The single most important trading system is – YOU

Boris Schlossberg

Standard economic thinking would have you believe that the bigger the financial incentive the better you will perform. The idea is that if I pay you more money you will exert more effort and will do the task better.

That’s actually partly true. Uri Gneezy, an economist at University of California at San Diego, paid college students $300 instead of the usual $30 to type a sequence of keys on the computer. Accuracy rates went up from 40% to 80%. For mindless rote activity higher incentive produces better results.

However, that assumption fails miserably when the task at hand requires even a modicum of cognitive ability. The same experiment of paying students tenfold to add a series of numbers in matrices showed a massive decline in success rates from 65% to just 40%.

An even more striking example of this dynamic occurred in poor regions of India where Gneezy ran an experiment asking people to pack tools in the most efficient manner. Participants were paid 10 cents, 1 dollar and 10 dollars each (10 dollars represented a month’s worth of wages for that cohort) At $1 per task 25% of participants succeeded in the task. When the payoff went to $10 every single person who took test failed it. That’s a remarkable insight into human psychology and goes a long way towards explaining why when you decide to “size up” on the exact same setup that you’ve been trading for years you suddenly start to bleed money.

The greatest thing about trading, aside from the potential for profit, the intellectual challenge of finance and the emotional engagement of the game is that the markets are probably the purest, biggest psychological laboratory in the world. If you are honest with yourself and step back to examine it you would have to admit that trading has probably revealed more about your true personality than any other activity you’ve ever done. Good or bad, the markets lay you bare in front of the world in ways that few other things in life do.

I was thinking about that a lot this week, after listening to a wonderful System Trader podcast interview with Mandi Pour Rafsendjani who, instead of focusing on yet another mind-numbingly boring quant system talked about what it really takes to be a successful trader. It’s a wonderful episode and I encourage you to listen to it -- but there were a few key points that she made which I thought were amazingly perceptive.

First and foremost if you are anything like me you probably got into trading for the sense of autonomy. You hate being told what to do. You hate working under other people’s rules and you like the sense of freedom that trading brings you, even with all of its crazy risks. But if you are that type of rebellious person, yoa u probably also hate paperwork and bureaucratic processes and record keeping. After all -- you are trader, not a bookkeeper!

Yet Mandi makes a very interesting point that it is precisely the structure of record keeping that is the gateway to the freedom you seek. Because it is only through record keeping that you will be able to improve. Mandi, who has interviewed scores of traders, notes that winners focus on facts and figures while losers focus on feelings.

Still, the record keeping she has in mind is unlike any you’ve ever seen before. Mandi will be the first to tell you that if you don’t have a setup that you can write out on the back of a napkin, you have nothing. In short, you need a clean, clear set of rules that will guide your trading. But keeping score of the winners, the losers, the drawdown, the entry and exit permutations, the instrument selections and all other usual suspects of trading is just the beginning. In fact for us in FX, the act of record keeping can be 99% automated with journaling websites like www.myfxbook.com.

When Mandi talks about record keeping, she has something else in mind entirely. She believes that record keeping of your state of mind is just as important as journaling your trades. Here are just some ideas she shares. Do you have a magic number of trades after which you get sloppy? For example, she notes that after five winning trades she tends to give a lot of her profits back. So now she simply walks away from the screen and works LESS. What about treating same trades in a different way? For example, when a trade initially goes into profit and then into a loss, do you have a hard time taking the stop versus a case of when a trade goes negative right away? (Guilty!) What about fixating on reaching a key dollar figure on your account equity (like say $10,000) which forces you to leave trades open because they haven’t reached your “target”? (Guilty!) What about trading a style that does not fit your personality because everyone tells you that’s what you are supposed to do? (Guilty!)

For me, the two greatest recent realizations have been that I am a serial, not a parallel trader. I do best when I trade one position at a time. (Read my New York subway column from a few weeks back for more details on that) The second most important realization is that I always lose money if I trade without an execution algo. If I am tapping buttons on my MT4 iPhone app as I dart in and out of the subway -- that is always the start of a journey to trading hell. I will ignore my sizing parameters, I will ignore my stops and I will inevitably cover for a loss after needlessly battling the market for days. On the other hand, if I am entering from a preset template off my well worn MT4 EAs, my control is assured. I may win or I may lose, but either way, I will do it properly and will not damage my account unnecessarily.

Using Mandi’s approach of recording your own state of mind as well as your trades has been an eye-opening process. The irony of her approach is that while winners may indeed be preoccupied with facts and figures while losers are obsessed with feelings, the key facts and figures aren’t actually the standard trade blotter, but the emotions you go through as you establish your trade. Losers may focus on feeling, but winners focus on recording and studying those feelings on a continuous basis. What becomes very clear as you listen to the podcast, is that profitability in trading is much less a function of tweaking your system parameters and much more the case of minimizing your tendency to make psychological errors. Walking away from the interview you realize that the single most important trading system is -- YOU.

In Trading Know When To Say When

Boris Schlossberg

As traders, we are always obsessed with the idea of how. How do we structure entries? How do we manage risk? How do we exit positions? All of those are legitimate concerns but I will argue that they all pale in importance relative to the question of when.

For the past month, I have been killing myself trying to design an FX day trading system that worked round the clock. No such luck. The system would work for a bit only to give everything back and then some. Nothing I did to its structure made much of a difference until I realized that it should only trade during the European hours. Why? Because this system is based on a continuation setup and prices have a much higher chance of continuation during the European dealing day than at any other time during the global day. In fact, if you were to run the numbers 70% of all price movement occurs during European hours. In retrospect, this, of course, makes eminent sense. Europe intersects both Asia and North America and therefore has the highest concentration of participants during its business hours leading to greater volume and biggest price moves. Now the system trades only during 0500 -- 1500 GMT and is doing much better.

In retrospect, it seemed obvious that day trading 24 hours per day is like wearing the same set of clothes for Siberia and Sahara. You will inevitably be wrongly dressed on the trip. Yet, as traders, we often get so immersed in our system developments that we forget this one very crucial fact. Indeed, in my opinion, this is the primary reason why almost all trading systems fail miserably -- they only focus on the how and never pay attention to when.

When is really a question that addresses context -- that most subtle yet most important element of trading. We all know that bad news gets bought in bull markets and good news gets bought in bull markets. In bear markets, it’s the exact opposite. The same inputs yet the output is diametrically different. And that dynamic doesn’t just apply to fundamental factors but to technical ones as well. In bull markets 20 period SMA will act as support. In bear markets, it will break and signal lower prices ahead. Context is everything.

Now the question of whether we are in a bull or a bear market is almost existential in nature and often impossible to answer until we are well within the regime. On the day trading horizon, however, the question of when is much easier to answer. One very obvious factor is scheduled news events -- be they economic releases, central bank meetings or political press conferences. Those events are usually known well in advance and can tell the trader when NOT to trade. Two of the best traders in my room, trade with very complex EAs. But they don’t let them run continuously. They are careful to turn them off ahead of the news and let the storm pass before engaging with the market. They both have ridiculously high rates -- and it’s not because of the setup rules (I know, I created those setups) -- it’s because they use those setups judiciously.

The when is much more important than the how.

They say trading is timing. That’s true in more ways than one. Most of us focus only on price action for timing and that may actually be the least important element of success. Choosing the proper time to activate your system is the real secret to profits in the market.

The Dirtiest Four Letter Word in the Trading Language

Boris Schlossberg

FOMO.

Fear of Missing Out is the dirtiest four-letter word in the trading language (it’s an acronym actually, but you get the idea)

In a great podcast Dr. Gary Dayton, who is practicing psychologist and is also a trader, uses the example of a parade to show how our mind forces us to do things that we would normally never do. Most of us watch happily watch a parade from the sidelines, and while we may enjoy the floats and the marching and may even cheer on the participants, few of us have the temptation to run into the parade and become part of the show. In that situation, our mind is able to make a clear delineation between spectacle and observation -- what Dayton calls mindfulness -- that allows us to keep our distance from the action.

Markets, of course, are different. To trade them we need to be both a spectator and a participant and therein lies the rub. The emotional pull of price action inevitably captures us in its grip and we wind up chasing trades. Who amongst us hasn’t bought the top tick or sold the lowest bar only to see the trade rip our face off? Virtually every massive loss I’ve ever had started out as FOMO which then morphed into “add to the position” play and eventually a painful loss that was much bigger than it needed to be.

Yet, as Dr. Dayton points out the old Nancy Reagan just-say-no-use-your-willpower approach will always fail. No matter how many times we tell ourselves we shouldn’t chase -- we will because our mind is controlled by emotions and suppressing them will never work. I invite you to listen to the full podcast which goes into the neuropsychology of aspects of the human brain and amygdala impact on our actions, but suffice it to say that according to Dr. Dayton the only way we can get better control over FOMO is by practicing what he terms, “mindfulness” which is another way of saying meditation.

Now if you are like me, and meditation is as appealing to you as a root canal, if the idea of contemplating your toothbrush, or thinking about the slickness of the soap as you do the dishes is something you know you will never do, then I have a better idea that may appeal to the trader in you.

I call this trick -- “market mindfulness”. The idea is to imagine the absolute perfect form that your set up should take (see my column from a few weeks ago -- Plato trades FX) and then open up the charts and look for at least 10 or 20 examples of that setup. Not only will this exercise create “mindfulness” because it will force you to focus on what you love, but it will also serve another much more valuable purpose. By looking through 10 or 20 charts of your “perfect” setup every day you will build up the vital psychological distance you need to resist FOMO at every turn. After all, once you know how a money making setup looks, anything that deviates from that is a lot easier to resist. And looking at the charts in the quiet of your home office is a lot more fun than meditating about your breathing.

Let Plato Design The Perfect Trading System for You

Boris Schlossberg

Plato’s cave is one of the greatest philosophical fictions ever invented. The idea that we don’t truly see the real world but only the mere shadows of things, that our perception of reality is limited by our own flawed senses is such a powerful concept that it remains a topic of debate and discussion 2500 years later, just as Plato’s work, the Republic continues to be the foundation of the Western intellectual canon.

In writing about Plato, Robephiles notes that “Plato was distrustful of the senses when it came to the ability to perceive knowledge. Plato knew that our senses could be fooled and he placed an emphasis on our abilities to think and reason rather than the knowledge gained from the study of the physical world.

This leads us to another famous metaphysical idea, The Theory of the Forms. Plato was fascinated by the problems of universals. An example would be as if I told you I had a dog. If I told you this you might picture a poodle or you might picture a mastiff or a chow or a border collie. These are all dogs yet each one is so different in its particulars. What makes a dog have its essential ‘dogness’? “

In an age of data science, Monte Carlo simulations and million backtests per second, the empirical model -- so successful in the physical sciences -- now completely dominates our world of social science of which finance and trading are a part.

But what if I were to say to you that maybe we have it all wrong? What if I were to argue that the endless data mining we all do -- the search for the perfect indicator, the perfect Fib level, the perfect volatility envelope are all just a giant waste of time. Ironically enough, empiricism would prove me right. Almost every trading system ever invented fails miserably under real-life conditions despite often showing perfect statistical accuracy often to the 99% confidence level. The irony of trading is that we put all our faith in an empirical model that empirically fail us.

But what if we set aside all of our modern tools of computation and started thinking like a 2500-year-old philosopher? What if we applied Plato’s Theory of Forms to the very pedestrian idea of a trend? Granted, trend can come in many shapes and sizes. It could be jagged and rambling with massive choppiness within it. It could be steady and smooth with hardly a retrace in the move. Or it could be something in between.

However, the “trendiness” of trend just like the essential “dogness” of dog is marked by some general characteristics that make it identifiable. In case of trend the best “class” of trend is one marked by higher highs in an uptrend and lower lows in a downtrend.

Thinking about this “Platonic ideal of trend” has really helped me refine my latest trading system. It made me eliminate any element that is extraneous to the setup -- and because it forced me to create much stricter rules for entry, I make much fewer trades. On the face of it that may sound like a negative to a daytrader like me, but in reality, it made my trades much more accurate than before. And it gave me clarity of analysis that I’ve rarely had before.

In the modern world, so full of experimentation and empiricism, we are conditioned to stay away from deductive reasoning. But perhaps the truth is just the opposite. Perhaps instead of running endless backtests to torture the price data, we should just imagine the ideal version of our setup. Perhaps in trading what we need is a lot less data science and a lot more Platonic philosophy.