Regarding Skew + Money Management

Newsletters and Trade services like this one like to highlight their performance numbers. Usually, this comes in the form of a success rate. ‘70% of trades are profitable’ may be the way the headline reads. Besides the fact that such statements are not terribly helpful unless verified by a third-party service, it can lead subscribers down a hazardous road if such a statement doesn’t come with education and qualification.

Further, the longer you are exposed to professional traders, the more you will realize how lofty figures over 60% can be. Those that have blazed the hard trail of trading for a living are lucky to sustain a win rate well over 50%. It is at this point I expect some of you to gasp. ‘Isn’t a 50% win rate break-even?’, you ask. Not necessarily.

The problem is win rate is deceiving.

I bet that we can find a failed trader somewhere in the world who had a win rate of 70%. I know many traders successful with not much more than a 50% win rate. I have had a profitable quarter with a 30% win rate. What’s the difference between the high win rate failures and the low win rate winners? Skew.

Skew

Skew is our term for the amount an average winning trade wins compared to the loss of an average loser. You’ve probably heard the trading adage, ‘Let your winners run, and cut your losers short’. Yet it is so hard to practice. The phrase ‘risk to reward’ is synonymous with skew.

This sounds basic but it is one of the hardest things to practice. Yet, the benefit of doing so is the difference between an utterly failed trader and a successful one.

The math is simple. If you see a skew of 4:1 in your trades which means for every unit of loss you experience four units of gain, you can lose 70% of your trades, and still profit long term. This is true provided you manage your bet size properly, which will discuss later. In my own personal trading, I stick to a 3:1 win ratio as a minimum but in crypto often find 10:1 trades.

Is it not inspiring that you can potentially lose most of your trades and still make a solid return trading over the long run?

Control What’s Controllable

Often people end up in therapy due to control issues. They want to control their environment and the people around them. Over time the therapist may help them control their reactions not their externalities. Traders are often the same. They seemingly try to will the market to make their trades successful. They want to be right. And they think that being right is a badge of honor.

That’s trading with ego.

The reality is we don’t control the market. We make trades based on our read of trend and structure. But the market can still do its own thing. Yet we can control our entries and exits. Trading for skew vs. success rate makes use of this truth.

Managing Bet size

We can control a third aspect of trading: our bet size.

Note you can still ruin a good trading account if you take only high skew trades but overbet. In general, we suggest limiting the loss on one trade to 1% of your account. You may choose to risk 2%-3% for some trades but you must be careful. This means that you have calculated the loss on the trade at the stop level and the total loss is no more than 1%.

If you set out to trade quantity 100 of XYZ coin, with a $10,000 account, and you calculate the loss of the trade at the stop at $500, or 5% of the account, you don’t have to avoid the trade. You simply need to trade a quantity of 20 to get to a stop loss of 1%.

To emphasize, this doesn't mean you set your stop loss at a 1% drop from your entry. We determine stops by where counts invalidate. If you are not clear about invalidation, do ask. You must size the position to fit the risk on the chart and the size of your account. 

1% is a simple guideline that assumes over 100 trades you’ll see the law of large numbers kick in such that you have a reasonable win rate, ideally over 50%, with healthy skew. Such a mix will make you profitable long term.

Pyramiding also creates skew. On the board, you’ll often see us take positions before the ideal entry. This respects the law that the market can turn earlier than we expect. However, in doing so, we are taking small positions and building them larger as they get deeper in support. If your full position is not put on until just over the stop, your risk is small and your skew is high.

Controlling FOMO

Trading this way can lead to FOMO. If you follow this disciplined approach, you may not always have a full position as you move to the target. FOMO is probably the most destructive emotion in trading, almost as bad as ego. When you trade this way, you learn to enjoy the profit on the positions you have. Over time you’ll learn to build on those working trades as tighter supports show.

Elliott Wave + Skew

While Elliott Wave can seem predictive at times, we cringe a bit when it is treated that way. However, because the Elliott Wave defines ‘laws’ of market structure, and where your view is invalidated objectively, it is a great analysis technique for defining skew. Since there are rules to the proportions of each wave structure we can define accurate entry and exit regions. That doesn’t mean we are always right. But if our read is right, even if only 50%, and are disciplined in managing what we can control, we can be successful long term.

Traditional technical analysis (TA) techniques are often no better in success rate and much worse at defining key price regions. Believe me, Jason and I are just as versed in a wide range of TA methods.

The truthful reality of EWT is that we’ll have hot runs and cold runs. When we are hot, you will make a lot of money. But when we run cold, you will need to manage your funds and do so by sticking to the disciplines we teach. We’ll be in the boat with you.

Ultimately this style of trading is good for mental health as well as the pocketbook. We relinquish control where we do not have it. We release ourselves from the ego that pervades so many traders and we focus on the disciplines of trading vs, being right.