The 25-Point Mantra: Discipline for Day Trading

The success that a trader achieves in the markets is directly correlated to one’s trading discipline or lack thereof. Trading discipline is 90 percent of the game. The formula is very simple: Trade with discipline and you will succeed; trade without discipline and you will fail.

I have been a trader and member of the Chicago Board of Trade (CBOT) for 20 years. During my successful pit-trading career as a scalper, I traded in three different contract markets: 30-Year Treasury bonds at the CBOT, the S&P 500 at the Chicago Mercantile Exchange (CME) and the Gilts at the London International Financial Futures Exchange (LIFFE). Currently, I also trade the electronic $5 Dow futures contract on the CBOT as time permits.

Although my formal academic education consists of a bachelor’s degree in business administration from the University of Denver, I never considered myself to be an extremely gifted student. I have no formal training in market technical analysis. I’m unable to even set up a Fibonacci study or Moving Average study on a charting package, let alone know how to trade with such data. I have no formal training in market fundamental analysis. I don’t understand the economic causal relationship between the actions of the Federal Open Market Committee and Treasury bond prices or equity prices.

How, then, have I been able to succeed, day after day, trading the markets for more than 20 years? The answer is simple: I trade with discipline, and I respect the market. When I’m wrong I get out immediately, and when I’m right, I don’t get too greedy. I’m content with small winners and I’m accepting of small losers.

Just as I now mentor my trading clients regarding performance, discipline and profit/loss management, I was mentored by one of the best traders ever to set foot on the CBOT trading floor, David Goldberg. David was a long-time spread scalper in the wheat pit and a principal of Goldberg Bros., at the time one of the largest clearing firms at the CBOT, CME and Chicago Board Options Exchange (CBOE). David taught me the rules of trading discipline. I listened to his guidance and gradually, over time, became more and more successful. The student has now become the teacher.

The Wheel of Success

There are three spokes that make up, what I call the “Wheel of Success” as it relates to trading. The first spoke is content. Content consists of all the external and internal market information that traders utilize to make their trading decisions. All traders must purchase value-added content that provides utility in making their trading decisions.

The most important type of content is internal market information (IMI). IMI simply is time and price information as disseminated by the exchanges. After all, we all make our trading decisions in the present tense based on time and price. In order to “scalp” the markets effectively, we must have the most live and up-to-date time and price information seamlessly delivered to our PCs through a reliable execution platform and/or charting package. Without instantaneous time and price information, we would be trading in the dark.

The second spoke is mechanics. Mechanics is how you access the markets and the methodology that you employ to enter/exit your trades. You must master mechanics before you can enjoy any success as a trader. A simple keystroke error can result in a loss of thousands of dollars. A trader can ruin his entire day with an inadvertent trade entry error.

Once you have mastered order execution, though, it is like riding a bike. The process of entering and exiting trades becomes seamless and mindless. Fast and efficient trade execution, especially if you are trading with a scalping methodology, will enable you to hit a bid or take an offer before your competitors do. Remember, the fastest survive.

The third and most important spoke in the Wheel of Success is discipline. You must attain discipline if you ever hope to achieve any level of trading success. Trading discipline is practiced 100 percent of the time, every trade, every day.

Review the following 25 Rules of Trading Discipline. You must condition yourself to behave with discipline over and over again. Many of my traders and clients read through the rules every day (believe it or not) before the trading session begins. It doesn’t take more than three minutes to read through them. Think of the exercise as praying — reminding you how to conduct yourself throughout the trading session.

1. The market pays you to be disciplined.
Trading with discipline will put more money in your pocket and take less money out. The one constant truth concerning the markets is that discipline = increased profits.

2. Be disciplined every day, in every trade, and the market will reward you. But don't claim to be disciplined if you are not 100 percent of the time.
Being disciplined is of the utmost importance, but it’s not a sometimes thing, like claiming you quit a bad habit, such as smoking. If you claim to quit smoking but you sneak a cigarette every once in a while, then you clearly have not quit smoking. If you trade with discipline nine out of ten trades, then you can’t claim to be a disciplined trader. It is the one undisciplined trade that will really hurt your overall performance for the day. Discipline must be practiced on every trade.

When I state that “the market will reward you,” typically it is in recognizing less of a loss on a losing trade than if you were stubborn and held on too long to a bad trade. Thus, if I lose $200 on a trade, but I would have lost $1,000 if I had remained in that losing trade, I can claim that I “saved” myself $800 in additional losses by exiting the bad trade with haste.

3. Always lower your trade size when you're trading poorly.
All good traders follow this rule. Why continue to lose on five lots (contracts) per trade when you could save yourself a lot of money by lowering your trade size down to a one lot on your next trade? If I have two losing trades in a row, I always lower my trade size down to a one lot. If my next two trades are profitable, then I move my trade size back up to my original lot size.

It’s like a batter in baseball who has struck out his last two times at bat. The next time up he will choke up on the bat, shorten his swing and try to make contact. Trading is the same: lower your trade size, try to make a tick or two — or even scratch the trade — and then raise your trade size after two consecutive winning trades.

4. Never turn a winner into a loser.
We have all violated this rule. However, it should be our goal to try harder not to violate it in the future. What we are really talking about here is the greed factor. The market has rewarded you by moving in the direction of your position, however, you are not satisfied with a small winner. Thus you hold onto the trade in the hopes of a larger gain, only to watch the market turn and move against you. Of course, inevitably you now hesitate and the trade further deteriorates into a substantial loss.

There’s no need to be greedy. It’s only one trade. You’ll make many more trades throughout the session and many more throughout the next trading sessions. Opportunity exists in the marketplace all of the time. Remember: No one trade should make or break your performance for the day. Don’t be greedy.

5. Your biggest loser can’t exceed your biggest winner.
Keep a trade log of all your trades throughout the session. If, for example, you know that, so far, your biggest winner on the day is five e-Mini S&P points, then do not allow a losing trade to exceed those five points. If you do allow a loss to exceed your biggest gain then, effectively, what you have when you net out the biggest winner and biggest loss is a net loss on the two trades. Not good.

6. Develop a methodology and stick with it. don’t change methodologies from day to day.
I require my “students” to actually write down the specific market prerequisites (set-ups) that must take place in order for them to make a trade. I don’t necessarily care what the methodology is, but I do want them to make sure that they have a set of rules, market set-ups or price action that must appear in order for them to take the trade. You must have a game plan.

If you have a proven methodology but it doesn’t seem to be working in a given trading session, don’t go home that night and try to devise another one. If your methodology works more than one-half of the trading sessions, then stick with it.

7. Be yourself. Don’t try to be someone else.
In all of my years as a trader I never traded more than a 50 lot on any individual trade. Sure, I would have liked to be able to trade like colleagues in the pit who were regularly trading 100 or 200 lots per trade. However, I didn’t possess the emotional or psychological skill set necessary to trade such big size. That’s OK. I knew that my comfort zone was somewhere between 10 and 20 lots per trade. Typically, if I traded more than 20 lots, I would “butcher” the trade. Emotionally I could not handle that size. The trade would inevitably turn into a loser because I could not trade with the same talent level that I possessed with a 10 lot.

Learn to accept your comfort zone as it relates to trade size. You are who you are.

8. You always want to be able to come back and play the next day.
Never put yourself in the precarious position of losing more money than you can afford. The worst feeling in the world is wanting to trade and not being able to do so because the equity in your account is too low and your brokerage firm will not allow you to continue unless you submit more funds.

I require my students to place daily downside limits on their performance. For example, your daily loss limit can never exceed $500. Once you reach the $500 loss limit, you must turn your PC off and call it a day. You can always come back tomorrow.

9. Earn the right to trade bigger.
Too many new traders think that because they have $25,000 equity in their trading account that they somehow have the right to trade five or ten e-Mini S&P contracts. This cannot be further from the truth. If you can’t trade a one lot successfully, what makes you think that you have the right to trade a 10 lot?

I demand that my students show me a trading profit over the course of ten consecutive trading days trading a one lot only. When they have achieved a profitable ten-day period, in my eyes, they have earned the right to trade a two lot for the next ten trading sessions.

Remember: if you are trading poorly with two lots you must lower your trade size down to a one lot.

10. Get out of your losers.
You are not a “loser” because you have a losing trade on. You are, however, a loser if you do not get out of the losing trade once you recognize that the trade is no good. It’s amazing to me how accurate your gut is as a market indicator. If, in your gut, you have the idea that the trade is no good then it’s probably no good. Time to exit.

Every trader has losing trades throughout the session. A typical trade day for me consists of 33 percent losing trades, 33 percent scratches and 33 percent winners. I exit my losers very quickly. They don’t cost me much. So, although I have either lost or scratched over two-thirds of my trades for the day, I still go home a winner.

11. The first loss is the best loss.
Once you come to the realization that your trade is no good it’s best to exit immediately. “It’s never a loser until you get out” and “Not to worry, it’ll come back” are often said tongue in cheek, by traders in the pit. Once the phrase is stated, it is an affirmation that the trader realizes that the trade is no good, it is not coming back and it is time to exit.

12. Don’t hope and pray. If you do, you will lose.
When I was a new and undisciplined trader, I can’t tell you how many times that I prayed to the “Bond god.” My prayers were a plea to help me out of a less-than-pleasant trade position. I would pray for some sort of divine intervention that, by the way, never materialized. I soon realized that praying to the “Bond god” or any other “futures god” was a wasted exercise. Just get out!

13. don’t worry about news. it’s history.
I have never understood why so many electronic traders listen to or watch CNBC, MSNBC, Bloomberg News or FNN all day long. The “talking heads” on these programs know very little about market dynamics and market price action. Very few, if any, have ever even traded a one lot in any pit on any exchange. Yet they claim to be experts on everything.

Before becoming a “trading and markets expert,” the guy on CNBC reporting hourly from the Bond Pit, was a phone clerk on the trading floor. Obviously this qualifies him to be an expert! He, and others, can provide no utility to you. Treat it for what it really is…. entertainment.

The fact is: The reporting that you hear on the business programs is “old news.” The story has already been dissected and consumed by the professional market participants long before the “news” has been disseminated. Do not trade off of the reporting. It’s too late.

14. Don’t speculate. if you do, you will lose.
In all of the years that I have been a trader and associated with traders, I have never met a successful speculator. It is impossible to speculate and consistently print large winners. Don’t be a speculator. Be a trader.

Short-term scalping of the markets is the answer. The probability of a winning day or week is greatly increased if you trade short term: small winners and even smaller losses.

15. Love to lose money.
This rule is the one that I get the most questions and feedback on by traders from all over the world. Traders ask, “What do you mean, love to lose money. Are you crazy?”

No, I’m not crazy. What I mean is to accept the fact that you are going to have losing trades throughout the trading session. Get out of your losers quickly. Love to get out of your losers quickly. It will save you a lot of trading capital and will make you a much better trader.

16. If your trade is not going anywhere in a given timeframe, it’s time to exit.
This rule relates to the theory of capital flow. It is trading capital that pushes a market one way or another. An oversupply or imbalance of buy orders will push the market up. An oversupply of sell orders will push the market lower.

When price stagnation is present (as typically happens many times throughout the trading session), the market and its participants are telling us that, at the present time, they are happy or satisfied with the prevailing bid and offer.

You don’t want to be in the market at these times. The market is not going anywhere. It is a waste of time, capital and emotional energy. It’s much better to wait for the market to heat up a little and then place your trade.

17. Never take a big loss. Only a big loss can hurt you.
Please review rules #5, #8, #10, #11 and #15. If you follow any one of these rules you will never violate rule #17.

Big losses prevent you from having a winning day. They wipe out too many small winners that you have worked so hard to achieve. Big losses also “kill you” from a psychological and emotional standpoint. It takes a long time to get your confidence back after taking a big loss on a trade.

18. make a little bit everyday. dig your ditches. don’t fill them in.
When I was a young bond trader, my goal every day was to make 10 bond tics. A tic is $31.25, so if I made 10 tics on the day, I would be up $312.50.

It may not sound like a lot of money to you, but it surely was to me. My mentor, David Goldberg, told me that if I could make 10 bond tics every trading day of the year, at the end of the year I would be up $72,500 in my trading account. Not bad for a 23-year old kid in 1982.

It is amazing how quickly your trading account will build up over time just by making a little bit every day. If you are a new e-Mini S&P trader try to make just 5 or 6 points per day. If you can do that you’ll have that $72,000 at the end of the year.

19. Hit singles not home runs.
Just as I don’t know of any successful speculators, I don’t know of any trader who goes into a trade expecting to hit a home run and then actually having it happen. You should never approach a trade with the idea that it’s going to be a huge winner. Sometimes they turn out that way, but the times that I have a hit a home run on a position is most definitely luck, not skill.

My intent on the trade was to produce a small winner but, because I had the trade on, and at the same time (as luck would have it), the Fed unexpectedly entered the market, I unwittingly had a huge winner. This probably has happened to me less than five times in 20 years.

20. consistency builds confidence and control.
How nice is it to be able to turn on your PC in the morning knowing that if you play by the Rules, trade with discipline and stick to your methodology, the probability of a successful day is high.

I’ve had years where I could count on one hand the number of losing days that I had. Don’t you think that this consistency allowed me to be extremely confident? I knew that I was going to make money on any given day. Why would I think otherwise? Making a little bit everyday (Rules #18 and #19) will allow you to trade throughout the trading session with confidence and control.

Remember Rule #9: If you make a little bit every day, then you have earned the right to trade bigger. Thus, by following the Rules of Discipline, your “little bit” can soon turn into much more profitable days.

21. Learn to sweat out (scale out) your winners.
The net effect of scaling out of your winners will be an increased average win per trade while keeping your losses to your pre-defined risk parameters.

You should never scale out of your losers. If your trade size is more than a one lot and your trade is a loser, you must exit the entire position en masse. If your trade size is more than a one lot and your trade is a winner, it is best to exit one-half of your position at your first price target.

If you trade with protective stop-loss orders, you should amend the order to reflect the change in trade size (remember you have exited one-half of your position) and raise or lower the stop price, depending on whether it’s a long or short position, to your original initiating trade entry price. You now are essentially “playing with the house’s money.” You can’t lose on the remaining position, and that’s obviously a fantastic position in which to put yourself. Place a limit order a few tics above or below the market, depending on your position, sit back and relax.

22. Make the same type of trades over and over again – be a bricklayer.
A bricklayer shows up for work every day of his working life and executes with the same methodology—brick by brick by brick.

The same consistency applies to traders, as well. Please review Rules #6 and #20. I have not changed my trading methodology and execution strategy in 20 years. I guess I’m the bricklayer.

23. don’t over-analyze. don’t procrastinate. don’t hesitate. if you do, you will lose.
I can’t tell you how many times traders have come into my office terribly depressed because they “knew” the market was going one way or another; however, they failed to put a position on. When I ask them why they did not put the trade on, their responses are always the same: they did not want to chase the market. They were waiting to be filled at the absolute best possible price (and never got filled), or only two out of three of their market indicators were present and they were waiting for the third.

The net result of all this procrastination and hesitation is the trader was correct in deducing market direction but his profit on the trade was zero. We don’t get paid in this business unless we put the trade on. Don’t over-analyze the trade. Place the trade and then manage it. If you’re wrong, get out. But you’ll never be right unless you actually make the trade.

24. all traders are created equal in the eyes of the market.
We all start out the day the same. We all start out at zero. Once the bell rings and trading begins, it’s how we conduct ourselves from a behavioral standpoint that will dictate whether or not we will make money on the day. If you follow the 25 Rules, you should do well. If you do not, you will do poorly.

25. It’s the market itself that wields the ultimate scale of justice.
The market moves wherever it wants to go. It does not care about you or me. It does not play favorites. It does not discriminate. It does not intentionally harm any one individual. The market is always right.

You must learn to respect the market. The market will mercilessly punish you if you do not play by the Rules. Learn to condition yourself to play by the 25 Rules of Trading Discipline and you will be rewarded.

Friday, 24 June 2011

Inside the Counterintuitive World of Trend Followers: It's Not What You Think. It's What You Know.


In his book, Trend Following, Michael Covel states that trend followers have a philosophy that informs their trading. What is all too easy to miss is that these philosophies aren’t after-dinner digressions. When trend followers say they have a philosophy, they are talking about how they know the world around them, and this knowledge is not from books. It is won from the world and is quite empirical.

The trend-following philosophy can be summarized in seven statements – taken in part from actual utterances of trend followers (and the rest used with poetic license as regards their principles). Each will be covered in detail in the ensuing paragraphs. They are:

• No one can predict the future;
• If you can take the would-be, could-be, should-be out of life and look at what actually is, you have a big advantage over most human beings;
• What matters can be measured, so keep refining your measurements;
• You don’t need to know when something will happen to know that it will;
• Prices can only move up, down or sideways;
• Losses are a part of life; and
• There is only now.

The difference between trend followers and other types of traders isn’t one of style. What trend followers do is outside the scope of normal human reactions. Frankly, their deeply counterintuitive strategy should alert other traders that something very different is going on.

SIDEBAR
------------------------------------------
Ed Seykota’s Trading Tribe

Trend followers tend to be careful observers who notice trends everywhere; those observations include their own emotions while trading. Ed Seykota’s investigations of how trends in emotions affect trading first appeared in his now-famous interview in the original Market Wizards book. “Win or lose, everybody gets what they want from the market. Some people seem to like to lose, so they win by losing money.”

Over the last decade, Seykota has extended these apparently paradoxical insights into trading and life with another set of assertions; that we need to feel our feelings – those we like and especially those we don’t like. If we resist our feelings, we wind up creating “dramas” in our lives and in our trading so that we have to feel these feelings. As he puts it, “The feelings you are unwilling to feel are your real trading system.”

In many emotionally charged situations, like trading, a full expression of our feelings is stifled by an inner judgment about these feelings. Seykota calls this a “k-not.” Avoiding these k-nots becomes more important than any stated goal. The way to untie these k-nots is to experience the feelings, but because these are the feelings we are unwilling to feel, we need the support and acknowledgement of others. Seykota insists that traders need to band together in “Trading Tribes” where they can encourage each other to face, embrace and celebrate these feelings through a process known as the Trading Tribe Process (TTP®).

In TTP, a trader voluntarily takes the “hot seat” and other Tribe members encourage him. According to participants, when a trader feels his feelings fully, he often experiences an “a-ha” along with spontaneous insights and revisions of previously problematic trading behaviors.

Whether this sounds offbeat or on the money may depend on your attitude toward men’s groups, warrior training or something similar. You can find out for yourself through Seykota’s website www.tradingtribe.com.
------------------------------------------

Take the adage every trader knows: “Cut your losses, let your profits run.” Clearly, every trader will agree that it is the hardest thing to do. Why? Is it because “a bird in the hand is worth two in the bush” (or in the account)? Or is it because when your dog runs away from home, he is usually back by dinner? Trend followers know about these experiences, and they know something else: They know that all of these examples are anecdotal. They are just personal experiences and beliefs that will bias their judgement. Trend followers know that these instances are not reliable guides to the nature of markets. All right then, what is?

No One Can Predict the Future
“There is no predicting anything,” the very successful trend follower, John W. Henry, tells us. What this means is that all of your hunches, intuitions and beliefs about how the world works are steeped in self-deception. Thus, despite pronouncements of a bunch of experts on television or elsewhere, tech stocks are not trading because of anything; gold is not moving for anybody. The Fed rate is not changing for a particular reason. It’s not that there are not market influences or market makers or reasons that markets change. There are. It’s just that there are so many of them. But to quantify them and to make a judgment about their relative weights and influences is beyond the possibility of anyone.

Trend follower and president of Dunn Capital, Bill Dunn, has a doctorate in theoretical physics. No one gets a doctorate in that discipline without understanding, in a deep way, the “three-body” problem. In the celestial version, Sir Isaac Newton found a way to mathematically describe the interaction of two bodies – the earth and the moon. To do this, he ignored all the other influences in the heavens. Enough for a start, he assumed his two-body solution would lead to solutions being found for the interaction of three, four and more. Two centuries later, they hadn’t. Finally, to speed things along, a prize was offered by the king of Sweden. It was won in 1889 by Henri Poincare, but not for solving it. He demonstrated that it could not be solved.

Professor Poincare found that with just three bodies, the behavior of each one affecting the other made it impossible to calculate directly what was going on, and therefore, how the bodies would affect each other. The same is true of the relationships between stocks, bonds and futures. Approximations are possible, but counterintuitively the more accurate that market participants try to make their models, the more these models cease to describe what is going on in the world.

The conclusion is, quite simply, that the world is much richer and more detailed than any model, and every model of complex behavior (starting with only three bodies) will fall short of a description that allows prediction. Was that too much detail? It turns out that trend followers are fascinated with the details of what is in the world and how it works. They live and work in the world of what is.

Look at What Is
If you can take the would-be, could-be and should-be out of life and look at what actually is, you have a big advantage over most human beings. Take these remarks by John W. Henry when asked how he created and maintains his discipline: “Well, you create discipline by having a strategy you really believe in. If you haven’t done your homework properly and haven’t made assumptions that you can really live with when you’re faced with difficult periods, then it won’t work. It really doesn’t take much discipline if you have tremendous confidence in what you’re doing.”

What are these assumptions? Henry is clear about them – “No one consistently can predict anything, especially investors…” and “…other investors are convinced that they can predict the future, and I believe that’s where our profits come from.”

Notice that Henry’s assumptions are not social givens such as, “I assume you are joining us for dinner,” or “I assume I’m going to be rich.” They are not even beliefs in the psychological sense, that is, a feeling of certainty about something that cannot be determined for sure. Many traders and trading coaches will read Henry’s statement and conclude that what they need is tremendous self-confidence, an indomitable belief in the likelihood their success. They will want to instill beliefs like, “I will be a great trader,” or “I deserve to be rich.” But these “success beliefs” miss the point when it comes to trend following. It isn’t what trend followers think of themselves that matters, it’s what they know about the world.

[Editor’s note: For more information on John W. Henry’s trading philosophy, please see his feature interview in July 2004 SFO.]

What Matters Can Be Measured
What kind of assumptions do you make if “there is no predicting anything?” If there is no predicting anything, what do trend followers do when they do their research? If they have already taken the would-be, could-be and should-be out of the scenario in order to look at what is, then what is?

All traders know that there are vast quantities of price data available. What trend followers measure is the likelihood of price patterns recurring – in other words, probabilities. With probabilities, the human feeling for a market, intuitions about price movements and the gratifying feedback of getting it right disappear.

Jerry Parker, top trend follower and president of Chesapeake Capital, reminds us that trend-following metrics and measurements are “…not intuitive, not natural, too long term, not exciting enough.” They are experienced as counterintuitive.

Market wizard Richard Dennis (whose hobbies include studying baseball statistics) is attributed with saying, “If your system makes a little money all year and loses a lot of money twice a year, reverse your system.” This sounds crazy, but Dennis has run the numbers, and the couple of wins will outstrip all the losses the rest of the year by a wide margin.

Trend follower trader Ed Seykota adds, “If you can’t measure it, you probably can’t manage it.” This certainly applies to Dennis’ example.

“When” Doesn’t Matter
You don’t need to know when something will happen to know that it will. Trend followers know there is a statistically significant likelihood that a big payoff trade is coming, but they do not know in what market and they do not know when, so they must take every trade their systems generate. They know the vast majority of the trades the systems generate will result in a loss or a small gain. Richard Dennis is reported to have had an extraordinary number of winning trades for a trend trader, 55 percent, and it is said that he still made all of his “real money” on less than five percent of his trades.

To do this, trend followers must live at least part of life in this larger, abstract and statistical scope of time. For trend followers, the everyday moments of trading participate inside a “campaign” in a certain market or instrument where traders see each moment as the possibility of a statistical opportunity. This tends to reduce the importance of individual trades. The price will move – that’s what is. There is a statistical probability for each outcome. One of the actual outcomes will happen.

Prices Only Move Up, Down or Sideways
Computerized trading software is so prevalent that traders can quickly create a trading system so complex that is it quite beyond their understanding. Meanwhile, clarity of thought and simplicity of design are the hallmarks of a good trend-following system. Trend followers know that however deep or complex their thinking is about trading, the input to their system is limited to one of three possible states – price increase, decrease or no change – and the final output of their system must be one of three actions, buy, sell or do nothing. This allows for fast heuristics.

Losses Are a Part of Life
In his classic, The Battle for Investment Survival, Gerald Loeb writes, “Accepting losses is the most important single investment device to insure safety of capital. It is also the action people know the least about and that which they are least liable to execute.” Though this statement should resonate with all traders, it has a special meaning for trend followers.

Trend followers tend to be more aware of the relationship between losses and gains than other types of traders. They realize that a large loss affects their trading gains over the lifetime of their portfolio. They realize that trading less frequently reduces the number of their losses as well as transaction costs and, so, is another effective means of preserving their capital.

According to Ed Seykota, elements of good trading include, “(1) cutting losses, (2) cutting losses and (3) cutting losses. If you can follow these three rules, you may have a chance.” Few non-trend-following traders realize that Seykota is talking about three different kinds of losses. The first two of them are offered above – reducing the largest loss by strictly limiting position size and reducing the overall number of trades. Only trend followers know about the third. To quote John W. Henry again, “The desire to have close stops to preserve open trade equity has tremendous costs over decades.” In essence, he is referring to cutting the exit stops that would turn trades into losses in volatile markets and greatly reduce eventual gains. This once again draws attention to the fact that trend followers, while trading in the same markets as everyone else, are living and working in profoundly different and more detailed worlds.

Does this make taking a loss easier? Yes and no. Yes, trend followers know they can’t know the future, that there are statistical opportunities for those who know how to exploit them, that they must respond to every opportunity, and that they must preserve capital to continue trading. They backtest this until they are convinced it’s the case. Then they set up their systems and take the trades that the system calls.

And no, trend followers are human and hate to part with something of value. The need for the adage “Cut your losses, let your profits run,” is much like the need for the Ten Commandments. We do not have to be told what is in our nature. In going against our nature, instinct and a lifetime of cultural conditioning, trend followers really earn their money.

What About the Rest of Us?
Some people call economics the dismal science. But those people haven’t talked to cognitive neuroscientists. According to their research, we humans have limited perceptual as well as information-processing abilities. When faced with decisions, whenever possible we tend to use simple rules and short-cuts, and we apply a criterion of sufficiency (good enough for now) – with little review of possible consequences and in a way that requires the least possible effort.

So, clearly, most of us will not measure up to the stiff requirements of successful trend following. On the other hand, these differences are due to the encouragement of some innate attitudes like curiosity about the world and some life-changing experiences like studying physics or learning about probabilities.

For example, Bill Dunn and Ed Seykota are graduates in physics and engineering. John W. Henry became convinced of his assumptions as a student when he collaborated with his college instructor on a strategy for beating the odds at blackjack. As any reader of Edward O. Thorp’s famous book, Beat the Dealer, can tell you, it’s all about the probabilities. In fact, the number of outstanding traders mentioned in Jack Schwager’s two Market Wizards books, some of whom started as gamblers, could fill a suit in a deck of cards. This makes sense. A trader who directly experiences the results of probabilities over and over again will become convinced that he doesn’t need to know the future to win. He will recognize that the odds/probabilities shift over time. If this sounds like an encouragement to join the current poker craze, it’s not. But if you do, keep in mind you are “at the table” to practice these odds-watching skills. The stakes need to be small enough that you are learning from your experience, not adding more traumas to your trading.

Another way to get started is to get more curious about the world of what is. Your children can help you with this, and even if you don’t have any, you can still take a walk in the woods and notice that the shape of the leaves, branches and the trees are similar each other. Or go shopping and notice how you respond to closeouts and one-of-a-kind items. Or how people decide on what to order in a restaurant. Fractal market analysis, behavioral finance and heuristics all started with people noticing these kinds of things about the world everybody else thought they already knew. So do many trading ideas.

Trend followers can’t trust their senses or their intuition or their better judgment. They deal in quantities and probabilities with bodies and minds designed for instincts and feelings. To paraphrase Woody Allen, their experience of the world may be untrustworthy, but it’s the only place they can get a great steak. Us too.

No comments:

Post a Comment