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Risk Management Game

  
  Education
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A random person is pulled off the street and given $10,000 to trade.  They have no prior experience which, on the bright side, means they have no bad habits, emotional baggage, or preconceived notions.  Before trading they go through a five day crash course on market basics (order entry process, chart reading, pattern recognition, etc…).  Suppose you are tasked with the responsibility of drafting a set of risk management rules which they are required to abide by.  The objective is to make them survive as long as possible in the trading arena so they can learn as much as possible through first-hand experience.

What types of rules would you set?

The ideal approach of course is to structure a set of rules which makes it as difficult as possible to blow up the account while still leaving them open to accumulating profits.  The goal isn’t so much helping them capture large gains as much as it is helping them survive.  After learning how to survive, then they can modify their approach to being more aggressive and seeking larger gains.

Here are two of my top rules: (more…)

3 Trading Principles

  
  Education
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 Success in trading is a function of talents and skills – Trading, in this sense, is no different from chess, Olympic events, or acting. Inborn abilities (talents) and developed competencies (skills) determine one’s level of success. From rock bands to ballet dancers and golfers, only a small percentage of participants in any performance activity are good enough to sustain a living from their performances. The key to success is finding a seamless fit between one’s talents/skills and the specific opportunities available in a performance field. For traders, this means finding a superior fit between your abilities and the specific markets and strategies you will be trading. Many performance problems are the result of a suboptimal fit between what the trader is good at and how the trader is trading.
 The core skill of trading is pattern recognition – Whether the trader is visually inspecting charts or analyzing signals statistically, pattern recognition lies at the heart of trading. The trader is trying to identify shifts in demand and supply in real time and is responding to patterns that are indicative of such shifts. Most of the different approaches to trading–technical and fundamental analysis, cycles, econometrics, quantitative historical analysis, Market Profile–are simply methods for conceptualizing patterns at different time frames. Traders will benefit most from those methods that fit well with their cognitive styles and strengths. A person adept at visual processing, with superior visual memory, might benefit from the use of charts in framing patterns. Someone who is highly analytical might benefit from statistical studies and mechanical signals. 
Much pattern recognition is based on implicit learning – Implicit learning occurs when people are repeatedly exposed to complex patterns and eventually internalize those, even though they cannot verbalize the rules underlying those patterns. This is how children learn language and grammar, and it is how we learn to navigate our way through complex social interactions. Implicit learning manifests itself as a “feel” for a performance activity and facilitates a rapidity of pattern recognition that would not be possible through ordinary analysis. Even system developers, who rely upon explicit signals for trading, report that their frequent exposure to data gives them a feel for which variables will be promising and which will not during their testing. Research tells us that implicit learning only occurs after we have undergone thousands of learning trials. This is why trading competence–like competence at other performance activities such as piloting a fighter jet and chess–requires considerable practice and exposure to realistic scenarios. Without such immersive exposure, traders never truly internalize the patterns in their markets and time frames.

Recommendations

  
Analysis, Education
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Books:

I highly recommend “Dark Pools” which is about how we’ve come to the point where trades are measured in picoseconds (a trillionth of a second) in order to remain competitive. Sounds boring, but it’s written in the same style as a Michael Lewis book and if you ever wanted to know how a guy with lizards running around in his server room helped narrow the average holding period for a stock from two years to twenty seconds, well this is the book for you.

I also read “Savages” and it’s prequel (probably not worth reading). This was before I knew Oliver Stone was doing the movie. A cross between Weeds and No Country For Old Men – really very entertaining fiction.

Other books I enjoyed the last six months: Ready Player One, Deer Hunting with Jesus, This Book Will Save Your Life, The George Martin series, Open City (about NYC), 1Q84, Horns: A Novel, The Fear Index, 11/22/63, Smonk, & The Digital Plague. (more…)

Have the proper mindset

  
  Education
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Trading is not for everyone.  There certainly is a high burnout factor among professional traders due to the stress involved.  Think of the markets as various shark tanks, with a certain number of sharks fighting for those scraps of meat.

Some of the work personality traits that will help you succeed over the long run include:

Having a thick skin, being able to remove emotions, ability to think clearly in the moment when all hell is breaking loose, attention to detail, pattern recognition, analytical mind, aversion to gambling for gambling’s sake, creative and innovative thinking.

These can be developed through experience, although some certainly have these more “ingrained” in themselves from the beginning.  Having a full life outside of your trading is also important – the ability to “switch off” and not take your trading results home with you each day will lead to a longer and happier trading career.

Trading Book Review Of the Week: The Three Skills of Top Trading

  
  Education
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This book is written about how three mutually reinforcing skills make a complete trader.

1). Pattern Recognition and Discretionary Trading.

Using the Wyckoff method you will see chart representations of how hot growth stocks are accumulated in bases for long periods of time. They eventually have pull backs then break out to new highs and trend. You will also see how they eventually have exhaustion tops on high volume that fail to rally and they begin to break down in distribution with lower lows and lower highs. The author encourages discretionary trading through experience by being able to identify market action through the models from past stocks. This work ties in nicely with the school of thought from legendary traders William J. O’Neil, Jesse Livermore, and Nicolas Darvas.

2). Behavioral finance and systems building.

The book teaches that readers must be flexible in their trading. We are merely a ship on a sea of market participant opinions. Follow the prevailing sentiment during the middle of the the trend, and go contrary to it at the extreme tops and bottoms. Hope, fear, and greed are the dangers and the movers of the market that cause support and resistance,  trends, and chart patterns. The action of the stock market is nothing more than a manifestation of mass crowd psychology in action. The Pruden model shows a chart of how accumulation, mark-up, distribution, and markdown works in the market tied to price, volume, sentiment, and time. It truly explains how the price pattern and charts in growth stocks generally play out historically. (more…)

5 Principles of Trading Psychology

  
  Education
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Trading is a performance activity
Like the playing of a concert instrument or the playing of a sport, trading entails the application of knowledge and skills to real time performances and this is the core idea behind my most recent book.  Success at trading, as with other performances, depends upon a developmental process in which intensive, structured practice and experience over an extended time yield competence and expertise. Many trading problems are attributable to attempts to succeed at trading prior to undergoing this learning process. My research suggests that professional traders account for well over three-quarters of all share and futures contract volume. It is impossible to sustain success against these professionals without honing one’s performance–and by making sure that you don’t lose your capital in the learning process. Confidence in one’s trading comes from the mastery conferred by one’s learning and development, not from psychological exercises or insights.

2: Success in trading is a function of talents and skills
Trading, in this sense, is no different from chess, Olympic events, or acting. Inborn abilities (talents) and developed competencies (skills) determine one’s level of success. From rock bands to ballet dancers and golfers, only a small percentage of participants in any performance activity are good enough to sustain a living from their performances. The key to success is finding a seamless fit between one’s talents/skills and the specific opportunities available in a performance field. For traders, this means finding a superior fit between your abilities and the specific markets and strategies you will be trading. Many performance problems are the result of a suboptimal fit between what the trader is good at and how the trader is trading. (more…)

Perhaps good traders aren’t born but rather made

  
  Education
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How much of trading success can be attributed to innate ability? The answer is, as Richard Dennis and Bill Eckhardt proved with their Turtle Trader experiment back in the early 80′s, none. Trading is a skills based activity in which we make decisions under conditions of uncertainty and risk. We can have uncertainty without risk but it is impossible to have risk without uncertainty.

What is innate that has an impact on our trading are habits. MIT’s McGovern Institute for Brain Research suggests that habit formation is indeed an innate ability which is perfected through experience. In particular, their research focused on the costs and rewards of certain choices using pattern recognition, much like trading.

Neuroscientists led by Institute Professor Ann Graybiel found that untrained monkeys performing a simple visual scanning task gradually developed efficient patterns that allowed them to minimize the time it took to receive their reward.
The findings not only help reveal how the brain forms habits, but also could shed light on neurological disorders where amplified habit-formation results in highly repetitive behavior, such as Tourette’s syndrome, obsessive-compulsive disorder and schizophrenia, says Graybiel.

The process of trading, from scanning the markets for a setup to closing the position, consists of a sequence of tasks. Over time we create habits by combining these tasks together in a process. Our tendency is to use heuristics or mental shortcuts to make the tasks easier on our brains. In doing so we open ourselves up to certain cognitive biases such as framing, anchoring and confirmation bias. If these are formed early in a trading career they can be detrimental to our equity curves and potential as a successful trader.

So perhaps good traders aren’t born but rather made. Traders are made by the habits they form. It takes, on average, 21 days to form a habit while taking much longer to unlearn one. Certain characteristic traits, namely Conscientiousness with two of its facets–self-efficacy and self-discipline, lend themselves nicely to forming good habits. Other characteristic traits, such as Neuroticism, can lead to bad habits. It’s therefore important to know what characteristic traits you bring to the markets.

If you’ve been in the markets for a while and find yourself unsuccessful, the culprit may be the habits and biases you’ve formed early in your trading. As humans our brains have a difficult time in distinguishing between good and bad habits. The good news is that bad habits can be changed into good habits through interrupting the habit cycle and changing the routine. Interrupting the cycle is easier than it sounds and well worth the effort as longevity in the markets as a successful trader is the reward.

10 Lessons for Traders

  
  Education
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1. Trading affects psychology as much as psychology affects trading – This was really the motivating factor behind my writing the new book. Many traders experience stress and frustration because they are trading poorly and lack a true edge in the marketplace. Working on your emotions will be of limited help if you are putting your money at risk and don’t truly have an edge.

2. Emotional disruption is present even among the most successful traders – A trading method that produces 60% winners will experience four consecutive losses 2-3% of the time and as much time in flat performance as in an uptrending P/L curve. Strings of events (including losers) occur more often by chance than traders are prepared for.

3. Winning disrupts the trader’s emotions as much as losing – We are disrupted when we experience events outside our expectation. The method that is 60% accurate will experience four consecutive winners about 13% of the time. Traders are just as susceptible to overconfidence during profitable runs as underconfidence during strings of losers.

4. Size kills – The surest path toward emotional damage is to trade size that is too large for one’s portfolio. We experience P/L in relation to our portfolio value. When we trade too large, we create exaggerated swings of winning and losing, which in turn create exaggerated emotional swings. (more…)

Revolutionary Trading Psychology

  
  Education
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Everyone thinks the market is a game of numbers. We use complex models, umpteen oscillators or retracement calculations and even a fundamental analysis of supply and demand – all based in numbers and about numbers.

But in reality, the numbers of the market are but an illusion.

Markets are only the vacillating prices that other human beings, using the same mathematically based tools, are willing to pay. For example, what can be expensive one day can be very cheap the next if a trend has ensued.

It is only a matter of perspective. And perspective is a matter of the judgments you make.

Judgments on the other hand will be influenced by both impulsive feelings and by intuitive feelings – or pattern recognition. The trick is to have all the data on the table so you can tell the difference.

In order to do this, us market participants need to do a couple of things – give up the notion of a iron-clad trading plan based purely on historical probabilities and replace it with a trading plan based on historical probabilities (yes you read that right) AND a systematic way to leverage your judgment under uncertainty. This way you can make a decision about factors that may now be in play for the future probabilities. I mean who thought the VIX could stay over 30 for 6 months? … I am just askin.

Now in order to do this successfully, you have got to learn to optimize your judgments – which means spending more time focused on deciphering and understanding them than you spend on deciphering and understanding the charts.

This is revolutionary trading psychology – and it works.

Three Principles of Trading Psychology

  
  Education
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Principle #1: Trading is a performance activity – Like the playing of a concert instrument or the playing of a sport, trading entails the application of knowledge and skills to real time performances. Success at trading, as with other performances, depends upon a developmental process in which intensive, structured practice and experience over an extended time yield competence and expertise. Many trading problems are attributable to attempts to succeed at trading prior to undergoing this learning process. My research suggests that professional traders account for well over three-quarters of all share and futures contract volume. It is impossible to sustain success against these professionals without honing one’s performance–and by making sure that you don’t lose your capital in the learning process. Confidence in one’s trading comes from the mastery conferred by one’s learning and development, not from psychological exercises or insights.
 
Principle #2: Success in trading is a function of talents and skills – Trading, in this sense, is no different from chess, Olympic events, or acting. Inborn abilities (talents) and developed competencies (skills) determine one’s level of success. From rock bands to ballet dancers and golfers, only a small percentage of participants in any performance activity are good enough to sustain a living from their performances. The key to success is finding a seamless fit between one’s talents/skills and the specific opportunities available in a performance field. For traders, this means finding a superior fit between your abilities and the specific markets and strategies you will be trading. Many performance problems are the result of a suboptimal fit between what the trader is good at and how the trader is trading.
 
The core skill of trading is pattern recognition – Whether the trader is visually inspecting charts or analyzing signals statistically, pattern recognition lies at the heart of trading. The trader is trying to identify shifts in demand and supply in real time and is responding to patterns that are indicative of such shifts. Most of the different approaches to trading–technical and fundamental analysis, cycles, econometrics, quantitative historical analysis, Market Profile–are simply methods for conceptualizing patterns at different time frames. Traders will benefit most from those methods that fit well with their cognitive styles and strengths. A person adept at visual processing, with superior visual memory, might benefit from the use of charts in framing patterns. Someone who is highly analytical might benefit from statistical studies and mechanical signals. 
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