Long & Wrong

In our imaginary market the price has twice rallied strongly from 100.00, because we are being as simple as possible we assume that it will do the same again. Also, again to make this as simple as possible, we will be deciding on a fixed entry, stop and target.

Entry

So where do I enter?

The obvious long entry is at 100.00 but it is such an obvious trade that perhaps everyone will get in ahead of me and we won’t get that low.

Raising my entry price increases the chances of getting filled but at the same time decreases my profit if I win and increases my loss if I lose.

Conversely, lowering my entry price reduces any loss and increases any profit. Although if I reduce it too far then the support will have been breached and the market will probably be heading lower or, as already noted, I won’t get filled and I’ll sit here and watch the price reverse without me.

So there are a few conflicting factors to weigh up here.  I’ll think about it later and move onto my stop.

Stop

Lowering my stop increases the amount I might lose, but it also decreases the chances that I will be stopped out just before the market eventually reverses.

Even if the price breaks well below the support it could still be a false break-out and I could be stopped out on what would eventually be a profitable trade.

This is also difficult, I’ll think about it later. I need to consider the final element of this simplified trade, my profit target.

Target

Increasing my target price decreases the probability that it will be reached but increases the return.  Math(s) can help me here, I need to place my target where it maximises the product of the probability of the target being met and the profit that would make.

That is simply the maximum point on a curve, a curve I can’t draw though. I’ll think about that later as well.

The Trade

Hang on, that last idea sounded a bit like ‘expectancy‘.  I can use that concept to simplify every element of this trade. I need to place my entry, stop and target such that the probability of the target being hit multiplied by the number of pips won is greater than the probability of the stop being hit multiplied by the amount lost.

Say what?

My Point (yes there was one).

What I am trying to say, and well done for making it this far, is that even the simplest trade is far from simple.

[@DT233... I've posted a chart, don't delete me!!]

This is interesting, well executed and clearly explained.  It is also related to trading in ways that would do your intelligence a disservice if I were to explain it…

http://www.bbc.co.uk/news/magazine-10729380

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.

You’ve had a bad week; 12 trades in total, only 2 of them winners.  You are trying to decide between drinking half a bottle of fine scotch or kicking the cat. But wait! What you really need is some maths (I know this is going to be a hard sell) and more specifically a Binomial Distribution Calculator.

Knowing you made 12 trades (n=12), knowing (who doesn’t?!) your  historical win rate is 35% (p=0.35) and knowing, but regretting, that you only had 2 winners (“fewer than” 3), you can calculate that the probability is 0.15.  In other words 15% or, more tangibly, 8 weeks out of the year will be this bad.

You learnt it at 14 and forgot it at 30.

So don’t shout at someone who asks you if you have had a bad week, just calmly tell them “that according to a binomial distribution the probability was just 0.1513“.  Then shout at them if you must, drink half a bottle of scotch if you must, but don’t ever kick the cat.

[Thanks to the person who gave me the idea for this post, the data however is all my own creation]

I had planned a post based around the equity curve simulator that I take every opportunity to plug. I do this  because I feel it is really important that people understand the extent to which the variance in their trading account is nothing but cruel, unfeeling, performance-independent chance.

I had only recently noticed, or at least properly appreciated, that the equity doesn’t converge as the number of trades increases. Contrast this to the way that the percentage of heads will tend to 50% as the number of tosses of a coin increases, as the standard deviation=square-root(N*0.5*0.5) where N is the number of tosses.

This non-convergence suggests that we can all trade until the cows come home but the amount of money in our bank will never absolutely reflect how good or bad we are at a trading.  I tried to do something really clever with the maths at this point to reach an important and paradigm-shifting conclusion.  However,I failed, so I am left with only half an argument, half a brain and half a post. I’ve let you down, sorry.

Even then, the money in the bank doesn't accurately reflect how good we are at trading.

I know that I go on a lot about probability but it keeps raising its ugly head again and again…

Out of the goodness of my heart I have been coaching  a few struggling traders.  I can’t offer any more than a moderate return after lots of hard work (because that is all that I can manage myself) but there still seems to be interest. You’d have to ask them what they have learnt from me but I do know what I have learnt from them – being comfortable with probabilistic, rather than deterministic, outcomes is key. Two basic scenarios have played out with sufficient frequency to convince me that they are important lessons in themselves.

1. After going through the basics of my approach to trading I invite them to sit on my virtual shoulder and watch me trade.  So I start another dull Monday morning and they think they are about to glimpse the Holy Grail.  My first trade loses, my second trade loses, my third trade does the same but my fourth trade, erm, also loses. It is around losing trade 3 or 4 that there is a sudden family emergency that means they have to leave their PC and I never hear from them again.  They probably consider me to be at best a fantasist and at worst a fraud.

They are not there at 16:30 on the Friday afternoon when 80 trades have returned a decent, and statistically significant, yield. Trading isn’t about Monday morning (either literally or metaphorically) it is about letting the law of large numbers play itself out in your favour.

2. My second lesson from mentoring struggling traders is that they seem to crave certainty.  What set of conditions will lead to a winning trade? The correct question of course is what set of conditions leads to a trade where the probabilities lead to a positive expectancy?  I can show you the perfect trading set-up according to my strategy and it might lose. I have  the proof though that over a sufficient number of trades it will make me good money.

We live in a world where we ‘do X to achieve Y’, well it doesn’t work here.  The best we can hope for is ‘do X to sufficiently increase the probability of Y’.  You do not nudge the win-rate ever closer to 100% by maxing the conditions ever more complex, uncertainty is part of the game, who knows when someone is about to sell a yard of USD/JPY and wipe-out your long?

This is understandably difficult to grasp (and even more difficult to apply).  The worst case of this kind of thinking is when they show me a trade that made them an absolute fortune because (their word) a certain set of conditions were fulfilled. They then go on and apply this same method  (sample size=1) again and again and again and, for those with deeper pockets, again and again and again.

The Doctrine of Chances

I don’t know how to shift people’s thinking into this ‘probability space’, perhaps if I could I would have a better success rate trying to help others.  There is plenty on the web about why we seem to struggle to think in this way, a readable starting point is here but there are no easy answers.