Why is All Trading Advice so Contradictory?


Trading is all about exits.
Nah -- trading is all about entries.
Trade with a minimum of 2:1 risk reward ratio
Nah -you’ll never make money if you don’t let your stops be bigger than your profits -- pigs get slaughtered.
If you want to make money trading follow your system rules.
Nah -- rules are meant to be broken -- they are just guidelines.

Spend an hour on the internet researching trading advice and you can easily conclude that this is a schizophrenic business and that no one has a clue as to what they are saying.

Trading advice may seem contradictory on the surface, but actually, it is not. It’s simply a matter of what trading model people choose to follow.

As I’ve noted many times before there are really only two ways to trade -- the lottery model and the insurance model. The lottery model is the traditional approach that looks for 2:1 or greater win ratio, has very few winners but makes sure that they are large enough to pay for the losers.
The insurance model, on the other hand, does the exact opposite, It tries to make almost every trade a winner and avoid losers as much as possible, but when it does get hit the loss is much larger than the wins. Just like the insurance business, it counts on winners (i.e. premium payments) to offset the rare losers.

Once you begin to view trading advice through the prism of these two models it makes much more sense. If you are following the lottery model and every potential trade could be a huge winner while the risk is generally small -- then, of course, you should follow the rules of your system and take every single trade. Discipline is paramount.

On the other hand, if you are trading the insurance way then passing up a single trade means almost nothing -- in fact, it may be hugely advantageous to do so, since you may miss a big loser which is the same thing as banking many winners. Discipline is actually idiotic and discretion is the key to success.

This also goes a long way to explaining why exiting early under the insurance model is actually very smart but under the lottery model can be ruinous. Under the insurance model, you are trying to avoid losses, your wins are practically guaranteed. So an early exit that avoids a major loss is the right move. On the other hand, an early exit from the lottery model can be devastating -- it’s the equivalent of losing your ticket before you can cash it.

The lottery/insurance duality also plays into trade selection. Lottery model traders should be very promiscuous with their entries (their risk is limited, but their payoff is large) but must be very disciplined with their exits (you need to bank massive wins to pay for a large number of losers.) Insurance model traders are just the opposite. They need to be extremely cautious with entries (the last thing you want to do is sell a life insurance policy to an overweight, chain smoking, motorcycle rider who doesn’t wear a helmet), but generally free to exit as they choose.

So when you hear two traders on the Internet yelling at each other, very often they are talking past each other.They are operating under completely different logic regimes. Therefore, before seeking anyone;’s advice or taking anyone’s criticism seriously understand your strategy and trade accordingly.

Boris Schlossberg

6 comments

  1. Michael says:

    As you said, you have written about this topic several times, but this time you have really clarified some things for me that has given me some ideas to test. Well thought out post Boris.

  2. Al Pascual says:

    You’re RIGHT. There’s no harm in taking profits. But this is a hard thing to do. Well, at least for me. Often times I’m like programmed to SELL at a price I would deem a good entry point. Then disaster sets in for playing Forex like a computer game. Not nical e.

  3. Ian Foster says:

    Why limit yourself by choosing either Lottery Model or Insurance Model?
    If you trade a Stat Arb technique using Value, then sure there is variablility about getting the ‘right entry’ since the Bigs may be in an accumulation phase for longer than you think – so you may not get the ‘home run’, though if you work your levels then eventually you will get the ‘home run’.
    So it makes sense to use a multi-unit Hybrid Model where you take some profit early (preventing the overall trade from making a loss), but you keep at least 1 unit as a ‘runner’ in case that entry was the ‘right one’. Then you can further scale-out at liquidity levels and scale back-in even bigger on pullbacks forming a much bigger overall position as it gets closer to the measured move + major liquidity target for a final exit.

  4. A. Cartagena says:

    Lottery model does not have to have more losers than winners it can be a 50/50, I was thinking this before that the only way to build a long lasting success in trading should be based on this 2 concept which to create at least a 50/50 winning rate or higher and a risk reward ratio which is above 1. If your strategy are based in these aspects I am sure that you will never be a loser in this market, granting that you can follow your trading rule all the time. But of course it is easier said than done, but at least trader traders knows what path he is into.

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