The business of speculation is based on the ability of the speculator to manage their risk and maximise their returns. Treat your CFD Trading as a business activity by changing the way you think about approaching your investments.

Many people believe that trading CFDs successfully is similar to gambling. There is a huge difference between a gambler and a speculator. A gambler will risk everything to achieve a given result, where a speculator will take a calculated risk for a return. Betting on red or black at the roulette table, means either you double your money, or you lose everything, with the green slot ensuring that over the long term you will lose.

There are professional card players that go to the casino and play to a simple strategy which gives them an edge over the casino. They know the number of cards that are being used and the probability that a certain card will come up. Using this knowledge they improve their returns by betting accordingly. If they are good the casino will throw them out. Fortunately this does not happen in the stock market.

Consider a simple game of chance, where you toss a coin 100 times. If it is heads you will lose your $1 bet and if it is tails you will win $1. On average this game should result in neither a gain nor a loss. But take a look at the chart below and you will see the outcomes that did occur from one set of random outcomes.

There are times when this strategy is profitable and times when this strategy loses money. The worst case situation is a loss of -$5 and the best case for this series of throws is +$4. It is possible to make money playing this game; provided that you have a large enough amount of capital to trade through the down times.

In this case you must have at least $6 to keep playing as you need to have enough to continue playing even after a loss of $5. A trading strategy like the one above will only benefit the broker long term. As a trader you would like to skew the odds in your favour.

A simple way to do this is to practice a money management strategy. This time with the same results you could allocate your capital differently. Start with a $1 bet and if you lose bet $1 again. If you win double up and bet $2. If you lose bet $1 and if you win again double up and bet $4. One more time, if you lose bet $1 and if you win double up and bet $8. Then start again betting $1 a time. Your capital must be at least 20 times your bet size, in this case $20 and when you have doubled your capital, take your profits and stop playing. The chart below shows the outcome of this strategy.

The drawdown in capital is larger than in the first game, but within the limits of your capital. During the 100 throws you do meet your profit objective and double your money. This uses a money management strategy to ensure firstly that you can survive the inevitable downturn in your results and secondly to take advantage of a winning streak and exit with your profits. Risk management is an important part of your trading strategy.

Consider the following distribution of the trades that occurred. Very few trades made a large gain and very few trades made a large loss, with most of the trades resulting in small gains or losses. Over a large number of coin tosses the distribution would be a smooth curve known as a normal distribution. In reality in the stock market the tails of the distribution would be fatter than normal. This is the result of extreme movements occurring more frequently in the stock market than would be statistically expected.

Another way to skew the odds in your favour is to use a stop loss. It is difficult to apply the stop loss in the trading game above, however if you can cut off the losses and let the profits run then you are adding to your profitability.

The chart below illustrates this with the large losing outcomes removed from the chart. Using money management above it was possible to turn a purely random gambling game into a profitable trading strategy. To be successful in the market you do not need to gamble and risk a large amount to receive a profitable result. It is possible to take a small risk and still achieve a profitable result. This is the business of speculation.

A gambler will buy a share at $1 and be prepared to lose the whole dollar, if the share dropped, with the belief that the share is going to go to $2. The risk to reward ratio is 1:1, they will either win $1 or lose the same amount.

A speculator will buy the share at $1 with a stop loss at 90cents and a target of $2. The risk to reward ratio here is 10:1, the speculator is prepared to lose 10 cents and may gain $1. This is a calculated risk and the risk money can be considered to be the rental or overheads of the business. The business must be profitable to stay in business.

A speculator will find a strategy that skews the odds in their favour and then implement that strategy to generate profits. To calculate your edge, look at a series of trades that you have completed. How often are you right? Divide this number by the total trades to calculate your hit rate. A hit rate of 50% or higher is acceptable. A hit rate of 30% can work provided your losses are kept very small. A hit rate of 70% or higher is very good.

Remember no strategy works every single time. Then do a comparison of your average win to your average loss. Your average gain should be 2 - 3 times your average loss. If it is higher then you are trading exceptionally well. If it is less then your margin for error is very small. If your average loss is greater than your average gain then it is back to the drawing board to determine a more profitable strategy.

Enjoy the business of speculation. It is very far removed from gambling at the casino, however a lot can be learnt from the gamblers. It is possible to win gambling and it is much easier to win speculating.

Manage your risk and skew the odds in your favour by cutting out your losing trades. It is one of the greatest businesses in the world, yet very few people ever take full advantage of the potential that is available. Start your business today.

Jeff Cartridge
LearnCFDs.com

9 January 2009

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