The Hidden Trade that is the Key To Long Term Success

Boris Schlossberg

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Ask most traders what are the possible outcomes of a trade and they will inevitably give you a binary answer.

You either win or lose.

But if we think about it for a second, there is actually a third choice. You can neither win nor lose. In short, you can basically not lose and close the trade out for even. If we go over our many trades, there are countless examples of trades that may have started out badly only to rally to breakeven and then ultimately fall apart.

The art of NOT losing is perhaps the most underappreciated skill in day trading. It is, in fact, the foundational strategy of high probability businesses like insurance and casinos. Insurance companies are of course notorious for eliminating any possibility of large payouts. They are in the business of collecting premiums but the moment a client presents any type of collectible risk they move swiftly to cancel the policy. The insurance companies much like casinos will make sure to rig the rules so that customer has virtually no chance at collecting a payout.

So in Las Vegas, they will stop you from counting cards in blackjack and in Hartford they will make sure to exclude all coverage of any malady you may already have. Indeed, the current debate on pre-existing conditions in Trump-care is simply an attempt by insurance companies to collect as much premium as possible while providing the absolute minimum coverage necessary to satisfy the contract. Indeed, as my wife just pointed out to me under Trump-care pregnancy will be considered a pre-existing condition and could cost insurance buyers as much as $17,000 in out of pocket expenses even if the woman has full coverage.

Now we can all lament the evils of the insurance business, but it has a lot to teach us about trading. The more I trade the more I realize that there are really only two viable models of making money. The low frequency, high-profit model where your wins are very few but are massively larger than your losses and the high-frequency high probability model where the losses are very rare.

We are all familiar with the fact that throughout the whole history of the stock market all of the gains have come from only 20% of all publicly traded companies. Fully 80% of stocks are long term losers. And even amongst the 20% of winners, it is only a handful of equities that are responsible for almost all the stock market returns.

That’s why index investing is so hard to beat. When you buy the index you are essentially buying the whole lottery pot and betting that you will capture the few jackpots that will pay for all the losing tickets. Little wonder then that the hedge funds have been getting killed looking for the diamonds in the ruff amidst a pile of garbage.

But there are other actors in the market that actually play a very different game. HFT (High-Frequency Trading) funds have gotten a bad rap for being nothing more that digital “front runners”, but in reality, they employ a wide array of strategies almost all of them focused on mitigating risk. In fact, HFTs are the kings of the “not lose” trade as they break even on as much as 50% of their positions per day and yet make money almost every single day. Big firms like Virtu have lost money only on one day in six years.

If we are day-trading, the insurance model is the way to go and the “not lose” trade should be studied much more seriously. It is the hidden key to long-term trading success.

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The Three S’s of Trading Success

Boris Schlossberg

One of the dumbest things I heard about trading is this very common refrain. “Trading is simple. All you need is a strategy with positive expectancy and the discipline to follow it.” That statement is so stupid on so many levels that I just shake my head in disgust whenever hear it.

First of all -- THERE ARE NO STRATEGIES. As I’ve said a thousand times before there are only two trades in any market -- continuation or mean reversion. What some traders call strategies are simply structures. Any algo that has a logical ruleset of IF A then do B is simply a trading structure designed to superimpose order on an essentially chaotic and mostly random activity. So no, your wonderful 500 lines of MT4 EA is NOT a strategy it’s just a STRUCTURE through which you choose to express your trading.

What turns that structure into semblance of a strategy is SELECTION. Now I know that all of you EA traders will start to tell me that you don’t select. You just lay it on your charts and go. Ha! What charts do you put your structure on? What pairs do you trade? What time of day do you trade? Do you turn off for news? Yadda Yadda Yadda. Even if you do none of those things you are still making an implicit selection -- you are basically betting on diversification which a choice like any other.

Selection of course is the art of the trade. No matter how good your structure. No matter how well you’ve thought things through, selection is actually the difference between winning and losing. And selection does not come from a back test. It comes from experience. It comes from observation. It comes from that most “unscientific” of places -- feeling the market. Feeling the market is no different from any other skill. You need to watch and watch and watch the screens and only then will you learn which price action to avoid and which to attack.

I am always amazed at the level of progress we made in my trading room. We now have many traders who are banging out 0.5%-1% per day -- and it’s certainly not due to the “brilliant” trading structure that I teach them, but rather to their ability to feel the market and analyse the key levels. The longer people trade with me, the more they observe the market, the better they do.

One key thing that everyone in my room does is use wide stops. This is yet another trading “rule” shattered to bits. Right after “ you gotta have a strategy” meme the second stupidest thing that gurus tell you is “use tight stops.” Except for martingaling nothing has lost more people more more money than tight stops. Tight stops are essentially a guarantee that you will lose all your capital in tiny little chunks or certainly die trying. Tight stops is the trading equivalent of a death by thousand cuts.

Most naive traders believe that stops are linear. In other words you are twice as likely to get stopped out with a 10 pip stops as with a 20 pip stop. WRONG! Because of the natural oscillation of the auction model ( which is what all speculative markets are) your chance of getting stopped out on a 10 pip stop is probably 4 to 8 times higher than on 20 pip stop and so on and so on. A good rule of thumb is that you want to use 1/2 the daily ATR which for most major pairs is about 50 pips as a proper stop value. That’s tight enough so that no single day’s loss will ruin you, but wide enough to avoid most of the intra-day noise. After all the function of successful trading is to AVOID stops as much as possible.

Here is a discount to our trading room

So STRUCTURE, SELECTION and STOPs are the three keys to successful trading -- and you really do need all three to work together like a fine tuned machine in order to bank those pips every single day.

Boris’s Formula For Trading Success

Boris Schlossberg

Some of you may be familiar with the Kelly criterion which is a formula used to calculate an optimal bet size allowing gamblers and traders to maximize their winnings. The proof for the concept can be complicated, especially if you are mathematically challenged like me, but the net takeaway of the Kelly formula is that on 1 to 1 payout you bet 2 times the probability percentage minus 100% of your capital. So that if probability is 60% you bet (2X60% -100%) =20% of your capital on any given trade to maximize your profits.

In real world of trading betting 20% of your capital on any one idea is insane and Kelly has been criticised for creating wildly inappropriate bet sizes for traders enamoured with the math but utterly unfamiliar with the non standard distribution properties of capital markets. (In plain English -- there is no such thing as fixed odds when it comes to trading.The game could literally morph from roulette with a tiny negative 49%-51% edge to the 1 out 1000 odds of a daily scratch lottery -- and this is the key point -- all on the exact same trading strategy.)

So given the fact that odds in trading are essentially an illusion, I have my own rather crude but I think more effective formula designed not to optimize gains but rather to contain losses to a manageable level.

Anyone who has ever traded for more than a month quickly realises that to survive in the market the key is to control losses, as gains pretty much take care of themselves. The simple math is that it takes 200% profit to get back to even from 50% loss, so the key to long term winning is to never, ever get to that -50% level in the first place.

So here is my day traders formula for controlling size.
Ask yourself the following questions:
What is the maximum amount I am willing to lose in a day?
What is my stop on my day trading strategy?
How many trades will I make per day?
What is my expected losing percentage?
How much money will I trade with?

On a hypothetical example let’s say I never want to lose more that 1.5% in a day (I am assuming a worst case scenario of 10 straight days of losses would equal to -15% of my account. Make your own assumptions on this- there is no wrong answers -- as long as you assume at least 5 losing days in a row minimum)
My stop is 25 pips
I will make 10 trades/day
My expected loss is only 20% ( 2 losers out of 10)
I have 10000 dollars to trade with.

In stress testing these variables I assume that my expected losses will be three times what they should be ( The good old rule of thumb that in any business plan you must double your expected costs and half your expected profits comes in very handy in trading. In other words ALWAYS assume that things will be at least twice as bad as you initially think. In my case I assume that they will be three times as bad)

So when you put all of these ideas together I basically trade at 10,000 units (one mini-lot) per 10,000 dollars of capital. This way if I lose six times out of ten I lose 150 dollars or about 1.5% of equity. (Yes I know I still have 4 more trades left, that could reduce my loses, but as I said I am assuming the worst, ALWAYS).

Now for those of you with a mathematical mind or an engineering degree this “formula” is laughably imprecise and full of utterly subjective assumptions. But that is exactly the point. This a formula is produced by the school of hard knocks rather than crafted through the elegance of Big Data algorithms. Its designed to be as robust as possible against a non deterministic distribution ( simple English -- I have no f-ing idea what will happen) rather than a beautifully written model that may ultimately bankrupt you.

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In any case I hope you find it useful.

Success in Investing and Trading Depends on the Exact Same Thing

Boris Schlossberg

I came across an interesting item in the news this week. Fidelity -- he massive mutual fund giant -- did a survey of the best performing customer accounts. Guess which accounts made the most money? The ones where the customers literally forgot that they had an account open.

Now you can make all the jokes you like about this, but the Fidelity study confirms once again that the key to successful investing is simply time. We know that the single most successful investing strategy ever devised is dollar cost averaging into a low cost diversified portfolio of equities. As long as stocks continue to have positive drift -- that strategy will beat 99% of hedge funds out there.

The reason this is true is that in investing you are simply playing the law of large numbers with time. If you hold an asset for 1 minute you chance of making money is approximately 48% (due to transaction costs) if you hold it for 10,000,000 minutes (about 20 years) you chance is 95% or better. The law of large numbers is the single most powerful force in making money.

Now the irony of the matter is that the exact same principle applies to trading. All of us have this ridiculous fantasy of sitting on beach, sipping a cool drink and leisurely making one or two killer trades from a smart phone that rake in thousands of dollars. If this is your idea of trading -- you will never make money. The “suave rico” approach to capital markets is a fantasy that you must wipe out from your mind,.

The fact of the matter is that if you want to succeed in trading you have to trade a lot. Most retail traders make two fatal mistakes that doom them to failure. They trade with leverage and they give up after three losing trades.

Want to know how many trades you need to make in a year to have a reasonable chance of success as speculator rather than an investor?


If you want to have a reasonable chance of making money you need to make between 500-1000 trades a year in order to mitigate all the typical challenges of trading in speculative markets (slippage, gaps, news bombs etc.) The bottom line is that if you trade you will be wrong a lot. Sometimes your strategy could have 5, 6, 7 stops outs in a row.

We have a killer new strategy at BK that is really making bank in this high volatility market, but I am not naive enough to project this run into perpetuity. I have studied the backtests and I know that the drawdowns will come. The difference however, between losing and winning in trading is to allow that law of large numbers to work for you.

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So in essence, successful investing and successful trading are one and the same thing. In investing you accumulate as many minutes of exposure to the market as possible. In trading you do as many trades as possible and let the law of large numbers lead you to profit.