How to Win Trading the Markets

When I first started speculating in organized markets, I quickly ran a $40,000 initial stake into $22 million. My technique was simple: I bought gold at $290. Each time it went up $10, I pyramided and added to my holdings with my profits.

Victor Niederhoffer
The Education of a Speculator

It takes courage to be a pig.

Stanley Drukenmiller
Managing Director, Quantum Fund

When I was a beginning trader, I met another trader who had run a few thousand dollars into one-half million dollars. He had managed this phenomenal feat by pyramiding a bull move in airline stocks. When I asked him how he did it, he replied, “Each day when I came into the office, I checked my buying power. If I had any, I bought more bonds.”

I was at once amazed and alarmed. What a risky way to trade! He put all of his eggs in one basket, and then continued to buy more at higher and higher prices. This man had clearly done everything wrong! He owned only one issue, so he had none of the benefits of diversification. And chasing after the stock as it rose struck me as extremely imprudent, since the average cost of his position continued to rise as well. That made him increasingly vulnerable, since even a modest correction to a point below his average cost would have wiped him out.

And yet, the proof was in the pudding. He had made a lot of money from a little–either through dumb luck, or crazed bullishness, or some craftiness beyond my ken. It took me years to figure out which it was.

1. He did his homework and set high standards.

My friend had kept all of his old charts, and he showed me hand-drawn, multi-year charts for every listed airline stock, as well as for many other leading issues. Each confirmed the other; at the time he began his operations, sizeable bases had formed in many stocks, each capable of supporting a large bull move. He became convinced that the broad market was set up for a substantial run.

Over the years, he came to realize that successful traders took losses on many, if not most, of their trades and made their fortunes on relatively few. He was looking for a big move. Small trades were of no interest to him. The standards he set for trade selection were extremely high. He was not willing to risk his capital on a trade which did not hold out the promise of a return many times his risk.

2. He focused his capital on the best of the best.

Out of his possible choices, he zeroed in on the airlines because of their huge potential. From the airline group, he chose to focus initially on relatively few issues.

Wasn’t this imprudent? What about diversification?

What happens when the painter mixes all the colors of his pallet together? Brown, or gray, or some dull, nameless color results. In the same way, over-diversification draws the trader toward the average; the more positions carried in a portfolio, the more likely that portfolio will produce average results. Above-average results require focus, not diversification.

Traders who seek a diversified portfolio often settle for multiple positions with only modest indications, as if many weak threads will together form a strong rope. Such trades seldom pan out. The best candidates stand out as exceptional from the beginning. Focus on those few opportunities which offer the best chance for profit.

3. He averaged up in the best performing issue.

Because he was using leverage, he created new buying power only when his positions advanced; no new buying power was created when they declined. Even if he had wanted to, he could not have averaged down. Instead, he was forced to average up if he wished to increase his share position.

The tactic of adding to winning positions just inverts the recommended tactic of cutting back on losing positions. This trader refined that tactic further by cutting back on laggard, albeit profitable, positions in favor of the position which performed best. Over time, his share position in the best performer grew, while his share commitment to laggard positions declined. His approach was to seed, then weed, his positions until only the best remained.

Research your trading candidates thoroughly, then take positions in a few of the best. Seed each candidate with initial capital. Then gradually weed out those candidates which under-perform, and reallocate capital to strongly performing positions.

4. He was ready and confident.

Most traders cannot stand to hold a profitable position. The temptation to nail down profits becomes overwhelming for those who have little confidence either in the trade or in themselves.

Confidence in the trade is the single most important element to winning big. To possess enough confidence to trade from strength you must:

Have confidence in your analysis. Know what technical elements you need to see in a trade, then find opportunities which match your requirements.

Know your threshold of acceptable risk, and do not cross it. One trader has said that he always cuts back his positions until he is able to sleep well. If you find that a trade is on your mind even when you are away from the market, cut back on your position until you no longer worry over it.

Most traders develop an area of special competence. Some prefer the long side, while others are more adept, and therefore more comfortable, on the short side. Some prefer volatile stocks, while for others, highly active stocks introduce too much short-term risk. Some prefer to position for the longer-term, while others trade intermediate swings or day-trade. Once you identify your area of special competence, you will have much less difficulty staying with winning positions.

My friend won big, not because of luck, but because hard work had uncovered a well-researched, sizeable market opportunity, and because he had acquired the self-confidence and savvy to play out a winning hand.

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