Long & Wrong

One of the most enduring trading debates concerns the ‘best’ reward:risk (R:R) to aim for.  My answer to that is as obvious as it is  boring (the one that maximises profit for  tolerable risk) but that won’t fill much of this white space. So lets instead look at one argument for lower R:R.

Two traders, A and B, have exactly the same expectancy per trade (5%) and make exactly the same number of trades per day (5). They will, over the long term, make the same  amount of money.

Trader A is happy to take trades with a R:R of 2 but Trader B holds out for 5.  With the same expectancy Trader B has a much lower win-rate than Trader A but that is OK because he makes more when he does win and this balances out exactly. Mathematically they are similar, but practically there is a big difference.

In a typical month of trading Trader A can expect 2 days where every trade loses, Trader B however will experience 8 of these days. That is a lot of pain in terms of draw-down and, if Trader B has emotions(!), a lot of emotional pain as well.

I am not defending low R:R systems, I am just adding some numbers that demonstrate how increased R:R markedly increases variance and pain.  If you are only bothered about the average annual profit then you can ignore this, but if 8 days of pain a month sounds intolerable then this might give you cause for thought.

I’m not even going to mention that The Gambler’s Fallacy shows us that after a losing day the probability of another losing day remains unchanged and, for Trader B, depressingly high.

An interesting (and on the face of it, remarkable) fact for you to start the week…

According to Associated Press (Stocks post biggest two week gain since November),

The week that follows the June expiration is often a losing one for investors. The Dow has posted a loss during that week for the past 11 years, according to the Stock Trader’s Almanac.

We’ll find out at the end of the week, just for fun I’m short at £1/pt. Proceeds to a good cause, losses to be reclaimed from the good cause (as if!).

Updated: Replace the number ’11′ above with ’12′! I entered when I got up on Monday and had to close the trade from a lay-by on Friday as I had taken the day off.  However, somehow in that chaos, it is a little under £300 donated to a good cause.

Not trading but something that, for me at least, is very closely associated with trading…

Take 2 before attempting to draw S/R lines.

According to a recent study, drinking coffee doesn’t make you more alert,

The millions of people who depend on a shot of coffee to kickstart their day are no more alert than those who are not regular coffee drinkers, say researchers.

A cup of coffee [...] only counteracts the effects of caffeine withdrawal that has built up overnight.

but another study concludes that whilst I may not be more alert I may have a healthy heart,

“It’s basically a good news story for those who like tea and coffee. These drinks appear to offer benefits for the heart without raising the risk of dying from anything else,” said Professor Yvonne van der Schouw, the lead researcher.

I’ll drink to that.

You remember the deal? I’ll post charts once the summer is over but until then I can indulge myself with the usual nonsense, including ‘3AM Thoughts‘…

Trading is a ridiculous activity. If you want to make money, unless you are in a tiny minority of people, then you would be much better off getting a real job, playing poker or backing a 3-legged horse. But we continue to put disproportionate amounts of effort into the challenge of profitability, the reasons for this fascinate me (and I don’t think the ‘gold at the end of the rainbow’ is the dominant one).

As is usual with these 3AM thoughts, let me digress for a while. Dogs have an incredible sense of smell thanks to their 200+ million scent receptors (humans have 5 million).  This provides them with incredible sensitivity, even capable of detecting cancer in patient’s breath. This ability is due to these multitude of receptors, having a larger part of the brain dedicated to this sense and an additional chamber in their noses where odours can be ‘amplified’.

Humans though lack this level of sensitivity, our sense of smell is perhaps  1/100th that of a dog.  This is because in our evolutionary history the sense of smell was less useful than another skill.  A good sense of smell requires a big nose and this obscures the face. Humans evolved as emotional beings who needed to be able to quickly analyse if a fellow human wanted sex or wanted them dead (and rarely, both). We gave up a big nose in favour of a face that provided emotional information.

This ability to sense other’s feelings is also closely tied up with our desire to trade.  Even with the advent of cheap videoconferencing there are salespeople clocking up tens of thousands of miles a year because they know that to do a deal you need to ‘look someone in the eye’ when negotiating (ideally without a large nose in the way).

So my 3AM hypothesis is that we love trading because it satisfies some ancient desire to buy and sell. We have been trading since the stone age, where early man overcharged his fellow man for a handful of flints and obsidian. In the same way that we will spend our weekends waiting to catch a fish to satisfy the ‘hunter within’ we will spend our weekdays trading to satisfy the ancient desire to buy and sell.

Only 3 or 4 months of this to go and then you can get feast your eyes on some chart-candy. I do though promise to be more practical next week.

The following is a transcript of a recent conversation. I have heavily edited it to make me sound smarter than I really am and to remove any irrelevant material (such as a brief heated debate on the relative merits of Adriana Lima and Gisele Bundchen). I was trying to trade but someone was taking a keen and not wholly welcome interest in my screens…

A.N.Other: So when are you going to make a trade or whatever it is called?

Long&Wrong: Well, the price is trending upwards so I am waiting for it to pull-back a bit, then I’ll buy.

A.N.Other: So it’s going to keep on going up?

Newton's 1st Law.

Long&Wrong: Corpus omne perseverare in statu suo quiescendi vel movendi uniformiter in directum, nisi quatenus a viribus impressis cogitur statum illum mutare.

[This is, of course, a complete lie. I didn't quote Newton's 1st Law of Motion in latin. I did though mumble something about objects in motion tending to stay that way]

A.N.Other:  If it’s going up why don’t you just buy now, why wait for it to go lower first?

Long&Wrong: It’s better to wait for a lower price then if it does go up I’ll make more money, and if it doesn’t I’ll lose less.

A.N.Other: So you might be wrong about it going up?

Long&Wrong: Quite possibly.

A.N.Other:  But if you wait and it does just keep going up then you’ll miss out, why don’t you just buy now. Go on!

Long&Wrong: I’d rather wait thanks. Missing a trade is not the end of the world. Expectancy=zero isn’t the worst ever trading decision. Actually, that’s quite interesting. Not taking action when that action had positive expectancy is a kind of virtual negative expectancy.

A.N.Other: What?

Long&Wrong: Never mind.

A.N.Other: So if the price fell all the way down here then you would definitely buy shed loads? [pointing annoyingly at the bottom right hand corner of the screen and leaving a fingerprint that I can still see now].

Long&Wrong: No, I’d be selling.

A.N.Other: But if it is good value a bit cheaper than now, then it must be going really cheap down there.

Long&Wrong: [Now getting a bit annoyed] It doesn’t work like that.

A.N.Other: [After a short sulk] But that’s stupid. If a house is a bargain at £180k then you would be crazy not to buy it at £100k.

Long&Wrong: Like I said, it doesn’t work like that. A cup of tea would be nice.

This conversation shows that I am intolerant and grumpy when trying to concentrate. It also though illustrates my trading strategy, or perhaps more properly my trading meta-strategy,  in a way I hadn’t really thought about before.  Whatever the details might be, two key aims are to always look for good value and to be very clear and unemotional about what moves my finger from the buy to sell key.

A fresh start demands a healthy dose of cynicism.  I get  bored of  those “earn thousands from home in just a couple of hours” and  ”trading the euro is easy” banner ads so I thought I would add a bit of opposing hyperbole, an imaginary job advert…

Situation Vacant – Retail Forex Trader.

Location  - Home.

Salary – Unlimited (in both directions).

Candidate Profile

The ideal candidate will be looking to escape the routine of working 9 to 5.  They will achieve this by working from 8AM (Sydney) to 6PM (New York).

Some experience of routine work, such as working on a production line, would be beneficial.  The succesful applicant will be required to repeat the same task over and over again without deviation. Although it may take them a few years to realise this.

This post offers a unique environment for the right candidate looking for promotion. There is none. Ever.  It’s the same job on day one as on the day you retire, although the chances of you making it to retirement in this post are so slim that we don’t bother with any pension scheme.

This career is guaranteed to provoke a negative response from friends and family so a thick-skin is required. You may be accused of single-handed destruction of third world economies, gambling with your children’s future or told every day to “get a proper job where you make stuff”. This career is ranked below estate agents and only slightly above international terrorists.

UK Applicants: This post is exempt from minimum wage legislation, you are not guaranteed £5.80 an hour. You are not guaranteed anything, apart from  crippling losses during your probationary period.

Of course it isn’t really that bad. Some days.

Every experiment should reach some conclusions…

I learnt from my recent experiment that public opinion is correct, you can’t trust traders!

I don’t know if one or more of you kept hitting F5 (to refresh the page) but someone clearly has.  Add to that some blatant (and inaccurate!) plugging from Jules and my post to see if anyone was still casting an eye this way received many more visits than any previous posting.

This causes two problems. It encourages me to start blogging again and Solfest will use this as evidence of how easy it is to falsify experimental data. He will then claim that the planet is actually cooling and we need to start extracting oil from tar sands to avoid an imminent ice age.

In the end I concluded that if someone has the time/ingenuity to fiddle the data then that is the kind of slightly corrupt readership that should be cherished. I am going to start writing the usual infrequent nonsense here over the summer and then plan something chart-centered in the autumn (fall!) on a new parallel blog.

Let the fun (re)commence…