Think and Trade Like a Champion

A fool and his money eventually part. But only a moron does it over and over again.

Mark Minervini has been around for decades, placing his first trade in 1983. He won the US Investing Championship in 1997, bringing a 155% annual return, nearly double that of the next competitor.

Mark is a trading legend and believes that through quantifying and breaking down every last detail in a trading plan you can achieve stratospheric returns. He has been featured in Jack Shwager’s “Market Wizards” book series (also worth reading).

Unlike traditional money managers who believe PEs should be low, Minervini actively buys high PE stocks as this is where the momentum and growth is.

Looking back at all of the stock market darlings, they all traded on ridiculously high PEs at some point allowing traders to make extensive returns. How he does this is outlined in his books.

Contents

The trading book is split into 11 chapters, and in the first he outlines the importance of having a trading plan. Most traders don’t have a trading plan, and most traders don’t make money.

Do you see the correlation?

Mark does not believe in calling audibles – trades in the moment – and firmly states reasoning for having criteria for entering and exiting.

As traders, we are prone to human emotions, and automation removes a lot of our own weaknesses.

Key themes

First steps to thinking and trading like a champion

Even the right knowledge and hard work will not ensure success. People can have and do both of these things but end up practicing the wrong things. This book lays down a workable strategy that can be replicated in order to achieve trading success.

Winners are people who cannot stand to win. This goes against the advice we heard as children: don’t be a sore loser. Champions decide to become winners, and it becomes their daily focus. Minervini gives the example that in 1990 he decided he made the choice to become a champion stock investor. This was seven years after he had made his first trade!

The tale of two wolves

There are two types of trader inside everyone. One is the builder, who is disciplined and focused on process. The builder wants to perfect their craft and trusts that results follow successful execution of the process. Mistakes are viewed as valuable feedback in order to learn.

The other trader is the wrecker. They are ego-driven and very fixated on results. If they get it wrong, they find someone else to blame! This trader looks for excuses and rarely succeeds in the long run.

We are both the builder and the wrecker, but which trader will determine our results? Who will you choose to be?

Embrace the process

A team of psychologists in Berlin studied violin students in the early 1990s, from childhood, adolescence, to adulthood. The group had roughly began at five years old with similar practice times. They found that at age eight, the practice times began to diverged, and by age twenty the elite performers had racked up more than 10,000 hours on average and the less able performers had less than 5,000 on average.

No “naturally gifted” performers emerged. There was a strong correlation between practice times and ability. If you want to become a great trader, then you need to put the hours in. More specifically, it is not necessarily the hours, but the constant refining and examining your results for improvement that will make you a great trader.

Always go in with a plan

Trading is serious business with real money on the line. Despite this, most people don’t have any plan, and thousands of pounds are punted on stocks daily without any idea of what could happen. This is because of the ease of entry to the market these days –  brokers are cheap, no license is required to buy shares, we can just fund our accounts and buy and sell at will. Little research or planning is done by many because greed take over and they only think about what they can win, which usually ends in disaster.

Have a process

By defining the parameters ahead of time, Mark establishes a base for knowing whether his plan is working or not.

Having key elements of a trading plan give us a base to work from and then the opportunity to constantly refine and make adjustments. There are several concepts that should be included:

1. An entry “mechanism” that determines exactly what will trigger a buy decision
2. How are you going to deal with risk? What will happen if the trade moves against you, or the reason you bought changes suddenly?
3. How are you going to lock in your profits?
4. How will you position size and when will you decide to reallocate the funds

Contingency planning

The goal of a stock speculator is to be prepared at all times, and the best way to do this is to create “what if” scenarios and responses. What if your internet goes down? What will you do, where will you go? I have had this happen to me in Germany where no cafes have wifi; luckily I knew where the closest Starbucks was to travel to.

Mark gives an example of his brokerage firm going down system wide, and and he now keeps a funded second account so he can short against his longs should he need to. Disaster plans may seem silly, but having one can avert disaster. What would happen if you woke up and as you were drinking your coffee calmly by your desk you realise your biggest position has had a massive profit warning and is gapping down 30%? Gap downs are not nice.

Priorities in order of importance

1. Limit your loss. Know what you’re prepared to lose and set a stop-loss.
2. Protect your line. Once the stock moves up and shows a decent profit the stop should be moved up near the breakeven point.
3. Protect your profit. Don’t allow good sized gains to slip away; use a trailing stop or a back stop.

Avoid the paralysis-regret cycle

Often, traders and investors buy a stock and then have no clue what to do next. All of us switch between two emotions: indecisiveness and regret. Both of these hinder us in the stock market, but we can remove them by having a detailed plan. Without one, we will constantly be questioning the same things:

Indecisiveness

• Should I buy?
• Should I sell?
• Should I hold?

Regret

• I should’ve bought
• I should’ve sold
• I should’ve held

This book is all about having rules and following them.

Approach every trade risk-first

Stocks don’t manage themselves. We manage them.

Every morning, Mark looks into the mirror and says to himself “you have the capacity to do serious damage to yourself today”. He does this to acknowledge his own capacity for self-destruction and to remember the most important words in trading: respect risk!

Where’s the exit?

Mark knows where he is getting out on every single stock, without exception, before he puts the trade on. He doesn’t focus on the upside, he looks at the downside.

Trading without a stop-loss is like driving a car without brakes. It might work for a while, but eventually, you’ll crash. A strong market may bail out the risky trader for some time, but in the end, those who trade without stops eventually stop trading.

Rules are meaningless without discipline

The problem with mental stop-losses is that it is easy to move the stops down when the stock goes against you. The old “let me get back to breakeven then I’ll sell” often comes into traders’ heads.

Every huge loss starts as a small one. The only way to protect a trade from turning into a huge loss is to take small losses before they snowball out of control.

Avoid the emotional stop-loss

Everyone has an “emotional stop-loss” – this is the point where the pain is too great than holding onto the loss. For most investors, this is far beyond the point where losses are optimal and these do significant psychological damage as well as significant portfolio damage.

Your firepower will be weakened and also your mindset. Don’t be the short term trader who becomes a long term investor on the account of holding onto losses they really ought to be selling.

Not losing big is the single most important factor for winning big.

As traders, losing is not a choice. It’s an occupational hazard. But how much we lose is always a choice. Trading risk-first is the rule that will keep you in the game when all of the undisciplined, unprepared, and unfocused are forced to the poorhouse.

Never risk more than you expect to gain

When we flip a coin the odds are always 50:50. But if we stood to gain £2 on a heads and lose £1 on a tails, how many times would you want to flip the coin?

Risking £1 to make £2 is a great strategy when the odds are even, but what if we are risking 10% to make 5%?

We would need to be right more than half the time to make money, almost 70% of the time. Most traders do not have this level of consistency and so to avoid losing we should never risk more than our average gain.

Your batting average

Mark gives an equation with which we can use to calculate how to build in failure.

Percentage of winning trades (batting average) * average gain / percentage of losing trades * average loss

If our batting average is low then we have built in failure; we can be wrong many times and still make money.

Adding exposure without adding risk

Mark likes to add to winning positions, and pyramid onto them as much as he can. By adding to positions he can double his exposure and move the stop-loss up to keep the same amount of risk.

This method uses paper profits to finance larger rewards whilst keeping the risk constant. Playing mathematical percentages that are in our favour will ensure our success in the long run.

Stock trading is much like poker as they are both about what happens over time. Playing the premium hands in poker is playing the best trades with the lowest possible risk. You can lose little and often but because of discipline and mathematical edge you can become a long term winner.

Know the truth about your trading

In business, what gets measured gets managed. KPIs and sales figures are all the subject of analysis and how they can be improved. This should be no different to your trading and you should seek to optimise every part.

The most important number is your average gain. For example, if you are gaining 15% on a trade on average, and you have a 2:1 reward/risk ratio, then your stop would need to be 7.5%.

Keeping track your portfolio on a monthly basis will ensure that you are constantly keeping track of your results. In good months, focus on what went right and how to extend the winners. In losing months, it can help to see where you went wrong.

Your personal bell curve

Mark recommends that we keep a distribution of our gains and losses on a bell chart.

The idea is that we have a very short left sided curve (the losers) and as we run our winners we should have long tails on the right on the curve. Cutting losers and running winners is what trading is about. With a positive batting average more data should be included on the right side of the chart than the left.

Turnover and opportunity cost

In the stock market, time is money, and so is opportunity. Small gains compounded over time add up have surprising effects.

Four 20% trades compounded turn £1,000 into £2,073.60 (not including trading fees). It’s much easier to hit four 20% trades than it is to hit one 100% trade. Six 10% gains will yield almost double the total return of one 40% winner.

Regardless of your metrics, the end goal is the same. Having your gains on average be larger than your losses, nailing down profits, and repeating.

A win/win solution to protect your psyche

As a trader often has to deal with regret and indecision, sometimes the best way to protect your psyche is to sell half when in doubt. Unsure if you should bank the profit now or let it run?

Selling half is the perfect solution. You bank some gains, but you retain a holding in order to benefit from the upside.

This strategy only works if you sell exactly half, as it becomes win-win whatever happens. If the stock begins to drop, then you’re glad you sold half. If the stock goes up, you still have half.

Do what most traders don’t do

If you want to become a successful trader, then simply look at what most traders don’t do and do the opposite. Most traders don’t respect risk, or have stops. Most traders don’t look after themselves physically, and trading is both an emotional and physical game.

By adopting healthier habits such as eating right and exercising regularly you will put yourself in a much better base to build from. In this business, you can either make money, or you can make excuses – but you can’t do both.

Compound money, not mistakes

Compounding mistakes can be a terminal mistake. Back when Mark started, he made the deadliest mistake of all: averaging down. Instead of cutting his loss, the rationale of buying more when the price declined was that he could lower his average cost and so remove the red ink quicker on his book.

This is a common theme in investing – if you liked the stock at £20 then you’ll love it at £15. Mark argues that this is exactly why accounts get blown up, because they compound mistakes and money [there are many successful investors who average down such as Peter Lynch but this is a summary of Mark Minervini’s book].

Cutting losses

The second chapter looks at why having a risk-first approach is the only approach a trader should take. If you can’t cut your losers, then eventually that loser will be so big you will have to stop trading.

There’s no shame in being wrong in this business, but staying wrong is a shameful choice.

If you want big returns in the stock market, then you have to do two things: 1) Make big money when you’re correct, and 2) avoid big drawdowns when you’re wrong. Losing is not a choice for a trader – it is an occupational hazard.

Many investors are scared to sell, because often when they sell, the stock reverses and makes them feel stupid. This is ego taking over. What if the stock doesn’t reverse and keeps going down? You never know. Once ego takes over, you hear those four very dangerous words: “just this one time”.

This is the slippery slope. It is similar to an alcoholic saying “just this one drink” or an addict saying “just this one shot of heroin”. Sometimes it will work, but if so then you are being rewarded for bad habits, and this only encourages the behaviour. This is dangerous behaviour as it can make you think you’re a genius, but the next time you do it the stock can fall 50% or even further – 100%.

The 50/80 rule

This rule says that once a secular leader has put in a major top, there is a 50% chance that it will decline by 80% and an 80% chance that it will decline by 50%.

Have a look at all the market leaders of yesteryear and see what happens. Every major decline starts as a minor pullback, and this rule serves as a cautionary reminder that we should not throw our good money after bad.

When to sell and nail down profits

Selling brings its own emotional pressures, and selling at a profit is not as easy as it looks. This is one of the biggest indecisive moments in trading, as selling too soon can leave you with regret, and selling too late can also leave you with regret! It is impossible to sell at exactly the right top.

The emotions of selling at a profit

There are two scenarios in which to sell. One of these is into strength. This is how the professionals sell, as they take advantage of the liquidity when the stock is moving in their favour in order to unwind their position. When the fish are biting – keep feeding them!

Another advantage of selling into strength is that the stock can reverse, and this can often be worse than the prices you were offered when the price was rising.

The base count

Knowing when and where to sell requires analysis, just as deciding when to buy does too. One way to assess the decision to sell is by working out where the stock is in its own cycle. This matters because it will help you gauge the likelihood of a continued move or if it is late in the trend.

When the stock is in the earlier stages of an upward move, we want to give the stock time to make a full scale advance. This could be a new leader about to make a huge move which we would want to capture. Late stage stocks should be treated differently as they are more likely to be putting in a top.

Evaluation and improve

Positive expectancy is covered along with how to use the statistics available to you to improve your trading.

If we don’t know what we are winning or losing, how can we know what we should be doing better?

Common mistakes are covered, and several chapters refer to Mark’s SEPA strategy on stocks. This methodology is US-focused, but the setups can be applied to FTSE and AIM. It is a breakout focussed strategy with certain criteria, but I have adapted it for London markets for my own trading. Position sizing is mentioned and how to position for risk.

The art of selling

The art of selling is covered extensively. Personally, I believe exits are far more important than entries, yet everyone focuses on their entry.

Not entering a trade will change on your P&L, but it is the cumulative effect of your winning and losing trades that will define your success as a trader.

Knowing when to sell, and when you should be getting out of a trade, are skills that benefit any trader or investor regardless of the instrument traded.

Mindset is key

Mental mindset is a great addition to this book. Psychology is an underplayed part of being a trader in my opinion. Anyone can do this job and be a successful trader, but not many have the determination or the attitude to succeed.

You can vastly increase your chances by literally changing how you think (if you read that comment thinking “that’s rubbish” – it’s likely you already have your beliefs about the stock market and are unwilling to change them. This will hinder you in the stock market because the market does not care for your beliefs).

Minervini really drives the home that trading is actually a business. If you don’t take it seriously, you will be crushed. Many AIM investors are sold the dream, but they don’t buy the risk that is left on the shelf. You can make huge amounts of money in this business, but only if you earn it.

Conclusion

This is a book to read, re-read, and re-read again. It is essential for anyone who wants to make serious money in the stock market to learn from someone who actually has made serious money in the stock market.

A lot of people are teachers and not traders, and all of the academics who preach that the stock market is efficient never beat the market (mindset!).