SnowBall Fight (and Other Insights Into Trading for a Living)

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

Let’s say that you are engaged in a snowball fight (It doesn’t matter how, why, or where you are engaged in the snowball fight). You are protected behind a wall of snow that you have previously built. It is in your best interest to make this wall as big as possible so that it will offer you even more protection from the snowballs. For each snowball that you throw, there are two types of snowballs being thrown back at you: white snowballs, and black snowballs. The white snowballs will stick to your wall and make it bigger (which is a good thing). On the other hand, the black snowballs will punch a hole in your wall that is equivalent to their size (which of course, is a bad thing). The size of each white snowball can and will vary. The frequency of these snowballs hitting your wall, however, will depend on how often you are throwing snowballs at the opposing side. Furthermore, for each snowball that you throw at the other side, you will get back a certain number of white snowballs or black snowballs (but never both). Your success in this snowball fight is measured by the size of the wall. How will you win this snowball fight?

Before I answer that question, consider that the size of the wall of snow matters quite a bit. For example, if the size of the wall is less than 10x bigger than one of the black snowballs, then you would have to be a cracker jack snowball fighter, because all it takes is a few black snowballs to obliterate your wall of snow. Not only that, but for each black snowball that punches a hole in your wall, you actually need a white snowball that is BIGGER in size than that black snowball in order to repair and restore your wall (it takes more time AND effort to repair something than it is to take it apart).

The other thing to consider is that the general, average size of the your white snowballs actually depends on the size of your wall of snow (among other things). If you have a big wall of snow, then the probability of you getting bigger white snowballs has increased. However, if your wall of snow is small, then chances are, you are not going to see very many big white snowballs. Not only does that makes it harder to recover from a black snowball hitting your wall, but your wall of snow will grow at a much slower rate.

The key to winning this snowball fight then, is to know what is under your control in this snowball fight. You cannot control the size of the white snowballs. You cannot control whether a white snowball hits your wall, or a black one hits your wall. But, you can control the size of the black snowball. And that is the key - make the size of the black snowball about 1/3 the average size of a white snowball, such that one snowball can repair the damage done by almost 3 black snowballs. And, you can always make educated and calculated guesses of the average size of the white snowballs that hit your wall based on past observations of these white snowballs. Follow this (seemingly) simple rule, and you will win the fight.

If any of this sounds familiar to you, then that means you’ve probably read Van Tharp’s famous book “Trade Your Way to Financial Freedom.” In this very comprehensive book, he uses the snowball fight metaphor (where white snowballs represent trading profit, black snowballs represent loss, and the wall of snow represents trading account size) as a way to help the reader understand position sizing, expectancy, and other keys to trading success. This metaphor is much better than the marble analogy that I described in my previous post on keys to effective trading. I’ve modified and extended Tharp’s snowball metaphor as described above so that it really helps to remind me of the critical importance of position sizing and controlling losses. The new insight that I gained from this analogy was how position sizing and controlling risk are actually dependent on each other. When using fixed dollar amounts for entering a position, and separately calculating the stop loss point, that dependency is hidden and will not be clear. But once you incorporate the amount at risk into calculating the size of your position, then it becomes pretty clear. Van Tharp does a pretty thorough job of explaining how to incorporate the amount at risk into calculating position size. If you don’t plan to read Van Tharp’s book, then at least take the time to check out one of the articles that TraderMike wrote regarding position size.

There is one important corollary that needs to be pointed out. My modified analogy above also serves to highlight the problems of being undercapitalized (which Prospectus also discussed here) - the smaller your account size, the slower and harder it is to grow your capital. This is because the size of your wins are relatively smaller. A 3R win on a 30k account (with R=1% of account size) means a 30R win on a 3K account size (with the same R=1%) - and how often will you experience a 30R win from a single trade? Right, so one subtle (yet important) corollary of this snowball fight analogy is that one of the requirements for entering the business of Trading for A Living is having sufficient account capital.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com