Category Archives: Q & A

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 !!

Trading Q&A – Discipline

Mentoring

Someone asked me a question on ‘how to be disciplined all the time?’ and there was no easy answer. He was disciplined in following his plan most of the times but could not do it 100%. Tried my best to address this typical mindset.

Here is the question (quoting it) and the complete reply-

Question:

“Is/was breaking system/method rules a problem for anyone here? How did you/do you plan to overcome it? It is a problem I struggle with often, I have many days when I dont break rules and suddenly, the gambler in me, the tuktuk in me all get out on a single day and try to destroy my profits. It is not a continuous thing, I do follow rules most days, the gambler and tuktuk guy remain suppressed until one day they rear their ugly heads. Would be great to get some help in overcoming this failure in part, almost feels like a character flaw”

Answer:

We all go through this from time to time. If a trader is disciplined 90 pct of the time and if occasionally there is a lack in trading discipline, the reasons could be multifold —

Probable causes of the problem:

1. Lack of fit between the trader and the trading system

Discipline problems are not due to trading woes. Usually, there is an underlying problem. Just as a problem maintaining the “discipline” of monogamy in a marriage is frequently the result of underlying relationship difficulties, failing to be faithful to one’s trading plans is often a sign of conflict between the trader and those trading plans.

When traders who are normally disciplined find themselves breaking their trading rules, the momentary lack of discipline are a symptom of a lack of fit between who the traders are and what their rules demand. A fine system on paper is unprofitable if it cannot be followed by a trader. A trading method not only needs to be good; it needs to be good for the trader. A trader and a trading system should be like lock and key – it should be a perfect match !!

2. Trader trying to fulfill his short term needs

Sometimes, the lack of discipline involve failing to take trades that are indicated. Other times, the problem is one of overtrading – taking trades that lie outside of one’s rules. If we think of momentary lack of discipline in other areas–cheating on a diet, for example, or procrastinating on work that needs to be completed–we can see that, many times, we act against our longer-term self-interest by becoming caught up in shorter-term needs. If, for example, we cannot tolerate boredom, we might eat to fill the void and break our diet.

Solutions

Problem # 1

Keep a journal and truly investigate each of your small trading discipline slips. Then view those slips as information, not as problems. What do they say about you? Which rules do you find yourself breaking, and what is actually conflicting with those rules?

Now look at your trading successes. What came naturally to you? What rules and plans can be derived from those winning trades? Don’t force yourself into a pre-made set of trading plans (usually derived from somebody else’s plan) but rather, identify what you do when you win and see how you can make *that* into your system. This is one of the primary reasons why ‘copying’ someone’s system never work in the long run.

Problem # 2

When discipline works, it’s often because people have found constructive ways to meet those short-term needs. The smoker who craves a cigarette may chew gum as a substitute oral activity.

The key to sustaining discipline is to identify the specific short-term needs that are occasionally overshadowing trading rules. Once you’ve made that identification, it is easier to then brainstorm constructive ways of addressing those needs. Traders who overtrade, for example, often have problems during quiet market times. Their needs are for stimulation. By creating stimulating activities during the trading day that don’t take them away from their screens, they can avoid using unwanted market activity as their stimulation.

Other times, traders fail to follow their rules because they don’t truly have confidence in their ideas. They front-run their own signals out of anxiety and wait for perfection in setups before they act. Their short-term needs often are for safety and security – they need to believe in what they’re doing. Very often this problem occurs when traders have short-circuited their learning curves. They are putting meaningful capital at risk before they’ve done small real-time trading that is needed to build a successful track record. You believe in your system when you see, in your own experience, that it works over time, across market conditions.

So, keep working on your problems and am sure you will better off gradually!!

Good luck and hope it helps

Trading Q&A Audio/Video 1

Audio/Video response to the tweet posted on April 26th 2018

Here is the A/V link:

Bouncing back slowly but steadily

Mentoring

A trader asked me a question about how to develop the discipline in following his trading plan. Am sure many of us can relate to the questioner’s mindset in ‘trying to recover the losses as quickly as possible’. It is clearly evident that the trader does not believe in bouncing back slowly. He is also well aware of the risks involved in trading stock futures on result days but he could not control the urge to put on a trade.

Here is the question (quoting it) and the complete reply

Question:

“Hello Madan – i know i have to focus on maximizing gain and have to stop weighing losses more than gains. If I look at my losses, have incurred heavy losses in trading stock future and that too on result days. I need to bury this desire to recover what I lost quickly. I find it difficult but would want to know if there is any mental drill to have disciplined approach.

I understand that trading in stock future on result days is very risky, after I enter a trade if it is in my favor it nurture my belief that being undisciplined at times helps u in profit but in the long run I am at loss due to these trades only”

Reply:

First things first – please do not answer these questions but just answer them to yourself.

1. Why are you trading the markets?

2. What is the need to trade on results day (knowing well that the stock can go either way)? If it is not part of the trading plan, why trade that day? For example, i don’t initiate new trades on RBI days. There is always another trade right? I know few traders trade on earnings announcements day but they have hedged strategies.

3. Why are you impatient to make back all the lost money back quickly? Why are we not respecting probabilities, distribution of trades and climbing up steadily?

4. We are aware that ‘profiting by breaking our system/rules can create havoc in the long run’ but we still take comfort in the fact that we are making profits by not following our plan. So, what thought process is giving us this pleasure?

5. Are our goals oriented towards P/L or oriented towards the process? Why are we so focused on P/L than focusing on the process?

Common observations about an undisciplined trader:

1. More often than not, traders do not trade to make money. Trading is not rocket science. It’s like making biryani – all the raw-materials and perfect ratio/sequence has to come into play. Once we figure that out, making a great biryani is just a process of following the routine. All the major restaurants follow routine in making their special dishes every day.

Most of the traders trade to regulate their emotional state. Once the trader becomes attached to the need to trade and make money quickly —and once his perfectionist voice of “I should have bought there” enters the picture–he is no longer grounded in markets. It’s when those frustrations build over time, becoming self-reinforcing, that traders sway away from their plan/system. What derails traders is that, at some point, we switch perceptual lenses and view the trade through the lens of profit/loss (P/L), not through the lens of probabilities, risks, and rewards.

Mentally rehearsing a mindset everyday (please read psychocybernetics and see how you can implement mental rehearsing in trading. It helped me tremendously) in which it is OK to miss moves–there will always be future opportunity–traders can prevent many of these train wrecks. The practice of taking a break during the trading day, reviewing one’s state of mind, and clearing one’s head is remarkably effective in this regard. Clearly identifying the parameters of one’s trade–the optimal size, a logical way to trail SL, stop loss points that put risk and reward into proper alignment–also ensures that you are controlling your trading, not the reverse.

2. Many traders formulate intentions for their trades and then wonder why they have veered from their trading plan. When we ask them about their trading plan, however, there is nothing written down nor is there anything specific that has been planned. Often, however, we will hear from traders that they’ve violated their discipline. When we ask which rules they’ve violated, they cannot give a definite answer. How can we violate a discipline that isn’t there to begin with? The problem is not that an excess of emotion interfered with their plans and rules. Rather, they were never sufficiently planful and rule-governed to begin with. So, there is no emotion involved (or progress to be made) when there is no plan to follow in the first place.

Essentially, in my opinion, the single greatest way to build discipline is to turn rules and plans into ‘resolutions’. That means that you have to give those rules and plans a life of their own. The more you think of them (mental rehearsing/writing them down in a piece of paper whenever you find time in a day), look forward to them, grade yourself on them and reward yourself for them–the more real they become. You are most likely to abandon rules and plans that haven’t been internalized as resolutions/commitments. This is where ‘mental rehearsing’ would help immensely. It enables us to internalize our plans/goals effectively.

Unfortunately, mere intentions are not strong enough to trap these trading errors. We need the emotional force of resolutions and the reliability of routines. Turning intentions into checklists and checklists into resolutions is a great way to ground yourself into best trading practices.

Last but not the least – being disciplined is a self-fulfilling phenomenon. The more you are disciplined, the more you will see stability in your trading and the more stability in P/L (bottom left to top right angle), the more disciplined we become. And the cycle continues.

Hope it helps. Good luck with your trading !!