Category Archives: Trading

Professional vs Amateur trader

Traders

This blogpost is a small effort to delineate the thought process of a Professional in comparison to an amateur trader.

Introduction

It is a common understanding that trading profit on any given trade can be construed as the compensation we receive for the risk we took on the trade. Traders take risk, in the sense they routinely make judgments with uncertain outcomes. So it would follow then, that good traders don’t try to eliminate risk as much as manage it, and instead, can increase their chance of profitability by better reducing that uncertainty !!

This can be accomplished by making better trading decisions than those that are less informed, less knowledgeable, and less skilled. Ultimately, it is not what the trader knows, but who he is. The really consistently profitable traders are able to ignore or subvert their natural tendencies to do what feels comfortable, and instead, do what is necessary, to be optimally profitable over the long run.

Amateur traders

1. Watch what other traders do and be sure to follow the crowd. After all, they have been trading a lot longer than him/her and hence, naturally they should be more ‘smarter’

2. Never worry about using stop loss orders. When the time comes, he will be able to sell his open position(s) and take a loss. Our emotions won’t even come into play. Besides, stop loss orders are for weaklings 🙂

3. Setting high standards to achieve and feeling beaten when they fail to meet their expectations. Suddenly,they are disappointed/stressed out,and prone to make trading errors. Losses start to mount,mood worsens and before they know it, they find themselves in a deep psychological hole of despair.

4. They dislike regret more than losses. Their avoidance of regret is more powerful than the fear of loss. It’s one thing to make a losing trade, but it is quite another to feel that we’ve made a mistake, and continually berate ourselves for making it.

Professional traders

1. They don’t give a hoot about anything/anyones opinions of what the market will/might do.The very news/opinions that surround them becomes the mortar for their brick wall of defense that protects their completely independent thinking (Keyword here is ‘Independent’)

2. They have incredible discipline to not buckle under pressure. They have a perfectly clear head and understand fully what they do and how they do it. Battle wounds and memories of defeat are more valuable to them than the money.

3. Their self esteem do not rise and fall with trading results. Their self concept is strong/durable and not at the mercy of the current, last, or next trade.

4. As they know that their experience in markets is a reflection of their personal life, they keep their personal life/finance in order as that will nicely percolate into their trading. They take care of their bodies with healthy diets/exercises, while understanding that recreation is a vital activity in keeping trading performance at peak level.

Conclusion

A budding trader’s goal should be to move from the 1st group (amateur trading) to 2nd group (professional trading) as early as possible. It is easier said than done though.

Please do remember that ‘Winning’ is just the culmination of lessons learned by making our own mistakes – not from other people’s mistakes. Many folks would disagree here and they believe that one can learn from the mistakes of others in trading. This statement is absurd, to say the least. Especially in an experiential profession like trading the markets where one has to go through the path on his own. Our biggest nemesis is in between the ears and one has to face their own demons(often unique) in trading.

Want to end this blogpost with this thought – ‘Professional traders attitude’ can be abbreviated as FEDCOP

Focused (on the trade only)
Emotionally Stable (treat winning and losing the same)
Disciplined (in trade management)
Confident (in methodology & risk management)
Objective (Unbiased)
Patient (to wait for the opportunity & to maximize profit)

Happy trading !!

Get comfortable being wrong

ComfortZone

Human nature is to be right all the time. Nobody likes to be wrong even in petty/useless arguments. This particular thought process is one of the primary reasons for many opting for methods that shows high winning percentage with abysmal Risk:Reward ratio. Many of the world’s renowned traders are trend followers and trend following usually delivers something that human brain is not used to – More losers than winners with superior Risk:Reward ratio.

Introduction

In trend following type of trading, the usual combination is low winning percentage with high Risk:Reward. This requires a trader to get comfortable with the fact that we will most likely be wrong more often than we are right.

That concept is tough for a lot of traders,as many of us believe that to be profitable we need to be right more than we are wrong. but nothing could be further from the truth. Yes, for scalping that is partially true, but for swing trading, with the proper risk to reward ratio, we can be profitable even if we are wrong more than we are right.

We just need to have the patience to wait for a trade to come, and also patience to wait for a trade to work.

Here is a blogpost on patience

Deliberate practice and patience

Trend following and surfing

Unlike surfing, we don’t get the luxury of knowing which direction the WAVE we are on is headed, but trust me, it is going somewhere and is not going to sit around in any one place for very long. This is the one and only guarantee in stock markets 😀

We may spend days watching for a sequence of events, enter a trade and get stopped out in minutes. But if we are a trend follower, we have to just get back up and start watching again. That is tough to swallow for traders who enjoy the adrenaline of a fast-paced trading environment

Trading and action

If a trader cannot wait and always in need of action, trend following will never work for him. For that matter, any kind of trading would be difficult.

Many traders love the frequent adrenaline rushes that come with trading. And, the more frequently they trade, the more they feel that they are hitting the fast forward button on their way to riches.

By the way, most successful traders and investors are systematic. Systematic sounds technical or quantitative but that’s far from the truth. All it means is that there is a process to guide proper decision making. When A happens they do Y, when B happens they do Z. Warren Buffett and Benjamin Graham has a very systematic process in searching for their stocks. Ray Dalio from Bridgewaters Associates has a very systematic fundamental approach to capital markets.

Trading and drudgery

Many a times, people ask this question to me. It always pops up in different ways –

Should i pursue the dream of becoming a successful/consistently profitable trader in spite of all these drudgery?

I remember a movie honcho once said that when people asked him if they should continue to pursue their dreams of movie stardom, he would always tell them ‘NO’. His reasoning was simple – no one destined for success would be dissuaded by him anyway, nor for that matter would they even have asked the question in the first place.

It’s that solitary “march to your own drummer” mentality that mark those ordained for success 🙂

Trading and negativity

So, to be effective in trading (and anything in life), kindly distance yourself from negative energy – no matter where it comes from. Let negative thoughts roll over like water. Negative thoughts, emotions, energy is destructive multiplier. It kills creative uni-directional thinking. Detach yourself from things, other people and immerse yourself in the price. Lose sense of time and space.

Think of an activity that you enjoy, we lose sense of time and space when we get involved right? So, let me ask this question then –

Why does trading have to be stressful, painful, edgy all the time?

Get comfortable being wrong and detach from negativity

Happy trading all !!

Your trading is exciting or boring?

Trading is boring

Introduction

Many folks find trading the markets pretty exciting. Why not? Seeing the tickers move wild can give great excitement to anyone and the prospect (not actually making money..just the prospect) of making money can give the best adrenaline rush . A fun-filled activity right? As a matter of fact, they become really sad when the markets are closed as there is no fun in mundane daily activities.

And there are certain set of people who find trading the markets as downright boring. Surprisingly, majority of the consistently profitable traders find this endeavor a really boring one. For them, it is a matter of doing the same thing over and over as long as it keeps on working. Without deviating and without looking for something new. Without getting antsy about “missing out” some great opportunity somewhere else.

Hard work and belief in the process

Let me get this straight – Trading is hard work at the start, but it should be effortless during the trading process. Good or professional traders know this really well. In fact, trading should be boring to some degree when we have our system and methodology down. The reason for this is we know when to pull the trigger and when not to. If market gaps against our position, we know what to do. We know how to react when the time is right. However, it requires hard work to get to this level of professionalism.

Two sides of the same coin

Trading the markets in itself is contrasting in nature. We must be confident, but ego-less. We must be mechanical but analytical, focused but relaxed, and disciplined but willing to learn. Our decisions may appear to be binary, buy or sell but they are markedly more complex.

Acquiring the knowledge of trading mechanics, maneuvers, ideas/strategies, and risk/money management is a relatively easy and determinate process. But, developing the mental skills of focus, discipline, objectivity, and self confidence are much more challenging.

In fact, it’s the one area of trading performance that gives the pleasure of incessant learning experience for the practitioner (trader) , and for some a continuous scuffle (and might feel like never-ending ordeal)

Trading and lack of knowledge

The problems and challenges we face in trading are not due to a lack of knowledge/information, but are due to a lack of patience and self-confidence. Once again, ‘it is never a lack of knowledge’. The sooner we understand it, the faster we can pave the path to recovery.

Enhancement begins with changes in how we choose to think, act and be. Positive changes that will only be realized when we make a decision – a choice to learn to let go off the selfish/self-defeating side of our emotions which blocks our minds and garbles our decisions.

Trading and self-introspection

I will be the first to admit that the journey onto becoming a successful trader is mired with twists and bumps all along, filled with great triumph, and frustrating distress, but everyone has the talent to succeed and the power to create value in their lives.

Now some serious questions to ponder upon —

1. Are you patient enough to wait for the planned trade set up?
2. Are you ready to wait until a valid buy / sell signal is triggered (not jumping the gun)?
3. Can you place and execute the required orders, before the prices move away from the price of entry?
4. Can you focus on your trade without any sort of disturbances, until the trade is completed.
5. Can you patiently follow your exit plan (even if the market moves up and down in-between)?

When we try to introspect by answering these questions, we readily identify that it is not our ‘lack of knowledge’ that is enabling us to lose money in trading but it is the lack of patience(in order to seek excitement).

So, let us focus on acquiring the non-glamorous skills and trading will become more boring than we would have ever imagined !!

Achilles heel of a Discretionary trader

Discretionary trading

Achilles’ heel was an unguarded weakness that ultimately brought down a hero of Greek mythology and this post is an attempt to understand the things that has to be kept in mind while designing a trading methodology as a discretionary trader.

As many of you know that am a mechanical(rule based) trader, my trading day is pretty monotonous and boring, many a times. The other group of traders are often called as ‘discretionary traders’. Both groups have their advantages/disadvantages and one should follow what they are comfortable with. At the end of the day, both discretionary and systematic traders have the same goal – making money.

What is discretionary/mechanical trading?

Discretionary trading is decision based trading – when the trading idea shows up in the charts, the trader decides(at that moment) whether to take the trade or not based on current market conditions. Discretionary trading does not mean random trading. Every trader(mechanical or discretionary) has a methodology to enter/exit the market – there are no two ways about it. For example, even if all the conditions are met for a trade, a discretionary trader will not take the trade as volatility is too low (current market condition) – so, basically the trader decides to let it go seeing the current market condition.

On the other hand, Mechanical trading is driven by rules. The trader do not make any decision on taking the trade but the system does. If A happens, then the trader go long and if B happens, the trader goes short. There is no element of decision making involved by the trader as everything is planned out beforehand and the trader just has to execute those trades.

Designing a trading methodology as a discretionary trader

There are certain things discretionary traders should keep in mind when they design their system. More often than not, the psychological pressure of making the ‘quality’ decision of whether to take the trade or not can overwhelm a discretionary trader. To understand this behavior, we need to analyze how our brain works.

A. How brain works?

Evolution has effectively given us (human beings) a dumb brain and a smart brain. The smart brain runs the show most of the times unless a threat is present/perceived and consequently, the dumb brain takes over. Why? The reason is very simple – Dumb brain is faster at making simple/resolute decisions. This avoids people taking a long time on making a choice as time is critical in predatory situations. If we take too much time to take a decision on ‘fight or flight’ situations, there is a good possibility of ending up in the jaws of a predator 🙂

B. Markets are there to get me

With this understanding in mind, one can easily comprehend why this could create a problem in trading as our natural responses can be inappropriate and the way we view/assess info changes when the dumb brain takes over.
Our brains are built to handle belligerent situations and hence, even in a normal situation in trading (like a loss – by the way, many dont consider trading loss as normal 🙂 ), we tend to do things like making “revenge trades”, which is treating the market like an adversary.

Think about it for a second – this is tantamount to curve fitting data so that it fits our trading model but only here, we are fitting the market to how our behavior and natural responses are designed to interact with predators. This is exactly why we see people saying ‘Markets are there to get me’

C. Demo trading and tunnel vision

As a discretionary trader, when we do demo trading of our ideas, we almost always get superlative results. The reasons could be multi-fold but the important one is so evident. When we practice in a non-stressful situation, we evaluate our success based on how our smart brain handles the situation. Under stress, in real trading, we might find that we fail to notice things that are obvious when we look at the same information after the stress has passed. People tend to overlook/ignore information that is contradictory to their analysis of the situation. In behavioral science, this is often called as “tunnel vision“.

Let us sit on this ‘tunnel vision’ for a moment. Like the airport traffic controller who ignores contradictory information (as he is affected by stress), traders fail to exit a losing trade, because our discriminative attention ignores things that indicate it’s time to get out of the trade. Practice (or demo trading) does help, but many traders find that their behavior is different under stress.

So, when a discretionary trader designs/practices a system, he needs to consider human behavior, psychology, and the human factors that were discussed here. In another post, i will discuss the difficulties in being a mechanical(systematic) trader.

Final thoughts

As it generally happens in any endeavor specific to a competitive pursuit, people end up with hallowed beliefs without subjecting them to rational scrutiny. The subject of ‘which style of trading is better’ is one such associated with the business of trading and is a favorite ‘peg to hang’ blame for failure in becoming a successful trader by many.

This blogpost does not favor one over the other – Pick the one that best suits you and pursue trading in that direction.

Happy trading all !!

Great lesson from Mahabharata – Visualization

Visualization

Most of you already know that am not a religious person but the mythological books can teach us many life lessons. So, my reading habit obviously gravitates even towards mythological stories/ books.

One such lesson can be learned from Mahabharata – it is about visualization.

What is Visualization?

Visualization is simply a mental rehearsal. We create images in our mind of having or doing whatever it is that we want. Visualization techniques have been used by successful people to visualize their desired outcomes for ages. The practice has even given some high achievers what seems like super-powers, helping them create their dream lives by accomplishing one goal or task at a time with hyper focus and complete confidence.

The typical visualization pattern comes from the sports world, where an athlete would imagine themselves winning a championship or standing on the podium receiving a medal.

The key to visualization is to visualize that we already have what we desire. This is simply a mental trick. Rather than hoping we will achieve it, or building confidence that one day it will happen, live and feel it as if it is happening to us right now. On one level, we know this is just a mental trick, but the subconscious mind cannot distinguish between what is real and what is imagined. Our subconscious mind will act upon the images we create within, whether they reflect our current reality or not.

Elite athletes use it. The super rich use it. And peak performers in all fields use it.

Visualization in Mahabharata

After losing in a game of dice, the Pandavas were exiled to the jungles as per the bet waged. So, one of those days, Arjuna – the great archer was eating his dinner in the light of an earthen oil lamp, when a gust of wind
extinguished the flame. Arjuna continued to eat, his hand accurately reaching his mouth every time he ate a morsel of grain in the dark. At this exact moment, a sudden flash of thought embraced his mind.

If it was so easy to accurately place a morsel of food in his mouth, due to force of habit, the food not going into his eyes or nose by mistake, why was it so difficult to aim and shoot down a target in the dark ? This fired him up and the restless soul set about practicing archery in the dark, after staring at the target all day in the sunlight.

The mission was very clear and simple – the mind should be trained to know where to shoot from memory, just as it knew where to guide the hand containing a morsel of food in pitch dark. After months of rigorous practice, twanging his bow all night, for months, Arjuna attained mastery of the dark. The hard work paid off and helped the Pandavas win the battle of Kurukshetra years later. This is sheer Neuro linguistic programming (NLP) in work and ofcourse a lot of visualization before entering the actual arena.

Key take way and usefulness in trading

We all are Arjunas but we just lack something important – a sheer target practice. The mind can and should be trained. Samurais train with their Katanas thousands of times before attaining mastery of the sword. History tells us again and again that it can be done.

In trading terms, Visualization can help us cope with stressful situations (like visualizing to stay calm when we are in a trade) and to reinforce good habits. If one has issue in pulling the trigger/exiting early/jumping the gun, Visualization can be immensely helpful.

Thoughts are things and they create the beginnings of getting any result. The thought process includes not only what we’re telling yourself, but also the pictures that those thoughts summon.

Happy trading all !!

Getting out of comfort zone

Comfort

We have often heard successful people mentioning in their speeches/articles that one should ‘Get out of their comfort zone’ to taste success. What this phrase really means?

If we really break down the phrase “Getting out of your comfort zone” it means doing things that we don’t feel comfortable with doing.

Historical references

1. In the 3rd century B.C, General Xiang Yu sent his troops across the Yangtze river to fight the Qin dynasty. While his men slept, he ordered all his ships to be set afire. Basically,they cant go back quitting. There is only one way ahead.

Next day he told them, you now have a choice – fight to win or fight to die. This technique was followed by the Spanish conquistador Cortes in the Sixteenth century in Mexico.

2. In World war – II, Group Captain Adolph Gysbert “Sailor” Malan of the Royal Air Force instructed rookie pilots – if you want to be a crack fighter pilot lad, learn to ditch your parachute !!

3. In Indian history, we have a great example of the battle that happened to capture Singhad fort. After the fall out of Tanaji, his Brother Suryaji cut the ropes with which the troops entered the fort and addressed them ” Either die fighting or Jump off the fort and die – Your choice” This happened around 1670 under Great Shivaji in the battle of Singhad fort near Pune.

Behavioral references

Psychology professors Dan Ariely (he is my personal favorite) and Jiwoong Shin conducted extensive tests on subjects on why people cling onto multiple dating. They found that male and female subjects often latched on to multiple dating partners, refusing to commit to a formal relationship for the fear of losing the comfort of other date partners. They wanted the “safety” or “comfort” of numerical strength.

Often in life, we are required to burn our ships like General Xiang Yu to cut out the option of retreat from a difficult situation as a measure of self-motivation. In extreme circumstances, ditching our parachute like Group Captain “Sailor” Malan advocated becomes necessary to come out of our lazy, comfort zone.

Disclaimer: This tactic however, needs to be extremely/well thought-out and strategised. Cannot be applied to every situation in life – extreme due diligence is required !!

Nevertheless, as they say, “Life begins at the end of our comfort zone”. So, lets get out of comfort zone and the whole world is ours to explore 🙂

Never start your trading day with an hungry stomach

Brain

Indian stock market starts at 9:15 am. Well past the usual breakfast time for many. Yes – this post is about food 🙂

Behavioral science has been blessed with many stalwarts. Roy Baumeister is one of them. As a behavioral scientist, he wanted to ascertain whether remaining hungry and / or craving for food (though not starving) impacted a human being intellectual performance. As it goes with many researchers, he conducted an experiment.

Details of the Experiment

Two batches of 30 students each, of equal IQ and academic performance were selected. They were locked up in separate rooms for 60 minutes and given an exercise to master in mathematics. In both rooms were ovens, which were halfway into baking cakes and cookies. B

Batch # 1 was instructed to stay away from the oven even after it finished baking and was banned from consuming a single cake/cookie. Batch # 2 was instructed to wait for the oven to cool off before enjoying the confectionery.

Result of the experiment

After the designated 60 min timeframe, Roy Baumeister found batch # 1 floundering in their mathematical questions, whereas batch # 2 breezed through it.

Upon interviewing them, students of batch # 1 admitted that majority of their mental energy was spent in fighting their salivating mouths, the aroma of the cakes & cookies and deep emotional craving for the goodies. This was a great revelation.

But, the experiment did not end there. The roles were reversed and batch # 2 was forbidden from savoring the cakes & cookies and their performance went south as well. This is a very critical piece of information that can be used by traders as it can affect our logical decision making capabilities.

Final thoughts

Next time you decide to skip breakfast because you’re in a rush, please do remember this experiment and how our mothers force-fed us before packing us off to school. One might call that as ‘love and affection’ but indirectly, it served us well.

Moral of the experiment – Never start your trading day with an hungry stomach 😊

Roy Baumeister Profile

https://psy.fsu.edu/faculty/baumeisterr/baumeister.dp.php

Happy trading !!

Twitter poll on expectancy

Trading Journal

I had put a poll on twitter yesterday with options to choose from various combinations of Winrate and Risk:Reward(RR)

Here is the twitter link:

44% of the voters chose Option 4, 32% of the voters chose Option1, followed by Option 2 and Option3 respectively.

Before getting into the groove of things, I would like to elucidate a bit about ‘Expectancy’ of a system. This term was coined by Van Tharp and here it is:

Expectancy = (Win rate x Average winner) – (Loss rate x Average loser)

If we insert this formula with the numbers given in the poll, We get the following –

Expectancy of System 1 = (0.5×2.2) – (0.5×1) = 1.1 – 0.5 = 0.6

Expectancy of System 2 = (0.7×1.2) – (0.3×1) = 0.84 – 0.3 = 0.54

Expectancy of System 3 (I meant to give the RR of system 3 as 1:0.8 but gave it as 0.8:1 – we will stick to what was given in the poll)
= (0.8×1) – (0.2×0.8) = 0.8 – 0.16 = 0.64

Expectancy of System 4 = (0.35×4) – (0.65×1) = 0.75

So, what is this expectancy? Expectancy is how much one can expect to make on the average over many trades. Expectancy is best stated in terms of how much you can make per rupee you risk. Tharp talks in terms of R-multiples but let us just focus on it in layman terms.

If someone risks 1% per trade and their system expectancy is 0.5, it just means that over a large sample of trades, he is expected to make 0.5% (1% x 0.5) per trade. So, if he has 100 trades in a year, he is expected to make (100×0.5%) 50% that year.

Surface level analysis of the poll results

1. It is quite obvious from the above calculation that higher the expectancy, greater is your chances of making money in the markets. So, as a new trader, it is pretty easy to select the option # 4 from the choices. No brainer there.

2. Few people pointed out that Option 1 is better as it is easy on psychology of the trader. It is true to an extent but if one is striving for better risk adjusted returns, option 4 is the obvious choice again (especially for a pure trend follower). Different people, different choices 😊

3. Some people take profits on the way and they would have naturally gravitate towards a better winrate system with lesser R:R. The traders who trail profits will almost always have a lower WR but better RR system in hand.

4. As I always advocate that there are various ways to skin the cat, nothing is right or wrong here. We just need to pick what is comfortable for us. But, if one has to analyse logically, it is option 4. On a side note, one comment mentioned that we need to find system that have a expectancy like the choices mentioned 😊. Fair enough !!

5. The traders who are new to the market gets enamored by the high winrate for a very simple reason – typically, they don’t want to take losses (Forget about newcomers – even the experienced lot do not like to take losses). Their mind can never get around in accepting the losses. So, they naturally gravitate towards high winrate as high WR typically means more number of winners than losers. But, what they forget is the other side of the coin – the Risk:Reward. They lose more when they lose and win less when they win. This has many statistical implications. We will see that in detail in the next section of this post.

6. Winrate and Risk:Reward should be seen together. They are like peas and carrots, day and night – always go together. This is why I like this expectancy as it nicely clubs both the parameters to give a logical view of the system in hand.

7. Few people have voted for option 3 as they feel high winrate can give them the psychological comfort – again, this is just another way of telling that ‘I don’t want to take losses’. As some great trader mentioned. ‘avoiding losses in trading is like you want to breathe in but don’t want to breathe out’. But if it works for you, great !!

In-depth analysis of the poll

1. Most of the stock market strategies employ trend following concept and the pure essence of trend following is to let the profits run. So, the detailed analysis is based on that assumption.

2. First let us dissect what High Winrate really means. Typically, a high WR system will have low Risk:Reward (compare to a low WR with same expectancy). This is a given. But, this also means that the average loser of a high WR system is usually larger than a low WR system(assuming the timeframe and expectancy are the same). In a trend following system, high WR is usually achieved by giving so much room for the market to catch the trend. Statistically, bigger SL will have a huge drawdown potential (am talking about maximum drawdown) and if the max DD is high, it is very difficult to proceed with the system for two important reasons –

a) The recovery factor will be high – meaning the number of trades it takes to get back to equity high(again) will be more and the problem exasperates if someone is trading higher timeframe. People grossly underestimate time drawdown – but it is a different topic altogether

b) Compounding can be a big problem for a system with larger max DD for obvious reasons

3. When a system has a bigger SL (again assumption is that we are talking about pure trend following systems with trailing stoplosses) like a moving average crossover system, the time the market spends between the entry point and stoploss is huge. This has so many psychological ramifications –

a) It can create havoc to our mind as it will feel that we are always in loss (even though it is not realized). One can draw analogy with an investor who enters a stock and the stock is underwater for 2-3 years. It is a very tough phase for that investor if he is still holding it.

b) It can force a trader to make mistakes (not following the plan) and just letting the emotions take the driver seat (how many of us have heard this ‘ I felt uncomfortable in the trade and got out but only to see the market moving in my favor again’). So, wider SL is a fertile ground for all these mishaps in the thought process.

On the other hand,if WR is less with smaller average losses, it will diminish the active trade time in grey area (between entry and SL) and give us a big advantage mentally.

4. Lesser WR and higher RR generally means smaller losses (compared to high WR and low RR/same expectancy system) and consequently, a trader can be well equipped for the proverbial series of losses in a row. One can place large number of bets or trades before we reach out max limit. So taking randomness into account, we give ourselves a fair chance to be in the game. Not to mention, these smaller SLs will also cap the maximum DD and will keep it nicely in control.

The below picture shows the 95% probability of losing streaks for various winrates. Even a 50% winrate system can have 16 losses in a row over 5000 trades. It is not a question of how but it is a question of when.

Workshop

5. On the flip side, Low WR and high RR will never have even distribution of profits as the system will turn positive only with large profits. If one misses those trades, then the performance would be pretty dismal.

6. The interesting thing is that most of us would feel better with a system that produces more winning trades than losers. The vast majority of people would have a lot of trouble with the 4th system (even though it has the best statistical advantage compared to other systems) because of our natural tendency to want to be right all of the time.

7. As I always say ‘there is nothing right or wrong’ in the markets. We just need to choose what is comfortable for us. The battlecry is ‘how to find the one that is comfortable for us?’. Very simple – try them all with minimum size. Your mind will naturally cling towards the one that is comfortable for you 😊

Happy trading !!

Law of Large numbers and its implication in Trading

Trading Journal

Besides loving to trade and playing cricket, I am an ardent subscriber to the statistical concept – the law of large numbers. According to probability theory, the law of large numbers is a theorem that describes the result of performing the same experiment a large number of times. Moreover, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

Let us look at some illustrations first before talking about its implications in trading.

Law of Large numbers and Coin toss

Law of large numbers is best illustrated by the example of a coin flip, which has a 50% chance of landing on heads. If we flip the coin twice, we have almost exactly equal chances of any scenario happening: heads twice, tails twice, or evenly split. The probability of getting 5 heads and 5 tails on ten flips is just 8% but that probability keeps increasing as we increase the sample size. If one flips the coin 100 times, the probability of getting 50 heads and 50 tails (P=0.5) increases to 70% and so on.

Below is a depiction of the Law of Large Numbers in action, for 1000 trials –

Workshop

As one can see, the more the sample size (trials) is, the probability of getting equal number of heads/tails increases.

Law of large numbers and casinos

Coin flips are interesting theoretically, but the Law of Large numbers has a number of practical implications in the real world as well.

A famous example is Casinos – who can forget the ringing sound of slot machines/clamoring laughters sound in the craps table of Casino halls. Casinos live and die by the law of large numbers. Each game has a house edge built into it, representing the average loss over the initial bet. Some sample edges are –

* Blackjack – 0.75%
* Baccarat – 1.2%
* Craps – 1.4%
* Roulette – 5%
* Slot machines – 5-10%

Over longer time frames, it becomes increasingly likely that the house edge will represent the casino’s profit margin.

Law of large numbers and trading

When it comes to trading, many misinterpret(in a negative way) this law of large numbers. They think that the more they trade, they would have more losses which leads to account blow-up. If a traders’ methodology has a statistical ‘edge’, and if he does not change the underlying parameters on the way, it is better for a trader to let the law of large numbers to work in his/her favor.

Trading decisions may appear to be binary – either buy or sell or up or down, but they are not. There are a critical variables which must be accounted for, such as how much am willing to lose/how to trail the profits, or in other words, what is the risk/reward of the trade and how do I manage the trade. So, there is something other than chance that comes into play when trading, and that is skill and technique.

It stands to reason then, that the better your skills and technique, the more you should trade. While Law of large numbers is important because it “guarantees” stable long-term results for random events, it follows that it is also important that our sample of trades is large enough to maximize the number of successful outcomes from our skillful trades and therefore maximize your earning potential. So, if it sounds so simple, why does traders do not allow this law to work for themselves? Why do they jump ships on the way(changing trading systems)?

Think about this for a second. The trader starts trading their plan with all good intentions. Things may or may not go well straight away, but sooner or later as the markets behavior ebbs and flows with/against the strategy’s strengths and weaknesses, losing trades will inevitably occur. At this point of time, the trader gets scared. They don’t like to give money back to the market, so they decide to try and modify the system to filter out trades like that last losing one. They begin to add indicators to charts, coming up with new ever more convoluted combinations, furiously testing to see what cuts out the most bad signals while leaving in place the good ones. A few times round this loop and suddenly, their chart starts to resemble something a seismologist might be more used to seeing than a price chart 🙂 As a result, again, the loop starts – they never let ‘law of large numbers’ to work as they dont stick around with one idea. Law of large numbers will be rendered meaningless if we keep changing the rules on the way.

Law of large numbers and behavioral difficulties

To let the law of large numbers work for us, we need to put trade after trade, over and over again without changing the underlying parameters. Just like onerously bolting on wheels on an automobile assembly line, making a series of trades can be very tedious. It may be hard to maintain self-control at times. It is understandable. We are human, and humans have a strong primal urge to seek out drama and action.

The kind of person who is attracted to trading is not the person who prefers tedium to excitement. This is the raw fact. If we are a trader, we’re probably the kind of person who has shunned a mundane 9-to-5 job for a more unconventional, adventurous profession (many come to trading for this reason). The excitement of working as a full time, active trader appeals to us. We thrive on the uncertainty and endless possibilities. What attracts us to trading, however, may also be a reason for our downfall, unless we are careful. We may be the kind of person who gets bored easily. It is quite possible that the long hours of self-control required to make a profit may be difficult to maintain. This is why many crave for action in the markets. So, eventually, they put on trades that is not part of their plan. It is exactly at this juncture, we break the ‘law of large numbers’ as it assumes that we do the same kind of trades(based on a definite idea) day in/day out. Essentially, we never stick around (or stick around with the same idea) for law of large numbers to work.

How to gain from Law of large numbers

It would be prudent if a trader(new and experienced alike) does the following –

1. Create a trading plan
2. Backtest the plan with large sample size (never fall victim to small sample skewing)
3. Determine your risk based on backtesting parameters
4. Create a money management plan
5. Stick to the plan to let the law of large numbers work

Final thoughts

It is illogical to subscribe to the theory that ” you’re only as good as your last trade. ” If you are going to trade for a living, there is no last trade, only the next trade. Whether, our last trade was a winner or a loser, it has absolutely no bearing on the outcome of our next trade.

Unlike gambling, a winning streak by a trader will NOT eventually be overcome by the parameters of the game, unless he somehow convinces himself that this is his inevitable outcome. Trading is not gambling where the house has the edge (let us not focus on the broker’s commission and negative sum game for a moment). Trading is a performance based activity that requires skill, technique, experience and above all, practice. Most important though, the trader must have the right attitude, focus, patience, and self-confidence, and then the trader will be the one who possesses the edge – not the other way around 🙂

Happy trading !!

Social media and its impact on the mindset of a trader

Mentoring

I have been active in Twitter for the past 6 months and this side of world seems to be filled with overly-expressive folks, especially, when it comes to trading. Traders bicker with each other like kids for everything under the roof and keep fighting that their method is the best in the markets. Even a 5-year experienced trader knows that there are many ways to skin a cat and one method is not superior to other.

Open disclaimer first – right off the bat, it may piss some people off but in long run accepting and learning to deal with these basic tenets will definitely help us to move into the small realm of successful traders. Please adopt the supermarket approach. If you don’t like something in this post, please ignore this rambling. This post is not intended to hurt anyone as I do not know 99.99% of the traders in-person. So, not directed to any individual or group. The pointers that are covered below are few of the several reasons that hamper a trader’s progress if he is active in social media during market hours. Whether you are involved in bickering/ego-fighting or just a spectator, the end-result is same, albeit with varied intensity.

1. When one is trading profitably and wishes to teach it to others (the psychological urge behind this teaching could be many but let’s stick to the point), he cannot expect his students to understand it the same way as he has understood. As it is almost impossible to convince a bear to be a bull once he or she has taken a position, it would be even more unfathomable to convince each trader to trade a certain way. I also conduct workshops and I don’t expect my participants to understand the mechanics of my trading style in a day. Once they keep practicing the concept, it might get internalized well in the mind (after dedicated practice) and the idea can open up many possibilities.

While we are at it, would also like to mention that just because we don’t understand a method, does not mean it is not making money for others. ‘Lack of understanding’ cannot be construed as the ‘failure’ of the method discussed. On the flip side, there are 100’s of ways to make money in the markets and it would be childish of us to ridicule other methods. It would be more childlike if we say that my method is superior to others and start chest-thumping – this is so prevalent in facebook/twitter unfortunately. Market returns are cyclical and method A might do better in certain circumstances than Method B – vice versa is equally true. Please understand that everyone has different time frames, methods and objectives. It is also prudent to remind oneself that “every dog has its own day

2. Stop justifying your methodology or trades – who are we are trying to prove here? We don’t need to prove anyone that we are successful in anything. So, why to some strangers? If one is successful in trading, he will exhibit patience as patience is every successful trader’s virtue – without exception. Patience comes with a sense of calmness and confidence. You know you are doing the right thing. Thus, there is no need to justify excessively. On the other hand, stubbornness often comes with anxiety and over-justification. When you find yourself trying too hard to explain what you are doing, you are being stubborn.

Any successful trait needed for trading (like patience, emotional control and discipline) will definitely be reflected in our other aspects of life too. Our family/friends would definitely see the massive difference once we become successful (not only in our finances but also in our behavior) – One of the important perks of being successful in trading.

3. Actually, most of the traders know the reason (or set of reasons) that make them lose money in the markets. But taking corrective action and doing the right set of things to turn profitable is something that individual has to do. Please do keep in mind knowing, and doing are two very different things

4. While people are told they won’t be successful overnight, most new/struggling traders don’t actually believe that. Social media never lets them believe it completely as every other trader is supremely successful in social media 🙂 They have an idea in their head that they’re smarter (Lake Wobegon effect), have it worked out, and will be able to make money quite quickly. So, always in the urge to make money faster and lose it actually.

5. As Master Oogway tells in the movie Kung Fu Panda “One often meets his destiny on the road he takes to avoid it.” (this quote is actually from a french poet Jean de La Fontaine). Most of the traders are determined not to lose money (rather than having a determination to ‘make money’) and in the process, they actually lose more money. Am not saying we are pre-destined to results but this one needs to be taken seriously. Knew many folks who have the aversion for loss and unfortunately, end up in trading (trading needs that loss digesting stomach) and struggle for years.

6. False hope also keeps our enthusiasm going in trading. We can attribute this ‘false hope’ to survivorship bias – We are likely to hear more stories of people making a killing than hearing about people losing everything because the people who lost everything are gone from the public eye and are not talking about it. The few who make money are sure to let everyone know about it (or others talk about them a lot) and thus create a sort of illusion–intentionally or unintentionally– that anyone can do what they did/do.

7. Easy money lure – the lure of making money each day in only a couple hours gets people’s minds spinning with possibilities. They imagine stopping everything and just start trading for a living immediately (For example, lot of chatter happened on Sept 21 2018 EOD about people buying far OTM puts for pennies and selling it for 200s..this kind of chatter happens a lot when mkt moves violently..this also feeds the mindset that money is easy in trading)

As a matter of fact, they would start dreaming about trading in a beach while sipping pina colada. Unfortunately, sand, water, sun glare and laptops don’t mix. You are not gonna get paycheck every month and you must be absolutely at the top of your game without distractions to make money long-run (this is exactly why I keep advocating to get off from social media/forums during market hours). Distraction and ego fights can damage our psychological forte and eventually, we start focusing on things that does not matter.

8. Long story short – stick to a well-defined plan and trade that plan even when it is uncomfortable (and it often will be). The vast majority of the population, and thus the vast majority of traders, buckle under this uncomfortable pressure – the same way we reach for the ice-cream instead of the carrots.

9. On the other side, social media and forums can have a positive/lasting impact on a trader if he can figure out a virtual mentor(mentor does not have to know you but you can follow his principles/thought processes). It can be a great resource of authentic information for new traders as well. But overall, it has never served a trader well if he loiters around in social media during market hours. This is not even debatable any more as the negatives over-weigh positives by a huge margin.

10. So, if you are a losing/struggling trader, try getting off from the forums/social media (for few months) during market hours. See if it has changed your overall mental resilience/trading. I can bet that this will be a great trade to put on as Reward:Risk seems very high. Risk = not being able to participate in conversations/getting updated about latest news, Reward = profitable trading without outside distraction.

Happy trading !!