Month: April 2012

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Clarifications to Some Basic Concepts in Probability

I wrote many articles on statistics over the years (Teaching a Grade 4 on Probability, Understanding the Market in a Statistical Way, etc.) and advocate traders to pay more attention to proper application of statistics in trading and model development.

I came across this educational video by Peter Donnelly from TED that explains several basic concepts in statistics clearly.

There is no point for me to repeat his work, so I will just include the video here.

 

 

In case your browser does not support HTML5 embedded video, here is the link directly to the lesson itself,

http://ed.ted.com/lessons/peter-donnelly-shows-how-stats-fool-juries

 

Relating to the Video

The HTH vs HTT occurrence frequencies – It is one of the most overlooked and misunderstood basic pattern recurrence behaviour.

Many rookie traders and trading model designers often assume that certain common patterns (price, indicator, geometry lines) are useless because of their potential frequent recurrences. What they have overlooked, is that, first the assumed common patterns are not that common (like HTH) and second, the importance of any recurring pattern is not how common or rare it is, but the consistencies in the expected outcome following the occurrence of such pattern.

Here is a good teaser – How often does S&P make new year high after the last occurrence has led to 1% (or more) drop in price?

The 99% interpretation issue – You think your trading setup has a 80% win rate is pretty good, think again.

Most successful traders know their own performance pretty well. They are often better than computers in analyzing real-time scenarios. In their heads, they can picture the possible scenarios and reduce that to actions that improves their profitability.

Such mastery is not just a plain 80% win rate or other simple measurement can do to discover or qualify a method.

80% win rate is an overall measurement. It does not take into account the separate performance of a correctly identified setup and a falsely identified one. Often traders cannot even distinguish the two scenarios for trading setups they use all the time.

For example, a 1-2-3 sell setup can fail and results in a bull flag upside breakout pattern. 1-2-3 sell setup works best if the trader can identify the strong resistance area to key off the setup.

A good combination can be 90% of the time you identify the trading setup at a good resistance zone where 90% of those identified setups result in profits, and that in the 10% of falsely identified setups, you still edge out 50% winners. The reason why this is a good combination is that your expected performance will likely to have good consistency.

A bad combination could be 50% of the time you identify the trading setup correctly and 90% profitable on those correctly identified ones. And then in the other 50% of trading setups, 70% of the time you edge out a profit. In this case, even though the historical performance is around 80% win rate, you do not really know why your setups are producing profit. In fact, that 70% winners out of the falsely identified setups could be just random outcomes. Worst yet, traders often try to improve the win rate by adjusting the stop loss which simply curve fit the trading setup to perform better on historical data. Those extra winners in the particular 70% is likely a result of that.

The rare case independency issue – Traders often make the mistake in thinking that since a (huge) losing trade based on a particular setup is very rare, why not double down, triple down, or bet the farm on the next occurrence of the trading setup. People justifying such measures are likely in a losing streak. In such stressed situations, bad ideas often pop up and this is one of them.

Even if the huge losses are rare and likely independent, that does not change the potential of the very next trade being a loser. Betting the farm or sudden increase in bet size in general will significantly affect the expectancies with your trading method. If it is not something you have anticipated and well planned out, it is just plain stupid doing that knowing the consequence can wipe out your trading account.

Professionals in various fields often misuse statistics – In the video Peter Donnelly pointed out this very important issue that infested our society.

Doctors, lawyers, economists, security analysts, etc. are not statisticians. Yet these professionals frequently try to draw conclusions and inference from data they have compiled. Often these inference are incorrect and misleading. Unluckily there is no rule or regulation to, say, revoke their professional licenses for misuse of statistics. At the receiving end of these analysis and conclusions, it is difficult for the public to protect themselves from these misleading information.

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Emotional Imbalance Can Impact Your Trading Decisions (and Profitability)

What I am going to talk about is not the kind of emotional roller coasters from life-altering events that we know for sure can cloud your judgement. It is something more subtle and will surprise a lot of people.

A Good Read

First, I have to mention the book Risk by Dan Gardner as one of the influences that drive me to write this article. I have the book for a long time. A reread of the book lately reminded me how easy people are affected by the environment they are put into. The implications of such influence on traders are profound and can affect their bottom line without them knowing the reasons at all.

There are two main points delivered by the book. First human mind functions with a 2-tier system – one by gut, and another one by our head. Examples after examples presented in the book on real-life events and experiments done by academics prove that humans can be conditioned by the information they get in touch with, without really reading or listening to them at all. Second is that once human gut is overwhelmed by a strong feeling, it in turn influence the opinion formed by the person in other issues as the logical part, the head, is suppressed.

All it takes is that a person is exposed to words / sound / visual that they can associate with a specific feeling or bias. Then the gut side of that person takes over. Opinions will then be biased disregarding the actual content of the news reports or articles these people that are going to read or listen to. The changes is subtle. Most of the time the opinion is just nudged a bit more towards the opposite end.

In normal situation, that is not likely going to affect people greatly because they can keep their opinions to themselves.

But the book shows us that when the biased opinions somehow formed right before decision making on important issues, it becomes a problem. From survey results, penalties given out to a sports team, emergency policy making, to people voting for their government officials , the biased opinions can really mess up the world.

The Sources can be Trading Related

Think about the news that people read in the morning – economic reports, earning results, overseas markets performances, etc.

All these reports are not written with plain wording. Instead, we see “strong economic data”, “disappointing results”, “overseas markets very bullish”, “spectacular earning”, etc.

All these words that one can associate with some kind of feelings, some we recognize consciously, some we don’t. Depending on the stories that a person read, it will shape this person’s mood without him/her knowing.

My guess is that if a person is conditioned in an aggressive or irritated mood, that can easily push the person to take on countertrend trades, oversized trades, or refused to cut losses. If a person is conditioned in a depressed or frightened state, the person will have difficulties pulling trigger or managing an existing position.

The Sources can also be Non-Trading Related

There are other news that are not related to the markets but you read them, heard them, listen them anyway. Keywords like “upsetting tragedy”, “happy ending”, etc.

The conditioning can also come from sound, visual images and physical contacts.

It can also be incidents like a prank done on you by co-workers, could not get a parking spot in 20 minutes, being reminded to exercise more by family members, etc.

It does not happen all the time, but occasionally the accumulated effect can be pretty one sided, and you will be conditioned without knowing.

Some Useful Techniques Known to be Helpful in Restoring a Balance Mindset

So many things can affect us, is there something we can do about it?

There are well known techniques people use to clear their minds. It can be simple and easy to do.

Techniques often used to clear the mind, empty your thoughts, or giving you the inter-peace:

  • exercise
  • a walk
  • a swim
  • meditation
  • breathing exercise

Many people find that in order for a technique to be effective, you need to do that consistently.

The important thing here is to clear your mind from thoughts you are stimulated earlier in the day by media, email you read, website you browsed, etc. or emotional swings from major issues in your life. Given enough practise of the same routine everyday, even if your mind was clouded, you would still gain a small window of time that your mind is not filled with prejudice.

That moment of a balanced mind would allow you to make an assessment of yourself whether you are fit to trade for the day.

A balanced mindset is not one without an opinion. It is one that is flexible enough to see other possibilities.

i.e. You can be very bullish as long as you have an exit plan that you are going to honour.

Some People Find It Difficult to Read Charts All the Time

I have seen many people, given enough training in basic chart reading techniques, produce inconsistent results in their chart reading analysis most of the time. The idea that external influence affecting a person is a plausible explanation.

Some people are just affected by other people’s opinions more easily.

Some are just more pessimistic overall comparing to others.

Some are more optimistic than others.

Almost all of us, one way or the other, would be affected by our emotion in making a trade. But some people are just affected by emotions more often than the others. For these individuals, it is very difficult to separate their objective analysis and emotional bias.

I am not sure to what extend the techniques mentioned above can do for these more emotional individuals.

The Goal – A Detached Mindset

Without a balanced view, the basic rule of letting the chart telling you the story is violated. The rest of the decision making process is no longer applicable. This is effectively turning trading into gambling and we know it is not a good thing. Worst yet, if the ability to accept a loss and move on is shutdown from the analytical process, a small loss is likely going to turn into a disastrous one.

If you find yourself struggling with trading from time to time and that it seems like the bad days coming from nowhere. Take some time to reflect on yourself to see if it fits the symptoms described here. If so, you should give the mind clearing techniques listed above a try.

The goal is to eventually detach your emotional side from your trading decisions. It sounds easy but it is quite difficult for most people.

Think of a physician – before qualifying as one, the rigorous training required is a process to enforce diagnoses done with professional knowledge and opinions with the goal to minimizing the impact of judgement affected by outside influence. Even with intensive training and actual experience, it is not possible to eliminate all the errors made.

Surgeons are generally recommended not to operate on their close relatives for a good reason – the emotional aspect of a person can affect his/her professional judgements.

After all we traders are just humans.