How many times have you scoured the web looking for strategies, traded them and then dumped them because you experienced a bunch of losses? Finding a strategy is one thing (and i’m not referring to crawling web pages), but knowing when to give-up on a strategy is something most of us never think about let alone act on by pulling the trigger.
So how does someone know when enough is enough? How does someone know whether a loss is what’s classed as an “expected loss” or not?
Lets hear what the big dogs are saying…
For those of you who’ve not yet read the book “Market Wizards: Interviews with top traders“, you’re missing out.
Jack Schwager (Author) interviews several big dogs in the investment and trading world. He does a great job of formatting the book in a question and answer layout. It’s nice and easy to read.
One man Jack Schwager interviews goes by the name of “Larry Hite”. From 1981 to 1988, Mint investment management company (founded by Hite) accomplished an average annual compound return of over 30 percent. This may not sound impressive but if you knew the amount he was managing and how consistent these returns were (from a risk adjusted perspective), you’d be more impressed. Today they manage billions and have grown their credibility via the numbers they push-out.
Whenever I read a book (in general), if I can extract just one or two points that I can either use or relate to in a profound way then the book was worth it. One of these profound moments for me in Market Wizards (above) was when Jack Schwager asked Larry Hite the following question:
“Isn’t it possible that the markets can change and the future will be very different from the past?”
He reminisces a small anecdote and then follows on to say:
“The insurance business provides a perfect analogy: take one sixty year old guy and you have absolutely no idea what the odds are that he will be alive one year later. However, if you take 100,00 sixty-year-olds, you can get an excellent estimate of how many of them will be alive one year later. We do the same thing; we let the law of large numbers work for us. In a sense, we are trading actuaries.”.
I read this book many years ago and this answer got me into the world of statistics in trading today.
The point Larry is trying to make here is that even though he has his strategy, he doesn’t want focus on the individual outcome of a trade nor try to predict it. Instead he assesses a larger population (e.g. more realised trades) to make any assumption or conclusion.
We’ve all heard the game of coin toss…
I won’t beat a dead horse on this point. In the game of coin toss and considering probabilities, the odds of getting heads over tails on one toss is a 50/50 split. That is if you only play the game once. If however I asked you what the odds are that heads comes up over tails and we tossed it 10 times, what would your answer be?
If you said 50/50 then you’re wrong to assume. Out of 10 tosses heads could have come up 80% of the time. Heck it could have come up 100% of the time.
Now play this same game a million times. What’s the odds of heads coming up over tails… Much closer to 50/50.
This is a basic principle of probability theory in highlighting “samples” over “populations”. The “population” might be the million tosses, whereas the “sample” is the 10 tosses. You see, small samples deviate away from what normally happens in a larger population. These small “samples” (the 10 tosses) can give a poor representation of what actually is (the population).
Traders dump trading strategies for a myriad of reasons but more common than not they dump them because of the above i’m alluding to. You as a trader might suffer 10 losses in a row. You’ve then dumped it but Joe Bloggs keeps trading it and hits a 30 win streak.
Now you might be thinking; well yea, that’s easier said than done to continue trading after 10 losses in a row, but man it doesn’t feel comfortable… My answer to this is: that’s because you don’t know enough about your strategy to trade it through choppy periods with confidence.
Armed to the teeth, locked and loaded…
Would you confidently go to war with no prior extensive combat training or understanding of weapon handling… If you were enlisted you’d have to but I can only imagine how unconfident you’d feel (petrified!).
Thankfully our lives aren’t on the line so the analogy is a little heavy for sure but either way I’m hoping you see my point.
Why would anyone trade a strategy but not fully understand what kind of distribution of wins and losses might come around in future “samples”. What kind of draw-down is plausible (and beyond what you might have seen in back-tests too…), what kind of standard deviation (volatility) is expected etc.
The more you know about what elements comprise a profitable trading strategy the more in control and confident you are. The more in control you are, the more you’re indirectly improving your psychology in trading. The more you have a grip on the psychology the more you can focus your energy into strategy development. The more you focus on strategy development the more likely you are to be making money…
There are several major facets to profitable trading and I am only grazing over one of them above (or rather, highlighting a common mistake people make!). Trading is as much about discovering these facets as it is about bringing all the pieces together. The discovery part is about wading through mountains of information online and trying to interpret whether it’s helpful or not. This can take years…. seriously… years of going round in circles.
Let us help you by clearing the path and guiding you through the foundations to profitable trading. Don’t waste your time being mislead or misinterpreting information out there. If you’re not already doing so be sure to check-out the Free Live Trade Room where other aspiring traders and professionals alike hang-out, talk markets, share tips and more importantly structure their trading.