The 30-Minute Stock Trader

by Laurens Bensdorp

  Profitable trading can be simple.

  I always used to think you needed to be a highly educated genius who knew every bit of financial news to be a successful trader. Most people think that. Once I realized that the news is all noise, and that your psychology is what determines results, my mind-set transformed.

  A perfect example is the famous “turtle experiment.” The strategy, created by Richard Dennis and Bill Eckhardt, was a simple breakout strategy with advanced position sizing. That was all. Yet the best-performing turtle achieved his results because he followed every rule. Some of the other turtles didn’t follow their rules strictly, and their performance suffered. They were all using good strategies, but the winner was the one who followed his most closely.

  The simplicity of a strategy, and its conceptual correctness, is what gives you your first edge. Then add proper, realistic objectives and a smart position-sizing strategy, and you’re set if you follow the rules. It’s not magic, just common sense.

  Only trade strategies that fit your personality.

  Long-term trend-following strategies work, and yet I don’t trade them as a single strategy. I only trade them in combination with other strategies. I know myself, and I tend to be impatient with strategies like that. You have to be willing to give back a portion of your profits with long-term trend following, and that frustrates me. It works for other people, but I know it will affect my psychology and cause me to ignore the rules, so I simply forget about it.

  Position sizing is key in helping you achieve your objectives.

  The strategy isn’t what makes you achieve your objective; position sizing does. I always thought that if I had a great strategy, I could make 100 percent a year. But it all depends on your drawdown tolerance, which determines your position sizing. If your drawdown tolerance is 10 percent per year, it will be hard to achieve a 100 percent yearly return. Your expected return (depending on your strategy) will be closer to 20 to 30 percent, at best. If you’re willing to lose 50 percent, you can shoot for the moon and potentially achieve a 100 percent return.

  It’s important to know that your strategy must have a statistical edge. You cannot turn a negative expectancy strategy (one that doesn’t make money in back tests) into a winning strategy by using a magic algorithm. That algorithm doesn’t exist.

  It’s not about which particular stocks you buy; it’s about your strategy, and your objectives, which define your position-sizing strategy and therefore your potential returns. Trading without a clear objective, as I did for years, is like driving with no direction, turning on whichever streets catch your eye. You won’t get to your desired destination.

  When in doubt, liquidate your position, or at least lower your exposure to the point that it doesn’t influence you psychologically.

  All good trading books discuss this. You must have an objective view of the current market. When you’re in the market, your brain tends to justify any type of market behavior, and all objectivity is gone. As soon as a position makes you anxious, get out. You can always get back in later.

  Let’s say you are long in a certain position. The market is going down, and you keep losing on that position. However, you’re frustrated, and you have a big emotional charge on this position. No matter what happens, you’ll defend it. You will find any reason why it’s good to stay in the stock, because you want to be right and not admit defeat. Of course, this is confirmation bias—the mind just feeding you with the information you want to hear.

  You must log all of your trades and mistakes.

  I hate documenting my trades, but it’s essential to be successful, because it gives you a wealth of insight. It tells you how your strategy is performing and the percentage of trading rules you’re following. For discretionary traders, you can document your thoughts of each trade, then later identify winning and losing patterns to evaluate your decision making. I’ve logged my trades, with mistake logs, since 2009, and I discovered there was a bug in my software that overstated testing results. If I hadn’t logged my trades, that would still be affecting me.

  You are not your thoughts.

  This Buddhist sentiment might seem an odd inclusion for a trading book, but it’s been one of my biggest insights. For years, I had limiting beliefs and low self-esteem, and this crushed my hopes at making money trading, not to mention my happiness.

  The internal chatter in your head is holding you back from creating a profitable strategy. I was living my negative thoughts, yet totally unaware of it, and it hindered my performance in both trading and life.

  Your thoughts are not reality; they’re your perception of reality. For example, I used to think only a few people had the privilege to know the secret formula of the markets, so I could never be successful. But I realized I only thought that because of my past, failed experiences. My brain connected the dots incorrectly, saying that my past failures must have guaranteed future failure. But the truth was, I just had to change my beliefs to believe it was possible, then find a winning strategy.

  Five years ago, I used to think all of my thoughts were true. I’ve since worked deeply on myself, and I’ve realized I was making everything up. My beliefs were all stories I told myself and accepted as true, even though they weren’t. After deep practice, I am aware of any thought that isn’t based on reality, so I can let it go. I no longer concern myself with what others think of me; they’re just thoughts that don’t affect who I am, as long as I’m being true to myself.

  I’m happier, and I approach problems differently. Problems used to consume me. Now, I know I cannot change external situations. I see everything as a minor issue, because blowing something up into a big issue does nothing to change the situation and everything to destroy my state of mind.

  Know your strength and weaknesses.

  I never knew who I was, so I didn’t do anything with 100 percent commitment or conviction. I knew I had potential, and I knew it wasn’t being used.

  My journey of self-discovery and psychological transformation changed everything. I realized I no longer had to be the model corporate-type person to succeed—I could be myself. Those people had their strengths, but they also had their weaknesses, and I had my own unique strengths.

  Now, I’ve accepted my weaknesses. I dislike working on details and have no programming skills nor the desire to learn. For that reason, I’ve hired a programmer to test my ideas. My biggest strength is creativity and the ability to create strategies, so I simply tell them to my programmer and double my leverage. I’m great at translating a complex, difficult world like trading into clear and simple-to-understand concepts.

  I used to be full of trading ideas but never followed through on testing or implementing them. By accepting and outsourcing my weaknesses to someone for whom it’s a strength, we both benefit, and I’ve succeeded with a more than 99 percent efficient application of my strategies. I’ve overridden my strategy on less than 1 percent of trades, and unsurprisingly, the profits have been massive.

  Create Your Strategy

  After you’ve understood these beliefs and how they relate to you, you can move on and create your strategy, which starts with defining your objectives. If you can define your objectives clearly, the development process of your strategy is actually quite simple, because you know exactly what you want it to achieve. Most people start with ideas, looking for strategies that work, but they don’t know what they’re looking for. You must start by defining your objectives, then moving on to identifying sound market principles.

  In order to clarify your objectives, start by defining your initial trading capital. That’s self-explanatory, of course: How much money are you willing and able to invest? But it’s important to write it down, so that the other steps are done properly.

  Based on that number, what’s the largest percentage drawdown you can withstand? We define that number in percentage points, but you need to be aware of what that number will look like in terms of your trading balance—in dollars lost. It’s easy to pick a number like
20 percent, but how many actual dollars is that, and are you sure you would be OK losing that much? I’ve met plenty of people with $1 million trading accounts who say a 20 percent drawdown is fine, then freak out when they’ve lost $200,000.

  Then consider: How long of a drawdown can you withstand? At what point will you stop trading and reevaluate? Do you differentiate between drawdown from base capital and profits drawdown?

  For both of these questions, visualize the loss in your account balance. Do you still want to trade your strategy, or are you anxious to get out? If your mental state will be affected, you need to set a more conservative number. The most obvious example was people who were trading buy and hold from 2005 to 2007 but who hadn’t defined their drawdown threshold beforehand. Then 2008 came, and they didn’t sell because they didn’t know when to. So they hit 50 percent to 70 percent drawdowns, sold everything, and refused to trade ever again. They weren’t basing their decisions on sound market principles but rather on just the temporary position of their equity.

  Since that time, the market has tripled in value. If they had set their risk tolerance beforehand, they would have sold earlier, gotten back in the game, started to make money again in 2009, and profited ever since. Their buy-and-hold approach still worked, but they let their emotions override the strategy.

  Don’t think only in terms of percentages losses. Think also in concrete terms of dollars lost. You need to be in a mental state where losing money won’t affect your decision making. Thinking in terms of percentages makes sense rationally, but humans are not rational when money is involved.

  You need to trust in your strategy 100 percent, because you put in the work to perfect it beforehand. You need to know that short-term losses, even losing months of 5 to 10 percent, are part of the process. If you’re down 5 percent, while your peers are making money, will you still follow your strategy?

  A general rule I’ve found is that people can handle about half of what they think they can. If your instincts say you can handle a 20 percent drawdown, start with a 10 percent max drawdown to be safe, and learn from experience. It’s far better to be safe than sorry, because overriding your strategy negates all of the work you did and destroys your finances.

  If you have past trading experience and were comfortable losing a certain amount of money, start there.

  By trading within your drawdown tolerance, you ensure that you’ll stay comfortable and therefore rational.

  I also recommend including a small margin of error in your strategy because you might make some trading mistakes and override your strategy occasionally. That’s not ideal, but it’s normal and not catastrophic if you’ve built in margin for error. If you set your compounded annual growth rate (CAGR) at 25 percent, are you OK with achieving 18 percent? And if your maximum drawdown is set at 7 percent, are you OK if it reaches 12 percent? Humans make mistakes, so make sure you’re OK with slightly worse-than-expected results, compared to your back testing.

  What is the CAGR you’ll use in back tests? The larger drawdown you defined, the larger CAGR you can achieve. The more potential risk you can tolerate, the more potential reward you can reap. But it’s important to define your risk first, otherwise you’ll shoot too high. It’s better to be safe than sorry. If you need to be conservative with your risk, that’s fine, but don’t expect huge returns. Lots of potential clients tell me they won’t tolerate a drawdown beyond 10 percent, but they want a CAGR of 100 percent per year. I tell them that’s not possible and to ignore anyone who tells you it is. You might get lucky for one or two years, but not long term. If you’re testing a maximum 10 percent drawdown, aim for a CAGR of around 20 to 30 percent. The longer you trade, the more you will realize that even the best strategies will have a larger than expected drawdown. Prepare for that beforehand.

  Will you trade on margin? You need to define if you will only trade the amount of equity you have, or if you are willing to go over that, on margin. For example, you can trade 150 percent of your account value, if 100 percent is long and 50 percent is short. That’s allowed, because your exposure is only 50 percent net long. The short positions are allowed to offset the long positions. However, are you comfortable trading on margin? Also, if you trade IRA accounts, know that you can’t trade on margin.

  How will you handle larger-than-expected profits? This would be a good problem to have, but you still need to consider it. Let’s say you’re trading a long strategy on volatile stocks, and you’ve tested a return of 25 percent per year. In your first year, you see a return of 120 percent, because of something like the dot-com boom. It’s important to answer beforehand: Will you want to withdraw capital? If so, you need a strategy in place that accounts for specific profit targets at which you will withdraw a specific amount of money. Otherwise, you’ll withdraw money and it won’t be accounted for in your strategy, and you’re in trouble. Many people can’t handle unexpected success. It’s also important to consider this on an individual scale. How will you react if you earn a 150 percent profit on one positon? If you’re going to feel compelled to withdraw money, you need to account for that. It’s fairly easy to design a position-sizing algorithm to help you with such a problem. Make sure that greed isn’t ruining your strategy.

  Everyone thinks this is a no-brainer, but greed always kicks in.

  Will you use a benchmark? If so, which one, and why? In my strategies, the benchmark isn’t important. A benchmark is a long-only performance of an index. We trade a suite of noncorrelated strategies, so we don’t really care what the benchmark does; we do our own, separate, noncorrelated thing. But the whole world and media is obsessed with benchmarks: What did the S&P do today? It’s important to think about how you will react if, for example, your strategy earns you 10 percent one year, but the index is up 40 percent and everyone around you is bragging about their long-only strategies. That could influence your mental state. It’s important to know how you’ll react to the news.

  Intellectually, it’s easier to understand that a benchmark is not useful for trading. As we’ve shown, the benchmarks don’t perform particularly well, and they have seen huge drawdowns. They’re simple and easy to beat, so you shouldn’t look at them, because outside noise will influence you.

  That said, reality sometimes interferes with this. Not everyone can ignore the news. Let’s say you’re trading a noncorrelated strategy of long-term trend following, mean reversion, and other strategies together. Suddenly, there’s a bull market like the 1999–2000 dot-com boom. All you’ll hear on TV and at parties is how easy it is to make money in the stock market. They’re handing out 60 to 70 percent returns, every year! Your friends are bragging, nonstop.

  Short-term, this is easy to deal with. But what if there are two or three years of outside noise? What if your spouse starts to ask, “Why is everyone making more money than us?” She doesn’t think you’re doing a good job, and you can’t blame her—all of her colleagues and friends are bragging, too.

  You know that there will be a turnaround—that the people creating noise will lose their money, eventually. But as we’ve drilled in—there’s no way to predict when the markets will turn. Are you patient enough to wait a couple of years? The years of noise could get to you.

  If you think there is a high likelihood of your hearing outside noise—from your friends, colleagues, spouse, or the media—consider the benchmark. Don’t be a slave to it, but consider it. Make sure that you will make outsized gains in bull markets, because otherwise, you may struggle to follow your strategy.

  The benchmark is only relevant in bull markets. In all other markets, you’ll be positive, while others are losing. As long as part of your strategy is long-term trend-following positions with volatile stocks, you should be prepared.

  As you’ll see in part 4, the first strategy—the “Weekly Rotation strategy”—is perfect for this.

  How will you react when you’re underperforming the benchmark by a little? A lot? Will you accept years when you underperform the benchmark? I don’t
compare my results to the benchmark, but some people like to. That’s fine, but make sure you have a strategy for when the benchmark outperforms you. Be aware that this will happen occasionally, but it shouldn’t bother you. When the markets are up huge, yes, the benchmark will beat you. But when the markets are down, you’ll be losing less than the markets. Long term, you’ll be making much more money than someone who follows the benchmark.

  Are you OK with cutting losses short and riding profits out? With trend following especially, people have a tendency to take profits and let losses run. It’s a normal, cognitive bias, but you need to be aware of it and not fall prey. People want to feel good about themselves, so they take a profit. Feeling good about yourself has nothing to do with good trading, though, and nor does taking a profit when you could have made more.

  It’s common for people to want to take a profit 80 percent of the time, but those profits will be small. Winning 80 percent of the time means you’ll lose 20 percent of the time, and people who behave like this will be unable to cut those losses short. The 80 percent of wins could be, say, $10 each, but the 20 percent of losses will run and could be $200 each. Despite “winning” 80 percent of trades, you would have lost a lot of money.

  Winning trading isn’t about winning more frequently; it’s about your overall balance. You’ll end up bankrupt if all you care about is taking profits, especially if you can’t accept losses. We’ve been trained since youth to see losing as wrong. We’ve been trained to never admit defeat, or that we were wrong.

  When we went to school as kids, we were graded for every exam—if you get A’s or B’s you’re “good,” and if you don’t, you’re “bad.” “Bad” students are forced to think that they can’t make mistakes, and they’re often stuck with this mentality for life. Well-meaning parents raise their kids to be afraid of making mistakes, by teaching right versus wrong. Even though I’m aware of this, I’ve done it with my own kids, accidentally. It’s unfortunate, but it’s reality.