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Be Thankful for “Fortune’s Formula”
There is perhaps no greater skill in trading than losing. To be successful you need to be comfortable with the idea of either losing small amounts frequently or large amounts rarely. In either case, the psychological impact is less than pleasant and almost every single trading error ever made stems from not being able to lose well.
Losing well is the fine art of not giving a f-. This is exceedingly difficult to do. Markets have novel and unexpected ways of torturing you, no matter how well prepared you think you are.
One very good trick to try is to walk back through any backtest you have and look at losing trades only. Quite often you will find that they can be clustered -- a sure sign of regime change in the market. However, the point of that exercise is not to tweak or curve fit the trades, but rather to imagine your reaction in the midst of the losing streak.
Athletes, gurus and all self-improvement books always teach you to visualize your winners. That may work in sport or real business, but in the Alice-in-Wonderland world of the markets, it’s much better to visualize your losers because that is where the real strength lies. If you can walk through the losing periods in your head, it makes it a lot easier to walk through them in a real trading environment.
Of course, The only ultimate defense against losses is small size -- mainly because small size make you honor your stops and therefore control risk. I’ve mentioned in the past the great benefits of trading any system on 0.01 lot for a good period of time, just so that you can become comfortable with its quirks.
Impatience is the enemy of all traders -- but there are two types of impatience that I generally see. The first is getting into trades at unfavorable prices as FOMO (fear of missing out) kicks in. That’s very common but can be overcome with strict entry and exit rules.
The second is far more insidious -- which is the impatience to make big money. That always causes traders to size up right away, which puts double pressure on them when the trade goes wrong -- the pressure of size and the pressure of losing. The pressure of loss is bad enough so it’s little wonder that the standard cycle of trading is -- lever up, get stuck in a losing trade, get margined out or close out in dejection losing more than 50% of equity and walk away with head bowed.
Trading tiny is a great way to start, but even when you are ready to trade bigger size, there is a great tool that all traders should use called the Kelly Criterion. Dubbed, “the fortune’s formula” in popular trading literature, it actually has some serious weaknesses that I will discuss in next week’s column, but its central thesis is pure gold -- and should be seared into every trader’s mind.
The principle idea behind Kelly Criterion is that a trader should never bet a fixed amount of capital per trade, but rather some percent of equity. This way when your equity declines you will bet less and when your equity increases you will bet more.
I’ll go through the Kelly Criterion in more detail next week, but for now, this is my holiday gift to you -- adopt a proportional trade size to whatever setup you are using, and your risk of ruin will decline markedly.