“Analysis can be equated with poker. Security analysts carefully follow the table talk of the game and examine the up-cards. Although analysts effectively follow and communicate these two aspects of the game, they either ignore or ineffectively guess at the other major element-the down-cards.” Read Full Post

“The most important rule of trading is to play good defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible draw down.” Read Full Post

“Gamblers think they are betting on red or seven but in reality they are betting on the clock. The loser wants a short run to look like a long run so the odds will prevail. The winner wants a long run to look like a short run so the odds will be suspended.” Read Full Post

“Many major problems people have in trading are caused by their expectations – of where the market is headed, how much money will they make from this trade, etc. One thing I learned that has helped me: it is wrong for a person to enter any market with any preconceived expectations.” Read Full Post

“The great danger is in confusing courage with bravery. The market is no place for heroics. That is for another battlefield. In the market place it often takes more courage to live than it does to die. The greatest courage is the one that lets you graciously admit that you are wrong when you no longer have a good reason to trade. The courage associated with the hero often destroys the courage that is needed to be successful. I have witnessed cases where temporarily successful traders have lost their touch because they lost their courage.” Read Full Post

“As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality.” Read Full Post  This can cause us to put the blinders on when we see negative information. It can also cause us to have a larger position than we should, or be over weighted to one position. Most important, it seems the more we overestimate what we think we know, we simultaneously underestimate what we don’t know ……the downside risk.  

“Great decision makers aren’t those who process the most information, or spend the most time deliberating, but those that have perfected the art of “thin slicing”- filtering the very few factors that matter from an overwhelming number of variables.” Read Full Post

“We have seen how good we are at narrating backwards, at inventing stories that convince us we understand the past. In spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude the rare events.” Read Full Post  Funny isn’t it, since the big, rare, unpredictable events are precisely what shape the world. Events like the automobile and the World Wars, the internet and the Beatles.

“Systems trading is ultimately discretionary.  The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change.  These decisions are quite important, often more important than trade timing.” Read Full Post
 
 
NEW – Weekly Blast from the Past!!

Those of you that follow this blog know that I am a big fan of a definitive trading plan. Having a plan however, does not equate to success, there are still limitations. One limitation is the small account. Unfortunately, the small account has many more obstacles to overcome to be successful than the large account. Let’s take a look at why that is the case.

Most commodity futures have underlying collateral value in the tens or hundreds of thousands of dollars. A gold contract for example is worth $113,000 today and crude oil is $82,000. When you add low margin requirements and increased volatility into the equation, you have a recipe for small speculation disaster.

So, what makes the larger account fair better in the long run?

Well, to name a few reasons, large accounts can afford to trade virtually any opportunity, at any time. There are 75 to 100 or so liquid commodity markets worldwide, and should buy or sell opportunities emerge, a large account can easily afford the margin and risk to trade them all. In addition, they can scale into and out of positions. This is in stark contrast to the small account where prudence dictates only having exposure in a limited number of markets with one contract.

Also, large accounts are not restricted from trading contracts whose volatility is relatively high. For example, a gold trade today with a 5% cash stop would translate into over $5600.00. That happens to be a little over one half of 1% of a million dollar account, yet over 11% of a 50K account.

Now, the devils advocate would say that “I wouldn’t use such a wide stop”, but it’s necessary to use expanded stops in expanded volatility to avoid being stopped out by “noise”. Also, as the contract becomes more valuable, the risk to trade it increases. Gold is not $400.00 anymore it’s $1130.00 per ounce. A 10% move now is close to three times the dollar risk of $400.00 gold.

To stay with the gold example, we run an in-house volatility filter that is currently suggesting that gold has $1238.00 of daily noise (around 12 dollars). So, if you are trading gold and would like to be “outside the noise”, 3 standard deviations would suggest a stop at $3714.00 (around 37 dollars). Even this wider stop does not insure anything, as we all know markets frequently make 3+ standard deviation moves on a routine basis.

So, in a nut shell the 50k account trading gold would have to risk close to 7.5% of his account (per trade) to hopefully stay in the game of trading gold. Good luck with that.

So, how can we trade a smaller account that has the probability of success equal to the large account?

One approach we have explored, and now successfully trade, is the concept of building a model that employs multiple systems, and multiple markets, along with an effective filtering process and risk management controls.

Let’s elaborate.

The process of running multiple systems over many markets will generate a fair amount of trades (like the large account). The filtering process, and the risk controls however, allowed us to filter down the many trades to a few “higher probability” trades. Since the small account cannot take on all the trades, it is the next best approach. This strategy attempts to identify a limited percentile of all the markets it tracks as being the best candidates, using a systematic process to select the few that the small account can handle in terms of volatility and risk.

The portfolio selection process is dynamic as opposed to static (like the small account). This means that from day to day the basket of markets we would trade can change due to strength, weakness and/or volatility changes. We feel this keeps our trades limited to only those markets with the best risk adjusted potential. This allows us to evaluate a very large portfolio (like the large account) while still keeping the number of trades and margin requirements very low to address the small account.

Monitoring a very large portfolio is critically important because if you initially limit yourself to a predetermined small portfolio, how do you know that those markets will be the best markets in the future? (Hindsight bias portfolio selection is a form of curve fitting and is a major downfall of many traders). If an exceptional opportunity develops in a market outside of your predetermined portfolio wouldn’t you want to take advantage of it? By trading with this type of strategy you don’t arbitrarily rule out any market that may perform well in the future and you have eliminated the tendency to pick a portfolio based merely on past performance (curve fit) considerations. See related post

If anyone would like to see more detailed research, feel free to contact me.

NEW – Weekly Blast from the Past!!

It continues to amaze me to watch the Wall Street Gurus apply scientific and fundamental logic to an illogical game. Not only does this cause traders, who buy into these scenarios, to underestimate risks, it also draws a crowd into the scenario, increasing risk further. As John Train said in his book Dance of the Money Bees, “The herd instinct seems to be the strongest human emotion, one that the race is constantly breeding off as the mavericks are liquidated. Happiness is running with the crowd.” 

If we place too much emphasis on the “quantifiable”, we run the risk of being blindsided by a changing world and changing markets. This upsets the balance between left brained analysis and the right brain instincts, both of which we should employ to be good traders. When we get sold on sophisticated models, that tell the future from past data, by very qualified and believable scholars, we underestimate what can go wrong. 

Bennett Goodspeed in his book The Tao Jones Averages points out, “Analysis can be equated with poker. Security analysts carefully follow the table talk of the game and examine the up-cards. Although analysts effectively follow and communicate these two aspects of the game, they either ignore or ineffectively guess at the other major element-the down-cards.” 

“On Wall Street what is known tends to get glorified at the expense of the unknown. We have become so caught up in our scientific methodology, that if something cannot be measured or counted, it will not be believed. As a result, we tend to adapt the world to our belief systems, rather than try to understand as it is.” 

This is not to say that one should underestimate their trading plan. It means don’t buy into it. Stay flexible, and always think in terms of what can go wrong. This is especially true these days, where momentum trades and “bubbles” have become commonplace. And when the crowd shifts, be assured that the controlled logic will give way to uncontrolled emotion. 

I think it pays to assume this can, and at some point, will happen. Your approach should have a “worst case” scenario, no matter how right you think you are. What if all my trades correlate and go bad all at once? What will happen to my account? 

Paul Tudor Jones in Market Wizards said “the most important rule of trading is to play good defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible draw down.” 

“Don’t be a hero, don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”  Read Related post

According to Wikipedia, “A game of chance is a game whose outcome is strongly influenced by some randomizing device, and upon which contestants may or may not wager money or anything of monetary value. Common devices used include dice, spinning tops, playing cards, roulette wheels or numbered balls drawn from a container. Any game of chance that involves anything of monetary value is gambling. Thus, every gamble is a game of chance, but not every game of chance is a gamble.”

So, not all games of chance are alike?

First there’s skill.

Well, unlike dice or the roulette wheel there are some games of chance that require a skill, like handicapping horses or trading. In essence, the roulette wheel is ultimately fate, where trading is a choice. A game where a person can polish their skills and make choices has a great advantage over a person who places a bet against certain odds, and waits for fate. After all, there are a number of professionals that make a living as card players or traders, yet few make a career out of throwing dice.

Then there’s time.

All games of chance are dominated by time. As Peter Bernstein puts it in his book “Against The Gods- The Remarkable Story Of Risk,” “Gamblers think they are betting on red or seven but in reality they are betting on the clock. The loser wants a short run to look like a long run so the odds will prevail. The winner wants a long run to look like a short run so the odds will be suspended.”

He goes on to say, “Insurance companies conduct their affairs in the same fashion. They set their premiums to cover the losses they will sustain in the long run; but when earthquakes and fires and hurricanes all happen around the same time, the short run can be very painful.”

Well, that sounds familiar to a trader. Good traders know they must also be properly capitalized for the short run surprises to insure long run success. As Bernstein says, “Time is the dominant factor in gambling. Risk and time are opposite sides of the coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

Then there’s choice.

In those games of chance where fate prevails, decisions are irreversible. We place the bet down on red and that’s it. There’s no going back. In trading however, we can sell something we just bought if we feel we made a mistake. Bernstein points out that Hamlet once said too much hesitation in the face of uncertainty is bad, “yet once we act, we forfeit the option of waiting until new information comes along. As a result, not-acting has value. The more uncertain the outcome, the greater may be the value of procrastination. Hamlet had it wrong: he who hesitates is half way home.”  

Hone your skills, respect time in the game and use your ability to choose, or use the rabbits foot. Remember however, that didn’t work out so well for the rabbitt.

Have you ever noticed that all the Wall Street firms are within pennies of each other when forecasting earnings? Have you ever noticed that they are all wrong (and occasionally right) at the same time? I doubt seriously if this is coincidence. It is more likely, that because they spend a lot of time speaking with each other, and reading the same numbers, they come to the same conclusions. It’s a variation on the old “circular argument” in philosophy. 

Webster defines the circular argument as “a logical fallacy in which the proposition to be proved is assumed implicitly or explicitly in the premises.” In other words, it’s absurd reasoning that argues A is the case on the grounds that B is the case, and that B is the case on the grounds that A is the case. 

“Why do you believe in Wall Street Analysts?” asked the skeptic. 

“Well, because they are the smartest guys and gals, from the best business schools in the world,” answered the investor. 

“So why do you believe that they are the best business schools in the world?” asked the skeptic. 

“Because The Wall Street analysts say they’re the best,” answered the investor. 

In any event, I read this joke over the weekend that reminded me of Wall Street, and how the Irrational pull of the circular argument can have a great influence on Wall Street thinking. 

A group of Indians gathered around the chief and asked if they were going to have a cold winter. Being a modern day Indian, and not aware of ancient secrets, the chief had no idea. In order to save face however, he advised the tribe to gather wood and prepare for a cold winter. 

A few days later the chief decides to seek some help from the National Weather Service, and was told by a meteorologist that “indeed they were expecting a cold winter.” The chief then advised the tribe to gather even more wood. 

After a few weeks, the chief felt like he should check in with the National Weather Service to make sure everything was on course, “Does it still look like a cold winter?” asked the chief. “It sure does,” said the meteorologist, “in fact, it looks like a VERY cold winter ahead.” The chief then advised the tribe to gather every piece of scrap wood in sight. 

Finally with winter right around the corner, the chief checked in one more time. “Does it still look like a cold winter,” he asked. “You bet,” said the meteorologist, “in fact, we are expecting one of the coldest winters on record.” 

“Really,” said the chief, “how can you be so sure?” 

“Because the Indians are collecting wood like crazy!” said the meteorologist.

Legendary trader Roy Longstreet was once asked by Intermarket Magazine, “Why have you succeeded in trading to such a degree and why do most traders fail?”  Roy answered “Many major problems people have in trading are caused by their expectations – of where the market is headed, how much money will they make from this trade, etc. One thing I learned that has helped me: it is wrong for a person to enter any market with any preconceived expectations.” 

He went on to say, “I know that there’s always the possibility that what I don’t want to happen, will happen. The market will not act in accord with my expectations. You have to ask yourself the question, how must you function to survive? The answer is to be able to accept a loss. Not having expectations makes it a little easier to accept a loss. You must realize that losing is part of soul growth, so to speak. It’s necessary. It’s hard to accept, but necessary.” 

This problem of attaching ourselves to an outcome is not exclusive to trading, but is a problem in investing in general. Expectations of higher and higher returns have become commonplace in an environment of lower opportunity to do so. Few people consider the fact that when they invest today, the riskless marketplace pays close to zero.  For example, the one month Treasury Bill pays $40 for a $100,000 investment, and inflation is running around -1.3%, based on the Consumer Price Index. 

All these things have an impact on available returns. Investors seem to recognize this fact when buying yield (bonds or CD’s), but not necessarily when dealing with other asset classes like stocks or commodities. For instance, the Ten Year Treasury Note will pay 3.59% per year for the next ten years, principal returned. We accept this or we would not buy the instrument. However, it’s not that simple when faced with other Investments. 

For example, earnings per share (EPS) in the stock market have historically grown two percentage points above inflation. So let’s say annual inflation runs at 0%, we are talking about 2% earnings growth. Assuming share prices rise with earnings, you will get 2% annual gains. With The Dividend Yield around 3% right now, that is a forecasted total return of around 5%. Now, do you think that the average person has invested in the stock market for a 5% return? 

I would guess they are looking for much more, and this opens the door for surprises. When the outcome is different than the expectation, we usually react emotionally, something that hardly ever works out. 

 So, if possible, discount the predetermined expectations, and stay flexible to do what’s necessary. Confucius once said, “The expectations of life depend upon diligence; the mechanic that would perfect his work must first sharpen his tools.”

Roy Longstreet, legendary commodity speculator once said, “To trade successfully, one needs two things: Knowledge and Courage. The knowledge you can learn or buy. Courage cannot be learned or bought. You either have it or you don’t. But you cannot succeed without it.” 

Most traders associate courage with the ability to put trades on and at times add to the position. They think it’s the ability to stay with the winners until they are geometric multiples of the losses. This does take courage, but I think there is some confusion that courage is an offensive trait, when in fact it is both offensive and defensive. What about the kind of courage it takes to quit when you’re wrong, and take the loss? The ability to “stand there and take it” like some tough guy might work in boxing, but it is counterproductive in the trading game. 

What about the courage to “keep on keeping on” when things look dismal? This is where you build character and get strong. When you look fear in the face and still do the thing you didn’t think you could do. Confucius once said, “To know what is right and not to do it is the worst cowardice.” 

Roy goes on to say, “The great danger is in confusing courage with bravery. The market is no place for heroics. That is for another battlefield. In the market place it often takes more courage to live than it does to die. The greatest courage is the one that lets you graciously admit that you are wrong when you no longer have a good reason to trade. The courage associated with the hero often destroys the courage that is needed to be successful. I have witnessed cases where temporarily successful traders have lost their touch because they lost their courage. They exceeded their stress point too many times. They became uncertain of their judgments. They sell when they should buy. They reduce when they should add. It is a wise trader who knows his stress point.”

If we want to become better traders, we need to rely more on ourselves, and less on the conventional wisdom offered by the industry experts. We have to build our own personal approaches. This process requires us to “try different things” for solutions to our problems. Personally, I have discovered many useful and profitable strategies by just testing different concepts and intuitions. I have also discovered a few useful strategies by accident. In other words, while testing one strategy, I discovered an even more significant strategy. This is fairly common. 

Dr. John Harvey Kellogg and his brother Will were searching for strict wholesome foods to feed ill patients, when Will accidentally left some boiled wheat sitting out. When it went stale, they hoped to roll it into long sheets as to not waste it, but it broke down into flakes. So they toasted the flakes, added some sugar and it turned out to be a big hit with the patients.  Kellogg’s corn flakes were discovered. 

The microwave oven was also accidentally discovered by Percy LeBaron Spencer of the Raytheon Company. He noticed that radar waves had melted a candy bar in his pocket. Further experiments showed that microwave heating could raise the internal temperature of many foods far more rapidly than a conventional oven. Now, what would breakfast be like without cornflakes or a microwave? 

The list goes on. Hypertension drugs led to Viagra and angiogenesis drugs led to the treatment of macular degeneration. Even Potato chips, penicillin and vulcanized rubber were discovered by accident.  In fact, a fair amount of what we claim was developed from research, was really accidental. Mostly it’s the result of undirected trial and error, packaged as controlled research. So, we should be out there every day exploring and testing our observations and intuitions, and trying to find application in our trading.

Author Nassim Taleb wrote, “America’s primary export, it appears, is trial-and-error, and the innovative knowledge attained in such a way. Trial-and-error has error in it; and most top-down traditional rational and academic environments do not like the fallibility of “error” and the embarrassment of not quite knowing where they’re going. The U.S. fosters entrepreneurs and creators, not exam-takers, bureaucrats or, worse, deluded economists. So the perceived weakness of the American pupil in conventional studies is where his or her very strength may lie. The American system of trial and error produces doers: Black Swan-hunting, dream-chasing entrepreneurs, with a tolerance for a certain class of risk-taking and for making plenty of small errors on the road to success or knowledge.”

It’s amazing to me how confident we humans can be about certain things. For example, if you ask someone if they are a good driver, they will most definitely say yes. In fact, a poll I read not that long ago said that 82% of drivers perceive themselves in the top 30% of all drivers. How in the world would a person know such a thing? A similar poll in the academic world found that when students were polled, 80% said they would finish in the top half of their class. Now, even I know that’s mathematically impossible. 

Michael Pompian, in his book Behavioral Finance and Wealth Management said, “The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which subjects over estimate both their own predictive abilities and the precision of the information they’ve been given. People are poorly calibrated in estimating probabilities- events they think are certain to happen are often far less than 100% certain to occur. In short, people think they are smarter and have better information than they actually do.” 

On CNBC for example, you will see a parade of experts that will tell you precisely where a market is going, or even more delusional, how the entire economy will unfold. The amazing part is they deliver their forecast with utmost confidence even though they have been mostly wrong in the past. They also seem to attribute any success to skill, never considering that luck may have played a role. What’s that old saying? Don’t ever confuse brains with a bull market. 

Although confidence is a good thing, being over confident can lead to arrogance and inflexibility when trading. Pompian goes on to say, “As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality.” This can cause us to put the blinders on when we see negative information. It can also cause us to have a larger position than we should, or be over weighted to one position. Most important, it seems the more we overestimate what we think we know, we simultaneously underestimate what we don’t know ……the downside risk.  

So I guess the moral of the story is being dead sure can sometimes lead to being just plain dead.

Do we really have a clear understanding of raw talent? Is there such a thing as a natural born trader? 

I think there is innate talent, but I also think it plays much less of a role in success than we think. Given two traders with equal aptitude, the one who works harder will win. Like any other field. 

Malcolm Gladwell in his book OUTLIERS, sites a study by The Academy of Music in Berlin. The study set out to discover just how far talent goes. In the study the schools most promising violinists were split into three groups. Group one was comprised of the “sure to be world-class” players. Group two were classified in a more “good” category and finally the “unlikely to play professionally” category. 

The students all began playing at roughly the same age, around five years old. They also practiced about the same three of hours a week. After a few years passed however, things changed. The students that would become the most successful began to escalate their practice sessions. By age twelve they were playing sixteen hours a week, and then thirty hours a week by the time they were twenty. It turns out, that by the age of twenty, the world-class put in over ten thousand hours as compared to about eight for group two, and four thousand hours for group three. 

Gladwell points out that “Their research suggests that once a musician has enough ability to get into a top music school, the thing that distinguishes one performer from another is how hard he or she works. That’s it”. 

I guess we could apply this to any school or profession. Larry Bird was not the most athletic guy in the NBA, but he would practice constantly, frequently shooting in the Boston Garden before or after games alone in the dark, hours on end. 

Gladwell also notes that John Lennon and Paul McCartney actually started playing together in 1957, before they formed The Beatles in 1960. By the time they hit some success in late 1963 they had performed an estimated 1200 times. In fact, they had played together over 10 years from the high school days, to the release of Sgt. Pepper’s Lonely Hearts Club Band. How many hours was that? I’ll bet more than 10,000. 

Even prodigies like Mozart, put in the time. His first recognized original masterpiece was concerto No. 9, which he composed when he was twenty-one years old. By twenty-one however, Mozart had been composing for over ten years. Not those 10,000 hours again! 

Some people think stress from working hard will kill you, but I think that depends on passion. Practicing hard at something you love is not the same as hard work. It only appears this way to people who don’t care for that particular endeavor. I constantly work on my trading and never feel like I’m working hard. In fact, not working hard enough at it is more stressful for me. It reminds me of the quote by Malcolm Forbes who once said “retirement has killed more people than hard work ever did.”