What’s a Stop For?

Boris Schlossberg

What’s a stop for?

Risk control obviously. Blah. Blah. Blah.

We all know that stop is the only thing that stands between you and financial ruin and yet we ALL ignore that advice once, twice, a million times over the course of our trading.

Why?

Because most of us don’t understand stops and see them only as a source of pain.

A stop is there only for one purpose only.

To. Make. You. Money.

That’s right. You heard me. A stop is there to make you money. If you are not making money -- you are doing it wrong.

The stop’s only function is to answer the following question -- how much room do I need for my trade to hit profit at a bigger expectancy than my stop? To review the idea of winning edge read my column from last week, but meanwhile, understand that you WILL LOSE. YOU WILL ALWAYS LOSE. The key to winning is to make that loss either much less frequent or just less than you profit.

It is in my view much easier to make the stop be less frequent rather than absolutely less money than your target. But that depends entirely on your personality. If you are the type of person who can hold for a 200 pip gain -- then sure you can have 50 pip stops and still win. Still, in all my testing experience it is much easier to find a positive setup with 1-4 risk-reward profile (risk 200 make 50) rather 4-1 profiles (risk 50 make 200). 4-1 profiles usually payout 18-20% of the time which makes them a loser (4-1 has a breakeven of 20%) 1-4 profiles can be accurate 85-87% of the time making them profitable.

But that is neither here nor there. The point is not to start a religious war about risk-reward ratios but to find a sweet spot for YOU.

In my day trading, I have found 1-2 risk-reward is just the sweet spot I need. I worked out my stop after I figured out what I can accept as a take profit. As you all know I have zero impulse control so I can only take 2 points in ES 20 in YM and 10 max in NQ before I start getting the joneses. So the question I had to answer was -- what was the reasonable stop on such a set up that gave me a winning edge? The answer was twice my risk putting my breakeven at 67%. Since I’ve been hitting 75%-80% of my trades I am very comfortably ahead.

Now here is the amazing thing that happens once you understand the purpose of the stop. You never again lift it. You not only accept it but you actually expect it as it all becomes part of your trading plan, just like food spoilage is part of a restaurant’s business plan.

Of course, you do your best to minimize it, but honestly, most of the time you don’t even think about it because you are focused on what really matters most -- the next good set up. This is the way it should be and I can’t tell you how much less stressful this becomes on a day to day basis.

You stop agonizing over every market beat and instead ask the only question that matters -- is my plan working in the current environment?

So, taking my last three columns together, here is what I think works in the market.

1. Don’t contort yourself to the market. Know your comfort level. Find your sweet spot profit and start from there.

2. Understand expectancy and the winning edge. Be realistic. (5% above breakeven is AWESOME!)

3. View your stop as a key part of a profitable trading plan and work on entries -- cause trading is timing and that’s all there is.

Happy Trading Guys!

How to Tell if Someone is Lying About Their Trading

Boris Schlossberg

I listen to scores of trading podcasts every week and here is one quick way to tell if someone is lying about their trading.

“I trade with 1:1 risk-reward ratio and I win on 80% of my trades”

100% bullshit.

Let’s first define what we mean by trading. Trading is the act of frequently buying or selling financial instruments in capital markets for the purpose of speculative gain. Let’s for the sake of argument say that a trader makes 2 trades per day. (The average is somewhere between 10-20 per day, but let’s indulge this claim made on podcasts all the time)

Ok, so I have a 10,000 account. We’ll trade at 10:1 lever for 15 pips target 15 pips stop twice per day. (This is actually the example I heard the other day on a podcast, so I am even making this up).

There are 250 trading days in a year.
I make 500 trades.
At 80% win rate I make 45,000 by year one.
Rinse and repeat.
By year two I now have $280,000 in my account.
By year three my account has swollen to $1,120,000.

In three years I have increased my account by 10X. Give me a decade and I will own the world.

Now let me explain why such claims are total bullshit.

Every trading strategy has something called the winning edge. It’s easy to calculate. The winning edge is basically the percentage difference between your win rate and your break-even point.

For example, if you traded with a 1:2 risk-reward ratio (risking 2 to make 1) your breakeven would be about 67%. If you won 70% of your trades your winning edge would be 3%.

Some points of reference. In blackjack casino edge is about 2%. In roulette, the edge is somewhere between 2-4%. Renaissance Technologies, the world’s most famous and longest-running quant fund has a winning edge of about 2% on the millions of trades it takes. Virtu and Citadel -- the biggest HFT market makers in the world -- are similar.

So, when someone on a podcast tells you they win 80% of their 1:1 risk trades that means they are claiming a 30% winning edge. (80% -- 50% breakeven rate).

They. Are. F-ing. Lying.

The reason why I get so upset about this is that it does a terrible disservice to many new traders who are trying to succeed at this game. It’s a Bernie Madoff type of hustle precisely because it seems so reasonable and attainable. Remember, Madoff ran his Ponzi scheme by being modest. He didn’t claim multi-hundred percent returns. He simply claimed a steady 1% gain every single month. His hustle was so toxic because it was so believable. Same with every BS artist on the web who claims they “rarely lose on their trades”.

Real trading is about losing all the time, every day. It’s about clawing out a 3% edge and trying to keep it for as long as you can.

Just for fun, I decided to take a look at the winning edge of someone who trades for real -- my partner Kathy. K has been on a blazing hot streak for the past six months putting up positive results 3 out of every 4 weeks while banking 1800+ pips in the process. Kathy basically trades with a 2.5:1 risk-reward ratio (these figures are rough estimates because she often cuts losers quickly but I was being specifically harsh in my estimates) for a 72% breakeven rate. Her win rate, however, is about 77% so she has been able to maintain a 5% winning edge for the better part of 2019. That may not sound glamorous but that was enough to produce one of the best streaks in FX over the past six months.

So don’t be fooled. Trading is a game of inches. Its rewards build over time but they are rich in experience and knowledge. So anchor your expectations properly, please.

Also, the next time you see a trader on Youtube and he is driving a Tesla -- then for SURE he is lying.

Trader… Control Yourself

Boris Schlossberg

What do you need to succeed at trading?

A great setup?
Lightning-fast execution?
Steely risk management skills?
All those nice-sounding ideas are utterly irrelevant to your success.

Why?

Because you will never follow the setup, speed is pretty much the same for everyone across the advanced industrialized world and no one has steely risk management skills.

We approach trading education all backward.

We focus on setups, backtests, leverage, execution, correlation risk and a million other factors that we think may give us an edge. And sure, if we turn those ideas into an automated system these become the primary elements of success. I just released a system that checks all those marks. K and I have been trading another system for many months already and it is by far the most profitable account I have.

But… all those systems have the sex appeal of a Vanguard index fund. They are slow. They are deliberate. They can be quiet for days or suddenly explode into an array of trades. If I ever had to actually trade the way my systems do I would blow brains out.

And that is the key element that we always miss.
The human element.

If we want to trade the market for fun as well as profit if we want to engage with the crazy, irrational, fascinating, thrilling, frustrating, infuriating, electrifying mess that is the global financial market we need to do it on our own terms.

Whaaaaaaat?

How can you make the market adapt to you? The market adapts to no one!

That’s true. But the key succeeding in its wild ocean of trades is to find a space where you can thrive under your own rules.

Can I tell you about my week?

All week long I have been trying to trade stock index futures the “right way” -- trading with trend, waiting for the retrace, using proper risk structure. Just like the system I designed.

One small problem.

I am an inveterate top and bottom picker. No matter how hard I try I always abandon continuation trades and look for the “turn”. Naturally, when I am trying to trade one way but actually trade the other, I also get into massive trouble with risk control. I abandon my stops, lever up on size and effectively turn semi-intelligent trades into mindless gambles.

Sound familiar?

So after a week of bleeding money and feeling totally out of control, I finally decided to forget the “right way” and decided to day trade indices “my way”.

First and foremost it meant short, small exits since no matter how good a trade I have I am never able to hold it for a long time. In fact, the longest I am able to hold a position in something like NQ (the Nasdaq futures) is for 20 points (or basically one-fifth of the typical daily range). Indeed my sweet spot is about 10 NQ points or between 20-40 minutes per trade. I am a guy who always goes for small dopamine hits. I never go for the big move.

Also, I don’t like to get stopped out a lot. Of course, no one likes to get stopped out, but there are plenty of traders who are comfortable losing 1 out of 2 trades. I am not one of them. If I lose more than 3 trades out of 10 I get very antsy and my “discipline” goes right out the door.

So what did that mean in practical terms?

That meant that my stops had to be bigger than my targets but not too big.
Ultimately I settled on the following ratios -- in NQ I traded 10 targets 20 stops in YM 25 targets 50 stops in ES 3 targets 6 stops.

Those numbers felt right to “me”. The market couldn’t give a flying f- about my ratios. But that didn’t matter because now I had control of myself and that in turn allowed me to be much more in control of my trading.

Suddenly I felt a much greater sense of calm because each execution became a semi-intelligent trade rather than a mindless gamble. In fact, by doing what I wanted to do rather than what I was “supposed” to do, I made less and less mindless gambles. My inveterate top and bottom picking throughout the day remained, but because I was much calmer now, doing things the way I wanted, I suddenly became much more patient, looking for key telltale signs of turn during the day. I stopped trying to accommodate to market and started instead to exploit it within my own means.

Did I make money? Hellz yes. I went 8 for 1 doing actually better than my win percentage goal. But that’s not really the point.

The point is that you need to make the market your own. You will never change. No motivational talks, no browbeating, no self-loathing or hatred will ever change your trading habits. If you want to have fun in the markets and actually try to make money you need to stop listening to anyone to tell you what to do and discover what it is that you ACTUALLY do. From there you can start to design an approach that makes emotional sense to YOU.

If we want to trade “properly” we should use robots.

If we just want to trade, we need to know who we really are and make peace with that.

Failure

Boris Schlossberg

Have you ever had to write an important sales letter, a vital business presentation or maybe even a eulogy for a loved one? How many drafts do you think you did? When I first started writing weekly research reports at FXCM I did maybe twenty to thirty templates before we settled on something we liked.

Bill Maher, who has been a comedian for decades and has been doing his weekly HBO show for most of this century says that to this day he often does twenty rewrites for his signature 2-minute monologue at the end of every show.

How about golf? Or tennis? Or basketball? How many putts, how many strokes how many shots have you taken in your life just to achieve a modicum of mastery?

Now imagine if we thought of every re-write, every missed putt, every double fault as a stop out trade. How many of us would achieve anything in life?

All human errors are basically mistakes in judgment or execution and all of us understand that we need to practice over and over and over and over again before we can achieve even a small measure of control. But trading is different. It’s the one activity most people quit within three months of trying. People will play golf badly their whole lives. People will practice singing or dancing for years and years. People will become obsessed with barbeque to the point of spending a small fortune on smoking equipment to produce a piece of meat they could buy for a few bucks from a restaurant.

But trading is different.
Why?

A few reasons I think, but one of the most underappreciated ones is that trading despite its lonely reputation is fundamentally a very public activity. There is no practice stage for trading. If you are trading futures, for example, your first trade is made on the Chicago Mercantile Exchange against literally the smartest people in the world. Imagine if you wanted to learn singing and your first lesson consisted of getting up in front of a sold-out crowd at Madison Square Garden competing against the cast of Hamilton.

How many people would succeed under those conditions? How many people would quit after three months of humiliation? Pretty much 90% -- which are the stats in trading.

The other reason is that trading is different is that the cost of failure is so much more acute. Imagine if every time you missed serve in tennis, or a putt in golf or misspelled a word on your report someone took out a whip gave you a couple of lashings. How motivated would you be to try again?

That’s pretty much what the market does to you every time you get stopped out. Maybe the physical pain isn’t the same but the psychological sense of humiliation and rage are identical. And of course the bigger the loss the more vicious the whipping.

So ironically enough the only way to make progress in trading is to accept that you will fail miserably every step of the way and enjoy it for all its worth. You are in front of a big crowd at MSG and you can’t sing? Who cares, tell them a joke, read a poem, tell them a story -- find a niche that plays to your strength. You may bomb, once, twice, twenty times but eventually, you will find something that resonates and by that time you will be a veteran at performing in front of the biggest, most important crowd in the world, while others (read demo traders) would have only practiced in front of three drunken customers at their local bar.

Next, you need to make the punishment less painful. Turn a whipping into a mild punch by trading smaller -- that only works by the way only if you drop $1,000 into your account instead of $100,000. It doesn’t matter what you tell yourself, whatever money you put into the account you will lose, which is why the single best way to learn is to drop $1000 into your account ten times rather than deposit $10,000 all at once.

But the bottom line to mastering trading is that you really need to enjoy the game. If you come to trading with the attitude of “I am only here for the money” you are essentially saying -- I will only play golf if I win the Masters. You’ve already lost before starting. That is the true failure in trading, everything else is just feedback.

2020_outlook_slides_finalB.pptx

How to Win in 2020

Boris Schlossberg

Ivan Lendl.

Not a name that any millennial will recognize, but if you were a tennis fan during the golden age of the sport in the late 1970’s and early 1980s that name will be very familiar to you.

Lendl was a towering 6 foot 2 Czech with a dour disposition and all the warmth of Count Dracula who dominated the sport holding the #1 ranking for 270 consecutive weeks during the decade. He had one of the best serves and the strongest, most vicious forehand in the history of the game.

One time when an opponent came to the net off a short volley Lendl launched a volley straight the guy’s body that literally blasted the guy with a force of a bullet. When he was asked about the sportsmanship doing such a thing in a post-game presser, Lendl ever the charmer replied, “I did not ask him to come to the net.”

Yet for all this prowess and intimidation Lendl had one glaring flaw. He had no power backhand. He would routinely run around his backhand during rallies and the truly top players at the time used to exploit that weakness mercilessly preventing Lendl from winning the major tournaments.

One day Lendl got sick and tired of coming up short during match play and took a few months off tour to learn how to hit a topspin backhand. Basically, he spent 6 to 8 hours each day on the court and didn’t allow himself to hit anything BUT a backhand while his opponents ran him ragged. During those sessions, he must have hit 2,000 or more backhands per day and after that training period, Lendl was never afraid to hit a backhand again.

In fact, his backhand became so fearsome that it was actually easier to hit to his forehand if you wanted to stay in the rally with him from that point on.

Lendl literally changed the neuroplasticity of his brain. Through endless repetition of a task, he taught himself a new skill.

When we are little kids our brains are very malleable and we teach ourselves everything through endless repetition, from walking to talking to reading to writing. As we get older and our need for new skill acquisitions diminishes our ability to train ourselves declines as well.

But it never goes away.

It simply requires time and patience and Lendl is perhaps the most dramatic example of an adult athlete already in his full prime and maturity teaching himself a new skill to become a champion.

So what does the dour Czech have to do with trading? Actually everything. All of us come to trading as adults, some of us are already well into our middle age. Our ability to learn new skills is deeply diminished but the time we take up the activity.

Furthermore, the skills we need to succeed are not the ones we are taught. Almost everyone who starts in the markets thinks that the key skill to learn is THE SETUP. Find the right formula and you’ll be making bank in no time.

Clearly, good setups require some time and education to develop. But setups are literally a dime a dozen. Talk to enough traders and you soon discover there are a hundred different ways to find an edge in the market.

What’s much harder -- and where almost everyone fails -- is in the ability to actually execute the setup to plan. Ask yourself these three simple questions:

Did I wait for my setup signal?
Did I take my setup signal?
Did I stick to the risk-reward targets of my set up signal?

Now ask yourself one last question.

Did I do it every time?

My guess, if we are honest about it, is that most of us only do all three 20% of the time. That’s why the single biggest key to winning in trading is the actual execution of the setup, not the setup itself.

So we need to practice the setup endlessly until every step comes as naturally as the topspin backhand came to the towering Czech. Fortunately, in retail trading, we now have access to micros in futures and 1000 unit lots in spot FX that allows us to hit as many “balls” as we need until we can train ourselves to execute properly.

Happy trading everyone!

Let’s make 2020 a championship year!

BKAcademy

99Deal

LifetimeDeal

The Most Important Thing in Trading

Boris Schlossberg

What the most important trading lesson I learned in 2019?

It wasn’t a new set up.
It wasn’t a new algo.
It wasn’t a new indicator.

All three came in handy -- but the lesson that really helped me trade better in 2019?

The need to forgive yourself.

There are no good or bad trades. There are only wrong or right trades. If the trade is wrong it must be stopped. But our inability to admit that we are wrong results in runaway losers that destroy our accounts.

It’s a tale as old as time and repeats itself over and over again because we are unable to forgive ourselves for being wrong so we make things much worse by trying to force the market to be right.

Trying to turn a bad trade into a good one is no way to live

But the power of forgiveness is extraordinary. Not only does it clear our mind and salve our conscience, but when done right it actually helps to improve our discipline. Because to forgive is not to forget. And once you’ve given yourself permission to forgive you are much more likely to accept your mistake, learn from it and not repeat it again.

In the end, it’s kind of ironic that in order to achieve discipline and excellence you actually have to accept and forgive your ineptitude and absence of control.

Happy Holidays to all

B

Your Chart is the Body of Proof

Boris Schlossberg

This week when we were Live Trading FOMC I uttered the following words:
“It doesn’t matter what you think.
It only matters what the market thinks.
If the market doesn’t think the way you do
You don’t move”
Not exactly Shakespeare, but like all great ideas it just channeled through me and I thought about it long after the webinar was over.
It seems such a simple thing and yet we almost never follow that rule.
I know I certainly didn’t and often paid a dear price for my arrogance.
But recently I started to watch “Body of Evidence” and suddenly a lightbulb went off in my head…

Well let me tell the story this way

PepperSmaller

This Blew My Mind

Boris Schlossberg

If you’ve been around capital markets as a New Yorker for a long time you’ve heard of Steven Schonfeld who has been prop trading for decades first as a classic day trading shop and now a full-fledged quant hedge fund. He is not nearly as well knows as Ray Dalio or Paul Tudor Jones but while the two titans of trading have barely been able to carve out single-digit numbers Shoenfeld has put 20% annual returns for past 6 years running -- an especially impressive accomplishment against a one way market that has managed to slaughter most of the hedge fund industry.

One of the great things about Schonfeld is that he is the quintessential New York character -- a no bullshit, salt of the earth guy from Long Island just like Josh Brown or even Stevie Cohen. This profile of him on Bloomberg is great and I highly recommend you read it -- but the quote that bowled me over had nothing to do with trading.

Schonfeld loves games of probability and is apparently an avid gin rummy player (so is Warren Buffet for that matter) and the article ends with the following vignette…

“Decades ago, after he won more money during a two-year stretch than four better players, they asked how he did it. He told them their mistake was to scold their partners for making bad plays.

“I don’t second guess,” he recalled telling them. “They can make the worst play and I say, ‘I would have done the same thing.’ Because of that, they play infinitely better on my team.”

“I don’t second guess” should be the motto we all live by. Because in trading that is all we do. We constantly torture ourselves for blown calls, late entries, bad executions, and just stupid seat-of-the-pants ideas.

In fact, I am convinced that it is because we are unable to forgive ourselves for our mistakes that we make much bigger ones. Think how much better it would be if we just shrugged off a bad trade and took a stop instead of fighting the market to a much bigger bloody loss.

Schonfeld understands that all games of chance are full of not only bad luck but poor judgments, but his ability to shrug off those mistakes actually makes him a much better trader than most.

He is just a regular guy from the Island who believes in forgive and forget. As we say in New York, he is a mensch that would make his bubbie kvell (a good person that would make his grandma proud)

It’s a classic example of not letting the perfect be the enemy of the good and a lesson we should all take from one of the best traders in the business now.

BlackFriday

Trading in the Actual Zone

Boris Schlossberg

Mark Douglas’s “Trading in the Zone” is a seminal classic of trading psychology. The book should be read from cover to cover but its essential tenents are :

1. Anything can happen.
2. You don’t need to know what is going to happen next in order to make money.
3. There is a random distribution between wins and losses for any given set of variables that define an edge.
4. An edge is nothing more than an indication of a higher probability of one thing happening over another.
5. Every moment in the market is unique.

Everyone one of those points is a fundamental truth trading and the title itself is a reference to the idea of trading without fear. When you are in the “zone” you focus on process rather than outcome and therefore build an indomitable psychological mindset that helps you perform to your best ability every single day.

Douglas’s points are timeless and true, but I want to discuss something much more mundane -- literally trading in the actual “zone”, which is often overlooked as a key ingredient to trading success.

This week I was in Philly for an impromptu gettogether with some of my oldest and dearest camp friends. Now I am a horrible map reader and whenever I get to a new place I usually just try to get the general direction of where I am going and then set out on foot. So against Google Maps better warning that I should take public transport or Uber, I simply stepped outside the 30th street station, found my way to Chestnut Street and then just headed to downtown Philly.

Philadelphia is less than 90 minutes away from New York but like almost every New Yorker I know, I never visit the place. Which is a shame. Because it’s a great city with a wonderful history, beautiful architecture, a thriving nightlife and generally a level of cool that no longer exists in the stodgy you-can-only-live-here-if-you-are-a-billionaire Manhattan.

But my walk down Chestnut was more than just a rumination on gentrification, it was an indelible lesson in geography. I quickly grasped how Philly is contained between the Schuylkill and Delaware rivers. As I crossed Chestnut and Broad I finally understood the term Broad Street Bullies ( a name given to the legendary 1970’s Philadelphia Flyers hockey team). And as I made my way towards the Delaware river I could see Indendence Hall on my right and literally imagined Franklin and Jefferson writing the country’s constitution.

My pedestrian stroll through the City of Brotherly Love made me more knowledgable about the place than any Google Map ever could. Nothing beats touch and feel for not only acquiring but absorbing knowledge.

Which brings me back to Trading the in Zone. Being mentally tough is a laudable goal for sure, but what about trading in the actual zone? What about studying every tick and quirk of the timeframe you trade. For the past several months K and I have been making Market Mapper tools to help traders see price patterns more intuitively. But it was only after walking those maket maps day in and day out that I started to pick up subtle clues to price action that improved my edge tremendously.

This is why wizened market veterans always talk about the need for screentime. And it’s absolutely true. There is just no substitute for engaged observation. That’s why newbies traders who are just looking for a “winning setup” always fail. There are no winning setups. There are only setups that you adapt to your own style. So just like a native of a city, I can point the tourist in the right direction but to truly discover the place you need to do your own walking and discover the Zone that works for you.

BlackFriday

What A Nobel Laureate Can Teach Us About Trading

Boris Schlossberg

Almost anyone who trades knows about the Sharpe ratio. It’s a measure of risk earned in excess of the risk-free rate per unit of volatility. The formula basically tries to answer the question -- how much risk did you assume in order to achieve that return. Now in our YOLO world where only the end result matters, one might ask -- who cares? Nevertheless, the Sharpe ratio is a useful tool to see if basically, you are one trade away from total ruin and every single money manager and trader on Wall Street must submit to its measurement before having any capital allocated to them.

The man who invented the Sharpe ratio, William Sharpe, is a Nobel prize-winning economist who is now retired, but he has not stopped putting his creative mind to solving investment problems. His latest project is what he calls the ‘Nastiest, Hardest Problem’ in Retirement, namely, how do you make sure your money will last your lifetime.

We live at an interesting time in history where the human lifespan in the OECD world has been extended by 150% while working years have basically remained static. This has created what in finance is known as a liability mismatch. Retirement assets are simply not elastic enough to sustain the new longevity The problem is massively aggravated by the volatility of equity returns. Imagine you’ve been investing diligently for 10 years and have built up a nice portfolio of 1M dollars off a total capital contribution of $500,000. Then in a span of 3 months, all those profits disappear and your original stake is now worth only $400,000. Ten years of wealth-building down the drain in less than a quarter. That’s what happened to investors in 2008.

Of course with the benefit of hindsight, we know that the markets not only recovered but doubled but many people -- in fact, most likely the majority -- panicked and sold at the bottom and then took years to get back into the markets. It’s easy to say that investors should hold through thick and thin, but as we know from trading nobody ever does. We all sell out at the bottom. At that moment no one is thinking about compounded returns 20 years forward. We are all trying not to become homeless tomorrow.

This is the precise problem that William Sharpe has tried to tackle and he has come up with a rather elegant solution to help investors protect themselves from their worst instincts. As he tells Barrons, “The idea is that you segment your money. It’s similar to using “buckets” but with a time component. A retiree might have a box for 2020 and a box for 2021, and 2022, etc.

In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. You have the key if you need to access the funds, but the idea is that, once a year, you would sell the assets in that year’s lockbox. You put all your money in locked boxes, to begin with, and you just happily open locked boxes. If you’re dead, your partner opens the lockbox, and if you’re both dead, your estate opens all the lockboxes that are left.”

Why is this better than just putting all your money into a single account stream? Two reasons. One is financial. By creating short term lockboxes that are essentially made up annuities, zero-coupon bonds, and TIPS, you assure yourself that you have the income stream to survive for the immediate future while allowing “long-tern” lockboxes remain in the equity market where the volatility does not affect your short term needs. The other reason is of course physiological. The math is the same in both scenarios. You only have so much money and it can only compound in a certain way given the performance of the assets. BUT! your ability to weather the market storm is much more durable if you were confident that your income streams were assured for the near term.

Sharpe’s segmentation idea really resonated with me because I have already been exploring it with my own trading account. Lately, I segmented my trading capital into various strategy “buckets” with a wide variety of lever and instrument factors. The results have been very promising. For the first time in my life, I have let strategies run without interference and they are really starting to perform.

Ever have a day when one bad trade tripped you up? And then you started to revenge trade and then the whole account got annihilated over what was supposed to be a 0.5% risk? This is exactly the problem that segmentation tries to cure. Because the true risk to our capital isn’t one bad trade, but what we do afterward. If you had no more money in your segmented account to revenge trade the damage would be contained.

Segmenting your capital by strategy, instrument and lever factor also has optionality embedded into the process. Let’s imagine you are a venture capitalist but instead of companies, you stake 10 different strategies in 10 different accounts. Now some -- perhaps most -- will blow up or lose 50% of value over time especially if you use even a mild lever factor. But one or two may be totally in sync with the current market environment and go on a massive tear tripling or quintupling their value. That’s all you need to be overall profitable -- but if you have all your assets in one account you will never have the mental strength to let the winning strategies run because you will be constantly looking at the P/L of the account and taking small profits to offset the big losses.

My example doesn’t even have to be that dramatic. You could just have most strategies tread water (which is what happens in real life, at least with me) while one or two make all the money. The Pareto Principle never goes away in life. William Sharpe’s great insight is to simply harness its value for all of us.

You Have to Be A Horrible Human Being to Be a Good Trader

Boris Schlossberg

There was a fascinating article in Institutional Investor last week arguing that money managers actually generate alpha and outperform the market. In other words, just like in other areas of life research and hard work pay off. However, almost all of that alpha is squandered because money managers fall in love with their positions.

“Active managers … can generate alpha of 1.2 percent annually, on average, at the portfolio level. That’s enough to beat their benchmarks after an average fee of 75 basis points (0.75 percent), the consultant found.

After evaluating about 10,000 “episodes” — full cycles of a given position from first entry to last exit — across 43 portfolios over 14 years, Essentia Analytics found that “alpha starts out strong and fades sharply with age.”
According to the report, “Investors often hold on to positions too long (a consequence, we believe, of the endowment effect), diminishing or eliminating whatever excess returns they were able to generate early on.”

The endowment effect is a nice sounding academic term, but I believe it masks what’s really going.

Since we are toddlers we are taught the following things.

Love those around you.
Be loyal to your friends.
Forgive and forget the errors of others.
Always give everyone a chance.

If we are any kind of a decent person these are the values we hold. They are so ingrained in us that we don’t even realize how they permeate our life and affect everything we do.

Trading, on the other hand, requires the exact opposite set of beliefs. It requires you to be a complete jerk.

Don’t marry your position.
Cut your losers.
Press your edge and annihilate those on the opposite side of the trade.

Trading requires a mercenary and transactional mindset that on some deep level is very much the opposite of how we perceive ourselves to be. That’s why “the forget and forgive” pep talk we constantly give ourselves inside our head never works.

Successful trading requires you to be ruthless. And the person you need to be most ruthless to is …YOU.

Until we stop making excuses for lifting stops, taking out-of-setup trades, trading way beyond our risk sizes and chasing trades after the signal has passed we will never master the game.

So here is to being a total asshole in the markets while trying to be a decent person in real life.

Throw it all Away

Boris Schlossberg

When I graduated from college my father wrote me a note that said, “Rent everything from underwear on out.” He probably never thought I would take him seriously, but I have. I’ve never owned a house. I haven’t owned a car in two decades and probably the most expensive thing I own now is the MacBook Pro I am typing this column on.

Much to the horror of my wife I like to buy my suits in bulk from Amazon (it’s amazing what custom tailoring, a nice shirt from Nordstrom plus a tie from Zegna can do for your wardrobe) I buy my watches Groupon and winter wardrobe consists of a 10-lot of black V neck sweaters from Old Navy which I will toss out by next May.

It’s not that I am cheap -- in fact, I rarely ever look at price tags or even check a restaurant bill -- it’s that I have never been particularly materialistic. I don’t have that pornographic desire to fetishize things. As long as something is comfortable and functional -- I am more than happy.

This isn’t a moral screed by means. When I am in other people’s houses who have curated many beautiful, expensive things such as paintings, furniture or fine China I am genuinely touched by the aesthetics of their taste. But can’t imagine such a life for me.

My first thought at being surrounded by many expensive items is the absolute dread of having to care and protect them. One of the great liberating aspects of my life is that I own nothing that I care about losing. Did my daughter spill chocolate on my suit? Garbage. Did my dog chew the inner lining of my shoe? Garbage. Did my watch get condensation on the crown? Garbage.

I often joke to my wife that I could leave with a carry-on and a knapsack and reconstitute my life anywhere. I’d just have to buy new screens. (She, on the other hand, would need the Queen Mary to move her possessions). This way of life may sound absolutely horrible to some of you, but the upside of my lifestyle is that I don’t suffer from the sunk-cost bias.

Sunk-cost bias, of course, is the single biggest challenge in trading and investing. It’s the human tendency to value what we pay for. The more we pay for something, the harder it is for us to let go. The bigger our trading position the harder it is for us to take a stop. Think about it. You have a system you like. You test it on real market prices at 1000 units per trade and you pretty much follow the rules to script. Then you decide to get serious and increase the size to 50,000 units and the first trade that goes against you -- you start to violate your rules. It’s easy to lose money on 1000 units, it’s much harder to accept the market’s judgment on a position 50 times as large.

That’s sunk cost bias and it sinks almost every retail trading account in FX.

I wish I could tell you that my lack of material desires makes me a perfectly disciplined trader. It does not. Despite my non-materialistic ways I am subject to the sunk cost bias as much as the next guy and have ruined many an account trying to resuscitate a large trade gone wrong.

But I do have an idea.

Create an FX version of my throwaway life. Suppose you have a $10,000 account. Take just $2,000 of it and put it into your “trading account”. Keep the other $8,000 as the “bank”. Think of the “trading account” the way I do about my Amazon suits. Be fully prepared to lose it all. Surprisingly enough this will provide you with the mental freedom to honor your stops. Using US margin regulations (which are around the mid-level of global stringency) you can trade 30,000 units at once and still have plenty of margin left for adverse price movement, This will make each trade meaningful but not terminal to your overall capital. The side benefit is that even if you lose your head and revert to the sunk-cost bias, market regulations will take you out at a margin call and will preserve up to 50% of your “trade account”. Worst case scenario you will lose between 1,000-2,000 bucks and will have 8,000 more left safely ensconced in the “bank”.

Is this the ideal way to trade? Is this the optimal way to trade? Is this the most efficient way to trade? No, no and no. But it is the most human way to trade and when it comes to the markets we need any crutch we can get.