I find this interesting, for the fun......

You Cannot Ignore the Fundamentals, Part II

by Van K. Tharp, Ph.D.  

In tip number 81, I gave you a ten question quiz on some of the fundamentals behind trading success.    Hopefully, you got the answers to the questions and now you can rate yourself.   So here are the answers.

1. You buy a stock for $25.  You want a 25% trailing stop.   Where is your initial stop?

Answer:  Your stop should be the current price times 0.75 or $18.75.  You take 75% of it, because if you subtract 25% of the price from the current price, you have your stop and that?s equivalent to 75% of the entry price. Give yourself 10 points if you got it right. 

2. The same stock moves as high as $40 and then back down to $37.   Where is your stop?

Answer:   You have a 25% trailing stop.   That means that each time the stock makes a new high (or closing high if you prefer) than you take 25% of that as your stop.  This is your new stop.   So the prior high was $40 and your new stop is 75% of that or $30.   When the price moves down you do not change your stop.  Give yourself another 10 points if you got it right.

3. You have a $25,000 account and you don?t want to risk more than 1% of your account on this stock.   How much of your account can you risk?

Answer:  Your risk is 1% of $25,000 which is $250.    Give yourself 10 points if you got it right.

4. Given your answer in question 1 and 3, how many shares did you buy?

Answer:  Your risk is $6.25.   If you divided your risk per share into your total risk allowed you would end up with 40 shares.  Again, give yourself 10 points for a correct answer.

5. You buy another stock for $38, but this time your stop is only 50 cents away.   How many shares can you buy to only risk 1%?

Answer:  Since your risk is only 50 cents, if you divide 50 cents into $250, you end up with 500 shares.   Give yourself 10 points if you got it right.

6. You think that?s too many shares, so you want to base your stop on the volatility.  The average true range over the last ten days of the stock has been three dollars.  You decide to base your allocation on volatility.   How many shares can you buy?

Answer: Here you divide your 1% risk or $250 by $ share.   Your answer is 83.33333333 shares. Round down to the nearest whole share, and your answer is 83.  Give yourself 10 points if you got it right.

7. Since your stop is still at 50 cents, how much are you risking on this position

Answer: You are actually risking 83 times 50 cents or $41.50.   Give yourself 10 points for that one.   Your allocation went down because it was based upon volatility.   Your stop stayed the same, so you are actually only risking $41.50.

8. What?s your total investment amount for the first stock and for the second stock?  How is this different from risk?

Answer: In the first example, you bought 40 shares of a $25 stock.   Your total risk was $250, but your total investment was 40 times $25 or $1000.   Notice that you have a 25% stop and that your risk is 25% of your investment   Give yourself 5 points for that one if you got it right.

In the second example, you either bought 500 shares based upon risk for a $19,000 investment or you bought 83 shares based upon volatility for a $3154 investment.   Either one is acceptable, so if you got one of those give yourself 5 points.

9. What is the variable that accounts for most of the performance variability that you are likely to encounter? (assuming that you have your psychology together).

Answer:  Position sizing.   Give yourself 10 points if you got it right.

10. What have I define self-sabotage to be in these tips?

Answer:  Repeating the same mistake over and over again.   Give yourself 10 points.

Bonus Question:   If you sold the stock at $50, you made a profit of $25.   That?s 4 times your initial risk of $6.25, so you made a 4R profit.

10 more points if you got it right.

Your total score could be as high as 110.

If you score, 100 or better, then your understanding of these fundamentals is excellent.  Keep up the good work.

If you scored 80-90, then you need a little work.  Figure out where you are weak, and do some homework.   Start with Trade Your Way to Financial Freedom if you have not read it.

If you scored 60-70, then you need a lot of work.   Again figure out where you are weak and make the effort to understand the material.   It?s not rocket science.   It?s simple math.

If you scored 50 or less, it might be because you are new to trading and these principles.  If that?s the case, then you have a little work to do.   If you?ve been studying this material for some time and still got 50 or less, then perhaps trading is not for you.

Sebastian Chong ? retired NUS associate Professor in Accountancy.

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