Discipline is a Lie – but Here is How You Can Trade Much Better

Boris Schlossberg

Executive function is a fancy scientific word for willpower or discipline. It’s how social scientists study our ability to control our impulses and the latest research has pretty much debunked conventional wisdom on the subject.

We have all heard about the famous marshmallow test where kids who displayed discipline at not grabbing a marshmallow right away were shown to be much more successful later on life seemingly proving that notion that self-control led to success. The truth is actually much more nuanced. What the test really showed was that rich kids who had no scarcity worries in their lives were much more likely to wait than poor kids, in essence proving nothing more than the fact that socioeconomic standing rather than character correlated with financial success later in life.

Still, the test provided a clue to what really matters which is context. A poor kid coming from a context of scarcity where the future is uncertain would very logically have a much stronger predilection towards present value while a rich kid for whom the present was much more stable could take a bigger risk on the future. (This little dynamic by the way explains why poor people spend their disposable income on the lottery while rich people buy bonds)

Yet within this idea of context, there were a few new discoveries that social science made. For example when scientists re-ran the marshmallow test with children controlling for socioeconomic background but this time told one set of kids that they were on the “green team” and that members of the green team waited for the marshmallow the executive function of those kids was much stronger and their wait times much longer even though they never met any members of their team. The mere concept of peer pressure was good enough to improve behavior.

Group support is one of the easiest and most effective ways to improve executive function whether it be exercising through a tennis league, joining a walking club, attending a Weight Watchers meetings or in our case trading together in a chat room where we can discuss markets and ideas in a social setting.

The net takeaway from the latest research is that discipline does not work. In fact, it is extraordinarily counterproductive as the mental energy expended on telling yourself to NOT do something actually weakens your resistance to the very thing you want to avoid.

According to scientists the better tactic is to create a plan that simply never exposes you to temptation while at the same time makes proper behavior as pleasant as possible.

I’ve actually managed to do all that with my own day trading recently without even realizing that I was using the latest cutting edge science techniques. I love to day-trade but my two biggest weaknesses have always been to make random trades out of boredom and fade the trend in an often futile attempt to find a bottom or a top.

A few weeks ago, however, as I was preparing for the Chicago Traders show I was going back through BK library of strategies and stumbled across #bkflow a strategy we used to trade in the heyday of FX volatility but abandoned a few years back. I took a look at it with a set of fresh eyes and realized that this could be a very good setup if it had a trend overlay filter. Then I got in touch with my programmer and coded the logic.

Now I have an algo that spits out 8-10 trade ideas for me per day. Ideas that are naturally on the side of the trend. The net result has been nothing short of astounding. I stopped making random trades out of sheer boredom because now I had legitimate setups to follow. I stopped trying to pick bottoms or tops as well.

Don’t get me wrong, I still use discretion on the selection and on exit -- but that is very much playing to my strength as I apply my analysis of newsflow and priceflow within the very clearly defined rules of the #bkflow setup. Here is how I traded it for the past two weeks -- and the best part is that it was totally stress-free.

bkflow.8.10.19

Executive function had very little to do with my trading success -- and that exactly how it should be which is why if you want to succeed in trading focus on making it easy and pleasant and ignore the discipline scolds.

In Trading the Power of Old and New

Boris Schlossberg

This week at the Chicago Traders Expo I was accosted by a group of young forex traders who peppered me with questions for a good have an hour and it was the best time I had all year.

The energy and curiosity of youth is intoxicating and it revved up my own enthusiasm for trading and sent me back to New York a better, more focused trader. One of the great side benefits of prepping for Chicago was going through my archive of strategies.

I am notorious for writing strategies and then abandoning them for the next great thing. But this time I actually applied a critical eye to my past ideas and was able to improve them by adding some current knowledge gained from the school of hard knocks. The net result was that I revived an old BK Flow strategy by applying filters from our current research and created a dynamite new day trading setup that we’ve been using all week long in the chat room. I am actually so excited about it that I think it will the core strategy in my day trading channel.

Looking at old ideas with fresh eyes can be incredibly valuable. One of my older concepts was to Trade Tiny. The idea was to trade the smallest possible size of 0.01 units on all your trades even if you had a five or six-figure account and could afford much larger positions. My argument at the time -- and I still think it’s absolutely true -- is that Trading Tiny eliminates almost all bad trading behavior. It allows you to trade much larger time frames with massive 200-300 pip stops because a loss on any given trade is only $20-$30.

In the realm of academia and logic size should not matter. It should simply be relative to your account. But in real life where psychology controls all size is everything. Regardless of your account size, it’s still easier to lose $40 on $1000 then $3000 on $100,000 even though proportionally the latter is a smaller loss.

But of course, we don’t think in proportions or probabilities. We think in absolutes. So when we trade a strategy that is 80% accurate and hit 3 or 4 losers in a row we are ready to ditch it the way Kendall Jenner dumps boyfriends. That’s why pain in trading need to be kept at an absolute minimum and Trading Tiny is the best solution.

But having developed scores of strategies since the time I first proposed that idea, I realized that now I can have the best of both worlds. I can keep my individual trade risk very small ensuring that I won’t pull stops or revenge trade or average down needlessly, but I can also generate a meaningful return even on a larger account by trading a variety of configurations for each strategy I have, diversifying by currency pair, timeframe and risk parameters.

By dividing up my capital by ten or even twenty slices I can create a very powerful portfolio of trades that will aggregate to a meaningful return while taking tiny individual trade risk.

This is a very cool idea and I would have never thought about it that way if I hadn’t looked at my past work and applied the lessons from my current research. In trading as in life getting young and old together can work marvels.

In Trading – It’s Never About YOU.

Boris Schlossberg

Here is the one question you need to ask before you push the trade button -- Is there anything going on that will make other people trade? If the answer is no, then the result for you will almost always be negative.

Like little children whose sense of narcissism is absolute we as traders always think that markets are about us. What can I do in the market today? How many pips can I bank?

The answer very often is nothing and none.

That’s because the markets are not about you, but about others. And if there is little reason for other people to trade price action will be nonexistent and so will most profit opportunities.

We think that the market is like a 24 hour -- 5-day week machine. But it’s not. It’s a social construct. It’s much more like a bar or a nightclub rather than the factory floor robot and if it’s 10 o’clock on a Monday morning you can be pretty sure that the bar or nightclub will be barren.

We are of course in the middle of our “Monday morning” moment in FX. Every summer, in July and August, most the people that matter to the market are off to St. Tropez or the Hamptons or Jackson Hole. The summer doldrums can be a maddening time for the retail trader, but they can also be the best time to learn what not to do -- namely force trades into the black holes of low volatility. This is a time when market makers love nothing more than to create false breakouts and breakdowns, sucker retail in and then flip the market on them.

With no major institutional order flow around, market makers can pretty much do as they please and that creates sinkhole sized traps for retail who are fooled into chasing price.

This week, I started my live day trading feed and one of the best decisions I made was to choose only one or two setups each day. Keeping it rare and keeping it tight by laying off risk as quickly as possible allowed me to surf the dangerous waters of the market without getting run over by market maker action.

The last trade of the week was particularly telling. All the funda data at the end of the week was pointing to a strong USDJPY tilt. CPI, PPI and even Fed talk by the end of the week was sounding more hawkish than dovish yet USDJPY could not push past 108.50. After the hotter PPI print, the pair just lay there unable to muster even a ten pip rally. One of my cardinal rules is that when the funda is positive but the price action is negative always go with the price because you are not seeing something critical in the market. What was it? I still don’t know. It could have just been market maker games at the end of the week. It could have been some large counterparty laying on massive risk-off positions because EURCHF was down by more than 2 standard deviations as well. Whatever it was, drove prices lower and I, fortunately, followed the flow to the downside -- because in trading it’s never about you -- it’s about what others are doing.

Trading Both Sides of the Market

Boris Schlossberg

Last weekend I was in Madrid for David Aranzabal’s annual Forex Day conference and as always it’s my favorite trip of the year. I love the food. I love the people. I love the city. I love the casual elegance of European way of life. But mostly I love hanging around traders talking markets.

Two of my colleagues Asharf Laidi and Rob Booker were presenting as well. In the heyday of retail FX growth before the GFC we were on the road always and used to see each all the time. Now we are all older, settled with kids and don’t around as much anymore. So it was a pure pleasure to catch up.

Each one of us trades in a radically different style. Each one of us has seen almost every imaginable market possible. And I think it is fair to say that as we grew older, each one of us has become much more humble in our approach to trading. That humility was evident when we sat down for coffee to discuss our specific techniques and discovered that we all do the same thing -- trade both sides of the market.

Ashraf is a classic techno-fundamentalist macro trader who can hold positions for months at a time. Such tactics require not only patience but the ability to withstand being wrong for hundreds of pips until your thesis plays out in the market. Ashraf noted that unlike in his younger days when he would stubbornly hold his view through long periods of drawdown, now he fully accepts being wrong in the near term and actually scalps ⅓ to ½ of his position in the opposite direction. This way he constantly reduces his cost basis on the initial idea making it even profitable when the market finally turns his way.

Robbie has a completely different approach essentially trading mean reversion with tiny, tiny size and a portfolio approach that often puts him on the opposite side of the market with similar pairs. He does not use stops and lets the offsetting trades net out to a positive return. He also does something very clever. He always makes sure that he is on the positive side of the carry. He told us a story of a short EURTRY trade that took 2 YEARS to resolve. During that time he lost 2,000 pips on the position as the lira disintegrated, but at the same time collected 3,000 pips in swap making the net position profitable in the end.

Unlike Asharf and Rob, I am much more of a classic algo-driven trader with exact entry and exit rules. And since I have the attention span of an ADD-addled 5-year-old, I generally never hold my trades more than 24-48 hours so my algos operate on a much shorter time frame. Yet, I too often find myself on both sides of the market. At least once or twice a week, one of my algos will open a long in some pair and when the price action goes against me will open a short in the same pair in a different account. This freaks BK members out as they can’t understand why I do that -- but the fact of the matter is that algos have picked up the signal that market conditions may have changed and while my “wrong” trade will most likely be stopped out -- my offset trade will take some of the string out of the loss by banking pips the other way. This by the way not only works on a granular level but on the portfolio level as well as sometimes Kathy’s strategies will take the opposite side of mine and will mitigate losses as well. It is, I think, the primary reason why the retooled BK service has been so successful lately making 1300 pips in past four weeks as contravening positions keep drawdown to a minimum and overall return positive.

They say that a true sign of intelligence is to be able to hold two contradictory concepts at the same time. There is no doubt that that principle holds true in trading as well where mental flexibility and psychological humility are the two key factors in long term success.

In Trading We Sell Greed, but Fear is the True Secret

Boris Schlossberg

This was the first week in five that I lost money on my weekly trades in BK and yet it was the best week I had.

I started out very long loonie, thinking that a relatively hawkish BOC, the high price of oil and decent eco data would give my trades a boost. I was also bearish euro as the pair faced the turmoil of EU parliamentary elections, the slowdown in Germany and the nasty fight between Brussels and Rome.

I was right but it didn’t matter. The loonie was bid up ahead of good news and euro sold down ahead of bad data, so the story impact was minimal and prices went against me almost from the get-go. Yet in the end, I managed to lose very little money which is actually the perfect way to trade.

A few weeks ago I noted that the only way to trade successfully is with a two target process, where you take half the trade off at some short risk target and let the rest float looking to bank 2 times risk or more. That second half of the trade is basically a lottery ticket. The “long profit” trade only happens 20-25% of the time but when does hit target that pip gain is responsible for the bulk of your overall return.

This, of course, is what everyone who provides trading education sells. “Risk one dollar to make ten!” “Double your account in a month!” “Trade one hour a day and make five figures a month!” The trading business is replete with bullshit because of course, that’s what we want to hear. We not only want to make money, but we want to make “easy money” with very little risk and massive payouts on a weekly basis. All trading education appeals to our instinct for greed which of course is why most traders fail miserably.

Greed trips us up in a million different ways. It entices us to chase trades with too much size but more insidiously it makes us hold on to losers way beyond reason and prudence. Most conventional wisdom says that we lift our stops because we are afraid of losing money, but I actually think it’s the opposite. If we were truly afraid we would get out. Instead, I think we hate the idea of not making money so stay in the trade against rhyme and reason desperately trying to claw back to even one pip profit so that we can feel like a winner.

How many times have you been in a trade that was deep against you -- maybe even a few pips away from the stop -- and then rallied halfway to your entry thus cutting your losses significantly -- but you refused to get out, hoping that it would “turn around” only of course to lose it all in the end?

I don’t think there is a retail trader out there who hasn’t done that at least a dozen times. The reality, of course, is that it is really hard to take losses just when things are starting to look up which is why I don’t even try. Our instinct for greed is impossible to tame so I prefer to work on my defensive skills. The beauty of short/long exit structure is that it locks in a small profit and instantly goes to breakeven ensuring that you won’t lose money on the trade. It essentially creates an institutional process for fear. And fear is highly undervalued in my opinion. Fear is the key factor that keeps us alive. Fear is what makes us spit out tainted food so we don’t get poisoned. Fear is what keeps us from crossing a five-lane highway in the middle of rush hour. Fear is what keeps us from rollerblading down a 3000-foot mountain road without a helmet ( Yes my younger stupider self actually did that once )

Unlike the romantic notion of bravery which gets all the accolades fear never gets good press, but as General Patton once said, “The object of war is not to die for your country but to make the other bastard die for his.”

Trading is very much the same way. Returns are made not through big gains but through avoidance of massive losses. Last week I was able to lock down small gains in EURGBP and EURCAD shorts before they blew up against me and that kept my weekly loss very manageable and kept my overall pip tally way in the green.

Hooray for fear. It’s the secret to trading.

The Difference Between Reaction and Response is Worth Hundreds of Pips

Boris Schlossberg

It’s been an intoxicating week at BK. We’ve been winning on every trade structure -- swing, news trading, day trading and even algo. A big part of the reason is simply the much more accommodative market environment. Nothing like pick up in volatility to make your continuation trades hit all their profit targets.

But it’s something more. The ability to win on both the news level and the swing level made me realize that I am starting to master a very distinct set of skills, that are really useful in understanding how markets really operate.

One common refrain that I often hear from retail traders is, “I never pay attention to the news. It can’t help your trades anyway.” Although I refrain from saying this to their face, my immediate thought is that the only thing stupider than that statement are traders who tell me, “I never pay attention to technicals, they are just squiggles on a screen.”

Both attitudes are woefully myopic because trading is always and forever a mixture of fundamental catalysts, market positioning (trend) and price levels. It is a multi-factor game and just looking at “squiggles on a screen” or chasing the latest headline is a sure path to ruin in trading because you are flying partially blind.

Still, because retail traders are predominantly technically oriented and pay only cursory attention to fundamentals it’s really important to understand the difference between news reaction and news response.

One of the reasons that so many retail traders are frustrated by news trading is that it seems to follow Murphy’s rule of law. Good news gets sold and bad news gets bought. Nowhere is this more evident than in commodity dollars where a few primary bank dealers control the order flow and enjoy nothing more than wrong footing traders who chase headlines.

Let’s understand what happens when FX news comes out. The moment the headlines hit the wires algos from HFT firms like Citadel and Virtu will sweep all the offers or hit any bids in a matter of microseconds. So often the move between pre-news and post news highs or lows is accomplished within a 1-minute candle leaving absolutely nothing for the point and click retail chasers who are fighting latency and wide spreads. Furthermore, the dealers who are on the opposite side of this flow have now inventoried a lot of one-way trades and need to carefully unload their position at a profit.

Contrary to the paranoia you’ve heard in retail chat rooms, dealers are not “always manipulating the market”. They are just doing their job as liquidity providers while trying to keep a positive P/L. So naturally, prices will often rise after an initial sharp drop or fall after a spike higher. That’s how the game is played, so don’t hate the player.

This is simply news reaction and in BK Live Trading I often take advantage of that dynamic by doing the exact opposite of what makes common sense and capture the “retrace profit” along with the dealers.

But news reaction is frankly chump change. The real money in FX trades is made on news response when a piece of data has far-reaching implications that go beyond the next few hours or even the next few days. A prime example of this dynamic at play was the RBNZ presser in March. The New Zealand central bank announced a clear shift to an accommodative stance, essentially warning the market that a rate cut was coming. The price instantly dropped but then actually consolidated and rallied for a few days after.

N00b traders would be forgiven for thinking that this was the end of the story, but for traders who actually understood news response this was just the beginning. That’s because the markets players who truly move prices -- the corporates, the hedge funds, the asset managers and the pension fund managers were making multi-month long adjustments to their positions that would inevitably have a directional impact on price. Sure enough a few weeks later the kiwi was substantially lower than post RBNZ and those traders who had the foresight and the patience to stay with the trade capitalized on the move.

I often say that day trading is for dopamine. We all want it. We all need it. But just like junk food it’s not really a recipe for long term success. Dollars are made on the Daily. It’s boring. It’s tedious. It’s certainly not sexy, but it’s where the real money in FX is made.

RBNZ.Example

Why R is the Most Important Letter in Trading

Boris Schlossberg

R in trading parlance is simply a uniform unit of risk with all your rewards are expressed as multiples of R. So a simple 10 pip stop and 20 pip target is a 2R trade. R can be expressed as pips, points, or dollars -- whatever suits you. The primary value of R is that it normalizes risk across all your trades, or bets as I like to call them.

Now the internet is full of “R Billionaires” -- traders who claim in podcast after podcast that they have a 70% win rate and 2.45R average. (Just to show you how ridiculous that is -- it’s a 145% return without any leverage or taking $10000 to $77 Million in 10 years). But trader bulls-t aside, R is a very useful tool that should be part of our trading process regardless of what strategy we use.

It’s essentially a risk framework, that can quickly tell you how and why you make or lose money in the market. But before we delve in further -- allow me to digress. I stated above that we should stop calling trades -- “trades” and start thinking of them as bets.

Why?

Because the word “trades” has a false connotation to it. Trades imply open-ended narrative structures that can turn into psychological crutches as we hang on to the story arc long past its ending because we are convinced that we are “right”. Bets, on the other hand, are binary and final events- which is exactly how we should approach what we do. As traders, we don’t “invest” in stories, we make market bets and play the odds via R. (Yes, I have been reading a lot of Ray Dalio lately and regardless of whether you think Bridgewater is a cult or not, his philosophy of radical transparency is the perfect way to view our role in the market)

Lastly, stop thinking about daily, weekly, monthly, annual returns. The question -- how much can I make this year should never enter your mind again. Time is a completely artificial construct. Annual returns are simply marketing bulls-t pumped out by Wall Street for civilians who have no clue how markets work. The only way to honestly evaluate your performance is over a number of bets and 100 is as good a round number as any. So, if you can achieve some positive multiple of R over 100 bets. You. Are. Winning. At. Trading. Everything else is just noise.

Now, in reality, 2R trades happen 25% of the time (did you really think the markets would give you any more than that?) Occasionally, certain strategies and certain pairs can give you 30%-32% win rates on 2R trades and that is as good as it can get, because just like a casino with 51%-49% advantage in roulette, you can make a lot of money out of a
thin edge.

The key, of course, is to mitigate risk as soon as possible. There are two ways to do it. You can move the stop to breakeven as soon as trade goes 1R in the money and then wait for 2R to hit 31% of the time. If the b/e stop happens 50% of the time you are well ahead on this strategy. (Simple math -- 50 bets you lose 1R, 31 bets you make 2R, net result +12R). But that’s tough to do psychologically. We like to get paid more than 31% of the time. So most traders use a T1/T2 approach that I’ve talked about before. In that scenario, you start with 2R risk, exit half the trade at 1R move stop to breakeven and exit 2nd half at 2R. In fact, the nirvana formula for such an approach is 45-55-30 split where you lose 45 trades make 1R on 55 trades and make 2R on 30 trades. If you can do that consistently you actually will be an “R Billionaire” one day.

Looking at markets through the prism of bets and R has really helped me spot my own weaknesses much quicker. About 4 weeks ago after a very long period of focusing only on systems, I started doing weekly prop trades for BK (basically K beat me into submission into doing it). The results are seemingly exemplary. I am up more than +500 pips on the recs despite Trump’s best efforts to disrupt the FX markets on a daily basis. But taking a look closer at what I was doing I realized that I had a glaring flaw in my approach. I’ve been using 100 pip stops 40 pip T1 targets and 100 pip T2 targets for essentially a maximum .7R. Generally, you want to keep your maximum R at 1 to 1.5 so that you can be positive on anything better than 50%. Not only was I making inferior trades but I was taking on risk that was utterly unnecessary. None of the winners ever went 50 pips against me. So going forward I am cutting stops to 70 pips -- that’s still not perfect -- but it does put me at 1R maximum bet which should be a much more resilient structure if I can stay above 50% win rate.

Up to now, I’ve been lucky. Going forward with better R, I hope to be good. Be sure to start using it in your own trading.

The Amazing Power of Negative Thinking

Boris Schlossberg

Positive expectancy is a foundational concept in our business. It is the idea that whatever system, whatever algo, whatever visual setup you use will result in profitable trades. The whole point of trading is that you need a method that is not just simply blind luck gambling in order to win in the long run. So backtesting, front testing, live testing are all good and necessary steps to finding something sustainable and robust to trade.

The problem comes with expectancy. Expectation is the single most toxic thing in trading.

Think about what happens. Say you research an idea. Code it. Chart trade it. Maybe demo trade it. Maybe dime pip trade it. Backtest it some more and feel really good about it. The moment you turn it on -- what’s going through your mind? You are excited! You are ready to make money! You are primed for success -- you are Dale Carnegie, Tony Robbins, Michael Jordan all rolled into one!

It doesn’t matter if you are a triple Ph.D. data scientist working on the most complicated market-making algorithm ever or a just a regular Joe retail trader looking to pull some pips from the market. As human beings, we all expect positive results.

And of course, we get the exact opposite. Not only are market conditions different from the backtest or different from the past two weeks of price action, but they are literally transformed into such a challenging environment where every single trade you take turns into a stop.

Suddenly you are 5%-10% in the hole. You a miserable and frantic and teetering on the state of what poker players call “tilt” -- a moment when you lose all rational faculties and start just trading randomly, swinging wildly at the market in a desperate attempt to. Just. Win.

Why?

Because you expected success. Think about it. You are never as vulnerable as when you expect something to happen. It’s almost never the results that kill us psychologically it’s always the expectation. The market, which is the ultimate poker game, knows this very well. The very point of all good poker players and market traders is to psychologically destroy their competition through deception and subterfuge. Once your opponent is defeated mentally it’s a piece of cake to defeat them physically.

So the market, in its very perverse way requires skills that are the opposite of everyday life. To win you actually need to walk into the ring expecting to lose -- because lose you will. Sometimes, like in the current Alice-in-Wonderland market for what may seem like an eternity. And the only way you will survive the pressure is to step into the arena expecting to lose. In the market, the power of negative thinking is the greatest superpower of all. Because if you expect to lose, you will trade small size. You will control your bankroll. You will take every trade. You won’t lift stops.

By expecting to lose, you will do all the right things to win in the long run.

I am always amused by financial planners who ask, “What is your tolerance for risk?” Clients always murmur something like “20%”. Do you know what the real answer is? ZERO. Nobody puts money in the market because they expect to lose -- which is why I am certain that Ma and Pa Main Street who have been brainwashed to buy every dip and hold the ETF forever, will puke up all the gains of the past decade at 50% loss because there will be a time when the market does not come back. Not in a month. Not in a quarter. Not in a year. Not even in a decade and none of them will have the trading skills and the mental strength to understand just what kind of a sucker bet they made.

Oh and by the way, if you still believe in the Horatio-Alger-pull-yourself-by-the-bootstraps-power of-positive-thinking approach let me leave you with this quote from Michael Jordan.

“I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. 26 times, I’ve been trusted to take the game winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.”

Prop versus Algo – Like Minetta Tavern vs. Mickey Ds?

Boris Schlossberg

This month, after endless prodding from K I went back to prop trading. Surprisingly, it’s going well. Even more surprisingly I don’t hate it. I know, I know -- for the past six months I’ve been screaming that the future of trading is rules-based algos, but trading prop has actually made me appreciate the art of the former as well really clarify the science of the latter.

Let’s agree on one thing. Prop is never going to go away. Human beings will always want to make decisions and furthermore the world of solely algos creates a recipe for disaster as machine choices either bring the markets to a halt (perfect equilibrium) where no trade can make money because all information is instantly factored into price) or worse markets crash with no support in sight -- (2011 anyone?) but this time REALLY NO SUPPORT which could bring the whole system to it knees.

In any case, human judgment will always be a part of markets because markets are ultimately human enterprises. So it’s good to think about how prop differs from algo and more importantly how each approach has vastly different end goals that we need to understand.

This week the Beyond Meat IPO launched to a 150% pop on the first day of trading, so hamburgers are really on my mind. Besides who doesn’t love a burger? Last week in Cali I tried BM burger right next to a “real” one and I really liked it more than meat -- but I will leave the sectarian battle to the food purists. What I want to propose today is that prop versus algo is very much like Minetta Tavern versus McDonalds.

Most of you probably haven’t heard about Minetta Tavern burger, but it is considered to be the best in the city. Again, I have no desire to fight a food war here (I am a guy who actually thought that burgers at Legal Seafood were some of the best I ever tasted, so I will leave my culinary judgment out of it), Instead I want you to think what it takes to prepare a perfect burger at a fancy restaurant. Each patty is carefully selected, checked a hundred times over for proper fat to meat content, individually cooked and dressed and presented to the patron in the most appetizing manner. Furthermore, if any flaw is discovered on the plate, the whole thing is quickly thrown away and a new one is made.

Prop trades are very similar. Each weekend I pour over all the charts, consider the event risk facing me, think about the current sentiment and positioning and try to put three perfectly curated trade ideas “on the plate”. Furthermore, if any of those ideas turn “sour” due to some fresh information in the market, I may decide to scrap the whole thing well before it hits my stop.

Now think about Mickey D’s. They are not trying to produce a great hamburger. They are trying to produce a “good enough” hamburger that they can serve a trillion times. That means that they take a lot of short cuts with their product, but on the other hand, produce the exact same patty in Dubai as in Detroit. No one at Mickey D’s can afford the Hamlet-like hesitation about the “perfect fat texture of their product”. Mickey D’s is looking for success in the aggregate whereas Minetta Tavern is looking for perfection in the particular.

And that ultimately is the difference between prop and rules-based algo.

The biggest problem most traders make is they attempt to turn each Mickey D’s patty into a Minetta tavern masterpiece and that is the road to ruin. Algo trades are not meant to be perfect. That means that they will suck a lot. They will be subject to idiosyncratic wobbles in the market. They will sometimes post six, seven, eight losers in a row -- something that would horrify a prop trader. But that is perfectly normal. As long as your quality control remains in place -- and for algo trades that means that you’ve created the best possible risk-reward structure and have not overleveraged the account in any way -- the long term expectancy will be positive and those pips will pile up.

The one key difference -- and this is perhaps the most important point of all -- pips profits do not pile up like hamburger profits. There probably no business that has less volatility than a McDonalds franchise. By that I mean, there are probably very few MCD franchises in the world that lose money on a daily basis EVER. That, of course, is totally not the case with algo trading. Pips come in batches and often leave in batches and you have to fully be prepared for a very lumpy distribution.

But in the end -- whether you trade prop or algo or both -- KNOW the DIFFERENCES -- it will help you succeed with each approach.

The Only Money Management System that Works in Trading

Boris Schlossberg

By now, everyone should be familiar with the Pareto distribution. Named after an Italian economist from the late 19th century it is colloquially known as the “80-20 rule”. In many disciplines in life, 80% of results come from 20% of factors.

Pareto first noticed the phenomenon with respect to land ownership in Italy where 80% of the land was owned by just 20% of the population. The distribution is not always exact but it is a good general approximation for how things work in real life. The Pareto principle shows up in phenomena as diverse as geography (80% of the population lives in 20% of cities in the US) software (80% of all computer errors in Microsoft products was caused by 20% of bugs) to of course income distribution (where roughly 80% of all assets in the US are owned by 20% of the population).

The Pareto principle is part of the larger structure called power laws and love it or hate it is an inextricable part of life that we need to accept if we are to understand how the secret of success.

Nowhere is the Pareto principle more evident than in financial markets which are the very quintessence of power laws in action with most spoils going to the very few. In trading, the universal truth is that 80% of your profits will come from 20% of your trades, or conversely if you choose to trade like an insurance company 80% of your losses (more like 90% in real life) will come from just 10%-20% of your bets.

This is precisely what makes trading so challenging for most people. It is psychologically impossible to accept losing 8 out of 10 times only to make everything back on just 2 big bets. It’s especially so because after losing 3 or 4 times in a row most traders pass up on a setup -- which inevitably turns out to be the one trade that is the winner that pays for all the losers.

Essentially trading is the art of looking for lottery tickets -- just read the history of any of the great traders from Soros to Tudor Jones to even Jesse Livermore and that fact become obvious.

So how do you create a money management system to accommodate the Pareto principle and at the same time make it psychologically palatable? The only way I know how to achieve that goal is with a short exit/long exit structure or as K and I always call it T1/T2. The idea is to always trade with 2 units. The exit on the 1st unit should be slightly less than the stop and in an ideal world allow you to win 60% of those trades. Then you move the stop on the 2nd unit to breakeven and aim for at least two times risk and maybe even three times risk on the second part of the trade.

This week in my coaching webinar we ran test after test of our trading strategy against a variety of major currency pairs looking at the past 100 trades in each. Inevitably the T2 target was hit between 19%-25% of the time, proving the Pareto principle right.

But!

Although on the face of it such payout odds would seem to be a losing system (run 10 trades with 50 pip stops and 100 pip targets and only win 2 out of 10 times) the blended strategy actually proved to be very profitable.

The reason the T1/T2 strategy worked was that the short exit eliminated about 20% of additional losses. As Warren Buffett and Charlie Munger often say the key to their success is not picking winners, but avoiding as many losers are possible.

The T1/T2 structure offers two key benefits. First it skews the math in your favor making the overall results positive or far less negative because it minimizes the number of losses, but more importantly, it creates a much more human-friendly trading environment by increasing the total number of winning trades.

By the way one final note on our tests this week -- only two out of ten currencies we tested produced positive results that were responsible for the vast majority of the overall pip profit, proving that the Pareto principle operates on the portfolio level just as it does on the single trade level.

There is nothing we can do about power laws in nature, but to accept their presence. But we can survive and thrive in the market environment if we start using the T1/T2 money management system to conquer both Mother Nature and our own behavioral biases.

In Trading Losing is a Feature not a Bug

Boris Schlossberg Uncategorized

One of the best things a trader can do is run the strategy tester function in MT4 on any 1-minute chart. Ideally, you’d like the test result to be positive in the end, not because it will show you how to make money, but because of what it will teach you about the nature of trading.

The one minute chart, as I’ve said many times in the past, is an amazing hack that allows you to look at hundreds of trades over just a few weeks of data. So run the strategy in MT4 and watch the graph dynamically build itself in real time as each trade gets added.

One thing you will never see is a straight 45-degree line running from left to right. There are no regular paychecks in trading, What you will see instead is the equity curve rising 10% in an uninterrupted fashion only to drop back to zero and then below it. You may see that a few times during the lifespan of the strategy and every time that happens more than 90% of you will stop trading the system. Yet in the end, after a few months or a year or even a few, the system could end up being incredibly profitable.

All of us come to trading with an absolutely wrong model of how things work. Sure, we can imagine, one, two maybe even three losses in a row. But after careful study, hard work and discipline we imagine that we can eliminate those mistakes and embark on smooth consistently profitable money making adventure.

Wrong.

To borrow a line from the software business -- losing is a feature, not a bug. In fact, almost all great investors lose or underperform for long stretches of time. Warren Buffett underperformed the market by a whopping 54% in the late 1990s and has had several drawdowns of 40% in his career. Almost no one who tried to copy his trades would have stayed with him through the losing times and yet his long term record is one the best ever.

That’s why the single greatest lesson any trader can learn is not risk management, or strategy selection or market analysis. All of those are crucial to long term success but will be utterly useless unless the trader accepts the fact that stomach-churning losses will never stop.

Here, the Oracle of Omaha can be a useful guide. You can’t make losses disappear, but you can do your best to survive them. To that end Buffet offers two great pieces of advice -- don’t do stupid things and don’t overlever your trades.

Both Buffett and his investing partner Charlie Munger have always claimed that their success came not from making smart choices but mostly from avoiding the dumb ones. If you are running a system and a given instrument is only producing mediocre results -- continuing to trade that instrument on that system is sheer idiocy. There is no guarantee that any of the well-performing instruments will maintain their edge, but there is almost complete certainty that a poorly performing instrument in the past will cause you losses in the future. Sure, there are exceptions to the rule but that’s precisely the point. Strategies are about rules, not exceptions.

Still, the single best advice from Buffett is not to over-leverage. Leverage is the single biggest reason why most retail traders blow up their account. You can survive a lot of adverse market regimes on low leverage but you can’t survive even one mistake on high leverage. That’s why it’s worth it to always start trading with no gearing whatsoever by trading one times equity per trade. The natural leverage of multiple positions will be more than enough to keep you on your toes.

You’ll Never Understand Trading Unless You Read This

Boris Schlossberg

If you’ve run hundreds of backtests over the past few days like I did you come to a startling conclusion.

There are no winning trading systems.

There are only systems that drawdown a little less than they run up.

EVERY SINGLE system you trade will lose money if you trade it long enough and sometimes it will lose a lot.

I call this the Law of Paying the Pip Piper. Basically, the absolute best that you can hope for is that your drawdowns are slightly less or equal to run-ups. So that a system that just made you 300 pips over the past few months will -- as surely as day follows night -- now proceed to lose you 150 to 250 pips over the next few weeks.

Why does this happen? Because market regimes change and every single system is optimized for one or the other set of conditions -- continuity or mean reversion -- or to put in more colloquial terms -- trend or tread. In continuity (trending) markets systems that bet on continuation will thrive. In markets that tread the exact opposite bet pays out. There is only one letter difference between trend and tread but that tiny change is all you need to make a lot of pips or lose them.

Trading is the closest thing we have in the modern world to the natural state of volatility. Our hunter-gatherer ancestors fully appreciated the idea that tomorrow will not at all be like today and more importantly that pleasant comfortable weather will inevitably turn into a miserable multi-week storm or rain and destruction. But the very goal of civilization is to completely annihilate the volatility of everyday life. We built massive furnaces up North which allow us to live in comfortable 65F weather in Sweden and we build massive air conditioning complexes in the south allowing us to do the very same in Las Vegas. We smooth out our income streams through the magic of “salaries” and smooth out our food supply chain through some of the most complex logistics ever imaginable so that it becomes as natural to eat a peach in December as in June regardless of whether it comes from Chile or Georgia. So little wonder that our modern mind, so carefully protected from the vagaries of nature is, so coddled by the myriad of tools of civilization is so ill-equipped to handle trading.

That’s why backtests are so useful. Not because they will provide you with the one answer to true riches. No, they’ll never do that. But they will show us the narrative of the trade. Like time-lapse photography, they will compress thousands of hours of market action into just a couple of minutes of results so that we clearly see how and why we will fail and how and why we will succeed. In short, the backtest will “uncivilize” our minds and open us up to the true nature of the task.

Now lest you think that these principles matter only to us lowly system traders and don’t apply to stock pickers, allow me to tell you about an exchange I had with the great Eddy Elfenbein this year. Eddy runs a great newsletter called Crossing Wall Street and you probably have seen him many times on CNBC’s Trading Nation. He is truly a great stock picker and his newsletter has beaten the S&P many years running. One time Eddy tweeted out about LUV (Southwest Airlines)

“Here’s a long-term chart of Southwest. Note the log y-axis to see how amazing the stock has been. Up 26,600% since 1980. RIP Herb Kelleher.”

I took look at that chart more closely and realized something and responded back to him,

“And yet Eddie it lost 75% of value between 2001-2010 -- that required real belief to hold on.” (This btw was way before its current troubles with Boeing’s 737).
To his credit, Eddy fully acknowledged that point.

So the point is -- if you trade you always have to Pay the Pip Piper -- even if you don’t trade FX.