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.

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.

Forget Right or Wrong – Here is the Only Thing That Matters in Trading

Boris Schlossberg

Wudda Cudda Shudda. A retail trader’s favorite pastime. If only I “wudda” taken that trade, I “cudda” made massive pips. I “shudda” just traded. What an idiot I am.

If you haven’t had that internal dialogue with yourself you clearly haven’t traded for long enough. Of all the things that frustrate me about trading the “wudda, cudda, shudda” game is the worst. You never, ever learn anything from it. You wind up feeling miserable and helpless and most importantly annoy everyone around you, who no doubt find your endless whining to be worse than whatever trade setup up missed.

The other day, however, it suddenly hit me as to why we continue to play this useless game. It all has to do with how we view our trading. Without even realizing it we view each trade we take in moral terms. The trade is either right or wrong. If we win the trade is right. If we lose the trade is wrong. It doesn’t matter if the trade made sense or not, all we care about is that the trade is a winner.

And that is exactly how we turn trading into gambling and lose all of our money in a month. Allow me to explain.

Last week, I was chatting with Rob Booker and we talked about how new traders just want the price action. They don’t care to learn about market structure, trade management, risk control or market news. They just want to trade, trade, trade. As a result, they become “liquidity fodder” (my new favorite term). Their stops or margin calls become the smart money’s take profits. It is essentially socially sanctioned theft -- just like Las Vegas.

But here is the thing. If you judge your trades on a right and wrong spectrum you’ve just become “liquidity fodder” because you have turned a probabilistic enterprise into a binary game. We all know intellectually that strategies are simply probability paths across time and price. But if you judge each trade as an isolated right or wrong incident you have basically stopped trading and started playing FX roulette.

Black or red.

I can’t tell you how many times I have seen traders quit a set up after they lost 2 or 3 trades in a row because of this right or wrong paradigm.

So how about this. How about, instead of using a false moral dichotomy we start treating trades as true or false. This is a lot harder than it sounds. In order for the trade to be judged true, it must follow every single condition of your set up. The outcome doesn’t matter at all. The only thing that matters is that the trade is true to your setup principles.

As I said this is a lot harder than it sounds. Once you start classifying trades as true or false you’ll notice how many times you cheat, rush and generally ignore your set up. Staying true to your rules means sitting on your hands above all else until every single variable lines up. But the benefit of this approach is tremendous. One, you’ll start to be much more selective in your trades. Two, you’ll stop crying like a five-year-old girl every time the trade does not work because you’ll have the confidence that it was a true setup. Three, and this is by far the best part of the process -- you will see success. Even when you pass up on “true” setups you will be pleasantly surprised that most of them work out exactly as you thought.

So take a deep breath. Stop acting like “liquidity fodder” to the market. Take control of your trading and change your mindset.

No more right or wrong.

Only true or false.