The Worst Mistake in Trading

Boris Schlossberg

So you a got a great setup going. You are banking pips each and every day. You decide to drop more money into your account, you increase frequency and … you lever up! Because it’s time to stop being a wussy! It’s time to make it rain!

I give you two, three days -- a week at most -- before your fantasies of “bricks on bricks on bricks” blow a hole through your account big enough to drive a double-wide through. You just made the worst mistake in trading -- you forgot about the Hidden Risk Relationship.

In any financial transaction you can achieve leverage two ways. The more common way that most of us are familiar with, is to simply borrow against collateral. That’s what margin is and we are all aware of its dangers. At BK we have a saying 4X for forex. It’s a shorthand for the maximum amount of leverage you should employ on any trade. It may seem ridiculously conservative to most traders, but if you want to stay alive in this game for more than a month then using 4 times your account size is about all you should do.

But if you are day trading. And I mean really daytrading where you do 5 to 10 trades every single day then 4X for Forex is way to aggressive.

But let me explain to you why. It has to do with the 2nd way to achieve leverage which is through turnover. If you ever worked retail you are well familiar with both concepts. You could borrow lots of money and stock the store with many items. Or you can flip over your inventory three times per month like Zara and achieve amazing leverage on your capital.

So when you are daytrading 10 times a day you are effectively flipping over your inventory. A lot. Which actually means you should use LESS leverage rather than more. Let’s say you use our 4X for Forex formula and you trade 10 times per day. That’s effectively 40x lever factor as you flip over 4X your equity 10 times per day. Do you think there is a chance that in doing 5-15 trades per day you could lose 3 or even 4 times on some days? You bet. At even a 25 basis point stop you are now down 4% in just one day. Do that a couple of days in a week and suddenly you are down 10% without even trying.

There is another reason why high leverage and high frequency do not mix. Revenge trading. No matter how much you promise yourself you won’t do it. You will. You’ll hit a couple of bad trades in a row. You’ll get pissed, and you’ll want to “get it all back” in one fell swoop. But if you are already trading on leverage that means you will have to lever up 10x, 20x to make up that one trade that brings you back to even. That is prescription for disaster. On the other hand, if you are trading at no leverage, even a few revenge trades won’t hurt you too badly. Certainly they won’t damage you permanently.

So the Hidden Risk Relationship comes down to frequency versus leverage. The more you do of one, the less you do the other. There is good reason why HFT funds trade only a couple of hundred shares per position. They understand that that returns are a function of frequency not leverage. It’s time that retail traders learned that lesson as well.

RBA Meeting Preview

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The Reserve Bank of Australia meets tonight and new central bank governor is at the helm.  Phillip Lowe, former RBA deputy governor succeeded Glenn Stevens and investors will be paying close attention to the new governor’s tone. Chances are he is going to play it safe and maintain the central bank’s upbeat outlook.  The last time they convened they expressed confidence in the trend of growth and labor market.  When Lowe spoke last month, he said the labor market is not as strong as the unemployment rate suggests and inflation is expected to remain low for some time. Taking a look at the table below, there has been as much improvement as deterioration in Australia’s economy since the last monetary policy meeting with broad improvements in China.  So while RBA Governor Lowe may be optimistic, the main takeaway will be patience.  AUD may fall on this but at a time when the central banks of the U.K., Eurozone, Japan and New Zealand are considering more stimulus, a neutral bias will make any declines shallow. In fact we believe the better trade is to be long AUD pre-RBA.



The Dumbest Investment Mistake That Everyone Always Makes

Boris Schlossberg

What is the single stupidest question that everyone in finance asks?

Show me your track record.

A track record is just about the worst way to make a investment assessment ever devised, yet everyone from the most sophisticated pension funds to the dumbest of retail traders thinks that that is the key to investment success.

That’s because all of us are subject to recency bias. We all assume that if you did well in the immediate past you are bound to do well in the future. Of course nothing can be further from the truth. Let me just throw a few names out for consideration. Paul Tudor Jones and David Einhorn.

Both of these guys are titans of the hedge fund world and if there was a Hall of Fame of investing they surely would make the cut. But if you were dumb enough to give them money over the past few years you would see nothing but losses.

This is far more common than you think. Take a look at mutual fund rankings and you will see that those in top quintile one year are very often in the bottom quintile the following year. In fact one the best ways to invest is to simply buy the worst performing managers and short the best performing managers on a portfolio basis. In short always bet against the jockey because horses and the terrain change. Alas the losing managers get fired and you can short most hedge funds or mutual funds -- so that is only a theoretical but not a practical investment strategy.

A much better way to analyse a trading manager is to look at his investment process. If the guys say “I never use stop losses” -- that’s pretty much a telltale sign to run as fast as you can away from the product, even if his returns show 10 years of uninterrupted gains. Nassim Taleb has the perfect analogy for this method. He tell the reader to imagine being a turkey. Every day rain or shine, the turkey gets fed. His “equity curve” is a perfect 45 degree ascending line showing no drawdowns whatsoever. Then on the day before Thanksgiving he gets his head chopped off and the equity curve goes straight to zero.

Ever since I read that passage I’ve been keenly aware of not falling for any strategy that makes me a turkey. That’s why looking at equity curves is so dangerous. You are seduced by all those profits -- but think about it for a second. What does it matter that the manager made all that money -- you will never see a penny of it. Since you didn’t trade with him then. You THINK you are getting all this reward because you are looking at the past performance but what you are actually doing is ASSUMING ALL THE RISK if you don’t understand the manager’s process.

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That’s why the dumbest way to invest is by looking at a track record. Yet we all continue to make that mistake.

The One Mistake Traders Make All the Time

Boris Schlossberg

Here is a mistake we make all the time.
We are sick.
We are tired and sleep deprived.
We had an argument with a family member.
We are rushing to a business meeting.
And in all those situations we put on a trade.
Just for fun.
For sh-ts and giggles really as the Brits call it.
Inevitably this is a trade that blows up a month’s worth of profits.
How do I know?
Because I’ve done it a thousand times. And so have you.
In trading we are so conditioned to believe that success lies in “strategy”, in that one perfectly tested algo that beats the market all the time.
But in reality success in trading depends really on only one thing -- focus.
Like a good athlete, a top musician, a skilled surgeon -- we all need focus.
Knowledge alone is not enough. Markets are brutal. If you day trade, blink and the exit is gone.
Almost all good boxers have the skills to fight if they practice enough. Just like most good traders generally know how to trade their strategy. But what separates the champions from the rest is situational awareness, The ability to adjust, sometimes just by as an inch to the environment around them.
Great traders are the same way. They can “read” the market and respond appropriately. But that requires focus.
Very often we forget that.
Most of the trading mistakes are not a function of bad analysis, but rather the result of bad focus.
So next time you are sick, tired, angry, distracted and are on the verge of hitting the buy/sell button. Do yourself a favor.

What Google’s Mistake Can Teach Us About Trading

Boris Schlossberg

The other day Google discovered that it was wrong. Yes the brainy we-are-smarter-than-all-of-you-combined Google, the we-will-be-the-first-trillion-dollar-company Google was wrong.

For the longest time Google assumed that the only the smartest, best pedigreed talent was worthy of hire. Even if you were 40. Google would ask you for your GPA and your SAT scores since they thought these would be quantifiable measures of your potential success.


Fortunately for Google, the company records everything and much to their credit they went back to analyse their employee interview records and manager evaluation forms and here is what they discovered. It did not matter whether you graduated summa cum laude from Stanford or MIT. What mattered, what made the best managers was just one quality -- consistency.

You see it doesn’t matter if you are brilliant, but a mercurial grump. Other people cannot function well in an environment where you are running hot or cold every 5 minutes micromanaging every decision. To achieve long term success in an organization employees need a consistent environment with clear goals and tasks in order to perform well.

After looking at this analysis, Google changed its hiring structure and stopped looking only for geniuses and started to hire managers with strong interpersonal skills and a disciplined mindset.

So what does this mean to us as traders? Quite a lot actually. When talking about markets it is laughable to entertain the notion of consistency. After all markets are the very definition of mercurial. If they weren’t there would be no risk to trading and also no reward.

Yet while markets can wild and volatile, our reaction to them must be as consistent as possible. I am sure that when you think about your trading mistakes most of them come not from the flaw of your setup but from the fact that you DEVIATE from your own rules all the time. You take trades that are impulsive, you change the stops and limits on your original positions, you decide that the EXACT OPPOSITE of your setup is what you should really trade. Certainly I do all those things and the results inevitable erode performance.

That is actually the very nature of the markets. They are meant to destabilize you not just financially but psychologically as well. Last night my son and I were arguing about some obscure fact regarding President Obama. He was certain he was right and wanted to bet money. I was only mildly confident in my position, but since I am the money and thus the market I said to him, “OK, If you are right, I will pay you double your weekly allowance, if wrong you get no money this week.” Even though he had better information than me he backed off the bet. At which point, I told him that he learned his first lesson in trading.

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So that is the Google lesson for us all. It doesn’t matter how smart you are. It doesn’t matter how well tested you ideas. It doesn’t matter how statistically robust your setup is. If you cannot maintain consistency of performance in the face of constant market mind games, you cannot succeed.