What Makes A Winning Trade?

Imagine that I just made some trades. Imagine that I did all my research, I read the balance sheets and government reports, I spoke with experienced traders and analysts and I examined the price charts. Imagine that I bought Facebook shares, I sold Soybeans futures and I bought the Aussie Dollar/USD cross*.

What determines which of those trades makes money?

The answer has nothing to do with the fundamentals. It has nothing to do with the monetization of Facebook users, or the demand for Soybeans or the performance of the Australian economy. Whether my trades make money depends on one thing only:

How and when I exit the trades.

I have read hundreds of books on trading. I have spoken to hundreds of traders. Every day, I read dozens of blogs and news articles regarding trading and investing. The vast majority of the discussion revolves around how to enter trades. What to buy and sell, what to initiate, and why.

A huge amount of attention is paid to how, when and why to enter trades, and almost none on how to exit them. That is strange, since it is the exit, not the entry, that determines if a trade is successful or not. By choosing different exit strategies, you can dramatically affect the odds of a trade being a winner or a loser.

For example, it is very easy to dramatically increase your win/loss ratio: Simply exit a trade as soon as it shows a profit, and never exit if it shows a loss. Your win/loss ratio will rapidly rise towards 100%. Unfortunately, your overall profit will likely suffer dramatically: you will have a high number of very small gains, more than offset by a small number of very large losses (see Expectancy).

Alternatively, you can design a system that has a very high Average Win/Average Loss ratio: Simply exit a trade as soon as it shows a loss of any kind. You will end up with a large number of very small losing trades, which the small number of very large winning trades will probably not pay for.

For all the focus on entries, a system that uses a random entry can do surprisingly well. According to David Harding,

“If you put in stops and run your profits and trade randomly you make money; and if you put in targets and no stops, and you trade randomly you lose money. So the old saw about cutting losses and running profits has some truth to it.”

William Eckhardt told a similar story,

“Many systematic traders spend the majority of their time searching for good places to initiate. It just seems to be part of human nature to focus on the most hopeful point of the trading cycle. Our research indicated that liquidations are vastly more important than initiations. If you initiate purely randomly, you do surprisingly well with a good liquidation criterion. In contrast, random liquidations will kill the best system.”

As a trader, you need to consider how you exit a trade just as much, if not more, than how you enter it.

* Not recommendations. Not.

Getting Rich Should Be Easy In A Country Where 39m People Go To Vegas

An understanding of Expectancy is at the heart of successful trading. Trading is a probabilistic game, and outcomes are expressed in terms of probabilities, not certainties.

Many amateur traders focus on one metric: the win/loss ratio or the Win Percentage. People like winning, and so having a high Win % feels good. It syncs nicely with other walks of life, such as sport: if your team wins more games than it loses the team tends to do well.

Unfortunately, the sporting analogy quickly breaks down. In sports, it does not often matter how much you win by: winning by a field goal or eight touchdowns still puts a “W” in the column. In trading, it very much matters how much you win by.

Imagine a trading system that produces ten trades. You win $100 on eight trades. But you lose $500 on two trades. Your Win Percentage is 80%, but you have lost $200 across all ten trades.

The Average Win/Average Loss ratio is just as important as the Win/Loss ratio.

Expectancy = (Win % x Average Win) – (Loss % x Average Loss)

or, in our example:

Expectancy   = (80% x $100) – (20% x $500)

= $80 – $100

= -$20

This trading system has negative expectancy. That does not mean it will always lose money: trading is a probabilistic game, and there is a reasonable chance of a string of winning trades. But in the long run, the system will lose money.

With a positive expectancy, the longer you play the more you win. With a negative expectancy, the longer you play the more you lose.

Which brings us to Vegas. Last year, nearly 39m people visited Las Vegas, of which 77% gambled. Almost everything in Vegas is a negative expectancy game for the public and a positive expectancy game for the casinos. The casino might not win each play, but the odds are in their favor. That is why casinos try so hard to keep you playing as long as possible. They even like it when you win, since that encourages you to play longer. They know they will win in long run.

In trading, it is important to develop a mentality or technique that puts you in the position of the casino, not the public. You do that by identifying and creating situations that have positive expectancy. You will not win every time. You may even lose the majority of the time: you can lose on 60% of your trades and still make money overall if your average winning trade is at least 50% larger than your average losing trade.

It appears that most people do not think about expectancy very much: the 39m people who gambled in Vegas last year to start with. Traditional fundamental analysis primarily deals projections and forecasts and very little with Expectancy. As Warren Buffett realized on his honeymoon, getting rich should not be a problem when plenty of rich, well-dressed people participate in games where the odds are against them.

I Suck. So Do You.

My last post pretended to not be insulting you when I said you had a flawed and emotional monkey brain. My only defense for being so rude is that:

a) I have an emotional and flawed monkey brain too.

b) This is the Internet, and you are allowed to be rude on the Internet.

The limitations of my brain fascinate me. Despite my fancy education*, I make logical errors, emotional decisions and biased judgments all the time. And that is just the ones I am aware of: an independent observer could probably spot many more.

This topic is of considerable importance for a trader. As a trader, your main enemy is not the guy on the other side of the trade: he hates you of course, but your main enemy is yourself. All of your trading decisions and non-decisions are influenced by your biases, and it is important to try to identify when they are at work.

The academic and popular literature dealing with how our brains actually work (as opposed to how economists would like to pretended they work so that their equations are neater) has grown significantly. Since I am currently on a beach vacation drinking brightly colored drinks with little umbrellas in them, please indulge me as I liberally reference other people’s hard work.

The excellent Psy-Fi Blog has a fantastic page of Behavioral Biases that gives a long list of irrational and slightly odd behaviors that investors exhibit. It is well worth a read.

Some of my favorites are:

Anchoring: our habit of focusing on one salient point and ignoring all others, such as the price at which we buy a stock.

Bias Blind Spot: we agree that everyone else is biased, but not ourselves.

Confirmation Bias: we interpret evidence to support our prior beliefs and, if all else fails, we ignore evidence that contradicts it.

Disposition Effect: we prefer to sell shares whose value has increased and keep those whose value’s dropped.

Framing: the way a question or situation is framed can determine your response.

Fundamental Attribution Error: we attribute success to our own skill and failure to everyone else’s lack of it.

Herding: we tend to flock together, especially under conditions of uncertainty.

Illusion of Control: we do things that make us feel in control, even if we’re not.

Loss Aversion: we do stupid things to avoid realizing a loss.

Overconfidence: we’re way too confident in our abilities, which seems to be an in-built bias that we’re unable to overcome without excessive effort.

Blogger Mark Dow identifies four main takeaways from the behavioral finance literature:

1) We overestimate our abilities, our uniqueness, and our objectivity, even more so when under emotional strain…

2) We systematically understate the role of ‘random’. We crave order, and we are willing to torture the facts to get there. But sometime things just happen, and sometimes problems don’t have solutions…

3) People will find a way to believe what they are incented to believe. As the saying goes, “The most dangerous place to stand is in between someone and what they want to believe”…

4) When presented with points 1, 2, and 3, almost everyone recognizes their validity, but believes at some level that he/she is exempt…

I recently read Thinking, Fast and Slow by Daniel Kahneman. It is an intelligent, interesting and well-presented book that I would recommend to anyone interested in why humans act the way they do, and to traders in particular. The book highlights a long list of human quirks and foibles that deviate us from the “rational man” so beloved of classical economics, including many identified by the Psy-Fi Blog.

For me, one of the key points that Kahneman made was that the participants in their experiments were often intelligent, educated people. When reading about the cognitive errors that people make in experiments, it is easy and satisfying to think “Oh, there’s no way I would make that mistake, it is so obvious”. Welcome to the Bias Blind Spot: we agree that everyone else is biased, but not ourselves.

I am biased and flawed. So are you. We both suck. I think that acknowledging that helps to make me a better trader.

* Potentially, this might actually be because of my fancy education. I trained as an economist, and economists are notoriously more selfish, biased and unaware than the rest of the population.

The Fundamentals Do Not Matter As Much As You Think

A large amount of time, money and effort is spent by traders, investors and analysts examining “fundamental data”: company balance sheets, market reports, news items, supply and demand analysis. Blogs, books, newspapers and analyst reports are filled with analysis of fundamental information.

For example, the extensive blogroll on FT Alphaville currently links to 89 blogs; my rapidly unscientific survey identified that about 86 of those deal with fundamental information, and one appears to specialise in pictures of bank CEOs looking like Austin Powers. Traders and investors spend an extraordinary amount of resources investigating and analyzing the fundamentals, looking for clues about how to place their risk capital to work.

The good news is that the fundamentals do not matter. Or at least, they do not matter as much as people think they do.

Most people seem to believe that if they do their research properly, if they are more thorough and diligent than that other guy, if they have just one more piece of precious information, then they will know what to do. And then they will make their fortune.

They are wrong. The fundamentals are a tool. At best, they are an important but minor piece of the puzzle of extracting positive risk-adjusted returns. At worst, they can be highly misleading and distracting.

It is crucial to realize that traders do not get paid for predicting the fundamentals. We get paid for making money. And making money is far more about managing risk than it is about guessing how fundamental data is going to change. As Michael Covel puts it:

“Trading is trading, and the name of the game is to make money, not get an A in “How to Read a Balance Sheet.”

Look at it this way: imagine I am like Biff in Back To The Future II, and I have a Magic Almanac from the future. Imagine that I tell you exactly what the US unemployment rate, the GDP level, the amount of crude oil in storage and the balance sheets of the top 10 largest public companies will look like in 12 months time. That would be pretty helpful, wouldn’t it? You could make some pretty good money of that, couldn’t you?

While that information would be a useful tool, there are several problems in turning that perfect knowledge into cash dollars. Even assuming that my Magic Almanac is correct, you will not know the most important things that will determine if you make money or not. Primarily, you do not know how the market is going to value a certain level of unemployment, or crude oil inventory or even a given balance sheet in the future.

Just as bad, even if you are pretty confident that the market is going from point A (today) to point D (in a year), you do not know the path the market is going to take to get there i.e. where are points B and C along the way? Without knowing that you could be taken out of your position before you get there, either by a margin call or by your own flawed and emotional brain*.

Fundamental analysis does not give answers to the vital questions of how to enter a market, what market to enter, with what position size, and when to exit. The answers to those questions are given by a traders’ risk management system. As Peter Brandt puts it,

“Analysts are paid by being right… Traders are paid by managing risk. These two skill sets are a world apart.”

Most successful traders do understand the fundamentals of their markets, but it is only a small piece of the puzzle of extracting positive risk-adjusted returns.

* No offense intended. You should know that your brain is flawed and emotional. So is mine. It is because we are descended from monkeys.