The Real Secret to Wealth is Not What You’ve Been Taught

Boris Schlossberg

Today we are faced with two opposite myths both of them wildly dangerous to your long-term financial health.

The “crypto/Lambo” myth is certainly much easier to understand and mock. This is the get-rich-quick myth that permeates all of trading. It comes in every flavor imaginable but the basic premise is the same. All you have to do is learn a few simple strategies and in a matter of months, you’ll be independently wealthy. It doesn’t matter what you trade -- stocks, options, forex -- the message is always the same. I. CAN. MAKE. YOU. RICH. Crypto is simply the latest incarnation of this age-old con, but equities work just as well. My personal favorite these days is a guy named Jason Bond (what brilliant scam name) whose Youtube ads are ubiquitous even on my five-year-olds Barbie channel (business rule 101 -- the faster someone talks, the more they are lying)

Of course, you can’t turn $1000 into $1 Million in a matter of years. Of course, you can’t make $10,000 per day every day in just a few hours of market trading. And no, of course, you can’t trade for a living with just $10,000 worth of capital.

But while the get-rich-day-trading scheme is easy to spot, the flip side can be just as deadly. This is of course is the you-don’t-have-to-do-anything to retire myth of index investing. The financial media constantly tells you all you have to do is drop 10% of your yearly income into an index fund and NOT DO ANYTHING. It will just magically compound to $1 Million! $2 Million! $5 Million! money pot and you will to retire to Boca and play golf with the sunshine boys for the rest of your carefree days.

Like all good myths, this one originated with a kernel of truth. Over the past 30 years the virtuous cycle of easy monetary policy (yes Virginia -- this is actually the MAIN reason stocks always go up -- check the 30-year bond for the past 30 years), massive technological advances and financial deregulation have created the perfect environment for the index investor. The financial press is full of gleeful stories of Mom and Pop savers eviscerating the Masters of the Universe on a daily, monthly, and multi-year basis. The “F-k me, I am a hedge fund manager” T-shirt, so popular in the early aughts seems as quaint now as the Lambo/crypto dream of 2017.

The message of the index myth is -- you don’t need to know anything, you don’t need to do anything, just buy the f-ing dip and money will grow like a magic tree.

I am not going to bore you with all the empirical data that I’ve already shared before how there are many, many periods in American history where that wasn’t true. I will, however, share just one interesting tidbit that I came across this week. Did you know that since 1962 (that’s 56 years) the return on Japanese equities is 2.72% per annum, for German equities it’s 3.46% and for Italian equities its … wait for it -0.38% per year! Now you can believe in American exceptionalism all you like but you would be beyond irresponsible to risk your financial wealth on that assumption.

In any case, there is something incredibly primitive about the index myth. What after all, is the difference between the indigenous people of the Amazon who perform the rain dance without understanding a thing about meteorological patterns and the index investors who perform the “saving dance” without understanding a thing about financial markets? Eventually, the drought comes. Eventually, there will be a time when 30 years worth of savings will evaporate in 30 days of the market meltdown and … the money will never come back. Don’t believe me? Just ask Mr. and Mrs. Watanabe who’ve never seen the Nikkei at its 1988 highs in their life.

So instead of falling for the get rich quick myth or the do-nothing-and-money-will-come-to-you myth, the reality is that we all need to become trader/investors. We all need to learn how to manage risk both in terms of size and stops. We all need to learn about algo trading. We all need to learn how to trade both sides of the market (not that there is anything with that). We. All. Need. To. Become. Active. Not. Passive.

It’s not glamorous to make 10 pips per day. It’s not easy either, but therein lies the true secret to long-term wealth. Because 10 pips per day will accrue to millions of dollars over years of trading. 10 pips per day is 25% per year -- which is huge if you understand the compound tables and even half that -- 5 pips per day -- is a pathway to financial security.

More importantly, it’s eminently doable. It’s doable not only from an absolute return point of view but from a volatility point of view. I can assure you that if you learn how to make 5 pips per day you will never put yourself in a position of losing 90% of your retirement savings in a matter of weeks. If you learn to trade actively, you will obtain the ultimate wealth building skill -- control.

The single most important trading system is – YOU

Boris Schlossberg

Standard economic thinking would have you believe that the bigger the financial incentive the better you will perform. The idea is that if I pay you more money you will exert more effort and will do the task better.

That’s actually partly true. Uri Gneezy, an economist at University of California at San Diego, paid college students $300 instead of the usual $30 to type a sequence of keys on the computer. Accuracy rates went up from 40% to 80%. For mindless rote activity higher incentive produces better results.

However, that assumption fails miserably when the task at hand requires even a modicum of cognitive ability. The same experiment of paying students tenfold to add a series of numbers in matrices showed a massive decline in success rates from 65% to just 40%.

An even more striking example of this dynamic occurred in poor regions of India where Gneezy ran an experiment asking people to pack tools in the most efficient manner. Participants were paid 10 cents, 1 dollar and 10 dollars each (10 dollars represented a month’s worth of wages for that cohort) At $1 per task 25% of participants succeeded in the task. When the payoff went to $10 every single person who took test failed it. That’s a remarkable insight into human psychology and goes a long way towards explaining why when you decide to “size up” on the exact same setup that you’ve been trading for years you suddenly start to bleed money.

The greatest thing about trading, aside from the potential for profit, the intellectual challenge of finance and the emotional engagement of the game is that the markets are probably the purest, biggest psychological laboratory in the world. If you are honest with yourself and step back to examine it you would have to admit that trading has probably revealed more about your true personality than any other activity you’ve ever done. Good or bad, the markets lay you bare in front of the world in ways that few other things in life do.

I was thinking about that a lot this week, after listening to a wonderful System Trader podcast interview with Mandi Pour Rafsendjani who, instead of focusing on yet another mind-numbingly boring quant system talked about what it really takes to be a successful trader. It’s a wonderful episode and I encourage you to listen to it -- but there were a few key points that she made which I thought were amazingly perceptive.

First and foremost if you are anything like me you probably got into trading for the sense of autonomy. You hate being told what to do. You hate working under other people’s rules and you like the sense of freedom that trading brings you, even with all of its crazy risks. But if you are that type of rebellious person, yoa u probably also hate paperwork and bureaucratic processes and record keeping. After all -- you are trader, not a bookkeeper!

Yet Mandi makes a very interesting point that it is precisely the structure of record keeping that is the gateway to the freedom you seek. Because it is only through record keeping that you will be able to improve. Mandi, who has interviewed scores of traders, notes that winners focus on facts and figures while losers focus on feelings.

Still, the record keeping she has in mind is unlike any you’ve ever seen before. Mandi will be the first to tell you that if you don’t have a setup that you can write out on the back of a napkin, you have nothing. In short, you need a clean, clear set of rules that will guide your trading. But keeping score of the winners, the losers, the drawdown, the entry and exit permutations, the instrument selections and all other usual suspects of trading is just the beginning. In fact for us in FX, the act of record keeping can be 99% automated with journaling websites like www.myfxbook.com.

When Mandi talks about record keeping, she has something else in mind entirely. She believes that record keeping of your state of mind is just as important as journaling your trades. Here are just some ideas she shares. Do you have a magic number of trades after which you get sloppy? For example, she notes that after five winning trades she tends to give a lot of her profits back. So now she simply walks away from the screen and works LESS. What about treating same trades in a different way? For example, when a trade initially goes into profit and then into a loss, do you have a hard time taking the stop versus a case of when a trade goes negative right away? (Guilty!) What about fixating on reaching a key dollar figure on your account equity (like say $10,000) which forces you to leave trades open because they haven’t reached your “target”? (Guilty!) What about trading a style that does not fit your personality because everyone tells you that’s what you are supposed to do? (Guilty!)

For me, the two greatest recent realizations have been that I am a serial, not a parallel trader. I do best when I trade one position at a time. (Read my New York subway column from a few weeks back for more details on that) The second most important realization is that I always lose money if I trade without an execution algo. If I am tapping buttons on my MT4 iPhone app as I dart in and out of the subway -- that is always the start of a journey to trading hell. I will ignore my sizing parameters, I will ignore my stops and I will inevitably cover for a loss after needlessly battling the market for days. On the other hand, if I am entering from a preset template off my well worn MT4 EAs, my control is assured. I may win or I may lose, but either way, I will do it properly and will not damage my account unnecessarily.

Using Mandi’s approach of recording your own state of mind as well as your trades has been an eye-opening process. The irony of her approach is that while winners may indeed be preoccupied with facts and figures while losers are obsessed with feelings, the key facts and figures aren’t actually the standard trade blotter, but the emotions you go through as you establish your trade. Losers may focus on feeling, but winners focus on recording and studying those feelings on a continuous basis. What becomes very clear as you listen to the podcast, is that profitability in trading is much less a function of tweaking your system parameters and much more the case of minimizing your tendency to make psychological errors. Walking away from the interview you realize that the single most important trading system is -- YOU.

Investing Discipline is Total Bulls-t

Boris Schlossberg

As an investor, how do you know if you are disciplined or stubborn?
If you go broke you are stubborn.
But if you survive and make money you are disciplined.
That’s laughably stupid if you think about it for longer than a minute.

Yet every single day you are bombarded with the conventional pablum that all you need to do is be “disciplined”, buy an index fund and keep buying more on a regular basis and 30 years later you will be rich. The underlying assumption is that the upward drift in stocks will continue infinitely. But the future is almost never just a slightly different version of the past.

Today, America is quickly losing economic power to China. It is destroying the only competitive advantage it has by banning immigrant labor which is responsible for almost all the intellectual contribution to the country’s economy. And it’s getting old. Everywhere you look the United States is a country of fat, old people in wheelchairs sucking up all the available tax dollars of Social Security and Medicare benefits, while the young struggle to live two to a room as they attempt to pay off their student loan obligations from which they can only escape through death.

So yes -- there is every possibility that the American Empire is following the path of Rome and that the wonderful 200 year plus run of progress and innovation that translated into a ever rising upward drift of equity prices could come to an end. And of course now that we find ourselves at the apex of equity valuation, not one person is thinking about the end of Pax Americana, just like the Romans submerged in their orgy of sex and violence of the Colosseum couldn’t possibly imagine that their way of life would be smashed to smithereens by hordes of primitive barbarians.

But I am getting too dark and frankly a bit off point. I have no idea when the US growth party will end, but it sure feels like it could be soon. More importantly, if it does end there will be literally nothing you can do to help yourself if you follow the conventional investing wisdom of the day. Discipline will lead to ruin as you just keep buying an ever falling asset.

The laughably false distinction between discipline and stubbornness (there is no way to judge which is which until you get the final result) was made very vivid this week by the tragic travails of David Einhorn -- a one time a hedge fund God, a Master of the Universe, the King of Value and the present day owner of Greenlight Capital who is suffering the humiliation of seeing his fund lose 20% this year. Again. Einhorn, who for the past ten years has been busy losing all the money that he made in the ten years prior, wrote a letter to his investors noting that, “Right now the market is telling us we are wrong, wrong, wrong about nearly everything….And yet, looking forward from today we think this portfolio makes a lot of sense… We have been accused of being stubborn, but one person’s stubbornness is another person’s discipline.”

To which the inimitable Matt Levine of Bloomberg, the best writer in finance today, responded, ”Yes! Correct! Let me make that a bit more explicit: If you have a plan, and you do the plan, and it makes money, people are like “good job being disciplined in sticking to your brilliant plan.” If you have a plan, and you do the plan, and it loses money, people are like “bad job being stubborn in sticking to your dumb plan.”

I mean! This is wrong! In fact, people regularly distinguish stubbornness from discipline, and evaluate the quality of your plan, without reference to current results; they care about the process by which the plan was arrived at and the quality of your reasoning and the convincingness of your explanation of how the plan will make money in the future. It is not incoherent to say “my strategy is good, and I am right to stick with it, even though so far it has lost money.” It is just kind of funny. And of course, in the long run, how would you distinguish stubbornness from discipline other than by results?”

Exactly.

But it doesn’t have to be that way. You don’t have wait until you lose 75% of your money -- whether you are a buy and hold Mom and Pop investor or hedge fund titan to find out if you are “disciplined” or “stubborn”. If you day trade and if you do it right (not correct, but right, meaning that you slice risk into teeny, tiny pieces by making lots of small trades, you will never put yourself into such a no-win situation. You will have near instant feedback on whether you are correct or not and more importantly you will have much greater control over your drawdown. My pal Robbie Booker showed me an account today where he made 12% return while drawing down just 3%. The best part is that he did it by trading 1000 unit size on a 10,000 dollar account.

That’s right he traded 1/10th leverage and STILL beat the S&P! But that’s not unusual. I have seen many traders in my chat room achieve 20% returns with 3% drawdowns all because they traded small and controlled risk on every trade.

That’s the beauty of day trading. The discipline is in the size and in the stop. You don’t need to come up with excuses. You don’t need to wait years to be proven right or wrong. Your results are there every day and you have much better control of your financial destiny.

The Absolutely Foolproof, Failsafe NYC Subway Trade

Boris Schlossberg

Presently, everybody hates the New York City subway. The system is slow, overcrowded, rife with delays and costs about $200 per month to ride. The single most popular connection between Brooklyn and Manhattan is being shut down for repairs for possibly years to come and the city has no solid plans for an alternative.

In the summer the platforms are 120F during the day and in the winter they can be 20F at the night. The Mayor hates the Governor, the Governor hates the Mayor and everyone in New York hates them both pining for the golden days of Mike Bloomberg who somehow without any monetary authority over the system (the subway is run by the state in New York) managed to clean it up and bring it kicking and screaming into the 21st century by actually installing electronic train arrival boards at every platform. That was the last innovation the system has seen this century.

The subway is such a sore subject with New Yorkers, that Miranda from Sex in the City is running for Governor of the State on this one issue alone, and while she is far behind Governor Cuomo right now, all it would take is one system-wide outage that lasts more than a day to kick his privileged ass out the door.

Still, despite all its shortcomings, the New York subway is a marvel of engineering. After London, it is the second oldest subway in the world with rail capacity that is greater than all the other subway systems in the US combined. Every day it moves more than 4 million people from point A to point B for a total annual ridership of more than a billion rides! That is a truly astounding achievement made more remarkable by the fact that amidst all that 24/7 movement of trains and people the system has had very few collisions in its history of operation. (The one recent exception was the collision of two work trains that injured a subway worker last year -- an exception that proves the rule, as you will soon see)

How does the New York subway avoid train collisions? Simple. It has an ironclad rule that no train can leave the station until the train ahead of it has left the station ahead. In other words, the NYC subway never puts itself into a situation where a train is traveling towards a station that may already have a train parked in it. This simple but very effective risk management technique has probably saved more lives than any other rule in the history of the system.

I was thinking about the New York subway the other day as I was heading back to my desk to trade the US session. It has a lot to teach us about failsafe methods in day trading.

How many times have you found yourself in a position of being long EURUSD long GBPUSD long AUDUSD and short USDJPY all at the same time? While you may think that you are holding four separate positions you are in fact just holding one. In reality, you are short the dollar at four times your trading size. It’s a hidden risk that few traders appreciate until it suddenly bites them in the ass. If the dollar suddenly strengthens you are stopped out not just once, but four times. The risk is even more magnified if you are also trading crosses that are all highly correlated. Of course, the setup can also go your way. If the dollar weakens all four positions will likely hit take profit. However, in day trading where most profitable systems trade with a negative risk-reward payoff such a setup usually produces a wildly negative payoff in the long run.

But what if we took a page out of the NYC subway playbook? What if we traded only one position at a time. What if we didn’t take any trades until the first trade resolved in a profit or loss? We would certainly miss some opportunities (probably less than you think) but on the other hand, we would have ironclad risk control on our account. We would trade sequentially rather than contemporaneously and would be far less vulnerable to an adverse move. Imagine the impact of a news bomb on your wrong-way perfectly correlated four contemporaneous positions that blow through all your stops and possibly even triggers a margin call. That is not a good place to be!

I fully understand that this one-train/one-trade structure may be a bit extreme for some of you. Perhaps you may want to loosen your rules to a maximum of two trades at a time or even three. Regardless of what you choose, we all have a lot to learn about risk control from the world’s least lovable but most active subway system.

Size Always Matters

Boris Schlossberg

One size for all or scale up for special trades? That is a never-ending debate in our business and I was reminded of it this week through an exchange of a tweets that really brought this issue to light.

On Thursday @FemaleTrader_A wrote, “Most of p&l in my life came from aggressively varying size and not from picking set ups. When RR in my favour+conviction, going really big, whilst being flat/small on the rest. Not cutting a bit, but cutting the whole thing.

$$ is at edge of ‘unpleasant’ usually…”

To which @Trader_Dante replied,”Totally get what you are saying although I had many times when my conviction was strongest and my bet size largest that I was wrong and ended up undoing a lot of work.
Now I only vary size based on stats personally.”

So who is right?

Well, the answer as is so often the case in trading is that it depends.

If you listen to most quant and algo driven traders the answer is obvious. Every trade should be the same size. That’s because the underlying worldview of algo trading is that every single trade is the same as the other. Algo traders view each trade with all the romance of Stalinist industrial planners -- it’s just a widget like any other so just stamp it out of your machine and go on to the next trade.

There are good reasons for following this protocol. If your trading strategy is based on some statistical sample set, especially one that’s large than varying size per trade will greatly skew your results from the expected value. If your system is based on high reward to risk profiles than you may get lucky and actually beat your expectancy, but more often than not if you are day trading the risk/reward skew is negative sometimes significantly so and in that case, size increase could be catastrophic to your outcome.

Yet history is full of examples of traders doing just the opposite. In fact, the greatest trader of all time -- George Soros -- is famous for stating that when you are right on something you can’t be big enough. His exact words were, “It takes courage to be a pig.”

The Soros GBPUSD trade when his Quantum fund broke the Bank of England and made $1 Billion in one day was the classic example of “have a hunch, bet a bunch” style that made him so profitable. Yet when you deconstruct what happened you realize that Soros wasn’t nearly as cavalier as he would have you believe. No doubt that the GBPUSD trade was massive, but its total risk was essentially limited to Quantum’s profits for the year. When Soros executed that trade his hedge fund was already up for the year by almost a billion dollars so the size of his bet on the pound was limited to profits, not capital. Still, it was a remarkable feat. Few of us would be willing to gamble a year’s worth of winnings on one single trade. And Soros did this many times throughout his career which is of course what makes him so great.

The history of Soros’s trading also shows that all trades are NOT the same. That there are points in market history -- inflection points when being a pig is absolutely the right thing to do. This, of course, requires nuance, understanding, context -- all things that are totally foreign to an algo trading robot.

Where does it leave us regular trading folk? Back to our own devices. You have to make peace with the approach you choose. I day trade FX majors every day. There are times during the session when I am very convinced that a combo of news and price action will move the pair in a certain way. Usually, I am right. But I never scale up. Like a grinder at the poker table, I keep all my trades the same size and focus on pumping out a few pips per day. It’s not glorious but I have a bigger goal in mind. I am focused on developing long-term low vol returns that I can compound for years to come. Furthermore, I know that when I am wrong BIG, I lose my emotional balance and it can take months for me to recover my equity as I spiral into a vortex of self-destructive behavior.

As always, trading is psychological rather than logical so you need to choose your path. Much as I would like to be like George Soros, I am a pip grinder instead.

In Trading Know When To Say When

Boris Schlossberg

As traders, we are always obsessed with the idea of how. How do we structure entries? How do we manage risk? How do we exit positions? All of those are legitimate concerns but I will argue that they all pale in importance relative to the question of when.

For the past month, I have been killing myself trying to design an FX day trading system that worked round the clock. No such luck. The system would work for a bit only to give everything back and then some. Nothing I did to its structure made much of a difference until I realized that it should only trade during the European hours. Why? Because this system is based on a continuation setup and prices have a much higher chance of continuation during the European dealing day than at any other time during the global day. In fact, if you were to run the numbers 70% of all price movement occurs during European hours. In retrospect, this, of course, makes eminent sense. Europe intersects both Asia and North America and therefore has the highest concentration of participants during its business hours leading to greater volume and biggest price moves. Now the system trades only during 0500 -- 1500 GMT and is doing much better.

In retrospect, it seemed obvious that day trading 24 hours per day is like wearing the same set of clothes for Siberia and Sahara. You will inevitably be wrongly dressed on the trip. Yet, as traders, we often get so immersed in our system developments that we forget this one very crucial fact. Indeed, in my opinion, this is the primary reason why almost all trading systems fail miserably -- they only focus on the how and never pay attention to when.

When is really a question that addresses context -- that most subtle yet most important element of trading. We all know that bad news gets bought in bull markets and good news gets bought in bull markets. In bear markets, it’s the exact opposite. The same inputs yet the output is diametrically different. And that dynamic doesn’t just apply to fundamental factors but to technical ones as well. In bull markets 20 period SMA will act as support. In bear markets, it will break and signal lower prices ahead. Context is everything.

Now the question of whether we are in a bull or a bear market is almost existential in nature and often impossible to answer until we are well within the regime. On the day trading horizon, however, the question of when is much easier to answer. One very obvious factor is scheduled news events -- be they economic releases, central bank meetings or political press conferences. Those events are usually known well in advance and can tell the trader when NOT to trade. Two of the best traders in my room, trade with very complex EAs. But they don’t let them run continuously. They are careful to turn them off ahead of the news and let the storm pass before engaging with the market. They both have ridiculously high rates -- and it’s not because of the setup rules (I know, I created those setups) -- it’s because they use those setups judiciously.

The when is much more important than the how.

They say trading is timing. That’s true in more ways than one. Most of us focus only on price action for timing and that may actually be the least important element of success. Choosing the proper time to activate your system is the real secret to profits in the market.

The Dirtiest Four Letter Word in the Trading Language

Boris Schlossberg

FOMO.

Fear of Missing Out is the dirtiest four-letter word in the trading language (it’s an acronym actually, but you get the idea)

In a great podcast Dr. Gary Dayton, who is practicing psychologist and is also a trader, uses the example of a parade to show how our mind forces us to do things that we would normally never do. Most of us watch happily watch a parade from the sidelines, and while we may enjoy the floats and the marching and may even cheer on the participants, few of us have the temptation to run into the parade and become part of the show. In that situation, our mind is able to make a clear delineation between spectacle and observation -- what Dayton calls mindfulness -- that allows us to keep our distance from the action.

Markets, of course, are different. To trade them we need to be both a spectator and a participant and therein lies the rub. The emotional pull of price action inevitably captures us in its grip and we wind up chasing trades. Who amongst us hasn’t bought the top tick or sold the lowest bar only to see the trade rip our face off? Virtually every massive loss I’ve ever had started out as FOMO which then morphed into “add to the position” play and eventually a painful loss that was much bigger than it needed to be.

Yet, as Dr. Dayton points out the old Nancy Reagan just-say-no-use-your-willpower approach will always fail. No matter how many times we tell ourselves we shouldn’t chase -- we will because our mind is controlled by emotions and suppressing them will never work. I invite you to listen to the full podcast which goes into the neuropsychology of aspects of the human brain and amygdala impact on our actions, but suffice it to say that according to Dr. Dayton the only way we can get better control over FOMO is by practicing what he terms, “mindfulness” which is another way of saying meditation.

Now if you are like me, and meditation is as appealing to you as a root canal, if the idea of contemplating your toothbrush, or thinking about the slickness of the soap as you do the dishes is something you know you will never do, then I have a better idea that may appeal to the trader in you.

I call this trick -- “market mindfulness”. The idea is to imagine the absolute perfect form that your set up should take (see my column from a few weeks ago -- Plato trades FX) and then open up the charts and look for at least 10 or 20 examples of that setup. Not only will this exercise create “mindfulness” because it will force you to focus on what you love, but it will also serve another much more valuable purpose. By looking through 10 or 20 charts of your “perfect” setup every day you will build up the vital psychological distance you need to resist FOMO at every turn. After all, once you know how a money making setup looks, anything that deviates from that is a lot easier to resist. And looking at the charts in the quiet of your home office is a lot more fun than meditating about your breathing.

Want to Trade Better? Use Dual Momentum

Boris Schlossberg

For years market researchers have known that momentum works. In a perfectly efficient market momentum should have been arbitraged away long ago, but the outperformance of the strategy has persisted for years, decades, even centuries. It is perhaps the single strongest evidence that markets are in no way fully efficient.

The simple explanation for the phenomenon is crowding behavior. Despite our large brains that can perform complex symbolic manipulation, we are nothing but glorified monkeys and the instinct for group behavior is so hardwired in our genes that we can’t help it, That’s why prices go to extremes and why momentum continues to work despite its seemingly excess returns. (See bitcoin).

However, making money from momentum is a lot harder than it looks. Momentum is, after all, just another word for trend and trend trading as we all know can be subject to horrid whipsaws that can drain away all the trend gains.

That’s why I was fascinated, the other day when I stumbled across an episode of Better System Trader podcast interview of Gary Antonacci who invented the idea of dual momentum.

Gary’s basic premise is that there two types of momentum -- absolute and relative. Absolute momentum shows a rate of change against the instrument itself, so for example if the S&P 500 is rising relative to last month it is showing absolute momentum. Relative momentum shows the instrument’s performance against related instruments say -- S&P 500 versus the DAX.

Gary’s thesis is that when both absolute and relative momentum is in place, the chance of outperformance vastly improves. There are numerous examples on his website with links to his book and there is even a better discussion of the concept on a blog that I found doing research for this column.

This is great reading both for intellectually curious and for those who invest for the long term, but how does it apply to us, traders? Ironically enough before I even came across Gary’s ideas, I stumbled upon the very same concept in my own trading. Playing Leibniz to Gary’s Newton I realized that dual momentum is crucial to my day trading trend setup as well.

As many of you know I have been refining my trend strategy for months and the EA is finally taking shape. It hasn’t reached the “Platonic” ideal, but it’s as close as it is going to get. Yet just as I was about to put the finishing touches on the code, I realized that I could improve my entries by adding an absolute momentum filter. If you assume that the basic trend breakout signal is evidence of relative momentum ( a currency pair is outperforming its peers) then filtering on time frames can help you a gauge the absolute momentum (i.e. a pair shows momentum on 1M vs. 5M or 1H vs. 4H and so on).

Since I trade on the short time frame, I now never take trades on the 1M chart if 5M chart does not confirm the trend. But the principle is universal. You can apply it to 1H vs. 4H charts or Daily vs. Weekly. The key concept is that both absolute and relative momentum must align.

As always this filter is more valuable for keeping you out of trades rather than taking them, but that’s precisely the point. The primary value of dual momentum is to keep you out of losing trades. That is its main advantage versus buy and hold investing and that’s why it helps with day trading as well. To paraphrase Ben Franklin on this July 4th -- a stop avoided is a take profit earned.

Let Plato Design The Perfect Trading System for You

Boris Schlossberg

Plato’s cave is one of the greatest philosophical fictions ever invented. The idea that we don’t truly see the real world but only the mere shadows of things, that our perception of reality is limited by our own flawed senses is such a powerful concept that it remains a topic of debate and discussion 2500 years later, just as Plato’s work, the Republic continues to be the foundation of the Western intellectual canon.

In writing about Plato, Robephiles notes that “Plato was distrustful of the senses when it came to the ability to perceive knowledge. Plato knew that our senses could be fooled and he placed an emphasis on our abilities to think and reason rather than the knowledge gained from the study of the physical world.

This leads us to another famous metaphysical idea, The Theory of the Forms. Plato was fascinated by the problems of universals. An example would be as if I told you I had a dog. If I told you this you might picture a poodle or you might picture a mastiff or a chow or a border collie. These are all dogs yet each one is so different in its particulars. What makes a dog have its essential ‘dogness’? “

In an age of data science, Monte Carlo simulations and million backtests per second, the empirical model -- so successful in the physical sciences -- now completely dominates our world of social science of which finance and trading are a part.

But what if I were to say to you that maybe we have it all wrong? What if I were to argue that the endless data mining we all do -- the search for the perfect indicator, the perfect Fib level, the perfect volatility envelope are all just a giant waste of time. Ironically enough, empiricism would prove me right. Almost every trading system ever invented fails miserably under real-life conditions despite often showing perfect statistical accuracy often to the 99% confidence level. The irony of trading is that we put all our faith in an empirical model that empirically fail us.

But what if we set aside all of our modern tools of computation and started thinking like a 2500-year-old philosopher? What if we applied Plato’s Theory of Forms to the very pedestrian idea of a trend? Granted, trend can come in many shapes and sizes. It could be jagged and rambling with massive choppiness within it. It could be steady and smooth with hardly a retrace in the move. Or it could be something in between.

However, the “trendiness” of trend just like the essential “dogness” of dog is marked by some general characteristics that make it identifiable. In case of trend the best “class” of trend is one marked by higher highs in an uptrend and lower lows in a downtrend.

Thinking about this “Platonic ideal of trend” has really helped me refine my latest trading system. It made me eliminate any element that is extraneous to the setup -- and because it forced me to create much stricter rules for entry, I make much fewer trades. On the face of it that may sound like a negative to a daytrader like me, but in reality, it made my trades much more accurate than before. And it gave me clarity of analysis that I’ve rarely had before.

In the modern world, so full of experimentation and empiricism, we are conditioned to stay away from deductive reasoning. But perhaps the truth is just the opposite. Perhaps instead of running endless backtests to torture the price data, we should just imagine the ideal version of our setup. Perhaps in trading what we need is a lot less data science and a lot more Platonic philosophy.

Never Drink at a Vegas Table

Boris Schlossberg

Molly’s Game is a movie that has nothing to do with the markets, but every trader should see it, for this one scene alone.

The movie centers around a life of brilliant Olympic skier, who after a career-ending injury, stumbles into the world of high stakes poker, running games for various celebrities and businessmen in LA and then NY. In this one scene in the movie, a very good poker player gets bluffed by the worst player at the table and completely loses his composure. The poker term for it is “going on tilt”. He starts gambling wildly desperately trying to get his stack back.

It’s truly painful to watch as loses hundreds of thousands of dollars on one bad play after another. Although the scene has nothing do with the markets, it instantly resonated with me as I remembered all my own moments of going on tilt after the vagaries of the market got the better of me. Just one bad fill, a to-the-pip stop that then went on to hit take profit, or one just missed take profit that then went on to stop me out were often all that was needed to trigger a nasty bout of revenge trading that left me considerably worse off than I was before. Molly’s Game will be forever seared in my mind as a testament to the fact that no matter how well you know the game, the true enemy is not the market but your own psyche.

All throughout the scene, Molly is begging the poker player to walk away from the table, but of course, he refuses. This made me think about Vegas and the fact that they love to serve you free drinks on the casino floor. Why do you think they do that? Because they know that the longer you stay at the table the greater the chance that you will give back all your winnings and your starting bankroll as well.

The market is very much the same way. It’s not that most of us can’t win at trading, it’s that most of us can’t keep the winnings we make because we stay at the table too long.

For the past few weeks, I’ve been running a continuous trend EA desperately trying to make it work on a 24-hour basis. The setup was extremely sound but inevitably it gave back all of its winnings on the very last trade of the cycle as it sold the lows or bought the highs. Regardless of the safeguards in place, the EA could not apriori anticipate the change of market regime. Finally, I realized that no EA ever could. That’s why in the history of all EAs there has never been a continuous EA that has ever made money, because as I’ve noted a million times, all algos are simply divided into two types of strategy -- continuity and mean reversion and for an EA to make money continuously would be like saying that a person can sleep and be awake at the same time ( side disclosure -- when I was younger I used to sleep with my eyes open, which freaked out more than one of my camp bunkmates, but that is not the same thing).

Anyway as soon as I realized that the problem with my setup wasn’t the strategy, but the fact that I kept running it too long, I changed my tactics completely and made my EA single trade only, entering the market only when evidence of a new trend was appearing. In a sense I started trading like a good poker player, entering the game only when pot odds favored my cards while perfectly willing to sit out any hands that did not meet my criteria.
End result?

+99.1 pips in live trading on BOE Rate Announcement day in less than two hours of stress-free work.

4 Simple Ways to Determine if Your Trading System is Truly Viable

Boris Schlossberg

One of the best trading resources that I recently discovered is Andrew Swanscott’s podcast called Better System Trader. Even if you are not interested in systematic research and just want to trade discretionarily, the trading insights from the interviews are worth a listen.

One episode I found very valuable is an interview with Art Collins who is long time systematic trader in US stock and bond futures. Art wrote a book, called Beating the Financial Futures Markets which I have yet to read, but his analysis of what makes for a viable trading system really impressed me so I thought this week I would share his ideas with you.

Before all else, Art makes a point that I’ve heard over and over again from many different traders. The single most important aspect of the system is that it be in sync with your personality. If you are like me and like constant action then trading 100 times per day on a 1-minute chart is perfectly fine, as long as you adjust the system to the reality you’ve chosen. If you are like Kathy and think that such an approach is utterly ridiculous and prefer to make 2-3 well-chosen trades per day using the four-hour chart -- that fine too. (I would rather get a root canal without anesthesia, but to each is own.)

That being said, Art has four key metrics to judge a system.

One.
Does it make sense? Do you understand the underlying drivers? If you do not understand what the system is doing you will abandon it at the first sign of trouble. Generally, as I’ve noted many times before there are only two types of trading systems -- continuity and mean reversion. Systems will naturally underperform in adverse market regimes, but If you have a favorable market environment (trending) and your continuity system is not performing you need to quickly assess what’s wrong and to do that you need to know how the trades work.

Two.
Don’t Optimize. Don’t Tweak. Don’t try to avoid the pain. Accept the drawdown because if you don’t it will only get worse. So if you are looking at a series of parameters make sure that if you chose a slightly different one the results will not be much different from all the other parameters. If they are that means your parameter is less than worthless because it only works on a particular set of data in the past.

Three.
At very minimum, the system must work on related markets. For Art that means that if the system is designed for S&P it must also work on Nasdaq and Russell. For us, in FX we need to make sure that the trade idea works on several related pairs, not just one. Earlier this week I had a system that looked very promising but when I analyzed the underlying data I realized that GBPUSD was responsible for 62% of the profit but it comprised just 16% of the trades. My new version was much better balanced with no pair accounting for more than 25% of the profit while comprising 16% of the portfolio. That’s the kind of distribution you want because that means you are capturing repeatable price behavior rather than one-off action.

Four.
And this is perhaps the most important and overlooked aspect of system analysis. Make sure that the bulk of your profits does not come from a very narrow time interval because then it’s a function of luck rather than skill. Since I day trade around the clock with fixed stops and losses, I avoid that problem by creating as much uniformity in my trades as possible. But if you trade on longer time frames with variable profits and losses you should study your results very carefully to make sure that they are not skewed by one or two lucky big trades.

Lastly, Art says that one of the best ways to analyze the robustness of a system is to divide the total profit by maximum drawdown -- something I’ve intuitively done for years and prefer much more than the traditional Sharpe or Sortino ratio measures. But even here you need to be careful. If your system has massively large stops it could provide you with a very unrealistic picture of its robustness. For example one of the best traders in my room had a “return on account” (that’s what this ratio is called) of more than 10. She was up 22% on equity with a drawdown of only 2%. But that’s because the system was trading with massive negative skew (the risk-reward was 1:5) so the losses were rare and provided a false sense of security. Fortunately, she wasn’t fooled by the data and traded at very low leverage to prepare for any large losses that could come like an avalanche. Generally, the return on account of 2:1 or better is a sign that you are doing things well and a much better way to assess the risk of the strategy than the simple risk/reward ratio of any given trade.

I’ll be in Madrid next week at the annual Forex Day show, so no column next week, but come say hi if you are there, it would be great to meet everyone at the show.

AUDUSD – Is that All There is

AUDUSD – Is that All There is

Chart Of The Day

At the start of the week, the Aussie got the bulls hearts racing as it barrelled through the .7600 level on much better than expected Retail Sales data. But the excitement didn’t last as the RBA quickly poured cold water over any expectations that the central bank would alter its neutral stance anytime soon.

The RBA kept rates on hold for 22nd consecutive month offering nothing new as far as future plans. It made a mildly positive remark about the trough in wage growth, but wages remain well below the RBA normal growth path of 3.5% and in the meantime the central bank remains concerned about the growing trade tensions between US and China, worried that Australia may bear the fallout of any trade war.

Today the market will get a look at the Aussie GDP data which is expected to rise by 0.9% versus 0.4% the month prior. A good print could put the pair back on track towards the .7650 level but the pair remains capped at .7700 for now. Still, the positive data this week should keep the pair supported and it looks like it made a clear longterm bottom at the .7500 level