Essence – Page 4 – Essence of Trading

August 5, 2014May 17, 2017

I Can Never Understand The Central Bankers

I am puzzled by the latest round of statements from the central banks. If these words were coming from a trader or a financial analyst, it is expected. When such statements come from central bankers, it is disturbing.

Like Some People To Act Stupid

The central bankers around the world mentioned many times over the past few months that they like to see the market participants to be more cautious, more fearful while the stock market has been roaring to new high after new high.

What do they mean by "like to see …. more cautious and more fearful"?

Are they saying that they like to see some people (obviously not everyone) to be bearish and somehow not participate in the big bull market while the others profit from it handsomely?

Isn’t that discrimination against a specific group of people within their countries?

Isn’t discrimination a crime in these countries?

Are the central bankers doing something now to make sure some people will act stupidly so that they can get a market that is more cautious?

Discriminatory Intend

These central bankers use money provided by their countries to support the stock markets from time to time has caused significant financial losses for a specific class of citizens, namely, the speculators who refused to believe their stock markets are being manipulated by their governments.

By similar logic, isn’t it discrimination against these speculators in favour of another group of citizens in these countries?

Any government officials doing something even remotely close to such level of discrimination would have their political career terminated for good.

Yet, central bankers can keep doing what they are doing with no consequence.

Qualification Matters

When we are sick we pay our doctor a visit.

When a developer needs to build a building he hires architects and engineers to make sure the building will be safe and sound.

In our society we hire professionals with proper training and scientific background to ensure the serious matters are taken care of properly.

Well, maybe there is an exception.

When a country is managing its monetary policies, they hire economists.

Sometimes, there are things I just do not understand.

July 14, 2014May 17, 2017

5 Similarities Between Profitable Day Traders And Professional Poker Players

I was having fun talking to an old friend who has been playing poker professionally for many years. He is one of those players who consistently making money from playing in poker halls and tournaments but seldom show up in the final tables. During our conversation, he raised the issues of player statistics and how the top players all play similarly statistically speaking. Even more interesting, he thinks the statistical behaviour of the professional poker players is very similar to consistently profitable day traders.

I did some research on the subject and can now confirm what my buddy told me is true. Here are 5 similarities between the professional poker players and profitable day traders that no one pays attention to.

Similarity 1: Very Selective

Non-professional poker players play at least three out of five games.

Professional poker players play only one out of five games.

The figure goes even lower to one out of ten during major tournaments. What it implies is that the professional poker players are willing to bleed chips until the right combinations show up. It is not just your hand that matters. It also depends on what is showing on the table at the time including the behaviour of your opponents and the cards that are visible on the table.

Profitable day traders are doing exactly the same thing when they trade.

Good day traders have the patience to wait for the right setup. More importantly, they scratch when the scenario is unfolding in ways reducing the predictability of the outcomes. In this sense, profitable day traders scratch as many trades as the number of games that the professional poker players give up in tournaments.

Beginners in day trading do not understand that scratching is perfectly valid and necessary as long as the decision is not made due to emotional influence. Having brass balls holding onto your trading mistakes does not make you a good trader. Having the courage to admit that you are wrong will allow you to focus on what is more important – the next trade.

Similarity 2: Well Prepared

Professional poker players are busy. When they are not taking a break they join as many tournaments as they can. It is not that they like to gamble. They understand that the more you play, the more likely the law of large numbers can work for you. They treat their poker games very seriously like a regular business.

Professional poker players also keep up their skills by studying the odds in various scenarios so that they are prepared in handling them when they encounter these difficult situations. It is not how well a poker player playing a perfect hand that counts. It is how well a poker player handles the difficult scenarios to stay out of trouble that protect their bottom lines.

Profitable day traders also use their time wisely when not monitoring the markets in real-time. They conduct research, review their own performances and keep up with latest financial world developments. The time and effort spent help these day traders stay competitive.

Similarity 3: Consistency

The statistics on professional poker players are very consistent. The top players all ended up behaving very similarly if only performance metrics are compared. In other words, the style of a professional poker player does not matter much on pure performance sense. The net winnings may vary a lot among the top players. But that is caused by the limited number of major tournaments available in comparison to the number of active professional poker players.

What this means is that the professional poker players have their emotions under control most of the time during tournaments. They understand that they have no control of the cards in each hand but they can control their responses to management the impact of the game on their overall performance. Hence they try their best not to invest too much emotion into any particular hand they are playing which allows them to perform more consistently.

In essence these professional poker players function like machines during the games. All the odds and scenarios are recalled from memory during the games to minimize guesswork. Many amateurs who have the luck to play against these professionals describe their encounters as facing the Terminators.

Majority of traders do not realize that they have no control over the markets they trade. There is no such thing as certainty in the markets similar to what the poker players are facing. Great day traders are well prepared like the professional poker players that they do not really waste any time analyzing the markets while trading. They merely execute their plans. This reduce their chance of making mistakes and promote consistency in their performance.

Similarity 4: Beat The Amateurs Not The Game

Professional poker players prefer large scale tournaments over the small scale ones. The main reason is that it will reduce their chances of facing very strong opponents in the first few rounds of the tournaments. The more amateurs in a tournament, the more likely the professional poker players can rank higher among the participants. Higher ranking alone means the odds of getting payout is greatly increased. Professional poker players are looking for income from the tournaments, making a killing is just bonus.

Profitable day traders understand that financial markets are like American football where the participants are all part of the game. It is not how great you are in absolute terms that matters. It is how weak your opponents are relative to you that allows you to beat them.

Hence good day traders seek for markets with better liquidity to find good trading opportunities. What it really means is that they are looking for higher concentration of amateurs to take advantage of.

Similarity 5: Profitable Excluding Outliers

Out of all the tournaments a professional poker player played, getting to the top 10% in a tournament only happens 10% of the time. It is long term statistics though. If you only look at a short time window (e.g. yearly), you may find some of these professional poker players getting to the top 10% in 30% (or even more) of the tournaments participated.

The winnings from those top 10% tournament winnings contribute approx. 50% of the winnings the professional players make. The other 50% of their winnings coming from the 50% of tournaments they participated in where they land at the top 50% but not making it into the top 10%. In another words, the professional poker players made money from 60% of the tournaments they participated in. They lose the buy-in in the rest of the tournaments they played.

What separate professional poker players from amateurs in terms of profit distribution?

professional poker players can net positive without the winnings from the exceptional top 10% winnings
professional players have 10% chance of getting to the final table while the amateurs stand at one percent

(Note: Since I cannot gather statistics on professional poker players whose specialty is poker hall cash games, I cannot tell if the same statistics is applicable to them.)

Good day traders are profitable without the glory trades nor the home runs. Make no mistake, those winnings add much to the bottom line similar to the professional poker players. But one has to realize that these winnings happen by chance thus one does not necessarily get them regularly. Good day traders can make sure their trading styles will allow them to capture the exceptional runs when they happen but that is all they can do.

Future Outlook

My friend pointed out that the professional poker players is an ever increasing crowd. It has been steadily increasing ever since the internet and TV popularize poker games. It used to take training partners and many face to face games to horn your skill. Now, if an individual is dedicated enough by memorizing the thousands of scenarios with the related odds in a particular poker game and improve skills through playing online pokers, one can become a professional in a few short years.

The problem, however, is that the big money is concentrated in major tournaments. When there are more professional players playing them, the less likely one can get to the top 10% for the major payouts. The retirement age for professional poker players is quite high as peak performance of the brain is not as brutal as physical intensive activities like sports. Hence the number of professional poker players will keep increasing and dilute the prizes unless more major tournaments are created with more prize money.

Professional poker players can always choose to play the poker hall cash games. The upside is more limited but you have the advantage of anonymity and flexibility with your work schedule. The downside is that you need the extra skillset to control your winnings so that you do not upset the crowd who feed you.

For day traders, since way too many participants are delusional with magic top and bottom picking techniques, the increase in number of profitable day traders is not as fast as the professional poker scene. The complexity of the markets blinds people from accepting the facts that price movements in all markets boil down to the order flow. Hence the financial industry will always find ways to talk their books and line their pockets at the expense of the ignorant public.

As financial markets worldwide keep growing in size and variety, the good day traders are getting more ways to stay profitable and more chances to make good money. In terms of future outlook, being good at day trading has more upside potential than professional poker playing.

Sources

Identifying Online Professional Poker Players: A Revealed and Stated Analysis Approach, Kahlil Philander, Brett LL Abarbanel – 2011

Poker Superstars: Skill or Luck?, Rachel Croson, Peter Fishman and Devin G. Pope

Quality of Professional Players’ Poker Hands In Perceived Accurately From Arm Motions, Michael L. Slepian, Steven G. Young, Abraham M. Rutchick and Nalini Ambady

What’s It Like To Earn A Living Through Poker?, Michael Shinzaki

April 10, 2014May 17, 2017

Having A Trading Edge Is Not Enough

Many aspiring traders who have a scientific or strong common sense background would arrive at the conclusion that if they discover an edge in trading, it is the answer to everything. They think all these psychology stuff on trading are not necessary as long as they have an edge on hand. They think that they will be able to trade to financial freedom and success easily, bypassing all the horror stories of psychological roadblocks many traders experienced.

This is a reasonable conjecture from someone who has not much trading experience. In fact, anyone who have not experienced at least a prolonged period of success in trading, would easily arrive at the conclusion the only thing they are missing to achieve trading success is an edge in trading. The belief that one can avoid dealing with trading psychology completely, or that having a trading edge on hand will overcome the psychological barrier is quite naive.

To understand the reasons why trading psychology is so important, you have to see it from the big picture perspective.

High Probability Trading Setups Are Overrated

When traders talk about a trading edge, they often mean just one kind of trading edge, the entry edge.

The idea is very sexy. If you have a way to determine a low risk entry point, everything else is secondary or even not important. That’s why people are obsessed with high probability trading signals. Every time someone talks about high probability trading setups, something like 90% winning rate, many people cannot resist the urge to check out the claim immediately.

The reality is not quite what the amateurs think. Entry edge plays a very small role in a good trading plan. In fact, any good trading plan would distance itself from dependency on high probability winning setups. It may sound contradictory but once you realize that high probability entry edges come and go, it is not so difficult to understand. For high probability technical setup, it can be hot for a few weeks to a few months but the winning streak will end. When it stops working or suffers normalization, you have to look for another way to engage the market.

As a rule of thumb, very high probability entry edge does not last. Long term structural biases work over a long period of time but they do not usually produce more than 70% winning rate when used without special money management considerations.

Entry Edge Is Not Dependable

No one can strike it big with just entry edge. Not unless you can scale your operation very quickly within a very short period of time while your entry edge is hot. That means you must be well capitalize to take advantage of the situation. But capital is exactly what the newcomers lack of.

The consequence of scaling too fast based on a single entry edge is often crash and burn of the trading account. Here is an example trading model that drop dead on its traders. Not knowing that the entry edge could still be valid but suffering from seasonal or other structural effects only, amateurs turn their back on their findings and continue to search for the next great entry method. Good opportunity to achieve their dreams of financial freedom wasted because of misunderstanding of the role of entry edge.

Entry edge is necessary but it does not have to be high probability setup. In fact, it better be a stable bias than one you have to replace frequently in your trading plan. Remember your dependency on unstable components will ruin your trading completely when it is no longer performing as good as you like it to be.

This is the reason why professional traders have two distinct strategies dealing with this issue.

1. Having a basket of trading setups to trade against a very small number of markets (or even just one market). It is important to remember how to apply money management rules with multiple trading setups.

2. Having a few trading setups (or just one) to trade against a basket of markets. I am not talking about just a few markets here, I am talking about at least 15 or more.

A Proper Trading Plan Include Many Kinds Of Trading Edges, Not Just Entry Edge

A robust trading plan gives you an edge with your trading from all aspects in trading. First, you need an edge with your money management to ensure your trading can survive a failure of your entry methods. You also need an edge with your exit techniques so that they are designed to give you strong survivor bias against your mistakes and execution errors. You need an edge to scale your trading properly so that you can optimize the growth of your capital and minimize the impact of drawdown period.

Think of a good entry edge as the ticket to get you on a boat ride. How the ride goes depends on the ship you boarded. Your decision in choosing the right boat for your ride, limited by the resources you have, will determine the journey you have. People are often quite reasonable with decisions on choosing their rides but no so with their trading plans.

Having the mentality of letting go of your attachment to specifics of your trading entries is important. It opens the doors to better trading performance.

Personalities Dictate Your Ability To Discover Entry Edge

When someone examine the historical data of a market, they view it with a bias. It is a personalized view of the data and attempts to find explanation of the price movements. This personal bias would lead to certain expectations of what the data may do given certain circumstances. Hence the chance of a normal person in discovering a trading edge from historical data will be limited by their understanding of the market, which, unluckily, being tainted by their personal prejudice.

In another words, your personalities will limit your ability to discover and accept an entry edge no matter how good they are.

For example, many great trading setups would never be considered or examined closely because assumptions are made before the data is even looked at. That’s why there are so many people who attempt to create their own special trading methods and so few have discovered anything that works out. It is not because there is some kind of trading secrets that has to be figured out by some genius. It is because majority of normal people cannot see the existence of orders and structures that are hidden in plain sight.

A Test Of Your Confidence In Your Entry Edge

Amateurs dream that once they have created a high probability trading system they would be able to make lots of money in a short period of time. It often works out in the beginning if the entry edge is a pretty good one. However, there is one obstacle to their financial freedom. It is not the trading models they have that is the problem. It is the traders themselves that is the real problem.

A trading setup with 80% historical winning rate does not stay at 80% all the time. Trading models do not have a straight line with their historical winning rate. It may not perform at the same level when deployed. Even if the trading setup performs its performance will still fluctuate.

When your model is not performing for a prolonged period of time, many people will start to second guess their models. It happens even if you have the model fully automated. It happens in your head. This is the situation where an unprepared mind will be devastated by all kinds of thoughts.

Trading Edge Is Not As Important As Your Emotional Stability

Nothing prepares you to handle such situation until you are conditioned, meaning that you have experienced enough number of drawdown periods such that you have been trained in handling these scenarios objectively. It is very rare anyone can stick to their plans following their trading models when things are not working out. The reason is that there is really no simple answer to the question whether your entry edge is no longer working or that it is just suffering its normal drawdown period.

During this difficult time, the trader’s character weaknesses will dictate the reactions to the situation. Someone who has not confronted their own personal weaknesses will not be able to handle such stressful situations objectively. They are pitting themselves into a corner with only bad decisions coming out of their messed up minds at the time.

Ignoring proper psychological preparation in trading has consequence. It is not just important to discretionary traders, it also applies to anyone who think they have a trading edge.

You Are The Edge

Having a trading edge, specifically an entry edge, is not the be all and end all solution to successful trading. It is necessary to have one but it does not need to be a high probability trading setup. The more important thing is to develop a complete trading plan that you, as a person, can really follow without suffering the emotional swings caused by the performance fluctuations.

Traders are not stamped from a machine with no emotions. As traders, however, we can plan ahead of time in a way that minimize the effects of emotions on our trading. Having a contingency plan in place to deal with potential drawdown periods will save you from making costly mistakes. Such contingency plans, however, require your understanding of your own strength and weaknesses.

As a summary, your focus on finding a trading edge should not be limited to an analysis of the historical data. It should be, instead, focused on developing yourself. Your ability to adapt to the changing environment is more important than a technical trading setup. Your ability to discover and identify the current market dynamics is many times more useful that a static entry edge. You are the trading edge if you can utilize your strength and handle your weaknesses.