What Really Matters in Trading

Boris Schlossberg

Trading can be deconstructed into three parts -- analysis, setup, and structure. We spend an inordinate amount of time on the first two components, but it may be the third part of the process that is most important to long-term success.

Analysis be it fundamental, technical or both is of course crucial to making good trades, but in the end it all boils down to handicapping human behavior. Every trade is an implicit IF/THEN statement that assumes some sort of causation. In a highly dynamic environment like the market where a new input could upend the underlying thesis anytime (just ask anyone who has ever run into a news bomb or some massive order that completely flipped the supply/demand balance) noise is a huge problem for anyone who trades. The shorter the time frame, the greater the noise. That’s why day trading is such a challenge and why I’ve been arguing that the 1-hour time frame is the shortest reasonable period for retail traders to consider.

Of course, we all want to trader shorter because longer-term charts are boring, signals are few and we have to practice the most dreaded four letter word in trading -- WAIT. The issue is further complicated by a seemingly sensible but highly deceptive assumption we all make -- shorter-term trading needs smaller stops, therefore we can use larger leverage. On the face of it, it makes sense. After all, a 10 pip or 20 pip stop is nothing! We can trade on 10:1 lever and still only lose 1% to 2% of equity max. But we always forget the noise factor. A choppy, intraday market can seduce us into false breakout three, four, five even ten times in a row. That’s how most traders lose 10-20% of an account in a day even they hold tight stops. The only way to survive the vicissitudes of daily price action is to actually risk just 10 basis point per trade, but who amongst us does that?

Pulling away from the endless discussions of day trading which often remind me of medieval debates about how many angels can dance on the tip of a pin, we need to realize that what really matters in trading is structure. By structure, I mean the risk/payout factors on every trade. Conventional wisdom always argues for a 2 to 1 risk reward approach. That’s nice in theory where you can argue that you need only to be right 40% of the time to make money, but in practice, it is impossible to do. 40% win rate implies a 60% loss rate -- and that is under the best circumstances!

Imagine losing six trades in a row before you hit a winner. Now imagine doing that five, ten, twenty, fifty times a year. The human psyche is just not designed for so much consistent disappointment. My personal experience with retail traders is that most people can tolerate three losers in a row. After that, they either get angry or depressed, but in both cases, they walk away from the setup -- even if it proves to be profitable in the end.

The only way to overcome this problem is to create a structure that is both logically and psychologically robust. And the only way I know how to do that is with a two target exit. You need a short target that can be hit frequently and long target that will be hit rarely but will pay for your losses when you hit it. By definition, such a structure calls for a 2 unit entry and therefore doubles your risk on every trade. That’s why this final part is KEY to making this structure work. In order for your trades to have a long-term edge, the sum profit of your target must be larger than your risk. For example let’s say you are trading with a 50 pip stop, a short target or 40 pips and long target of 100 pips. There are three outcomes to this trade. You lose 100 pips. You make 40 pips and the second unit stops out at break even. Or you hit both targets and make 140 pips. Notice that in scenario number three your total profit of 140 pips is greater than your risk of 100 pips. That’s exactly what you want. If you have strong set up a third of the trades will stop out at -100. A third will bank 40 pips and the final third will make 140 pips and pay for all the losses.

Almost every quant will tell you that scaling out of a trade is not a logically optimal strategy. And they are absolutely right. And absolutely wrong. To succeed in the markets you need a plan that is both logically sound and psychologically optimal which is what makes this structure so robust.

The Perfect Time Frame for the Retail Trader

Boris Schlossberg

I’ve been running a variety of my algos, both for the BK chat room and for my own account and the longer I trade the variations the more it becomes evident that the one hour chart is the perfect frame for the retail trader.

There are two principal reasons for this. The one hour is responsive the daily swing flows of the market while at the same time long enough to avoid the random ebb and flow of intraday prices. As retail traders, we simply can’t compete on the sub pip level of market makers and HFT algos. It’s akin to driving the Autobahn in a Chevy Cruze. No matter how hard you try you will never be able to drive against the BMWs, the Audis, the Mercedes’ and the Porsches.

It is fun to try, however, which is why we all gravitate to the 1-minute or the 5-minute chart. But the spread, the commission, the market volatility create an almost impossible execution environment and that’s why we should allocate most of our capital to the longer time frames (say in a 70/30 split) in order to truly optimize the chance of success.

The 1-hour chart is no panacea and certainly won’t guarantee success and is not even immune from news bombs which could flip sentiment in an instant and wipe out perfectly good trades. Still, it is slow enough to catch most of the more meaningful market signals and it allows for larger stops and limits which by their very essence protect you from the randomness of the lower level charts.

Yet even on lower level charts, the algos have taught me that less is more.

There is nothing quite like attaching a new EA on 12 or more pairs and seeing it trigger a multitude of trades on 1 minute and 5 minutes charts. It’s exciting! It’s fun! It’s action packed! But very soon you see one, two, three trades go sour all once and then it’s no longer enjoyable. The profits of the past few hours begin to melt away and then quickly turn to losses and then to truly bad losses, especially if you are trading your regular size. Very quickly you realize that you can’t trade a lot and win. You are not a market maker with infinite capital, split-second execution and access to near choice spreads. You are price taker like it or not and that means you need to choose carefully.

That’s actually one of the great advantages of trading retail. Unlike market makers and HFT algos, you are not compelled to trade. You can step away anytime you want -- that’s a huge edge that most retail traders overlook because they just want to be in a game. But an algo, even a very good one quickly shows you the folly of your ways.

On my 1-minute chart, I’ve winnowed myself down to just three pairs and 5 most liquid hours of market trade. That means I may only do 2-4 trades per day. And that’s enough. In fact ideal. The more you trade, the more you lose -- it’s the everlasting truth of the markets but algos help you discover it, mighty quickly.

My Robot Trades Like Warren Buffet But I Can’t

Boris Schlossberg

The other day I saw a Youtube video of a guy trading the NFPs on his iPhone. He was randomly buying dips in USDJPY at clips of $1 Million, $3 Million, $5 Million at a time against an account size of $5000 USD.

Never mind that he was an American trading illegally with an unregulated overseas broker. Never mind that he was trading at 1000:1 lever factor. Never mind that he was never actually going to see a dime of his winnings (Do you REALLY think any broker who offers 1000:1 lever will actually return your money?)

In a few short hours, he turned that $5000 into 20K and I must admit it was exciting to watch. And that’s exactly what’s wrong with that video. It was the ultimate “dollar and a dream” lottery moment. It was that perfect hit of dopamine that we all crave from the market and of course, it is the road to ruin. Leverage is the opiate of the FX market. It can make us feel like a hero, but the high always wears out and the crash always comes.

The truth of trading is a lot more mundane. Like a sex scene in a Hollywood movie, like a comedy routine written from scratch, the reality of the situation is considerably more pedestrian and far less glamorous than we think. It’s 10 pips and a cloud of dust. Over and over and over again.

Which brings me to Warren Buffett and my robot. Today I read a very interesting article about Mr. Buffett that had a very different take on his success. In Buffett’s Underrated Investment Attribute the writer argues that Buffett’s greatest is skill lies not in picking great investment ideas, but rather walking away from bad ones. The writer gives the example of Sears which in 2005 looked like a toss-up -- yet Buffett passed on the idea without giving it a second thought, not because he was certain that it would go bankrupt but because he knew that turnaround would be hard and Buffett, the ever-astute investor, and ultimate realist wanted to spend his time owning stable, growing businesses that were easier to assess.

That approach dovetails with Buffett’s rule #1 for investing -- “Don’t lose money” which is then quickly followed by rule #2 which is “See rule #1”. Indeed if you look Buffett’s track record, it’s not that he consistently makes more money than the market, its that he loses LESS.

If we as traders are honest with ourselves, we’ll all admit that our underperformance is always caused not by the good trades we missed, but by the bad trades we refused to walk away from. Even as I sit here aimlessly tossing more lots against a rising USDCAD position, I have to admire my robot (which is trading my serious money) as it rests quietly perfectly happy not to engage with the market until a legitimate setup shows up.

That’s a thing about robots. They don’t need excitement. They don’t need dopamine hits. They don’t need to be always right. They are perfectly happy to grind it out, one trade at a time over and over again. And since we can’t all be Warren Buffett, they are as close to his temperament as we’ll ever get.

My Computer Trades Better Than I

Boris Schlossberg

This week I finally realized that my computer trades better than I. I’ve had this running argument with my friend Rob Booker for more than a decade about the advantages of algo versus prop trading and like Don Quixote tilting at windmills I insisted that human judgment was always crucial to the markets.

This week I finally had to concede that I am wrong. It’s not that algo trading is much faster, much less error-prone, much more focused than the human mind and eye. It’s all those things of course. Algo trading does something that I certainly can’t -- it provides consistency.

Lately, I’ve been following James Clear, the author of Atomic Habits, on Twitter and is recent tweet really opened up my eyes. Clear wrote, “You have to STANDARDIZE a habit before you OPTIMIZE a habit.” This seems so obvious to us yet think how hard it is for human beings to standardize on anything for long. Hell, I am one of the most habituated people I know and even I am getting tired of eating carrots every day.

Not so with algos. Algos will be happy to take the exact same setup the exact same way over and over and over again. Algorithms provide standardization even if you can’t. That’s extremely important because you and I know that as human beings we drift. The essence of our nature is to experiment, to seek new things to always deviate from the norm. That’s our greatest advantage as a species, but it’s also our biggest curse in trading.

Now when I say my computer trades better than I, what I mean is that I made my computer trade better than I. By standardizing its entry and exit process I could intelligently assess strategy performance and then optimize the settings. Computers don’t think -- they execute. The thinking part is still up to us. That’s why you don’t run a 5-minute algo in front of NFPs. That’s why you shut down scalping algo during roll when spreads could be wider than your stop. Human judgment is still crucial but on a broader assessment of risks rather than on individual trades.

After watching my trend algos beat me on the 1-hour chart, on the 5-minute chart and even on the 1 minutes chart I have finally made peace with the machines. I let them do their thing and I don’t even get mad when they bombard me with a series of stop outs. Instead I calmly asses why and then I determine if I can do anything to improve it. This ceaseless process of execution, standardization and optimization -- all done under real market conditions with real money is the only way I have been able to achieve consistency in my trades and those of you who have been watching my daily videos on twitter must have noticed.

But valuables as algo trading has been, I have fully relinquished control of the screen to my MT4 robots. I’ve accepted that my trend structure is undeniably more efficient and profitable when traded on an algorithmic basis. But I still go toe to toe with the market when it comes to counter trend plays. Ironically enough my fade trades have become better and more consistent precisely because I’ve relinquished control over trend setups. By freeing my mind, the machines have done what machines have always done thought civilization -- they have freed me to pursue higher level more creative tasks.

In Trading – Great is NOT Good

Boris Schlossberg

In our winner take all world, we are often told to try the best, do the best, be the best.

That advice is a road to ruin in most aspects of life and very certainly in trading.

The very latest in research suggests that human accomplishment does not come from trying to push ourselves to the limit, but rather from gradual and consistent repetition and improvement.

As Brad Stulberg writes, “Take the case of Eliud Kipchoge, who just shattered the marathon world record. He’s literally the best in the world at what he does. Yet Kipchoge says that the key to his success is not overextending himself in training. He’s not fanatical about trying to be great all the time. Instead, he has an unwavering dedication to being good enough. He recently told The New York Times that he rarely, if ever, pushes himself past 80 percent—90 percent at most—of his maximum effort during workouts. This allows Kipchoge to string together weeks and weeks of consistent training. ‘I want to run with a relaxed mind,’ he says.”

The paradox of performance is that when you push less you achieve more. Stulberg again, “This mindset improves confidence and releases pressure because you don’t always feel like you’re coming up short. It also lessens the risk of injury — emotional and physical — since there isn’t a perceived need to put forth heroic efforts every day. The result is a more consistent performance that compounds over time. Research shows that sustainable progress, in everything from diet to fitness to creativity, isn’t about being consistently great; it’s about being great at being consistent. It’s about being good enough over and over again.”

This is certainly true with trading. We are always pushing for more -- more edge, more leverage, more trades when we should all be pushing for less. It’s perfectly ok to take profits early. It’s perfectly ok to miss some setups. It’s perfectly ok to trade on very low leverage for as long as you want. Every one of those behaviors will push you toward success whereas the exact opposite of those behaviors will guarantee failure. Trading -- like marathon running -like almost everything in life -- is a test of endurance.

There is an old movie with Paul Newman and Robert Wagner called Winning. It’s about the 24 hour race at LeMans. (It was actually the catalyst for Newman becoming a professional race car driver later in life). In the movie, Wagner plays a hot shot driver who “breaks things” because he always pushes everything -- the car, himself, the people around him too far. Wagner is the quintessential example of what not to do in trading. In his quest for excellence, he winds up only with failure.

It’s easy to see how that can happen in trading. Hell, I’ve been the Robert Wagner character many times in my life. Always looking to “optimize”, always looking to push trades beyond their limit. But recently I created a process to change that behavior. And it all starts with the 0.01 lot.

Basically anytime I have an idea for a setup or strategy I start trading it with 0.01 lot. My iron clad rule is to trade at least 10 times at that tiny size, but the more I do it, the more I realize that at least 30-50 times is best (this assumes you are day trading, which is all that I do). The money is real, the quotes are real but the size is so tiny that it does not dissuade you from pursuing the setup even after multiple stops out. More importantly, it is truly amazing how many things you notice the more you trade. Every setup and I mean EVERY setup will change its rules as it develops under real market conditions. That’s because even if you have years of market experience your original notion of how the trade should proceed will come with preconceptions that actual market price action will very quickly destroy. But here is the thing. The more you trade your set up. The more you adjust it to actual market conditions. The more accurate it becomes. The more confident you will be.

That confidence will allow increasing the size to the next level which in my case is 0.1 lot -- and inevitably when the losing streak appears you will not abandon ship. You will have that reservoir of confidence from the 0.01 lot days to ride out the drawdowns. This is where the power of gradual improvement really pays off. This is where you realize that good is not the enemy of the great, but rather its basic building block and at that point, you can finally step up to your regular trading size knowing that you have created a truly durable setup to trade.

Why Technicals?

Boris Schlossberg

Those of you who’ve been reading me a long time, know how skeptical I am of technical analysis. Trading technicals in a void is like making medical decisions solely on the thermometer reading. At their core technicals are simply signals for sentiment or momentum. That’s all.

Given the funda context sometimes technicals can be an excellent forecasting signal and sometimes they can be a horrible one. One thing is for sure. With very few exceptions (such as major price milestones) technicals almost never drive price action -- they simply reflect it.

Pure technicians always get angry at me when I say that, but the proof is in their own actions. How many technicians will stand down ahead of a fundamental release of data? If price action was everything then you can you just ignore funda at will. Go ahead take that long ahead of NFPs. We all know how well that works.

You can, of course, trade off long-term charts and ignore the day to day noise but even there you are still subject to funda drivers. Tell me -- how did those weekly charts do on the Brexit vote? (Hint -- they walked you straight into a trap).

Anyway, my point isn’t to prosecute the case of what drives price action -- that argument has been settled a long time ago. Rather, I’d like to ask a simple question -- what are technicals good for?

Some die-hard fundamentalists will say -- absolutely nothing. Technical indicators, after all, are simply derivatives of price and therefore lagging by definition. But, as they say in the software business that’s a feature, not a bug.

Why would derivatives of price be useful to traders? Precisely because they can provide a visual narrative that can be difficult to see any other way. Indicators smooth out the randomness of prices and allow the trader to separate the signal from the noise. Take something very simple such as short-term moving average crossing a long-term moving average. Every major price regime change in the market starts with that dynamic. Now granted many of the moves fail to produce a sustainable trend, but by quantifying, standardizing and classifying each successful move you can sometimes tease out a meaningful edge and ride the wave to profit.

Technicals can also act as a check on your ego. If you are absolutely convinced that price should move one way, but technicals are actually showing the opposite chances are that you are wrong. One of my favorite setups is to have news print one way, but price action react the opposite. In that situation, technicals are almost always right.

Ever since our days on the savannah, we have been pattern seeking animals. It’s what kept us alive to the present day. Technicals are simply a unique manifestation of the same dynamic in a different environment. Instead of lion behavior, we watch price behavior and while that information is as incomplete to us as the herd movements were to hunter-gatherers, it is nevertheless valuable. It helps to inform our experience. It provides distinct knowledge which we can then try to turn into trading wisdom.

So even if you are diehard funda trader, you need to look at the charts. They tell a narrative that could be the key to your next profit in the market.

The Trade Before the Trade

Boris Schlossberg

Nick Maggiulli who writes a wonderful financial blog called ofdollarsanddata, posted a piece this week that really caught my eye. Titled, Why The Best Predictor of Future Stock Market Returns is Useless, the post deals with a very interesting indicator of stock market returns -- the average investor allocation to equities. Basically when investors exceed the historical average, allocating say 70% or more of their funds to stocks, equities perform poorly over the next 10 year. When the allocation is below the historical average the performance is much better.

Nick sketches out the basic investing model here:

Here is how the AvgEquityShare model works:
Start by investing in stocks (S&P 500).
When demand gets too high (>70% average equity allocation) => sell your stocks and move into bonds (5yr Treasuries).
Stay in bonds until demand gets too low (<50% average equity allocation) => sell your bonds and buy back into stocks.
Repeat steps 2-3.

That’s it. I chose the 70% upper limit and 50% lower limit to have round numbers that also corresponded to different return regimes (aka I data-mined this using backtests). If you run this model you will find that from 1987 to 2018, $1 would have grown into $43 compared to only $24 for “Buy and Hold” (almost 2x better dollar growth), with a far better drawdown profile -- the AvgEquityShare model is half (-23.2%) of what “Buy and Hold” delivered (-50.9%).

Though I could show you many other performance metrics that illustrate how much better the AvgEquityShare is than “Buy and Hold” it wouldn’t matter. Why? Because when we dig into the details we realize that the AvgEquityShare model would’ve been near impossible to hold for any typical investor.”

He then presents this chart that basically shows you would have to give up the massive run up from 1996-2002 in order to follow the model properly.


No doubt he has a point. FOMO is a very powerful emotion that can seduce us all into some very bad decisions. Ask anyone who bought Bitcoin at $16.000 or Ripple at 3 bucks. But let’s step back and analyze his point. Can you really argue that buy and hold is better? Will anyone really be able to hold through a 50% decline and continue investing for the long run?

This question is especially relevant on a day like today when the Dow has crashed 1000 points and many investors are starting to ask -- is this the top? (Hint: YES)

To be fair to Nick he fully acknowledged the false dichotomy of the premise and we went back and forth on twitter discussing this:

Screen Shot 2018-10-10 at 7.00.59 PM

But Nick’s column really made me think because what it really demonstrates is the need to truly understand your trading premise before you ever push the button. In short, you need to know the trade before the trade.

In Nick’s model, the success of the AvgEquityShare is obvious under even the most cursory examination. It makes nearly twice as much money with 1/2 the risk. It’s clearly superior to the Buy and Hold. But it comes at a cost of staying out of the market for long stretches of time. Yet, if you knew ahead of time that those are the costs, wouldn’t you be much better prepared to sit out the manic runups?

I have a new day trading strategy that trades trend on the 1M chart. But it only works if I follow a very specific set of rules. So, for example, today I missed the 70 pip move in USDJPY and yesterday I missed the 120 pip move in the pound. But that’s ok. The strategy is never meant to capture those type of moves. I make my 20-25 pips when I can. I keep my risk very low and I grind away trying to make 200 pips net each month, comfortable in the knowledge that the strategy is doing EXACTLY what it is supposed to do.

And for me, that is the true lesson of Nick’s column. It’s not the strategy that matters, it’s having the proper expectation for that strategy. In fact, I would argue that 90% of all our failures as traders ( certainly 90% of mine) are due to the fact that we woefully misalign our expectations and our strategies. That’s why fully understanding the “trade before the trade” is perhaps the most important strategy of all.

How to Take the Fear Out of Trading

Boris Schlossberg

What is the biggest problem in trading?

It’s fear.

That’s because trading is the only business in the world where every decision you make has a 100% chance of uncertainty. Unless you are cheating, there is literally no way to know how the next moment in the market will unfold.

Sure other businesses have variance. If you own a donut store you don’t know if one day you’ll sell 100 or 500 donuts. Weather, seasonality, competition all have their say in almost any business, but I doubt you’ll find a donut shop owner who’ll tell you that today he may sell zero donuts or he may sell 500. Such a wide variance just doesn’t exist in any other sphere of business life yet in trading it is a daily occurrence.

You can go days, weeks, sometimes months selling zero donuts in trading and that sense of extreme uncertainty is responsible for more mistakes than just about any other aspect of the business.

Ever taken a trade, got stopped out and then got spooked from taking the next one which in retrospect proved profitable?

Of course, you have. Trading may be the business of uncertainty, but I am 100% positive that everyone who is reading this sentence has had that experience.

So what to do?

How do we conquer that fear?

I don’t think we ever fully overcome the problem, but here are a few ideas that can help you stay calm amidst the perpetual uncertainty.

Trade in sets. This is especially true if you are day trading as 80% of FX retail traders do. Don’t think of a single trade as a distinct individual event. If you are a trading a system, estimate how many times that system should trade during a given week.

Let’s say your system trades 20 times per week and on average generates 16 winners and 4 losers. If you hit a losing trade then just think of it as part of the weekly set.

Understand also that not every week is a winner and you could have a run of bad sets. If the week is a loser examine each trade -- was it done to spec? If so then there is no need to change anything. You simply hit an expected losing cycle.

You see what I’ve done there? I’ve actually made my field of vision more blurry. I’ve moved away to an eagle’s eye view of trading. I’ve stopped obsessing about every pip on the chart, every tweet, every noise from my squawk box. I look at the system as a broad narrative story rather than the drama of the minute.

The other thing that helps with controlling fear and uncertainty is to understand just how little you need to make in order to double your money. If you are trading a $10,000 account you only need to make $40/day to turn the account to $20,000 by the end of the year that’s actually pretty hard) but if you made just $10/day you would make 20% on your money and become top 1% of all traders in the world.

The Incredible Power of Having a Losing Mindset

Boris Schlossberg

Trading to Win.
The Winner’s Attitude.
Five Ways to a Winning Mindset.

Trading blogs are littered with advice about winning and while their intent is noble, they couldn’t be more wrong and their advice is actual poison to your success.

Take a step back and think about any competitive human activity. It is basically a study in failure and losing. In FIFA 2018 World Cup Croatia took 115 shots on goal -- the most of any team in the tournament. Care to guess how many actual goals they scored? 14. That works out to an 88% fail rate. Croatians, the Cinderella story of the summer only succeeded 12% of the time.

In American football, Alex Smith of the Kansas City Chiefs is considered to be the most accurate passer of 2017 season. His completion rate? Just a bit better than half at 56%.

In poker, Phil Hellmuth is one of the greatest players of the game. He has been playing professional poker for 30 years. Each year there are at least 50 WSOP tournaments which means since he started playing there have been more than 1500 events. He holds the most bracelets of anyone who has ever played the game. How many? 15. How many times has he been at the final table? 58 times. Basically, he fails 97% of the time.

The biggest winners in the world lose. They lose a lot. And if we want to have any chance of being like them, we need to understand that losing is not just part of the game. It IS the game.

Yet when it comes to trading we suspend all rational thinking and approach the market with the ridiculous expectation of winning every trade. Or 9 out of 10 times. Or at worst 8 out of 10 times. But even if we had a great trading system that won 80% of the time, the reality of probability means that we could have 100 trades where the win rate was only 50% and another 100 trades where the win rate was 90%. We could go on for months underperforming the win rate percentages by 20, 30 even 40 percent and not be doing anything wrong. Despite that reality, most retail traders will they stop trading the system if they hit 3 losers in a row. If they hit 10 they quit altogether.

Developing a winning mindset does little to fix this problem. In fact, it hurts you immeasurably. A winning mindset creates the false expectation of a win, so just one or two losses completely destabilizes your psyche. You double up on the position. You pull you stop. You punch your screen. In short, you lose control, not because your execution is bad, but because your expectation is completely at odds with market reality.

Now imagine if you approached each day expecting to lose money. Let’s say you are day trading. You set a total risk budget of 50 pips while trading positions with 15 pips stops and every trade you take you FULLY EXPECT TO LOSE.

What happens then?

Well for starters you let your strategy be. You don’t second guess every pip of adverse movement and close out positions too early. You TRADE TO PLAN because you have given yourself the permission to lose. You are not annoyed, angered or frustrated. Your mind is actually clear and calm which means you can analyze the next setup with a much better attitude. If a winner comes, it’s a pleasant surprise, rather than your God-given right and you can continue to look for the next trade and work on improving your process.

Think how much better it is to have a LOSING MINDSET. You are unfazed by a losing day, a losing week or even a losing month. It all becomes part of the job and it allows you to stay in the game much longer than the average retail trader, which in the end is how winning is really done.

Day Traders – Counter-Trend is Your “Friend”?!!!

Boris Schlossberg

The Trend is Your Friend. Trend Trading to Win. Don’t Fight the Trend. The trading business is littered with these sayings to the point where this view has become the conventional wisdom.

Try as I might I have never been very comfortable trading trend. I am always at my most relaxed when I am selling offers on a rally or making bids on a dip. I fully understand that this is much more a quirk of my personality rather than any special property of the markets, but lately, after watching all my counter algos perform markedly better than my trend ones, I’ve started to wonder if counter-trend trading is actually objectively better.

When I speak of trading, I mean day trading. My average trade hold time is 1 hour or less and on that time frame, the counter may just be better than the trend. One key reason is FX is a naturally bounded market. Unlike stocks which have a clear upward bias built into the instrument (the stock rises as the company grows), currency trading is range based by nature. Countries rarely go out of business (unless the are Argentina :)), so the ebb and flow between the major economies is always cyclical and always mean reverting. Most of the time, grand themes which are responsible for large trends, are absent which means that dealers will run levels back and forth, again favoring the counter-trend approach.

But there may be another, more technical reason for why counter trades are better on the ultra short-term time frame. Few retail traders know about the “last look” rule, but it is the fundamental part of the FX market. Matt Levine of Bloomberg, my all-time favorite financial journalist, explains it far better than I could, so I will just quote him here.

“I have a certain perverse fondness for ‘last look.’ The idea is that a market maker quotes a market on a thing—offering to buy it for $100.10 or sell it at $100.15—and if you come to her and say “yes okay I will buy it from you at $100.15,” she gets a brief chance to say “never mind.” If the price has moved against her in that brief delay—if now the thing is trading at $100.25 or whatever—then she doesn’t have to do the trade at $100.15. On the other hand, if the price has moved in her favor—if now it’s trading at $99.95—then she cheerfully executes your trade at $100.15. This is obviously good for the market maker; I once wrote:

It is as perfect an embodiment of “heads I win, tails you lose” as you could ask for: If the price moves against the customer, the bank wins; if the price moves against the bank, the bank decides not to play.

There are, I think, two things you can do with that model. One is, you can stop there, and say that last look is good for market makers and bad for their customers, that it’s a way for banks and other dealers to extract value from investors, and that it’s basically unfair and inefficient and should be banned.

The other is, you can assume that financial markets are fairly competitive and that in a market with last look—one where market makers have the opportunity to avoid adverse selection by getting away from trades that immediately move against them—the value that market makers extract from last look will be returned to investors in other ways. Specifically, it will be returned to investors in the form of tighter spreads. Perhaps in a market without last look the market maker would quote at $100.05/$100.20, knowing that if she sells at $100.20 there’s a good chance the market is going even higher. But in a market with last look she’ll quote at $100.10/$100.15, knowing that she’ll only sell at $100.15 if the market doesn’t seem to be going higher. So investors get to buy at $100.15 rather than $100.20, saving five cents. This benefit can be a little illusory—they only get to buy at $100.15 if the price is stable or going down—but it’s not nothing. If you want to buy a relatively small quantity of the thing in a relatively quiet market, tighter spreads with last look really should save you money.”

Now like it or hate it, last-look is a fact of life in FX and may even be coming to equities soon. But whether you think it’s a scam to bilk a few pips from traders or a necessary part of a fractured market that allows for ultra-tight spreads, it may explain some of the anomalies of why counter works better than trend. By its very design, last-look will generate inferior execution on trend trades which are flow-based by nature, as dealers will reject prices until the move has paused.

Before you get all conspiracy theory on me, understand that this is a rare occurrence. The FX market is highly competitive, most dealing tickets, especially the small retail sized ones, will be filled instantly. Yet at a time when you need liquidity most when prices are moving at their fastest in one direction or another, the prospect last look rejection rises markedly.

This, I believe explains some of the execution skews towards countertrend -- because after all if you are buying when everyone is selling, the market will be more than happy to fill you.

Again, these are differences at the margin, but in short-term trading where every fractional pip counts, the margin may actually be the edge.

If you are trading off the 4-hour or the daily chart, none of this wonky market structure discussion matters. In fact, you actually benefit from tighter spreads and the issue of trend vs, counter-trend becomes a matter your strategy and your personality. But if you are day trading with trend, you should at least be aware that the deck, if ever so slightly, may be stacked against you.

How To Win 99.9995% of the Time

Boris Schlossberg

Imagine performing one of the most complex tasks in modern life and doing it with 99.9995% accuracy, irrespective of your intellectual ability, cultural background or physical prowess. That’s what the civil aviation industry achieves every single day.

The modern airplane is one of the most complex systems known to man yet only one of 200,000 flights ever experiences any kind of life-threatening emergency. That’s a much safer record than driving a car. So how? How does modern aviation transcend human stupidity, cultural bias, and mental distraction to generate such an enviable safety record?

They use a checklist.

The notion of a checklist goes back to the earliest pre-WW2 days of modern aviation when a series of PREVENTABLE accidents caused by EXPERIENCED pilots forced the industry to create a protocol that can be used by ANYONE to reduce the risk of error.

On its face, the checklist can be mind-numbingly boring -- make sure the switch is flipped on. Make sure wipers work and many other minor details that are easy to gloss over and ignore. So the checklist by itself is not enough to assure success. The key is to get voluntary coordination to adhere to the checklist every time. During WW2 the US Air Force realized that the checklist was not enough. Pilots needed to have a compelling narrative in order to follow it.

The narrative in aviation is of course death. Pilots were given many instances when ignoring the checklist resulted in a crash. Additionally, flying authorities realized that checklists are much more effective in a group setting where the whole group accepts its value and each member double checks the checklist taking responsibility for the whole group. That’s why co-pilots check with pilots and the degree of compliance in the aviation industry is nearly 100% resulting in such a stellar safety record.

Unless you trade in a group, compliance in trading becomes your own responsibility, but traders, especially algorithmic traders, can benefit enormously from a checklist. Trading an EA is very similar to flying a plane. Everything from -- is this thing on, to are all switches (parameters) properly configured, to is the EA off at certain times can be confirmed through a checklist.

A simple checklist for an MT4 EA can be something like this:

Is my VPS working?
Is my EA on and Auto Trading Turned on?
Is my trade size correct?
Is my stop value correct?
Are my entry parameters correct -- check each one?
Is my EA turned off xx hours ahead of event risk?
Is my EA turned off for the day on ALL charts?

Anyway, you get the idea. It is in practice relatively straightforward, but even looking at this modest list, if you were honest, you would probably admit to yourself that you missed a few key steps at least once a week that may have resulted in unwanted losses.

The basic checklist for the control of inanimate machines is a simple affair. But what if you had to deal with a greatly complex environment full of danger and uncertainty? If you think I am talking about financial markets. I am not, I am referring to medicine where the recent application of checklist procedures has been able to reduce deaths by as much as 47% on surgical outcomes.

Surgery is of course very similar to the markets. You are applying well-practiced techniques, yet every patient (trade) is different. At any given time the environment can change from calm to a crisis in a blink of an eye -- what do you do then?

In medicine, the checklist goes beyond, do-I-have-the-right-tools-and-is-everyone-in-place to deeper questions of what do we do if things go really wrong. Atul Gawade, the author of Checklist Manifesto (a modern day Chekov) and the leading proponent of checklist practices in surgery, recounts a time when he nicked a key artery in the patient, an unfortunate stroke that would have surely resulted in death, were it not for the fact that the team’s checklist contained a note that the tumor was particularly close to this artery and the anesthesiologist stockpiled a massive amount of blood in the OR which saved the patient’s life.

The what-do-I-do-if-all-hell-breaks-loose checklist can be particularly valuable in trading.

Some possible questions could be?

What do I do if I placed 10X my normal size?
What happens if I am carrying more than my maximum of open positions?
What do I do if I lost 10% of my account in one trade?
What happens if my internet goes down?
What happens if my VPS goes down?
What happens if I have 3 losses in a row?

Notice that the second type of checklist is much more open-ended and forces you to think through the most unpleasant scenarios before they actually occur. This is incredibly valuable as it will minimize the chance of making a bad situation worse.

It’s important to understand that the checklist in and of itself will not make you profitable. You need a strategy to do that. But so much of the trading edge lies not in looking for an opportunity, but rather in eliminating the error. To that end, the checklist gives the trader the most valuable tool of all -- control.

7 Most Interesting Trading Stories This Week

Stumble Your Way To Success

Boris Schlossberg

This week I weighed in under 200 lbs for the first time since Bill Clinton was President and my hair was jet black. I’ve lost more than 10% of my body weight -- but this isn’t a pat-myself-on-the-back column it’s just a story that may amuse you.

About 5 months ago I found myself at a very swanky wedding on Nantucket and as you can imagine it was replete with every conceivable delicacy you can imagine. The weekend was truly a movable feast of food, but on the last night of festivities, I found myself in front of a mound of crudites and big bowl of hummus. And just like that old Reese’s Peanut Butter Cup commercial I dipped the veggie into hummus and realized, “Hey! This is really good.”

Returning home, I decided to make veggies and hummus my main meal of the day. I live in New York, so of course, there was a hummus place two blocks up the street that made the freshest stuff, and I just started eating it every day. Now there is no doubt that I have a compulsive personality. I have ten exact same dark blue suits hanging in the closet. I have 15 black henley shirts in my drawer. I only buy GEOX slippers. You get the idea. Basically, I try to keep things simple. If I like something I’ll just do it over and over and over again. Eating veggies, hummus and a hard-boiled egg every single day is not for everyone but it’s easy for me.

Anyway, I am doing this for several months when I stumble across a TED talk about the brains of primates. Did you know that our brain is only 2% of our body mass yet consumes 25% of all our daily energy needs? Did you know that our closest relatives -- the chimpanzee and the bonobo monkey eat up to 8 hours a day in order to satiate themselves? So how come we don’t have to do that? Because we discovered fire and food that’s cooked packs a much greater caloric punch after it is transformed by heat. Raw food has to be masticated and digested and therefore our closest primate relatives spend almost all their time foraging and eating. Fire, on the other hand, turns out to be pretty much the foundation of civilization and what makes us different from all other animals on earth. So as I am chewing on a carrot watching this video I realize that basically, I am living like a bonobo monkey. I am essentially eating raw food all day so my caloric intake is not that dense, but because all those veggies have fiber I am not really hungry.

Every day I also go for a walk. I absolutely hate to run, but I read somewhere that walking is almost as good so I put on a podcast and stroll up and down the West End Avenue -- which once you get into the 100’s can be quite hilly. One day I wonder what it would be like to make that uphill walk with a backpack. I stuff a few books from the library (the textbook on corporate taxation makes a particularly good deadweight) and I trek along listening to whatever is new on Stitcher that day. I come back considerably more sweaty and exerted but feeling good. So I research this backpack thing and it turns out that this is the primary form of endurance training for all of US Armed forces (which are considered to be some of the best trained units in the world). The army calls it rucking and they do it with considerably more weight (up to 200 lbs) on your back as you hike 20 miles of trails -- but the idea is the same. It gets you in shape. Turns out that rucking will burn up three times more calories than plain walking, because as we all know -- gravity is a bitch.

So why do I tell you this story in a trading column? Because dieting and trading share very similar results -- 90% of people who try either activity fail. Indeed, the behavioral literature for both can be copied almost verbatim. So how did I become part of the 10% that succeed? I didn’t follow a “strategy”. I didn’t practice “discipline”. I didn’t “sacrifice” anything. I basically stumbled into success like almost all successful people do. The point is that there is no formula for succeeding that works for everyone. There are a million unique formulas that work for someone. You just need to know who you are and you need to be open to where the possibilities may lead.

I spend most of my time developing systems for traders, but almost no one in my group follows my rules. Indeed the most successful traders make my strategies their own -- and I in turn often borrow ideas from them. That is the true lesson of my weight loss journey. Success is simply a process of discovery which is a fancy way of saying, feel free to stumble all you want.

7 Most Interesting Trading Stories This Week