You play for a living, it's like any other job. You don't gamble, you grind it out. Your goal is to win one big bet an hour. That's it. Get your money in when you have the best of it, protect it when you don't. Don't give anything away. Always leave yourself outs. Applies to a player's life away from the game same as it does at the table.
HOLY GRAIL OF TRADING/INVESTING - CUT YOUR LOSSES SHORT. LET YOUR PROFITS RUN.
5 Important Points
1. Stop Loss: Set protective stop as soon as you enter a position. The stop price should be decided before entering a position. Move protective stop to break-even when price moves in your direction (more than the average daily range). It might be a good idea to sell a part of your position (for e.g. one third) for a reasonable profit. By doing this, there will be less pressure to sell early since you have already cashed in; and if the trade goes against you, there is at least some profit from the trade. Use trailing stops for the rest of the position to ride the move.
2. Psychology: Never trade impulsively, stick with your edge/plan. Never ever add to a losing position (unless you already have a plan thought out to scale into a position at different entry points); add only to winning positions (progressively smaller amounts). Don’t be influenced by others; stick with your edge/plan. It is important to forgive yourself when you make a trading mistake despite your best efforts.
3. Technical Analysis: Reduce or dispose your position if a trend line you are watching is violated, especially with heavy volume. Don’t hope that the trend line break is a fake one. Never trade based on indicator divergence (with price) alone. Divergences can go on for a while, with price continuing to make higher highs and the indicator continuing to make lower highs (or price making lower lows with indicator making higher lows).
4. Money Management: Try not to lose more than 2% of your capital on a single trade. Stop trading to re-examine the situation if you lose more than 6% of your capital within a month or have consecutive losing trades.
5. Hard Work: At the end of the day, record your trades and the thought process (including charts if possible) that went into making those trades.
Humility
1. Trade in accordance with your comfort level.
2. Always use a model.
3. Avoid buying out-of-the-money options.
4. Don’t buy more time than you need.
5. Know what strategies are equivalent and use the optimum one at all times.
6. Trade all markets.
7. Have a little humility.
Examples Of Edges
An edge is something that someone has that gives them an advantage over another party. This advantage cannot be learned or its value would be diluted. An edge is usually very expensive to acquire. There are large barriers to entry. For example, option market makers use to have a huge edge. But they PAID for it through their seat memberships. LTCM had an edge. They provided liquidity for the world debt markets. So they earned a spread for providing liquidity. They got to borrow money at virtually no cost as well. Citadel has an edge via their ability to own order flow and execute trades with zero slippage, and in many cases at a discount or premium to the marketplace. Floor traders at the CME and CBOT use to have an edge by trading in front of order flow. They PAID for this through their memberships. Some hedge funds in the past were able to get news before other people could and trade off of it. They were able to get order flow info by calling around. That was an edge. Some futures traders are able to execute their orders faster than other traders by getting priority in the queue ahead of other people. They paid for this through technology cost. Arbitrage is a legitimate edge usually vis-a-vis providing liquidity. Other edges existed in tax laws, information flows, PIPES, convertible bonds arbs, etc. These are all legitimate edges. They all came out at a cost. Very few people could execute these edges. They were not learned, they were created or acquired. Being able to buy XYZ when it breaks through a moving average is not an edge. Selling something after a gravestone doji is formed is not an edge. Buying a market that is oversold on some oscillator is not an edge. Market profile is not an edge. Neither are using support or resistance levels. Neither is fundamental analysis.
Blame Yourself
Trading futures is by far the toughest instrument to trade. Stock is the easiest, followed by options, then futures and spot FX. Most people simply do not have the right genetic makeup to trade futures. It doesn't matter if they are trained or not. Futures work against almost everything we naturally believe. It's analogous to a wannabe actor in Hollywood that is blaming his agent for not getting any acting work. The problem is whether you are Al Pacino or John Doe, your shot at stardom is slim to none, regardless of your agent. Blaming your agent, Hollywood, the studios, etc for your failures is simply not genuine on your part. The odds of success are terrible no matter where you are. Sure, no one wants to get screwed on commissions, bad equipment, terrible work environment, etc, but that is NOT the reason why you failed. The first step to making it in this business is your ability to be honest with yourself. Until you do that, other factors do not even enter into the equation.
Control Your Destiny
Most traders struggle in low volatility environments, i.e. in bullish markets. Bullish markets are one of the toughest to trade (easy for investors). Generally most traders do well in highly volatile and liquid markets. This does not just have to be index markets but could also be commodity markets. There is no excuse with all the products offered around the world to be stuck trading bad products. Trading is the most challenging, yet most rewarding job in the world. To be able to independently support yourself without doing "deals" or trying to sell crap is quite an enlightening experience. The last few years have actually been very challenging for most traders, but things are starting to pick up. Besides, this is the only job where YOU control your destiny, not some corporation or individual that needs to buy your product so you can put food on the table.
Skill v/s Edge
Let's play a game. Say I have a sports touting service. I call you every week; give you my picks for this week's college and pro football games. You pay me a fixed amount of money up front for this information. I tell you I have all sorts of inside information. My results are well documented throughout the industry; I rarely ever, ever lose. I am the BEST. I charge you $500 for this week's picks. I give you my college football 3 team parlay as well as my Sunday Lock of the year. As usual, I come through in flying colors. I pick every game correctly. You are amazed, but it's only week you tell yourself, let's see how I do next week. I call you once again; give you my picks and yet again, I come through and pick 4 out of 6 winners. The process repeats itself week in and week out. I keep calling, and you keep winning. You are beside yourself. You can't explain it. You tell all your friends about me, they don't believe you. I have now won 18 weeks in a row!!! You keep betting bigger and bigger. I never lose! So finally we get to the playoffs, your friends have been won over and decide to call me. I give them my picks. They bet huge. They get killed! They call you up and scream at you. You say, what are you talking about? Only then do you learn that I gave your friends the opposite picks that I gave you. You later discover that this is actually the con. That I call thousands of people every week with picks. I give one side to half the people and the other side to the other half. Every week, I only call back the winners. And every week, half my clients win. Till we get to the playoffs and I have 50 customers, yourself included, that have never seen me lose.
You see, it's very easy to get very lucky. But just like in life, rarely are things what they seem. Don't fall for it. The world is full of streaky winners. Lots of them. Ever wonder why the average person can't replicate the streaky winner? Skill and edge are not the same thing. A lot of people have skills. Few have edges. Yes, there are a lot of lucky people who have been streaky and profited by being at the right place at the right time in history. Not all people, but a lot of people. Guys that make money, make money because they either have an edge, or they are simply great traders. Usually if they don't have an edge, a trader will wish to trade the product that has the least vig or obstacle to being profitable. Edges are not learned, they are acquired. And they are very, very expensive to acquire. Skill can be learned. And again, one can make money WITHOUT an edge. But if you must trade a product with a high vig, you better get yourself some "edge". The definition of edge is something one has that others do not have. Not easy replicable. Anyone can get lower commissions. Edge and skill are not the same thing. Not even close. You cannot learn an edge. A lot of skilled traders blow up. Edge speaks for itself. There is nothing wrong with skill. Skill is very important. But you cannot convert skill to edge. Look, this is circular logic here. You say you have more skill than everyone else, hence you have an edge. So what is stopping everyone else from acquiring the skill you have thereby giving them edge? See? And round and round we go.
Not saying skill is a bad thing. Quite the contrary. Skill is not edge. No matter how many hours you spend in a batting cage, you will never be Barry Bonds. No matter how many hours you spend on the driving range, you will never be Tiger Woods. Skill and edge are NOT the same thing. First of all, if you think for a second that you could spend enough time on the links to beat Tiger Woods you are insane. Tiger Woods, Michael Jordan, etc, are born with an innate skill that one cannot just acquire on their own. Tiger was playing better golf at age 4 than most golfers as adults. This is not to say no one can beat Tiger or become better than him. But they will be BORN with that ability. It won't come from spending a few extra hours at the driving range. Technology is irrelevant unless you are going to handicap Tiger and play with the new clubs while Tiger is forced to play with the older clubs. If you compete with Tiger and use the same "clubs", Tiger will kick your ass each side of Sunday. Not much you can do about it. Someday, someone might come along that is better than Tiger. Someone that can BEAT Tiger or his records. That means someone will have to win 100 plus tournaments, whatever Tiger will have won by the end of his career, and win those tournaments playing against equal opponents using the SAME equipment. Athletes like Tiger are rare and few and far between. No amount of practice will make an average player as good as Tiger. You need above average skill to become a good trader and make good money. That is your edge! The above average part.
There are a ton of different methodologies out there regarding trading. And they all work. But for some people none of them work. Using the same methodology two people may yield completely different results. However using different methodologies two people may find similar success. There is no end-all method or solution to the markets, the key to profitability (edge) is not in the method, but the man behind the method, and his mastery of the method, in conjunction with his mastery of his own mind (psychology). In other words, skill. Maybe that’s why you don't see the successful traders going around telling everyone how they do it. The reason everyone can't just learn it is because it’s NOT easy. Trading is hard, it takes experience, and many times, it takes huge losses to learn the true skills. Not everyone has the patience, or money to put up to finally acquire these skills. Most the stuff that works in the stock market goes directly against common sense and normal psychology. If it was so easy everyone would do this and get rich! No matter how hard you practice, you won't be Tiger Woods or Barry Bonds. Just like no matter how hard you practice you probably won't be managing a few billion like Soros. But if you practice enough, you might become a very good golfer, or baseball player. Or hey, maybe you can even make pretty good living trading stocks. At least better than a school teacher. But on a side note, skilled traders blow up all the time. In many cases it's simply a black swan type event that they can do nothing about. Has nothing to do with skill. "Luck and chance happen to us all."
Trading Should Be Like Military
The fact of the matter is, most people do not belong in this business. But they try it anyway because they are either so freaking greedy that they think they are going to make millions or they are so freaking lazy and love the idea of skipping work, leaving when they want and making their own hours. The bottom line is, holding their hand and telling them what a great guy they are and buying them pizza and telling them everything will be OK is bullshit. Trading should be like the military. You should get the shit kicked out of you. You can't treat traders like children. You need to treat these people like adults. And accept the fact that you are not suppose to succeed. You are there to make a living! And yes, it's a very tough job. The only way to succeed is toughen yourself up. It's simply the fact that most people simply are not cut out for this job.
Garbage In, Garbage Out
1. Follow the trends. This is probably some of the hardest advice for a trader to follow because the personality of the typical futures trader is not "one of the crowd." Futures traders (and futures brokers) are highly individualistic; the markets seem to attract those who are. Very simply, it takes a special kind of person, not "one of the crowd," to earn enough risk capital to get involved in the futures markets. So the typical trader and the typical broker must guard against their natural instincts to be highly individualistic, to buck the trend.
2. Know why you are trading the commodity markets. To relieve boredom? To hit it big? When you can honestly answer this question, you may be on your way to successful futures trading.
3. Use a trading system, any system, and stick to it.
4. Apply money management techniques to your trading.
5. Do not overtrade.
6. Take a position only when you know where your profit goal is and where you are going to get out if the market goes against you.
7. Trade with the trends, rather than trying to pick tops and bottoms.
8. Don't trade many markets with little capital.
9. Don't just trade the volatile contracts.
10. Calculate the risk/reward ratio before putting a trade on, then guard against holding it too long.
11. Establish your trading plans before the market opening to eliminate emotional reactions. Decide on entry points, exit points, and objectives. Subject your decisions to only minor changes during the session. Profits are for those who act, not react. Don't change during the session unless you have a very good reason.
12. Follow your plan. Once a position is established and stops are selected, do not get out unless the stop is reached or the fundamental reason for taking the position changes.
13. Use technical signals (charts) to maintain discipline - the vast majority of traders are not emotionally equipped to stay disciplined without some technical tools.
14. Have a disciplined, detailed trading plan for each trade; i.e., entry, objective, exit, with no changes unless hard data changes. Disciplined money management means intelligent trading allocation and risk management. The overall objective is end-of-year bottom line, not each individual trade.
15. When you have a successful trade, fight the natural tendency to give some of it back.
16. Use a disciplined trade selection system: an organized, systematic process to eliminate impulse or emotional trading.
17. Trade with a plan - not with hope, greed, or fear. Plan where you will get in the market, how much you will risk on the trade, and where you will take your profits.
18. Most importantly, cut your losses short and let your profits run. It sounds simple, but it isn't. Let's look at some of the reasons many traders have a hard time "cutting losses short." First, it's hard for any of us to admit we've made a mistake. Let's say a position starts going against you, and all your "good" reasons for putting the position on are still there. You say to yourself, "It's only a temporary set-back. After all,” you reason, “the more the position goes against me, the better the chance it has to come back - the odds will catch up." Also, the reasons for entering the trade are still there. By now you've lost quite a bit; you sell yourself on giving it "one more day." It's easy to convince yourself because, by this time, you probably aren't thinking very clearly about the position. Besides, you've lost so much already, what's a little more? Panic sets in, and then comes the worst, the most devastating, the most fallacious reasoning of all, when you figure, "That contract doesn't expire for a few more months; things are bound to turn around in the meantime." So it goes; so cut those losses short. In fact, many experienced traders say if a position still goes against you the third day in, get out. Cut those losses fast, before the losing position starts to infect you, before you "fall in love" with it. The easiest way is to inscribe across the front of your brain, "Cut my losses fast." Use stop loss orders, aim for a $500 per contract loss limit...or whatever works for you, but do it.
Now to the "letting profits run" side of the equation. This is even harder because who knows when those profits will stop running? Well, of course, no one does, but there are some things to consider. First of all, be aware that there is an urge in all of us to want to win...even if it's only by a narrow margin. Most of us were raised that way. Win - even if it's only by one touchdown, one point, or one run. Following that philosophy almost assures you of losing in the futures markets because the nature of trading futures usually means that there are more losers than winners. The winners are often big, big, big winners, not "one run" winners. Here again, you have to fight human nature. Let's say you've had several losses (like most traders), and now one of your positions is developing into a pretty good winner. The temptation to close it out is universally overwhelming. You're sick about all those losses, and here's a chance to cash in on a pretty good winner. You don't want it to get away. Besides, it gives you a nice warm feeling to close out a winning position and tell yourself (and maybe even your friends) how smart you were (particularly if you're beginning to doubt yourself because of all those past losers). That kind of reasoning and emotionalism have no place in futures trading; therefore, the next time you are about to close out a winning position, ask yourself why. If the cold, calculating, sound reasons you used to put on the position are still there, you should strongly consider staying. Of course, you can use trailing stops to protect your profits, but if you are exiting a winning position out of fear...don't; out of greed...don't; out of ego... don't; out of impatience...don't; out of anxiety...don't; out of sound fundamental and/or technical reasoning...do.
Now to the "letting profits run" side of the equation. This is even harder because who knows when those profits will stop running? Well, of course, no one does, but there are some things to consider. First of all, be aware that there is an urge in all of us to want to win...even if it's only by a narrow margin. Most of us were raised that way. Win - even if it's only by one touchdown, one point, or one run. Following that philosophy almost assures you of losing in the futures markets because the nature of trading futures usually means that there are more losers than winners. The winners are often big, big, big winners, not "one run" winners. Here again, you have to fight human nature. Let's say you've had several losses (like most traders), and now one of your positions is developing into a pretty good winner. The temptation to close it out is universally overwhelming. You're sick about all those losses, and here's a chance to cash in on a pretty good winner. You don't want it to get away. Besides, it gives you a nice warm feeling to close out a winning position and tell yourself (and maybe even your friends) how smart you were (particularly if you're beginning to doubt yourself because of all those past losers). That kind of reasoning and emotionalism have no place in futures trading; therefore, the next time you are about to close out a winning position, ask yourself why. If the cold, calculating, sound reasons you used to put on the position are still there, you should strongly consider staying. Of course, you can use trailing stops to protect your profits, but if you are exiting a winning position out of fear...don't; out of greed...don't; out of ego... don't; out of impatience...don't; out of anxiety...don't; out of sound fundamental and/or technical reasoning...do.
19. You can avoid the emotionalism, the second-guessing, the wondering, the agonizing, if you have a sound-trading plan (including price objectives, entry points, exit points, risk-reward ratios, stops, information about historical price levels, seasonal influences, government reports, prices of related markets, chart analysis, etc.) and follow it. Most traders don't want to bother; they like to "wing it." Perhaps they think a plan might take the fun out of it for them. If you're like that and trade futures for the fun of it, fine. If you're trying to make money without a plan - forget it. Trading a sound, smart plan is the answer to cutting your losses short and letting your profits run.
20. Do not overstay a good market. If you do, you are bound to overstay a bad one also.
21. Take your lumps; just be sure they are little lumps. Very successful traders generally have more losing trades than winning trades. They don't have any hang-ups about admitting they're wrong, and have the ability to close out losing positions quickly.
22. Trade all positions in futures on a performance basis. The position must give a profit by the end of the third day after the position is taken, or else get out.
23. Program your mind to accept many small losses. Program your mind to "sit still" for a few large gains.
24. Most people would rather own something (go long) than owe something (go short). Markets can (and should) also be traded from the short side.
25. Watch for divergences in related markets - is one market making a new high and another not following?
26. Recognize that fear, greed, ignorance, generosity, stupidity, impatience, self-delusion, etc. can cost you a lot more money than the market’s going against you, and that there is no fundamental method to recognize these factors.
27. Don't blindly follow computer trading. A computer-trading plan is only as good as the program. As the old saying goes, "Garbage in, garbage out."
28. Learn the basics of futures trading. It's amazing how many people simply don't know what they're doing. They're bound to lose, unless they have a strong broker to guide them and keep them out of trouble.
29. Standing aside is a position.
30. Client and broker must have rapport. Chemistry between account executive and client is very important; the odds of picking the right stock the first time are remote. Pick a broker who will protect you from yourself: greed, ego, fear, or subconscious desire to lose (actually true with some traders). Ask someone who trades if they know a good futures broker. If you find one who has room for you, give him your account.
31. Sometimes, when things aren't going well and you're thinking about changing brokerage firms, think about just changing account executive instead. Phone the manager of the local office, let him describe some of the other account executives in the office, and see if any of them seem right enough to have a first meeting with. Don't worry about getting your account executive in trouble; the office certainly would rather have you switch account executives than to lose your business altogether.
32. Broker/client psychology must be in tune, or else the broker and client should part company early in the program. Client and broker should be in touch repeatedly, so when the time comes, both parties are mentally programmed to take the necessary action without delay.
33. Most people do not have the time or the experience to trade futures profitably, so choosing a broker could be the most important step to successful futures trading.
34. When you go stale, get out of the markets for a while. Trading futures is demanding, and can be draining - especially when you're losing. Step back; get away from it all to recharge your batteries.
35. If you're in futures simply for the thrill of gambling, you'll probably lose, because chances are the money does not mean as much to you as the excitement. Just knowing this about yourself may cause you to be more prudent, which could improve your trading record. Have a business-like approach to the markets. Anyone who is inclined to speculate in futures should look at speculation as a business, and treat it as such. Do not regard it as a pure gamble, as so many people do. If speculation is a business, anyone in that business should learn and understand it to the best of his/her ability.
36. When you open an account with a broker, don't just decide on the amount of money, decide on the length of time you should trade. This approach helps you conserve your equity, and helps avoid the Las Vegas approach of "Well, I'll trade till my stake runs out." Experience shows that many who have been at it over a long period of time end up making money.
37. Don't trade on rumors. If you have, ask yourself this: "Over the long run, have I made money or lost money trading on rumors?" O.K. then, stop it.
38. Beware of all tips and inside information. Wait for the market's action to tell you if the information you've obtained is accurate, then take a position with the developing trend.
39. Don't trade unless you're well financed, so that market action, not financial condition, dictates your entry and exit from the market. If you don't start with enough money, you may not be able to hang in there if the market temporarily turns against you.
40. Be more careful if you're extra smart. Smart people very often put on a position a little too early. They see the potential for a price movement before it becomes actual. They become worn out or "tapped out" and aren't around when a big move finally gets underway. They were too busy trading to make money.
41. Stay out of trouble, your first loss is your smallest loss.
42. Analyze your losses. Learn from your losses. They're expensive lessons; you paid for them. Most traders don't learn from their mistakes because they don't like to think about them.
43. Survive! In futures trading, the ones who stay around long enough to be there when those "big moves" come along are often successful.
44. If you're just getting into the markets, be a small trader for at least a year, then analyze your good trades and your bad ones. You can really learn more from your bad ones.
45. Carry a notebook with you, and jot down interesting market information. Write down the market openings, price ranges, your fills, stop orders, and your own personal observations. Re-read your notes from time to time; use them to help analyze your performance.
46. "Rome was not built in a day,” and no real movement of importance takes place in one day. A speculator should have enough excess margin in his account to provide staying power so he can participate in big moves.
47. Take windfall profits (profits that have no sound reasons for occurring).
48. Periodically redefine the kind of capital you have in the markets. If your personal financial situation changes and the risk capital becomes necessary capital, don't wait for "just one more day" or "one more price tick”; get out right away. If you don't, you'll most likely start trading with your heart instead of your head, and then you'll surely lose.
49. Don't use the markets to feed your need for excitement.
50. Always use stop orders, always...always...always.
Piper Comes Knocking
Everyone trades direction. Some trade the direction of the underlying; some trade the direction of volatility (option traders) and some trade the direction of the pair. But we all trade direction one way or the other. There is always a directional aspect to a pair trade as you want the spread to either narrow or widen. Every trader trades direction in one form or another. A bond trader that trades the NOB spread (notes over bonds) is trading direction. A trader that is long dispersion (trading long equity vol/short index vol) is trading direction. For example, the guy that sells 5 delta verticals for .30 credits risking 9.70 makes money every month. He would most certainly agree with you that it's much easier to sell volatility the way he does vs. having to make a call on the direction of the market. But when we have one sharp move that wipes out all of his yearly profits in one month and then the following month there is another sharp move that wipes out 50% of his account. The result is the same. Sure, for 11 months he got a free pass. But sooner or later, the piper comes knocking and he wants to be paid. Trading is a tough business no matter what product you are trading or what your style is.
Commissions And Slippage
Commissions are tough to overcome. But not nearly as tough to overcome as the slippage you will encounter when you are forced to take action. In order to make money, you're going to have to predict something. If you get the direction of the underlying wrong, it will be extremely hard to make money even if you get volatility right. No strategy has an edge as a strategy itself. The edge lies in the trader. Every strategy requires doing one of two things, make a directional prediction or a volatility prediction and don't buy anything from anyone that tells you any different.
Is Trading Fun?
Look, you can warn people all you want. You can give all the disclosures you want. At the end of the day, you can't make anybody do anything. Lot of guys say how wonderful it would be to trade other people's money or trade on a salary. Do you guys have the faintest idea of how tough that is? The constant pressure everyday to perform? Some of the guys act like running a 100 million dollar fund would be fun. Fun? You think it’s fun telling your investors you lost half their money. You think its fun getting fired from your salaried job after 4 weeks because you were underperforming and after you already bought that condo and that new car and now you are out of a job? Come back to the real world. This is a tough business where most people will not make it. The best you can hope for is to find an honest, reliable firm that will surround you with good traders to learn from, good rates, and all the back office support to make sure your trading goes smoothly.
Perfect Option Position
There is no such thing as the perfect option position. A more appropriate phrase would possibly be "the optimal option position". The position is optimal because it combines attributes that market makers generally would like their position to have. That is one that is short dollar premium in the front month and long vega in the back. This position would allow one on the floor to scalp around the position to pay for the back month options while maintaining an unlimited upside/limited risk profile. There is no such thing as a good or bad strategy, only good or bad traders. You can give a guy all the edge in the world, and if he can't trade, sooner or later he will blow out. Too many people are searching for the grail. But at the end of the day, if you are not a damn good trader, you will not survive trading options, futures or stock for speculation. No one wants to hear that.
Catching A Falling Knife
There are lot of guys that get lucky at the casino, it's not because they are right. Sooner or later, that "buy on every dip" mentality will lead you to the poor house. No matter how much money you have behind you. Refusing to admit you are wrong when the market repeatedly says you are is a mistake. No trader in their right mind should ever take that kind of heat. Market always comes back. But shit man, with that reasoning every trader is a genius. Look at everyone trying to short the rally. Eventually they will be right. But for God's sake, when you are wrong, you are wrong. The idea behind trading is to make the kinds of gains WITHOUT taking that kind of risk. Anyone can dollar cost average a stock or a commodity until it moves their way. Many did that in the late 90's with tech stocks until they blew out in 2000. How many blew out buying Crude oil futures all the way down citing strong underlying fundamentals that it should go higher. How many have been shorting index markets citing a very weak economy, war, interest rates, blah, blah, blah. Where has that gotten them?
Refusing to admit you are wrong and just doubling up every tick against you until you are proven right. This is why guys blow out. Fundamentals are great when the trades work out for you. But they are tragic when they don't. Think of all the bears shorting tech stocks too early in 1998 and 1999. In the end you may be proven right, but over the short term, you could lose everything. Hence the famous quote, "the market can remain irrational longer then you can remain solvent." Many traders make a great living trading with no edge. And just because you have an edge does not mean you will ever make a dime. If it's working, keep doing it. There is no edge in trading off of something that everyone has access unless there is a lot of ambiguity involved, which usually there isn't with stock fundamentals. Pretty straightforward.
Let's say you bought a stock from $8 all the way down to $2. And on the way down, the fundamentals were all intact. Everything looked great. No reason not to buy. But let's say by the time it got down to $2, suddenly some information was revealed that showed that this thing was a dog and the fundamentals have drastically changed and there was no reason to hold it. What would you do? See, you can buy a stock with faith in the good fundamentals, but you are making the assumption that the fundamentals are going to stay strong in the future. Now, that is normally not a big deal as most people would bail on a stock after a 5% or 10% loss and maybe re-enter the stock later. But if you are going to take 50% to 75% hits on a stock, this is definitely a concern. A good trader could have looked at that stock and the fundamentals and said, OK, fundamentals look great, technicals look awful. Stock is making lower lows every day. I'm going to wait for this stock to bottom and show some signs of strength, and then I'll start buying it if the fundamentals are still good. They would not just jump in and try to catch a falling knife. There is never a good reason to let a position go that much against you, no matter how much money you have.
Tails Trading System
Trading is a game of probabilities. Imagine we're flipping a coin. Heads I win one dollar - tails you win one dollar. Simple. Heads and tails will each come up half the time, and we'll both neither win nor lose. However, unknown to me, you have a loaded coin. For every 100 throws, heads comes up 49 times, and tails comes up 51 times. You now have a license to print money. Let's call it the "Tails Trading System". All you have to do is sit back and bet on tails forever. Eventually, you'd win all my money (and anyone else's who took you on). All any trading system gives you is an "edge". A favorable bias. Something that is more likely to happen than not. Whatever trading system you use... e.g. ... pattern breakouts, trend-following, fibonacci, moving averages, channel following, oscillator signals, bollinger bands, swing trading, opening gaps...... you are relying on a positive bias. Essentially, the trading system is saying "when 'x' happens... 'y' usually follows". Sometimes it doesn't. Most of the time it does. And all your trading system does is help you identify high probability trades, enter them correctly, and protect yourself while allowing your profits to grow.
Now some trading systems are better than others. But don't get caught up on the search for the perfect system... You know, the trader's Nirvana... the elusive "Holy Grail"... the system that delivers profits on demand and never, ever gets it wrong. Find a trading system that you like. One you feel comfortable with. One you understand. Then stick with it. Be consistent. A cool, disciplined, trader will take an average system and make money with it. A nervous, arbitrary trader will take a brilliant system and wreck it. All traders have "good" days and "bad" days. Some days you'll make small profits. Other days you'll make small losses. And once or twice a month, on average, you'll make big profits. That's how you make money as a traders. It's not 9 till 5. Problem is, you never know when the big trades are due to arrive. Like our "Tails Trading System" above, the one time you don't take the trade is exactly the time the market takes off and never looks back. You MUST see the big picture. Realize that the current trade is only one of many. On that basis, the current trade hardly matters. It's like a piece of plankton in a very large ocean. Trading is all about managing risk and then surrendering yourself to the oldest law in the Universe: The ancient law of probability.
Black Swans
1) They cannot be "accurately" predicted. I predict one day an alien space ship will land on the white house lawn. Two hundred years from now, it actually happens. Does that make it a black swan? Yes. Sure, I predicted it, but there is no way I can accurately predict exactly when aliens will land on the white house lawn. What good is a prediction if there is not an accuracy component to it? That's like saying one year; the Cubs will win the World Series. Which year! Anybody can throw shit against the wall; some of it is bound to stick.
2) After the event happens, it has to appear to be obvious in hindsight. Once aliens make contact with us, everyone will say, well of course, it was bound to happen sooner or later.
3) And the 3rd one, the event has to have significant importance. Aliens landing and making contact with us would certainly change the way we see the world and we would never be the same.
Some events which are black swans are 9/11, Google, the first World War, the computer, etc. As you can see, black swans can be both positive AND negative. None of these events were accurately predicted. Sure, you can make a very broad blanket statement; one day there will be a nuclear holocaust. Then when it happens, you will say you predicted it. But the fact of the matter is, you will NEVER predict when that will happen. Saying that it will happen in the next 1000 years is not a prediction. What were some other possible black swans? The devaluation of the Deutsche Mark in 1920, the AIDS virus, the assassination of Jack Kennedy, etc.
Logic Wins. Impulse Kills
1. Never Let a Winner Turn Into a Loser
2. Logic Wins, Impulse Kills
3. Never Risk More Than 2% per Trade
4. Trigger Fundamentally, Enter and Exit Technically
5. Always Pair Strong With Weak
6. Being Right but Being Early Simply Means That You Are Wrong
7. Know the Difference Between Scaling In and Adding to a Loser
8. What is Mathematically Optimal Is Psychologically Impossible
9. Risk Can Be Predetermined, but Reward Is Unpredictable
10. No Excuses, Ever
11. Don't risk more than what you and/or your family can reasonably handle.
12. Simplicity works. It doesn't just work, it works amazingly well.
13. Buying stocks at multi year low is a winning strategy.
14. Patience pays.
15. Discipline pays.
Hallmark Of A Good Trader
Trading success comes from consistent application of a positive expectancy system. Consistent application comes from total confidence in your trading system and in your own ability to always act in your own best interests. Unfortunately this confidence only comes from success. You can't fake it through positive thoughts. Catch 22 situation - you can't trade successfully unless you have total confidence in yourself & your system, and you can't have total confidence in yourself & your system until you trade successfully. The fact is, trading has to be about one thing. Making a profit. If you do it for any other reason, you are probably doomed to failure, because you'll operate from emotion instead of the cold, mechanical thinking that's the hallmark of a good trader.
Direction v/s Volatility
There are two ways of making money in this business. You either need to be a damn good directional trader, or a damn good volatility trader. You'll often hear guys say things like "I don't care what the market does, I'm safe". That is not a volatility trader. People work very hard in this business forecasting future volatility and future price action. It's comical that some think you can just slap on a spread and make an adjustment here and there and make money. Yet, many of the late night infomercial groups tell you it's just that easy. You hear all the coin phrases: "I can always adjust", "I can leg into a fly", "my spreads are safe because they are DOTM", "I can only lose my debit so I'm not worried", "I have edge from my theta", etc....... And it goes on and on. You will never hear a professional trader utter these phrases. They are usually the mark of an amateur. This is a very tough business. If you are going to make it, it's because you develop into a great trader. Not because you can slap on spreads at good prices. Look at it this way. Most "professionals" in this business do not make money. The amateurs almost don't have a chance. Not saying it's impossible, some will. But the ones that do is mostly attributable to random luck.
When you talk to people who do this part time or on the side to a full time job they usually point out a lucky stock they caught or they walked into an index before a huge move quite by accident. Very seldom do you find part timers that earn consistent income month after month without adjusting for risk. In other words, are they outperforming a benchmark with the same or less risk? If they are not, they should just invest in that benchmark. If they are, then they are doing something right. But you find those people few and far between. Sooner or later, traders revert to a long term mean which is usually the benchmark. Very few can actively beat that benchmark over long periods of time. Not saying you can't make money on the side by trading part time. That's a separate issue. We are talking about outperforming a benchmark here, not just making money. There are outliers out there, but we have to discount those as in any study. Benchmark meaning something that you could invest in that produces similar returns. Many people by default use the SP 500 by default. You could use the CBOE buywrite index if you like to sell premium. There are many ETF's out there that use particular trading styles that might be similar to yours. The bottom line is, if I can invest my money in an ETF and make 10% a year without putting any labor into it, why would I want to bust my ass working long hours on top of my regular job just to make 12% a year?
Every vol trader is making a de facto directional bet whether he knows it or not. And every directional trader is making a vol bet whether he knows it or not. This is where many trader shortcomings are. This is why at the end of the day; you need to be a decent directional trader. Anyone that sells vol is making a defacto bullish bet on the market all things constant. Unless he is running a discrete dispersion strategy. If I sell front month gamma, the last thing I want is for the market to roll over hard. If I sell back month vol, the last thing I want is a hard selloff causing vols to spike. This is what it means by vol traders being an indirect directional trader. When I sell vol, it's usually because I think the markets are going higher. If I buy vol, it's usually because I think we are going to sell off. Why would I ever buy vol with a bullish market outlook? So at the end of the day, whether you are trading direction or trading vol, you are really trading direction regardless. One cannot make the argument that simply because of the wide placement of strikes that they don't care about direction.
Interview With Nassim Taleb
In the eight years since his first book, Dynamic Hedging: Managing Vanilla and Exotic Options, crowned him a celebrity in the derivatives world, Nassim Taleb has been expanding the focus of his work beyond the confines of finance while delivering his ideas to ever-larger audiences. The 45-year-old has been cited in testimony before Congress, participated in Pentagon think tanks and lectured at the respected Courant Institute of Mathematics. He has seen his most recent book, Fooled by Randomness, becomes a bestseller, with editions in 17 languages. Taleb is the first to boast that everything he learned about risk, he learned on the trading desk. Born in Lebanon but forced to flee amid the onset of civil war in 1975, he flourished as a student, ultimately obtaining his MBA from the University of Pennsylvania's Wharton School and his Ph.D. in applied mathematics from the University of Paris. Throughout the '80s and '90s, he held senior positions at a slew of Wall Street's biggest derivatives desks, including UBS, Bankers Trust and CSFB. In the early '90s, he walked away from the Street to trade as a local for 18 months on the CME. He's currently the head of Empirica LLC, the investment company he established in 1999. For the most part, he has forsaken the day-to-day grind of trading to focus on research via an endowed professorship at the University of Massachusetts. He's also working on his next book, about randomness in society at large. It's called The Black Swan, named for a worldview he developed around the idea that most people tend to ignore, or live in denial of, the reality that large, random and unexpected events -- black swans -- can and likely will happen eventually.
Would you describe yourself more as a writer or an academic?
I refer to myself as an epistemologist of randomness.
Do you miss trading?
I've been a trader for 20 years, and I still hate trading as much as I did the first day. I have some form of addiction [laughs]. It's love-hate.
Although you now have people who trade for you, can you share with us a little of your methodology?
I specialize in way-out-of-the-money [fat] tails, but I don't like to buy volatility. A lot of people think I just buy volatility, but that's not true, and I laugh when I hear that said about me. I like to sell volatility and buy tails, which is the opposite of what a lot of people think I do.
Please elaborate.
Some of the products we used to offer customers were strategies that were viewed as protection strategies -- buying puts, buying strangles or buying butterflies, for example -- but one thing about fat tails is that the farther you're out on them, the less you have to be right from a probability standpoint. I specialize in options that are between 10 and 20 sigma out of the money. Let me explain better: Let's say I consistently buy a one-month option that is 20 so-called sigma out of the money. How long can I bleed the cost of purchasing those options and still be made whole when a sigma-20 event finally occurs? Years, we suppose. You want to know how many years? (Laughs loudly) More than 5,000 years!
You've been portrayed as a critic of Modern Portfolio Theory.
It's a scam, all of it -- Markowitz, Sharpe, it's just like astrology. Take pension funds, for example. They want to show that they perform proper due diligence, so they say, "We use MPT developed by Nobel Prize winners" and hire consultants who generate fees by supplying them with variations on these models. That way, when they have a problem, they can always say, "Hey, look -- I'm using the industry's standard method of investing." They've made a science out of nothing. Everyone knows it's a joke. The practitioners know it's a joke, but it's a self-feeding mechanism, and nobody wants to abandon it now. This brings us to another big problem we have in finance -- fund managers whose objective function is not necessarily to deliver value. Let's say you make a dollar every day and lose a hundred once every hundred years. People are not going to wait 20 years to evaluate your strategy; they're going to review it every single year and then promote you or demote you based on that year's performance.
So all you have to do is manufacture pseudo alpha and deliver it, and you can show consistent returns and a Sharpe ratio that's very high over a small time frame. Then you're going to be well-compensated. Its perception arbitrage: showing someone statistics that are meaningless.
That sounds to us like something you wrote in your book Dynamic Hedging concerning how a lot of traders get compensated. You called it "accounting arbitrage," yes?
Selling an option that's worth a dollar 100 times is not as attractive as selling a 50-cent option 500 times, because you care only about how many bonuses you get before it blows up on you.
Does this mean you think that the compensation structure for hedge-fund managers is flawed?
People think I'm cynical about hedge funds when, in fact, I'm extremely positive. I think they're a great mechanism. A hedge fund can be so much smarter than a bank or other financial institution in allocating its resources. The problem is I'm very cynical about these big hedge funds, or funds of funds, which are gaming the system.
What was it like working with the Pentagon?
People in the military understand very well that you cannot take things at face value. That you have to look at rare events. They understand hindsight bias very well, and they have a sense of mission. They pay attention to the process and not to results, which is exactly the opposite of Wall Street. I was very impressed; the thinkers I encountered in the Pentagon made me feel ashamed to be talking to them, because they are far more sophisticated than I will ever be.
Were these military people receptive to your ideas?
The people who like my message are those in the military, venture capitalists and pure traders -- people who are devoted to truth and less interested in appearances.
Speaking of venture capital, what are your thoughts about hedge funds moving into more non-public investments?
I'm glad that hedge funds are smart enough to invest in private-equity deals that have not yet reached that mature point. (Venture capitalists) look like idiots locally, but cumulatively it's a phenomenal business, a virtuous business.
A virtuous business? We've never heard venture capital described that way.
Any business that can "make big and lose small" -- that is, long the tail -- is a virtuous business. Economic loss always seems to come from "make small, lose big" (strategies) -- i.e., short options.
So who is it, exactly, who doesn't get your message?
Finance Ph.D.s. I don't really understand why anyone would want to pursue a finance doctorate. If you're interested in finance as such, just become a practitioner. If you have intellectual curiosity, you can study philosophy, biology or history, or something interesting.
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