Tag Archives: trading

Backtesting an idea/system

Traders

Backtesting is a topic that always attracts one set of traders and despised by the others 🙂 The topic is pretty vast and this blogpost is just a basic primer on Backtesting. It is gonna be a long one but i believe, it will be worth your time 🙂

Let us etch something in our mind very clearly before getting into details – Discretionary trading methodologies/ideas cannot be backtested. You need a set of rigid entry/exit rules to backtest the idea. There are no 2 ways about it. One can act smart and twist words around it but there is no backtesting for discretionary systems – period.

Introduction

Backtesting an idea (in trading terms) is to gauge how a set of trading rules performed on historical data. But, many folks who come into trading just do data mining. Data mining simply scans historical dataset for rules that would have worked in the past. We have read this disclaimer various times that ‘past performance does not guarantee future results’ But still, the professed value of backtesting is based on the premise that historical tendencies/patterns repeat.

Backtesting and its efficacy

So, the popular question is if ‘past performance does not guarantee future results, why backtest an idea/system in the first place? One could very well save the time, effort and sleepless nights right?’ This is an argument that has some validity, up to a point. It is definitely true that past performance is not indicative of future results. But does it therefore mean that historical testing has no validity? I don’t think so.

Here is a case in point. Let’s say you want to build a model of the sun rising. Every day for a month, you get up before dawn, and wait for the sun to appear. Every day, it rises in the east. So, you build your model, run it for tomorrow, and it “predicts” that the sun will rise in the east. Will it? Who knows for certain? Some strange axis switching or earth rotation reversing could occur overnight or a cosmic phenomenon might occur (which could be understood only by Late Stephen Hawkings 🙂 ) and the sun could rise in the north, south, or west. Highly unlikely, yes, but so was the financial crisis of 2008, Nifty flash crash in Oct 2012 and the recent coronovirus debacle. Outlier and unexpected events can and do happen.

If such a calamity occurs, does it mean that the model is useless and never should have been built? No, but certainly you would have to now take into account that the world you modeled has changed significantly. So, having a model based on history is much better than completely guessing. With guessing, you are likely to be looking the wrong way when the sun rises tomorrow morning 🙂

Strategy and psyche

Before getting into the nitty-gritty of backtesting, I would like to clear few hitches of system development. It is imperative that the trader should come up with a system to backtest based on his/her traits and psyche.

1. Let us say that you are a profit-target based trader and dont believe in trailing the profits much. If someone gives you a profitable(system with positive expectancy) blackbox system to trade, sooner or later, you will abandon the system or will tweak it in few trades. Reason is very simple. The system skeleton and ideologies are not attuned to your psychology(the belief you have about how markets operate). A profit target based trader cannot trade ‘trailing stoploss’ based system (and vice-versa is also true) as there will be internal conflict. Please understand that psychology is like fingerprint – it is unique. Hence, it is very important that we choose a system that is attuned to our psychology.

2. If a trader cannot digest 10 losses in a row of a trend following system, there is no point devising one and backtesting it. If your psychology/understanding about the markets do not match what the system can offer, then you shouldn’t be trading that system. Manipulating the rules because you are intolerant with the results can turn a winning system into a big losing one. If you can’t live within the anticipated parameters, then you need to develop or find another system. If one is devising a system for intraday to backtest and he is known to hesitate on taking quick decisions, then it could prove costly in live trading. If a trader vacillates for even two minutes to enter a trade in an intraday system, then that could be the deciding factor between a winner and a loser. With a longer-term trading system, the entry is generally not so critical and hesitation errors are forgiven usually.

Ways of producing backtesting results

Before venturing into the topics in detail, i would like to state that am a big proponent of ‘bar-by-bar’ backtesting as it has number of advantages (but takes a lot of time) compared to automated backtesting (using code).

1. Historical backtesting

This is a kind of testing done by most of the charting software nowadays. You create a few lines of code and they spit out the results with myriad number of statistical parameters. This kind of testing also encapsulates the major problem in backtesting – over-optimisation and curve-fitting (did not get into the definition of these terms as they are commonly known). There is virtually no chance that the results in the future will be close to the ‘optimized’ results. The results are just too “tuned” to the data used in the test.

If a system has indicators (with parameter numbers) incorporated in it, there is higher chance of optimization and curve fitting. Once can play from 1 to 500 as value of the moving average and the s/w will spit out results in seconds. A trader will be tempted to choose the best MA (say 283) out of 500 MAs and guess what, real trading would suck big time as curve-fitting has been done nicely with the past data.

2. Out of sample testing (OOS)

If one is persistent on optimization in backtesting, this kind of testing can be a savior. So, here a trader can test 3 years of historical data testing (automated) and run numerous iterations of optimization but run the following year bar-by-bar. Of course, nothing can beat bar-by-bar testing of a well formed idea (with zero optimization) but this will help those folks who are a bit lazy in backtesting bar-by-bar.

3. Walk forward testing

Walk‐forward analysis is simply the aggregate of many out‐of‐sample periods, stitched together. So, 2 years of automated testing + 1 year of OOS testing followed by 2 years of automated testing followed by 1 year of OOS testing. Once we have a set of 4-5 years of OOS testing, we put them all together and create the statistical parameters. In this testing method, we can get the best of both worlds – a bit of bar-by-bar testing and optimization (if needed)

Importance of data in backtesting

For an accurate evaluation of any system, the data must be impeccable. Online free data will not cut it (a saying flashes through my mind right now – ‘penny wise, pound foolish’). Without correct data, system testing is useless.

Purity of data is another very crucial requirement. Any anomalies or mispriced quotes will have a direct impact on the system’s test results and can skew the results extensively. Cleaning of data is not an easy task and often must be relegated to professional data providers.

Parameters to look out in backtesting

As most of these terms are self-explanatory, I would just like to list out the most important parameters to watch out for.

Percentage profitable, Total number of trades, Max consecutive winning/losing trades, Net points (after cost), Maximum drawdown, max time take to come out of DD (Recovery factor), Ratio of average yearly profit to max DD (Calmar ratio). Max loss and max profit are not that important to me as they are singular events.

I am not a big fan of the popularized ratio – Sharpe ratio. There are 3 reasons for it.

1. It does not include the actual annual return but only the average monthly return. Thus, irregularities in the return are not recognized.

2. It does not distinguish between upside and downside fluctuations. As a result, it penalizes upside fluctuations in the same way as downside fluctuations.

3. It does not distinguish between intermittent and consecutive losses.

Optimization of backtested system

Once we have a trading methodology and an initial set of parameters, it is time to fine tune our approach. The principal folly of optimization is the tendency to curve fit. The problem is more pronounced with systems that involve indicators with numbers (like moving averages, RSI, etc). So, if one is dogged to optimize using a software, use the walk forward testing technique discussed earlier. By doing this testing, one can easily assuage the apprehension of curve fitting to a large extent. Word of caution here – fine-tuning a system just increases the level of false confidence that eventually will be dashed in real time when the system fails. I have backtested numerous systems in the past and have always followed this route – take a concept/idea, create rules based on the concept and test it bar-by-bar without optimization even a single time. Yes – it is an arduous task but in my opinion, it’s well worth the effort and time.

Final thoughts on backtesting

Traders are especially captivated of the percent profitability, or accuracy of a system. In practice, we should not target a specific win/loss ratio – the goal is to create a profitable system (= system with positive expectancy) in accordance with the trader’s psyche. It doesn’t matter whether you get there via relatively few but comparatively large winners, as is the case of trend-following systems, or smaller wins with a tendency to compensate losses and much more. It also could be a combination of the above. Eventually, the totality of the system is all that matters.

Please be cognizant of the fact that several trading luminaries have owed their successful careers to simple trend-following systems. These systems tend to produce winning trades close to 30%. And there is almost always some giveback of profit before a winning trade is closed out. A position’s equity high is never anticipated and profit targets are not used. It’s therefore easier for a trade to wind up as a loser. So essentially, the cardinal parameters of a system (with positive expectancy) could vary from trader to trader but search for the holy-grail system has to stop sometime.

Happy backtesting all !!

Procrastination and ways to overcome it

Traders

I always wondered why traders never get to the point of creating a solid trading plan/system and the reasons behind this phenomenon.

I love writing articles about trading psychology and this topic made me come out of hibernation. This blogpost is a small attempt to see the probable reasons behind procrastinating in formulating a system – from a psychological perspective.

Introduction

Procrastination – we all know what it means and many even admit that they are procrastinators. In the world of trading, many get convinced that a proper trading plan/system is the first and pivotal step to be taken (at least the majority of us :)) but when we try to develop a system, we face this ‘procrastination’ demon. They never start developing one or drop the ball on the way.

Many a times, becoming aware of why something happens is the first step towards changing that pattern.

Procrastination and fear of failure

In my opinion, the primary reason for procrastinating in developing a system is ‘fear of failure’. This fear can manifest itself into various forms –

a) If someone had ventured into trading without a methodology/plan (99% start this way), they would have either blown the account or figured out how risky trading could be. So, part of us may be very scared of the consequences of trading any more that we will have difficulty in starting to develop the system.

b) More often than not, folks would have quit their job to start trading fulltime (or trading for a living – by the way, both are different things 🙂 ), but we are so afraid of the results of not trading well (that happened in the past) that we cannot complete the job of developing our system.

c) Lack of self-confidence – Based on past experiences, we might be uncertain of our ability to perform or just a general lack of self confidence, and this leads to procrastination.

d) If the time pressure to perform is greater, then it will invariably create more fear of failure and let us procrastinate on the things that are needed to develop a trading plan.

Procrastination and fear of success

This point will be counter-intuitive to many but lets face it.

a) Fear of change that success brings in – People fear success because it will bring something new. A change from status-quo.

Lets say that we become rich (by your own definition) and based on our 3rd party experience, we dont like the implications of what it means to be rich. One of the implications could be that your friends no longer want to associate with you as your lifestyle has changed

b) We might have a notion that wealthy people are evil-minded and parsimonious in their ways. If one does not want to be stingy or evil-minded, then there will be internal resistance in making money and hence keep procrastinating a probable way/process involved in making lot of money (trading with a plan/system)

Procrastination and fear of work/lack of interest

a) It is easy to just log into the computer in the morning, enter some random trade based on somebody’s recommendation/news and exit whenever there is a ‘feel’ of profit/loss is enough 🙂 . It takes lot of strenuous effort and commitment from a trader to create a well-thought out plan without any major loopholes.

On top of that, many loathe the sheer amount of work involved in backtesting the system for 10+ years. We have started enjoying the luxuries of modern vagaries that it feels almost archaic to go back to the basics and do things the hard way.

b) If someone told us to create a system and if we don’t like that person (for whatever reason), we tend to feel resentment towards developing a system. We don’t want to be like that person and hence we keep procrastinating. The more we dislike the idea of developing the trading system, the more we tend to push it away.

This essentially means that we will leave the toughest part of the job for that portion of the day when our energy level is low. We do this for any activity that we detest/lack interest in.

Procrastination and lack of understanding/objective

a) It is unfortunate that there is no proper understanding of how to create a trading plan/system. There is a structured process to follow in creating one and not much literature floating around on this less-discussed topic.

b) Traders who start trading usually does not know what they really want out of trading or a trading system. Getting our objectives down is 50% of the task. Until we have your objectives written down, we have no way of knowing what we want or knowing when we’ve got it.

How can we even monitor our advancement, a major factor in ongoing procrastination, until we know exactly what we want? On the contrary, once we know what we want, we can set deadlines for each phase of the system development.

Overcoming procrastination

1. First and foremost step is to realize that procrastination comes from us and we need to take control of the situation. Start today, however small the step/action maybe. There is no better day than today.

2. Worst case is you spent few hours/days/weeks of your time but let us think about the average/best case of start doing something today. We have spent/spending too much time on non-productive things anyways 😊

3. Don’t let the perfectionism get in our way. Even if the quality of the work is poor, it is very important to try something and fail rather than wondering what if.

4. Eat the elephant one bite at a time. Write down your objectives for trading (being vague kills clarity) and steps involved in developing a trading plan/system. Get to know the process involved in developing one. If developing a trading system looks onerous, break it into pieces and create smaller chunks to accomplish.

Final thoughts

None of the businesses started or flourished without proper due diligence/business plan. Why trading should be an exception? This begs to a very important question on our thought process about trading as a profession?

If one is serious about it and think money can be made through trading, not coming up with a plan/system is completely illogical.

As the popular saying goes – ‘ A journey of thousand miles begin with a single step’. We might delay but the time will not. So, lets kick that ‘procrastination’ bucket hard and take that first step today.

Good luck all in developing your trading plan/system !!

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 !!

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 !!

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 !!

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 !!