Newsletter of Danny Merkel - Issue #101
Welcome to 2023. And congratulations on getting through last year’s shitstorm.
The fact that you’ve made it this far suggests that you’re probably passionate about trading. That’s good because without passion, it would be all too easy to give up after such a challenging year.
But to succeed at trading, you need more than just passion. You also need to be good at risk management. And while passion isn’t something that can be taught, risk management is.
Even if I can make a slight improvement of 1% in the way you view risk, that could translate into thousands of dollars over the course of your trading career.
However, learning about risk management is boring, which is why nobody ever talks about it. That’s unfortunate because risk management and position sizing will have a greater impact on your profitability than any other aspect of trading.
Illustrating the importance of position sizing in a fun way remained an unsolved problem for me until I experienced a brief moment of great mental clarity while I was locked-down in isolation for months in a hotel in Bangkok.
By using a standard deck of cards, I created a game that simulates several critical aspects of trading:
The way it works is that you take a standard deck of cards and you pick out only those shown in the photo above. Your new deck should now only contain 22 cards.
From there, the game is played like Blackjack where one person is the dealer, and you could have 1 - 5 players who are playing against the dealer.
The dealer starts by shuffling the deck of 22 cards and each player makes a wager before a card is dealt.
After all players make their bet, the dealer selects a card from the deck. If the card is a “face card” then each player loses whatever their bet was and the money goes to the dealer. This represents the harsh reality of Trend Following trading that most trades lose money.
On the other hand if the card is, for example, a three then the player triples their bet. The best card a player can receive is a nine, in which case they win 9X whatever they bet, which shows that Trend Followers occasionally nail down a huge winner that pays for the many small losses.
Once the round is over, the card that was dealt is re-inserted back into the deck and shuffled. The game continues until all players run out of money, or until the dealer runs out of money.
Now this game may seem quite simple, but it actually illustrates seven key concepts that are absolutely critical for trading success:
You can lose money most of the time, yet still be profitable. Just like many Trend Following strategies, the game loses money 64% of the time. But as Ed Seykota says “one good trend pays for them all.” Said another way, as Dan Zanger puts it“You can afford to be wrong when your winners are 10 times the size of a small losing trade.”
You don’t need to know what is going to happen next to make money.
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