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.

Best Articles I Read this Year…

Boris Schlossberg

The Power of Negative Thinking
NY Times

If you are an American your true religion isn’t Christianity, Judaism, Buddhism, Islam or even atheism. It’s Positive Thinking. I still remember the hand printed poster in my high school football locker room that stayed taped to the door for four years. Conceive. Believe. Achieve. As Americans, we are indoctrinated into the cult of Positivity with no less fervor than I was indoctrinated into the wonders of Communism as a Young Pioneer in Russia.

And it is perhaps because that I am Russian and therefore naturally skeptical from birth, that I always suspected that this American obsession with positive thinking was pure bullsh-t. This article opens your eyes not only to the mindless stupidity of always being positive (putting that pasted Tony Robbins smile on your face can actually be counterproductive – in fact, Tony Robbin’s whole act (much as I love it) is pure bulls-t. Turns out that coals are terrible conductors of heat, so anyone can walk over them as long as they do it quickly – no special mindset required) but also shows the value of thinking negatively.

Don’t get me wrong. I hate Debbie Downers. I am “American” to the core. I am always willing to try new ideas. But this article teaches you that you shouldn’t fear negative thoughts, but embrace them. It notes, “The Stoics recommended “the premeditation of evils,” or deliberately visualizing the worst-case scenario. This tends to reduce anxiety about the future: when you soberly picture how badly things could go in reality, you usually conclude that you could cope. Besides, they noted, imagining that you might lose the relationships and possessions you currently enjoy increases your gratitude for having them now. Positive thinking, by contrast, always leans into the future, ignoring present pleasures.”

One of the greatest joys of aimless Net surfing is that you get to stumble across some brilliant fresh voices that can help you understand reality with a much clearer and more accurate perspective. Tim Hanson is one such writer I will be following in 2017 as everything he writes is remarkably insightful. This year, however, one blog entry stands out. In Value at Risk he shows not only the need but the absolute necessity for overconfidence. Yes – overconfidence – because without it we would never achieve anything. Also, this article is a nice counterpoint to the one above. But please take a look at the Teacher’s grading table and tell me that it doesn’t remind you of the 1 by 10 trading method I wrote about last week.

Lastly here is a story that should make all of us who day trade feel good. Efficient markets? Bulls-t! In How Behavioral Biases Lead To Hard-To-Capture But Sustainable Alpha Michael Kitces shows how investors make the same mistakes over and over again and how savvy traders can take advantage of these mispricings to achieve Alpha. Reading the story on recency bias I realized that most of our Boomer strategies are basically designed to take advantage of that common flaw in human behavior. Note the article doesn’t say profitable trading is easy. Only that it’s possible.

All the best to everyone in 2017.
Peace, joy and love and happy trading