The Monotony of Trading

Boris Schlossberg

MT4Traderfest 2019 -- A FREE Weekend Webinar Spectacular for All Retail Forex Traders

Someone on Elite Trader posted this the other day, “People never realize the monotony of trading. Making money is exciting but can you go stay in and day out with the same repetitive discipline and not get bored when the market is slow or you are accumulating losses.”

Of course not.

Which is why so many of us get in trouble with prop trading, which above else requires the discipline to NOT trade. Take a walk down memory lane and it’s almost certain that most of your biggest losers were simply bored trades gone wrong.

Which is why it’s been such a pleasure lately to hand over most of my trading to my robot who has no problem with boredom and can sit in a position for a day, a week, a month -- whatever it takes.

We’ve had an extraordinary week in BK so far, capturing 500 pips in our little algo land. And sure, most of it is due to the confluence of strategy and market regime and when things change we can puke up just as much (hopefully less) but the thing that struck me the most about the past few weeks is how robots have made us much better prop traders.

I was sitting at lunch with K today (who has been absolutely killing it with her prop calls in the chatroom this week) and remarked how much better her market vision has been recently. Same with me. My own little prop account in which I putz around on the side has been consistently green every day since the start of the year.

And then it hit me.

The robots have taken all the pressure away. There was no longer a need to “find fresh” trades every day. The robots found them, took them, managed them. This gave us the time to think, to react intelligently to the news putting us on the right side of the trade more often than not. The prop-trading got better without much effort on our part.

Mind you, this isn’t an argument for 100% algo trading (although you do NEED to COME to my MT4 Traderfest this weekend) rather this is just a simple observation that sometimes the best benefits of algo trading are ones you didn’t even consider.

Willpower is Bulls-t.

Boris Schlossberg

MT4Traderfest 2019 -- A FREE Weekend Webinar Spectacular for All Retail Forex Traders

Willpower.
Discipline.
Self-control.

For decades we’ve been told that these are the foundational principles of successful trading.
I am here to say that these are all lies.

Now I come from a family that survived rape by the Cossacks, Hitler’s killing fields in Stalingrad, Stalin’s killing fields in Siberia and endless rounds of interrogation by KGB.

My mother, at the age of 80, when told by doctors to lose weight in order to help her malfunctioning heart valve, lost 30 pounds in 6 months by literally eating a single prune every day until dinner without so much as a single peep of complaint. So you could say that I am quite familiar with the power of willpower. And yet I am here to tell you that its bulls-t.

Don’t get me wrong. Willpower is important. The more you have, the better are your chances of success, but the latest evidence from scientific studies shows that willpower is a finite resource and if we squander it on too many decisions we will inevitably fail to control ourselves.

Think about it. How many times have you told yourself you will honor your stop, honor your setup, honor your size -- and actually did so for a week, a month or perhaps even a year -- only to succumb to one false temptation of a trade an unwound all of your gains in a matter of hours?

It’s not your fault. We are simply made that way. Every single person has a breaking point. Everyone. To paraphrase a billboard I once saw -- its a matter of chemistry, not character. The more scientists study human behavior, the more they realize that we all have only a finite amount of mental and physical strength to resist the stressors in our life. Some have more, some less -- but the bottom line is that the romantic notion of a cowboy trader, completely self-contained, self-controlled and immune to any and all pain -- be it physical or psychological is complete nonsense. Willpower requires immense mental focus and we can only sustain that focus for so long.

Have you ever traded 30, 40, 50 times in a day? You are inevitably mentally exhausted and almost always at breakeven or barely profitable by end of the day.

Why?

Because you’ve made too many decisions which almost certainly made you lose focus and make errors. No matter how much willpower you applied, I bet you made more money on days when you just made 1 or 2 well-chosen trades.

I’ve been thinking a lot about willpower over the holidays after I handed off all of my trading execution to my EA robots. Here are just of the things I did not have to do. I didn’t have to check the size or the entry side of my trade. I didn’t have to manage risk or take profit. I didn’t have to select the pairs. I didn’t have to time my entries or check quotes every two hours of my sleep. I outsourced a massive amount of clerical decision making to my computer, which never tired, never made a mistake and actually managed to trade through the flash crash with panache while I was having a blissful dinner with my eldest child only vaguely aware that USDJPY dropped 500 pips in 50 minutes for essentially no reason. If I was at the screen at the time, I can almost assure you I would have done much worse than my algo, as the emotion of the moment would no doubt overwhelm my willpower.

Now please don’t get me wrong. I am not arguing that algos are some magic success formulas that print money on demand. Algos can and do lose money all the time. There is no such thing as a set it and forget it strategy. But it is a truly massive difference in both focus and performance when all you need to do is manage the algo rather than the dirty work of managing the trade. By using our willpower on only the most important functions of trading we conserve our focus and apply the discipline where it matters most.

With my algos humming away in the background, today’s NFP was one of the least stressful sessions of the year for me. I was able to see the field of play with much greater clarity, much to the delight of the BK chat room members who banked very decent pips off my calls.

So while I can’t promise you that algo trading will make you profitable, I can guarantee you that it will make you a better trader. Which is why I am hoping you can come to our FREE MT4 Traderfest next weekend and learn about the advantages of rules-based trading. It’s time for the machines to help us conserve our willpower for times when we need it most.

MT4TraderFestHeader

Three Trading Truths I learned This Year

Boris Schlossberg

1. “Never” and “always” are the two most dangerous trading words in the English language.
Idiotic statements like “smart money is never wrong” or “this setup always works” are a straight path to a blowup. The other day I was watching a YouTube video with more than 150K views where the guy was arrogantly pitching as his own the SSI strategy that K and I helped develop back in our FXCM days. Basically, the FXCM SSI index measures the client positioning in any given currency pair and then takes the opposite side especially as the positioning goes to the extremes. Now generally that is mostly a good idea. Most of retail is usually on the wrong side of the trade most of the time. But not always. In the case of SSI the FXCM brass was so sure of their new little indicator that they convinced a large French bank to trade the model with a very sizable prop account. Unfortunately, at that time the euro went on about a 3000 pip slide with no stops along the way and as retail kept getting shorter, the bank kept getting longer and blew out more money than you can imagine. So no. The “dumb money” is not always wrong and you can lose even on “never-gonna-happen” bets. The only proper way to use those words in trading is: “There is always a chance I am wrong,” and “I will never bet my whole bankroll on this one trade idea.” In short, the most important things I learned in 2018 is to be humble. Always. And arrogant. Never.

2. Robots trade better than I.
After years and years of resisting rules-based trading, I finally realized that my strategies are much more profitable when they are executed systematically. Robots don’t hesitate on entries. Robots don’t pull stops. Robots don’t sleep and miss out on trades. Robots don’t accidentally hit a buy instead of a sell button and robots don’t trade ten times the intended position size (unless you configured them wrong). None of this means that systematic trading will automatically make you profitable, but it does offer you a multitude of advantages over point and click trading. One of the traders in my chat room noted that we should view our trading robots as assistants -- and I think that a perfect analogy for how we should view the systematic process. There is no such thing as set it and forget it trading. Robots help you with execution and logical structure, they free you from the tyranny of looking at every tick on the screen but it is still up to you to analyze and adjust the strategy and always be aware of the market. The future of retail trading is robot. The sooner you realize that the better a trader you will become.

3. F- passive. After several years of ranting against the mindless advice of Bogleheads that passive investing is the only way to get rich, we are finally seeing the disaster that it truly is as we close out the worst December in market history. The pain is just starting. If you have all your retirement money in equities prepare to possibly lose 50% of your money, just like Bitcoin traders. The worst part is that passive investors couldn’t do anything about it even if they wanted to because they don’t have the skills to manage risk. They’ve been taught to ask no questions and drop money in their retirement account every month, with the same monolithic fervor of a North Korean people’s rally. Even if I am 100% wrong ( and I certainly can be -- see #1) most passive investors will not survive this dip because they are completely unaccustomed to risk and they certainly capitulate at the bottom. On the other hand, we retail traders live and breathe risk every day and at very least know a thing or two about position sizing and stops. So let the passives enjoy a few more months of illusion. As market regime changes from an unending one-way rally, we retail traders will be ready to surf the price waves and keep risk under control. Here is to a great 2019!

Happy Trading everyone.

What Marriage Therapy Can Teach You About the Markets

Boris Schlossberg

Don’t worry. I am not in counseling. My relationship is fine, thank you very much, because my wife and I naturally do two things that all therapists seem to prescribe -- we give each other plenty of space and we accept rather try to change each other’s behavior.

But I am not here to talk about my marriage, instead, I want to discuss Esther Perel’s marriage therapy podcast -- “Where Should We Begin?” which contains a wealth of wisdom for any relationship you have, including the one with the market. You may not have heard of Esther, but she is definitely internet famous with a TED talk that has been seen more than 13 Million times and a best selling book called Mating in Captivity.

Every week Esther does a therapy session with a troubled couple that she then edits into an hour-long podcast. The podcast has the voyeuristic pull of a detective story as she prods and pulls the hidden bits of each person’s background to create complex and fascinating explanations for why we do the things we do.

But mostly the podcast is remarkable for the throwaway pensees that Esther dispenses throughout the show in her Belgian accented English. One of her key ideas is that “You can either be right or you can be married.” which any successfully married person will tell you is eminently true.

In markets, this can be summarized as “You can either be right or you can be profitable.” The more I trade the more I appreciate the absolute truth of that idea. For the longest time, I believed that you needed to trade with large negative risk-reward ratio because you needed to be “right” to win. But as I started to develop systems that move closer and closer to even money bets I realized that being right is hugely overrated.

If you can learn to accept your spouses worst habits your marriage will be much happier. No matter how many “tweaks”, no matter how many “behavioral adjustments”, no matter how many “talks” you have your spouse is unlikely to change. People almost never change their core self and neither do the markets. Capital markets, in fact, are far more efficient and far less pliable than people and that means your opportunity for profit is more limited than you think. I used to always tell traders that you can win big or you can win often, but you can’t win big often. Now I’ve come to accept that your edge can be even slim yet viable. If you can win 55%-60% on even money bets you will be set forever but that means you must be accept losing. A lot. Trades come in streaks and a 55% edge can easily result in 4,5,6, sometimes even 7 losers in a row and still be viable.

Which brings me to my favorite Esther Perel saying -- be reflective, not reactive.

Anyone who knows me for more than a minute knows that I am the embodiment of reactive behavior. There is no debate I won’t join, no argument I won’t start, no fight I won’t jump into at a moments notice. And of course, that behavior spills over into trading all the time. Did I get stopped out? Well, f- that, I am going in again, at double the size because the market is full of morons and doesn’t know what it is doing. Of course, reactivity rarely succeeds.

So today I tried something different. Today was ECB day and after Draghi’s lame attempt to bluster his way through what is clearly a hemorrhaging Eurozone economy, I was convinced the euro should fall. It did initially, but the drop was shallow and I was stopped on the rebound. Pissed, I re-shorted again but price refused to buckle. That’s when I decided to take Esther’s advice to trade reflectively rather than reactively. One of my oldest and truest trading rules is that if funda points one way and price goes the other trust price. Much as it pained me to do so at that moment, I reversed the trades in the late afternoon NY session even though I saw no reason for why the pair should rally. Of course, rally it did, because sellers ran out of orders and dealers were able to squeeze the late shorts for 20 pips into the close. Thank you very much. Acting reflectively beats acting reactively anytime.

As traders we spend all our time looking at some logical construct to beat the market, forgetting that at the core trading is a psychological rather than a logical enterprise. Our relationship with the market is a kind of marriage. In some cases that relationship may be even more durable and more intense than with our spouse. To trade well we all need Esther Perel’s therapy from time to time in order to keep the spark alive.

What Really Matters in Trading

Boris Schlossberg

Trading can be deconstructed into three parts -- analysis, setup, and structure. We spend an inordinate amount of time on the first two components, but it may be the third part of the process that is most important to long-term success.

Analysis be it fundamental, technical or both is of course crucial to making good trades, but in the end it all boils down to handicapping human behavior. Every trade is an implicit IF/THEN statement that assumes some sort of causation. In a highly dynamic environment like the market where a new input could upend the underlying thesis anytime (just ask anyone who has ever run into a news bomb or some massive order that completely flipped the supply/demand balance) noise is a huge problem for anyone who trades. The shorter the time frame, the greater the noise. That’s why day trading is such a challenge and why I’ve been arguing that the 1-hour time frame is the shortest reasonable period for retail traders to consider.

Of course, we all want to trader shorter because longer-term charts are boring, signals are few and we have to practice the most dreaded four letter word in trading -- WAIT. The issue is further complicated by a seemingly sensible but highly deceptive assumption we all make -- shorter-term trading needs smaller stops, therefore we can use larger leverage. On the face of it, it makes sense. After all, a 10 pip or 20 pip stop is nothing! We can trade on 10:1 lever and still only lose 1% to 2% of equity max. But we always forget the noise factor. A choppy, intraday market can seduce us into false breakout three, four, five even ten times in a row. That’s how most traders lose 10-20% of an account in a day even they hold tight stops. The only way to survive the vicissitudes of daily price action is to actually risk just 10 basis point per trade, but who amongst us does that?

Pulling away from the endless discussions of day trading which often remind me of medieval debates about how many angels can dance on the tip of a pin, we need to realize that what really matters in trading is structure. By structure, I mean the risk/payout factors on every trade. Conventional wisdom always argues for a 2 to 1 risk reward approach. That’s nice in theory where you can argue that you need only to be right 40% of the time to make money, but in practice, it is impossible to do. 40% win rate implies a 60% loss rate -- and that is under the best circumstances!

Imagine losing six trades in a row before you hit a winner. Now imagine doing that five, ten, twenty, fifty times a year. The human psyche is just not designed for so much consistent disappointment. My personal experience with retail traders is that most people can tolerate three losers in a row. After that, they either get angry or depressed, but in both cases, they walk away from the setup -- even if it proves to be profitable in the end.

The only way to overcome this problem is to create a structure that is both logically and psychologically robust. And the only way I know how to do that is with a two target exit. You need a short target that can be hit frequently and long target that will be hit rarely but will pay for your losses when you hit it. By definition, such a structure calls for a 2 unit entry and therefore doubles your risk on every trade. That’s why this final part is KEY to making this structure work. In order for your trades to have a long-term edge, the sum profit of your target must be larger than your risk. For example let’s say you are trading with a 50 pip stop, a short target or 40 pips and long target of 100 pips. There are three outcomes to this trade. You lose 100 pips. You make 40 pips and the second unit stops out at break even. Or you hit both targets and make 140 pips. Notice that in scenario number three your total profit of 140 pips is greater than your risk of 100 pips. That’s exactly what you want. If you have strong set up a third of the trades will stop out at -100. A third will bank 40 pips and the final third will make 140 pips and pay for all the losses.

Almost every quant will tell you that scaling out of a trade is not a logically optimal strategy. And they are absolutely right. And absolutely wrong. To succeed in the markets you need a plan that is both logically sound and psychologically optimal which is what makes this structure so robust.

The Perfect Time Frame for the Retail Trader

Boris Schlossberg

I’ve been running a variety of my algos, both for the BK chat room and for my own account and the longer I trade the variations the more it becomes evident that the one hour chart is the perfect frame for the retail trader.

There are two principal reasons for this. The one hour is responsive the daily swing flows of the market while at the same time long enough to avoid the random ebb and flow of intraday prices. As retail traders, we simply can’t compete on the sub pip level of market makers and HFT algos. It’s akin to driving the Autobahn in a Chevy Cruze. No matter how hard you try you will never be able to drive against the BMWs, the Audis, the Mercedes’ and the Porsches.

It is fun to try, however, which is why we all gravitate to the 1-minute or the 5-minute chart. But the spread, the commission, the market volatility create an almost impossible execution environment and that’s why we should allocate most of our capital to the longer time frames (say in a 70/30 split) in order to truly optimize the chance of success.

The 1-hour chart is no panacea and certainly won’t guarantee success and is not even immune from news bombs which could flip sentiment in an instant and wipe out perfectly good trades. Still, it is slow enough to catch most of the more meaningful market signals and it allows for larger stops and limits which by their very essence protect you from the randomness of the lower level charts.

Yet even on lower level charts, the algos have taught me that less is more.

There is nothing quite like attaching a new EA on 12 or more pairs and seeing it trigger a multitude of trades on 1 minute and 5 minutes charts. It’s exciting! It’s fun! It’s action packed! But very soon you see one, two, three trades go sour all once and then it’s no longer enjoyable. The profits of the past few hours begin to melt away and then quickly turn to losses and then to truly bad losses, especially if you are trading your regular size. Very quickly you realize that you can’t trade a lot and win. You are not a market maker with infinite capital, split-second execution and access to near choice spreads. You are price taker like it or not and that means you need to choose carefully.

That’s actually one of the great advantages of trading retail. Unlike market makers and HFT algos, you are not compelled to trade. You can step away anytime you want -- that’s a huge edge that most retail traders overlook because they just want to be in a game. But an algo, even a very good one quickly shows you the folly of your ways.

On my 1-minute chart, I’ve winnowed myself down to just three pairs and 5 most liquid hours of market trade. That means I may only do 2-4 trades per day. And that’s enough. In fact ideal. The more you trade, the more you lose -- it’s the everlasting truth of the markets but algos help you discover it, mighty quickly.

My Robot Trades Like Warren Buffet But I Can’t

Boris Schlossberg

The other day I saw a Youtube video of a guy trading the NFPs on his iPhone. He was randomly buying dips in USDJPY at clips of $1 Million, $3 Million, $5 Million at a time against an account size of $5000 USD.

Never mind that he was an American trading illegally with an unregulated overseas broker. Never mind that he was trading at 1000:1 lever factor. Never mind that he was never actually going to see a dime of his winnings (Do you REALLY think any broker who offers 1000:1 lever will actually return your money?)

In a few short hours, he turned that $5000 into 20K and I must admit it was exciting to watch. And that’s exactly what’s wrong with that video. It was the ultimate “dollar and a dream” lottery moment. It was that perfect hit of dopamine that we all crave from the market and of course, it is the road to ruin. Leverage is the opiate of the FX market. It can make us feel like a hero, but the high always wears out and the crash always comes.

The truth of trading is a lot more mundane. Like a sex scene in a Hollywood movie, like a comedy routine written from scratch, the reality of the situation is considerably more pedestrian and far less glamorous than we think. It’s 10 pips and a cloud of dust. Over and over and over again.

Which brings me to Warren Buffett and my robot. Today I read a very interesting article about Mr. Buffett that had a very different take on his success. In Buffett’s Underrated Investment Attribute the writer argues that Buffett’s greatest is skill lies not in picking great investment ideas, but rather walking away from bad ones. The writer gives the example of Sears which in 2005 looked like a toss-up -- yet Buffett passed on the idea without giving it a second thought, not because he was certain that it would go bankrupt but because he knew that turnaround would be hard and Buffett, the ever-astute investor, and ultimate realist wanted to spend his time owning stable, growing businesses that were easier to assess.

That approach dovetails with Buffett’s rule #1 for investing -- “Don’t lose money” which is then quickly followed by rule #2 which is “See rule #1”. Indeed if you look Buffett’s track record, it’s not that he consistently makes more money than the market, its that he loses LESS.

If we as traders are honest with ourselves, we’ll all admit that our underperformance is always caused not by the good trades we missed, but by the bad trades we refused to walk away from. Even as I sit here aimlessly tossing more lots against a rising USDCAD position, I have to admire my robot (which is trading my serious money) as it rests quietly perfectly happy not to engage with the market until a legitimate setup shows up.

That’s a thing about robots. They don’t need excitement. They don’t need dopamine hits. They don’t need to be always right. They are perfectly happy to grind it out, one trade at a time over and over again. And since we can’t all be Warren Buffett, they are as close to his temperament as we’ll ever get.

My Computer Trades Better Than I

Boris Schlossberg

This week I finally realized that my computer trades better than I. I’ve had this running argument with my friend Rob Booker for more than a decade about the advantages of algo versus prop trading and like Don Quixote tilting at windmills I insisted that human judgment was always crucial to the markets.

This week I finally had to concede that I am wrong. It’s not that algo trading is much faster, much less error-prone, much more focused than the human mind and eye. It’s all those things of course. Algo trading does something that I certainly can’t -- it provides consistency.

Lately, I’ve been following James Clear, the author of Atomic Habits, on Twitter and is recent tweet really opened up my eyes. Clear wrote, “You have to STANDARDIZE a habit before you OPTIMIZE a habit.” This seems so obvious to us yet think how hard it is for human beings to standardize on anything for long. Hell, I am one of the most habituated people I know and even I am getting tired of eating carrots every day.

Not so with algos. Algos will be happy to take the exact same setup the exact same way over and over and over again. Algorithms provide standardization even if you can’t. That’s extremely important because you and I know that as human beings we drift. The essence of our nature is to experiment, to seek new things to always deviate from the norm. That’s our greatest advantage as a species, but it’s also our biggest curse in trading.

Now when I say my computer trades better than I, what I mean is that I made my computer trade better than I. By standardizing its entry and exit process I could intelligently assess strategy performance and then optimize the settings. Computers don’t think -- they execute. The thinking part is still up to us. That’s why you don’t run a 5-minute algo in front of NFPs. That’s why you shut down scalping algo during roll when spreads could be wider than your stop. Human judgment is still crucial but on a broader assessment of risks rather than on individual trades.

After watching my trend algos beat me on the 1-hour chart, on the 5-minute chart and even on the 1 minutes chart I have finally made peace with the machines. I let them do their thing and I don’t even get mad when they bombard me with a series of stop outs. Instead I calmly asses why and then I determine if I can do anything to improve it. This ceaseless process of execution, standardization and optimization -- all done under real market conditions with real money is the only way I have been able to achieve consistency in my trades and those of you who have been watching my daily videos on twitter must have noticed.

But valuables as algo trading has been, I have fully relinquished control of the screen to my MT4 robots. I’ve accepted that my trend structure is undeniably more efficient and profitable when traded on an algorithmic basis. But I still go toe to toe with the market when it comes to counter trend plays. Ironically enough my fade trades have become better and more consistent precisely because I’ve relinquished control over trend setups. By freeing my mind, the machines have done what machines have always done thought civilization -- they have freed me to pursue higher level more creative tasks.

In Trading – Great is NOT Good

Boris Schlossberg

In our winner take all world, we are often told to try the best, do the best, be the best.

That advice is a road to ruin in most aspects of life and very certainly in trading.

The very latest in research suggests that human accomplishment does not come from trying to push ourselves to the limit, but rather from gradual and consistent repetition and improvement.

As Brad Stulberg writes, “Take the case of Eliud Kipchoge, who just shattered the marathon world record. He’s literally the best in the world at what he does. Yet Kipchoge says that the key to his success is not overextending himself in training. He’s not fanatical about trying to be great all the time. Instead, he has an unwavering dedication to being good enough. He recently told The New York Times that he rarely, if ever, pushes himself past 80 percent—90 percent at most—of his maximum effort during workouts. This allows Kipchoge to string together weeks and weeks of consistent training. ‘I want to run with a relaxed mind,’ he says.”

The paradox of performance is that when you push less you achieve more. Stulberg again, “This mindset improves confidence and releases pressure because you don’t always feel like you’re coming up short. It also lessens the risk of injury — emotional and physical — since there isn’t a perceived need to put forth heroic efforts every day. The result is a more consistent performance that compounds over time. Research shows that sustainable progress, in everything from diet to fitness to creativity, isn’t about being consistently great; it’s about being great at being consistent. It’s about being good enough over and over again.”

This is certainly true with trading. We are always pushing for more -- more edge, more leverage, more trades when we should all be pushing for less. It’s perfectly ok to take profits early. It’s perfectly ok to miss some setups. It’s perfectly ok to trade on very low leverage for as long as you want. Every one of those behaviors will push you toward success whereas the exact opposite of those behaviors will guarantee failure. Trading -- like marathon running -like almost everything in life -- is a test of endurance.

There is an old movie with Paul Newman and Robert Wagner called Winning. It’s about the 24 hour race at LeMans. (It was actually the catalyst for Newman becoming a professional race car driver later in life). In the movie, Wagner plays a hot shot driver who “breaks things” because he always pushes everything -- the car, himself, the people around him too far. Wagner is the quintessential example of what not to do in trading. In his quest for excellence, he winds up only with failure.

It’s easy to see how that can happen in trading. Hell, I’ve been the Robert Wagner character many times in my life. Always looking to “optimize”, always looking to push trades beyond their limit. But recently I created a process to change that behavior. And it all starts with the 0.01 lot.

Basically anytime I have an idea for a setup or strategy I start trading it with 0.01 lot. My iron clad rule is to trade at least 10 times at that tiny size, but the more I do it, the more I realize that at least 30-50 times is best (this assumes you are day trading, which is all that I do). The money is real, the quotes are real but the size is so tiny that it does not dissuade you from pursuing the setup even after multiple stops out. More importantly, it is truly amazing how many things you notice the more you trade. Every setup and I mean EVERY setup will change its rules as it develops under real market conditions. That’s because even if you have years of market experience your original notion of how the trade should proceed will come with preconceptions that actual market price action will very quickly destroy. But here is the thing. The more you trade your set up. The more you adjust it to actual market conditions. The more accurate it becomes. The more confident you will be.

That confidence will allow increasing the size to the next level which in my case is 0.1 lot -- and inevitably when the losing streak appears you will not abandon ship. You will have that reservoir of confidence from the 0.01 lot days to ride out the drawdowns. This is where the power of gradual improvement really pays off. This is where you realize that good is not the enemy of the great, but rather its basic building block and at that point, you can finally step up to your regular trading size knowing that you have created a truly durable setup to trade.

Why Technicals?

Boris Schlossberg

Those of you who’ve been reading me a long time, know how skeptical I am of technical analysis. Trading technicals in a void is like making medical decisions solely on the thermometer reading. At their core technicals are simply signals for sentiment or momentum. That’s all.

Given the funda context sometimes technicals can be an excellent forecasting signal and sometimes they can be a horrible one. One thing is for sure. With very few exceptions (such as major price milestones) technicals almost never drive price action -- they simply reflect it.

Pure technicians always get angry at me when I say that, but the proof is in their own actions. How many technicians will stand down ahead of a fundamental release of data? If price action was everything then you can you just ignore funda at will. Go ahead take that long ahead of NFPs. We all know how well that works.

You can, of course, trade off long-term charts and ignore the day to day noise but even there you are still subject to funda drivers. Tell me -- how did those weekly charts do on the Brexit vote? (Hint -- they walked you straight into a trap).

Anyway, my point isn’t to prosecute the case of what drives price action -- that argument has been settled a long time ago. Rather, I’d like to ask a simple question -- what are technicals good for?

Some die-hard fundamentalists will say -- absolutely nothing. Technical indicators, after all, are simply derivatives of price and therefore lagging by definition. But, as they say in the software business that’s a feature, not a bug.

Why would derivatives of price be useful to traders? Precisely because they can provide a visual narrative that can be difficult to see any other way. Indicators smooth out the randomness of prices and allow the trader to separate the signal from the noise. Take something very simple such as short-term moving average crossing a long-term moving average. Every major price regime change in the market starts with that dynamic. Now granted many of the moves fail to produce a sustainable trend, but by quantifying, standardizing and classifying each successful move you can sometimes tease out a meaningful edge and ride the wave to profit.

Technicals can also act as a check on your ego. If you are absolutely convinced that price should move one way, but technicals are actually showing the opposite chances are that you are wrong. One of my favorite setups is to have news print one way, but price action react the opposite. In that situation, technicals are almost always right.

Ever since our days on the savannah, we have been pattern seeking animals. It’s what kept us alive to the present day. Technicals are simply a unique manifestation of the same dynamic in a different environment. Instead of lion behavior, we watch price behavior and while that information is as incomplete to us as the herd movements were to hunter-gatherers, it is nevertheless valuable. It helps to inform our experience. It provides distinct knowledge which we can then try to turn into trading wisdom.

So even if you are diehard funda trader, you need to look at the charts. They tell a narrative that could be the key to your next profit in the market.

The Trade Before the Trade

Boris Schlossberg

Nick Maggiulli who writes a wonderful financial blog called ofdollarsanddata, posted a piece this week that really caught my eye. Titled, Why The Best Predictor of Future Stock Market Returns is Useless, the post deals with a very interesting indicator of stock market returns -- the average investor allocation to equities. Basically when investors exceed the historical average, allocating say 70% or more of their funds to stocks, equities perform poorly over the next 10 year. When the allocation is below the historical average the performance is much better.

Nick sketches out the basic investing model here:

Here is how the AvgEquityShare model works:
Start by investing in stocks (S&P 500).
When demand gets too high (>70% average equity allocation) => sell your stocks and move into bonds (5yr Treasuries).
Stay in bonds until demand gets too low (<50% average equity allocation) => sell your bonds and buy back into stocks.
Repeat steps 2-3.

That’s it. I chose the 70% upper limit and 50% lower limit to have round numbers that also corresponded to different return regimes (aka I data-mined this using backtests). If you run this model you will find that from 1987 to 2018, $1 would have grown into $43 compared to only $24 for “Buy and Hold” (almost 2x better dollar growth), with a far better drawdown profile -- the AvgEquityShare model is half (-23.2%) of what “Buy and Hold” delivered (-50.9%).

Though I could show you many other performance metrics that illustrate how much better the AvgEquityShare is than “Buy and Hold” it wouldn’t matter. Why? Because when we dig into the details we realize that the AvgEquityShare model would’ve been near impossible to hold for any typical investor.”

He then presents this chart that basically shows you would have to give up the massive run up from 1996-2002 in order to follow the model properly.

Nick

No doubt he has a point. FOMO is a very powerful emotion that can seduce us all into some very bad decisions. Ask anyone who bought Bitcoin at $16.000 or Ripple at 3 bucks. But let’s step back and analyze his point. Can you really argue that buy and hold is better? Will anyone really be able to hold through a 50% decline and continue investing for the long run?

This question is especially relevant on a day like today when the Dow has crashed 1000 points and many investors are starting to ask -- is this the top? (Hint: YES)

To be fair to Nick he fully acknowledged the false dichotomy of the premise and we went back and forth on twitter discussing this:

Screen Shot 2018-10-10 at 7.00.59 PM

But Nick’s column really made me think because what it really demonstrates is the need to truly understand your trading premise before you ever push the button. In short, you need to know the trade before the trade.

In Nick’s model, the success of the AvgEquityShare is obvious under even the most cursory examination. It makes nearly twice as much money with 1/2 the risk. It’s clearly superior to the Buy and Hold. But it comes at a cost of staying out of the market for long stretches of time. Yet, if you knew ahead of time that those are the costs, wouldn’t you be much better prepared to sit out the manic runups?

I have a new day trading strategy that trades trend on the 1M chart. But it only works if I follow a very specific set of rules. So, for example, today I missed the 70 pip move in USDJPY and yesterday I missed the 120 pip move in the pound. But that’s ok. The strategy is never meant to capture those type of moves. I make my 20-25 pips when I can. I keep my risk very low and I grind away trying to make 200 pips net each month, comfortable in the knowledge that the strategy is doing EXACTLY what it is supposed to do.

And for me, that is the true lesson of Nick’s column. It’s not the strategy that matters, it’s having the proper expectation for that strategy. In fact, I would argue that 90% of all our failures as traders ( certainly 90% of mine) are due to the fact that we woefully misalign our expectations and our strategies. That’s why fully understanding the “trade before the trade” is perhaps the most important strategy of all.