Welcome to MarketPulse, Australia’s most insightful look in to the markets and trading! In this week’s MarketPulse we are going to continue the discussion started in last week’s article regarding the creation of a robust and effective trading system.
Last week we learnt the importance of understanding the expectancy of our trading systems. Expectancy helped us determine whether our trading system was likely to be profitable in the long run. Traders who do not know their expectancy can be said to be ‘trading blind’.
In this week’s article we’re going to investigate how important the concept of consistency is in developing our trading systems.
Garbage in – garbage out
Ever heard of the term garbage in-garbage out?
It’s a term used by computer programmers to describe how incorrect input will result in an incorrect result from the computation of the code. It makes perfect sense doesn’t it? Put simply, it means if you do the wrong thing, you can expect the wrong result.
Consider this: Is it the computer’s fault that it didn’t do what we wanted? Of course not! We did not enable the computer to perform in a satisfactory manner.
Well, our trading is much the same, but with the markets replacing the computer. The market is an inanimate object perfectly developed over the years to process both good and bad inputs and to deliver traders corresponding results. Give the market a set of inconsistent and poorly designed inputs, and guess what you are going to get!? (You’re going to lose money!)
Conversely, give the market a set of well crafted and consistent inputs and we should be equally rewarded. In each case it is not the fault of the market that an undesirable result is achieved, but rather that of the skill, or lack thereof, of the programmer.
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This is the basic premise behind the need for traders to develop a system. There’s two ways one can look at our present results:
1. I am being consistent, but am getting a bad result with my trading – therefore I must be doing something wrong. What do I need to do to change in my inputs and therefore improve my outputs?
2. I am random in my process and therefore am getting a random result with my trading – where am I going wrong?
In the first instance, we have a consistent approach but are not getting the desired results. We at least have a reference point for making improvements. If we continue to do the same thing we will continue to get an inferior result. We need to change what we are doing to get a different result. We need to do something different to break the cycle.
In the second example, we are getting a random result which includes some success, but also unfortunately large and frequent bouts of underperformance. Our account balance see-saws up and down with the markets. We can’t seem to take that ‘next step’ to consistent and long term profits. Because we are equally random in our approach, we therefore experience random results.
So which scenario would you rather be in? Scenario one where we are consistent in our approach but are consistently losing money, or scenario two where we are random in our approach and are randomly experiencing bouts of both success and failure?
In answering this question first consider: if we do not have a systematic set of rules to determine how we trade, then how do we expect to get consistent set of output data to help hone and improve our trading performance?
If our trading approach is random, then so too will be our results. We will never know which elements of our trading approach are delivering us the desired performance, and which elements are delivering us the undesired performance.
We need to systemise our input, so we can better analyse our output (i.e. Scenario one is better because at least we have a consistent reference point for improvement!).
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Hey Mr (Ms) Stupid!
At this point, we’d like to quote Paul Tudor Jones on what is one of this writer’s favourite market sayings. Just as a quick background, Tudor Jones is one of the most successful traders of our time, having made literally hundreds of millions over the years out of the markets.
In the classic trading title Market Wizards by Jack Schwager (compulsory reading for all traders), Paul recounts a time early in his trading development at which he was sustaining financially and psychologically crushing losses. His poor performance was reflecting perfectly his poor risk management techniques.
In an epiphany, Paul realised that if he consistently risked too much capital, he would consistently endure an eventual massive loss which would send his trading account back to its starting balance (or worse!) Therefore, he concluded that the only way to get a different result was to reverse whatever it was which gave him the undesirable result in the first place.
“I said ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather that pain?’”
Paul realised that if he consistently performed an action, that of risking too much per trade, he consistently experienced an inferior result. Once he changed his process, his results changed accordingly. The rest is as they say – history!
Often, it is this realisation that trading does not have to be a painful or fearful experience that triggers us to take that first step to developing a trading system. The important thing to note from Tudor Jones’s story is it’s far easier to identify where change needs to be made, and then measure the impact of a change, if we are perfectly consistent from the outset.
Unfortunately most traders are far from consistent in their approach. They are likely to be using a mix of analysis methods and trading informational inputs, not knowing which is effective and which is detrimental to their performance. They can’t even define exactly what it is they do to enter a trade because it is a little different each time…they’re doing nothing more than pretending they know what they’re doing and then hoping for the best!
If you take anything away from this week’s article, it should be this: If you get consistent with your inputs, you will get consistent with your results. If you get consistent with your results, you will get an idea on how to improve your performance. Don’t do this, and you’ll never get out of the performance rut you’re now stuck in.
A trading system is a set of well defined rules designed to improve the probability of a favourable outcome, and to ensure that favourable outcomes deliver greater performance than losses from unfavourable outcomes. This is the very essence of the expectancy equation. A systematic approach will breed consistency, from which all true and sustainable performance improvement flows.
In this Strategy Centre article, we simply wanted to set the course for readers in developing a trading system and to inspire you to undertake a more consistent, rules-based trading approach. If you can relate to some of the concepts we have discussed, it’s likely you are experiencing a high degree of frustration over making the same mistakes time and time again (and inevitably getting the same undesirable results!).
Well, the best way to fix these mistakes is simply not to make them in the first place! By developing a set of rules to determine how we act in every instance in the share market, we can guard against such errors. Furthermore, we will be presented with a good set of data from which to determine where undesirable results have come from – and therefore make the necessary changes to deliver improvement.
Next week, we look at the elements required to actually build a robust trading system.