trading anyway because they focus on and expect to have big winners which cover all the small losses and still leave large profits.

These traders prefer more volatile asset classes such as biotechs, penny stocks, crypto, or even options. These traders may employ a strategy of longer term holds to capture the bigger gains but may also employ a more frequent trading strategy. Their focus is on finding big opportunity on a few well placed bets; similar to a venture capitalist.

Profile 2 – Win Big

Like the Win Big Extreme trading style, this is also a highly profitable approach to the market. 

This profile describes people who are also patient enough to endure losses. They won’t strike out into the unknown (with all its risk) to find the motherlode, but will work the seam with positive energy. They wait for those wins that make their efforts worthwhile, hold to a procedure in their trading, and don’t get thrown off track easily. This profile is reminiscent of a highly optimistic person who remains positive despite the negative experiences and comments of those around them. The system of trading they prefer is to take calculated risks in a repeatable procedure. They are looking for trades that will win one out of three times or better.

They know they will have to prepare for losing streaks. They don’t know which trade will be the big winner, but they know that such a winner will certainly come along. This expectation helps them carry out their strategy as a repeatable process. They are confident in their approach, even though most of the time they will experience carefully controlled, small losses

These traders don’t take rejection personally and, in fact, they look at rejection as the best way of uncovering those big opportunities that are so exciting. They cut their losses short and are able to emotionally equipped to handle frequent losses. 

These traders prefer more volatile asset classes and prefer to hold positions in a shorter to intermediate time frame. However, if they choose to trade stocks, they are well prepared to hold times lasting a few weeks to several months.

These traders tend to be unemotional, decisive, disciplined, good with numbers, and focused on the long view. They like competing against others and measuring their accomplishments against them.

 Profile 3 – Just Win

This profile describes traders who look for leveraged trading opportunities. They tend to spend more time analyzing a company’s competitive position, management team, market valuation, fundamental analysis, earnings announcements, and anything else that helps them reduce their risk and contribute to their profits. 

Their Natural Trading Style reflects this because they have a 50% win ratio (or near that) and they typically risk the same amount on the trade as the amount they stand to gain. This means they only have one factor to focus on: being right a little more than average. If they can achieve a 53% win rate, they will likely be profitable in their trading. If they can increase their trading edge a little more and experience a 56% win rate, they will likely outperform the markets on a consistent basis. 

These traders are careful. The details matter to them. They like to study things out and understand them fully. They tend to plan their entire journey before starting. They feel mastery by knowing as much as possible about a topic and will work diligently to learn about the topics that interest them.

While these traders enjoy researching the markets and the feeling of confidence such knowledge gives them, they might also suffer paralysis by analysis. One trap these traders may fall into is a desire to know what tomorrow’s price action will be so they can place a trade today. In this pursuit, they may evaluate too many or conflicting data points resulting confusion and increased fear.

These traders tend to invest in more controllable, less volatile asset classes and hold their trades anywhere from about two weeks to two months.

These traders are studious, analytical, detail and task oriented, voracious readers, and smart with good short-term memories. They are excellent researchers and are conscientious about using valid data and high-quality reports. They are highly focused, determined, and not easily dissuaded or distracted from a goal.

 Profile 4 – Win Frequent

Counterintuitively, this high-win rate trading style is not as profitable as most people assume. Use the calculator to see why.

These traders are cautious, extremely loyal to friends and loved ones, and love to give and receive compliments. They prefer to stick with what works and tend to accept advice from people they perceive as more knowledgable or experienced. They are a bit of a perfectionist and don’t like to make mistakes. When mistakes are made, they will work to eliminate them from their behavior or business processes. 

Because they like to avoid mistakes, they prefer cautious and consistent profits over big, flashy wins. These traders would prefer a 100% chance of winning a $400 prize over a 50% chance of winning a $10,000 prize.

These traders fear loss. They choose market approaches which give them a high probability of winning even at the expense of larger potential profits. As such, they often choose to sell options for the higher win rate and more consistent profits.

These traders will generally hold for shorter time frames though in their need to be right, they may hold on to their losing trades for long periods of time. These traders will struggle with the natural bias of a need to be right. This bias will make it difficult for them to sell losing positions quickly or tightly control their losses. 

These traders enjoy the feeling of a winning trade so much they may struggle take profits. This may cause them to turn a profit into either a loss or a less profitable trade which reduces their overall profitability.

Those who identify their natural trading style as Win Frequent will attempt to maximize winning consistency in their trading by sticking with what works and minimizing losses when they come along. They prefer systems which win 67% or better. These people understand that many small losses may be wiped out by a larger loss which they work to manage as tightly as possible. Success in this profile requires a winning percentage of 70 to 73% while maintaining a risk to reward ratio of no more than 2 to 1.

Traders with smaller accounts who identify as Win Frequent or Win Frequent Extreme will struggle to be profitable even with a higher win rate. To be successful these traders must have a large trading edge and adapt that edge as necessary to changing market conditions. These traders must also limit any “user error” from their trading.

These traders are friendly, approachable, well-liked, hard working, studious, structured, and good at carrying out clear procedures. They enjoy puzzles and games and have an aptitude for and can win fairly easily. Can be uncertain or indecisive at times, until they feel they have learned enough to be confident.

 Profile 5 – Win Frequent Extreme

Most people start out in this profile believing that a high win rate is the best way to achieve a high profitability in their trading. The challenge is that it can be difficult to sustain this trading style successfully with smaller accounts because over time the comparatively larger losses can wipe out all the smaller wins if those losses come bunched in close proximity.

Those who choose to employ this approach will need to identify as large of a trading edge as possible while reducing any “user error” as much as they can. These traders will want to use the calculator to identify the amount risked per trade and annual trade frequency that will help them achieve their desired annual rate of return.

Like an “A” student, someone who works to get the right answer and get the best grades in every class, this person prefers to measure success by winning as often as possible. Their intent is to have many streaks of consistent, small wins, and to have the predictability of consistent small gains as the focus of their investing. They are less concerned about the size of their gains than they are about avoiding losing trades.

Like those in the Win Frequent trading style, people who identify with this profile accept the possibility of having an occasional losses larger than many gains. So they must seek to reduce the impact of these losses by working to keep risk no more than 3 times their average gain.

These traders will generally look for strategies that win a high percentage of the time. Their hold times will be short to intermediate though this can vary.

Like those in the Win Frequent category, these traders will struggle with a need to be right. This need will affect their trading decisions and keep them focused on avoiding loss. However, a less known struggle those who need to be right experience when trading is taking profits. 

These traders are likely to suffer from a strong and mostly negative narrative about their trading and may even think of a profit as a loss simply because they did not get in at the low or get out at the high. These traders must be careful about the euphoria experienced from a winning trade and avoid holding their positions too long.

All traders should  put together a watch list of trade candidates they would like to own. This exercise is especially important for Win Frequent Style traders who will need to become familiar enough with their stocks to be comfortable trading them.

 

The power of alignment

All traders must face two realities. First, the markets are messy, uncontrollable, and random. Second, they emotional reactions to price changes are also messy. If a trader focuses only on the potential gains and employs a strategic approach at odds with their own risk tolerance, it will ultimately be a losing strategy because the trader will not be able to trust it when they most need to do so…during losing streaks. 

Aligning a strategic approach to your Natural Trading Style means your thought process, emotional reactions to pressure, and life experience will all support your efforts to be successful. You’ll be more likely to continue trading it and following your rules exactly. You will likely not second guess your decisions or be tempted away from following your trading process.

A complete trading process built around the lens through which you currently experience your world is the fastest way to begin experience consistent results. It provides clear expectations about results that feel comfortable. It’s also the only way to gain trust in your ability to get predictable, sustainable results.

This means it will be easier to trust your trading process even during losing streaks. It will be easier to see opportunity and to take advantage of it. It makes it more likely that you’ll make the shift from focusing on or feeling emotional response to individual trade outcomes to where it should be: how well you followed your trading process.

Making this shift gives you a big advantage over other trades and will result in more consistent results. It will also help you make consistent improvements to your process as you gain experience and even more trust in your trading process.

Approaching the markets with a fuller understanding of the tradeoffs and opportunities associated with each Natural Trading Style will help you make adjustments to your trading strategies and investing time horizons as you gain experience and confidence. We encourage you to practice trading with the Stop Loss and Profit Target ratios defined by your Natural Trading style using the Chart  Game.

Use the Chart Game initially as you practice setting your exits relative to your entries. We encourage you to run through a Chart Game simulation at least 3 times. The more you do this, the more you’ll see that it is possible to get consistent and predictable results over the 30 trades even though it is impossible to control the outcome of any individual trades. This “just works” and the more you practice, the more deeply this confidence will bury itself in your soul and the more excitement and motivation you’ll have to overcome any resistance and implement these concepts into your trading. 

Other lessons get into more detail about natural trading styles, the strategies which correspond to each, and how you can optimize your efforts for greatest profitability. In other words, we’ll show you how you can increase your trading edge and expected profitability by using simple and time-tested techniques.

Research has shown that the average American closest in age to retirement has only saved $25,000.  Anecdotal evidence shows how difficult it is for younger people to find great paying jobs and begin a career path leading to financial freedom. Everyone seems to be working on side hustles to help them make ends meet. 

Trading is the best way for you to catch up a retirement, increase your weekly income, or having financial freedom. Making $8,000 work at 50% a year for 10 years will turn you into a millionaire. This process is simple but not easy. Use your time with us to work through the walls of resistance that always face those who seek greatness.

Don’t wait.  The best time to have started this process was 30 years ago…the second best time is today!

Happy Trading!