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1. A small win: You take a profitable exit, this is usually a short term trade.
2. A big win: You let a winning trade run when you are on the right side of a trend. This is the biggest contributor to profitable trading as it increases the reward side of your risk/reward ratio. Trailing stops are the best tool for creating big winning trades. You leave your profit side open for as far as it will go.
3. A small loss: You exited a trade for a loss when your entry signal was invalidated by price action going against your position. Your stop loss was usually triggered quicker than you expected.
4. Break even: Your time stop was triggered or you moved your trailing stop back to even after being in a profit.
There should not be a 5th scenario. You should never experience a big loss. If you can get rid of big losses, you have a great chance of being profitable for years to come. The tools for eliminating big trading losses is proper position sizing based on a market’s volatility, well set stop losses. and flexibility in accepting when your trade is not going to work out. Big trading losses is the primary reason the majority of traders are not profitable.
“There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future, when the odds will be running against you. You can also lose a good bet no matter how sound the underlying proposition, but if you keep placing good bets, over time, the law of averages will be working for you.” – Larry Hite
There’s two types of market returns. Alpha and beta. Beta is what you get for diversifying and passively holding the market. Alpha is the opposite. It requires an edge, of which there are three: informational, analytical, and behavioral.
And as Ray Dalio says, “Alpha is zero sum. In order to earn more than the market return, you have to take money from somebody else.”
Harvesting alpha takes significant work because it involves separating someone else from their capital. And that someone else is trying to do the same to you. Most traders and active investors are in the game to produce alpha.
The competition among alpha players is what creates mostly efficient markets.
Once in awhile, Mr. Market throws a tantrum (or gets too excited) and a mispricing occurs. This opens up an opportunity for alpha players to profit. These opportunities often don’t last long. Other alpha players swarm to take advantage the second they detect blood in the water. Once enough catch on the market returns to an efficient state i.e. random forward returns.
Using this mental model of the game we can deduce that high quality trading is episodic, not continuous.
Trying to capture alpha continuously would be like playing every starting hand in Texas Hold’em. Expert poker players know that it’s virtually impossible to win long-term with the bottom 80% of starting hands no matter how good your post-flop play is.
In trading, it’s impossible to harvest alpha every single day. The market is highly competitive and Mr. Market rarely screws up with such high frequency.
Being a trader, you need to learn to patiently sit through long stretches of getting dealt duds. In poker we call this “sitting in Siberia.” This is when you have to sit and fold for hours and hours waiting for cards that have a positive expectation while the rest of the table has fun pushing chips into the middle. Trying to trade during these “Siberia moments” in markets is a profitless endeavor over the long haul.
Continuous trading creates subpar performance because exposure to inefficient market states get mixed in with exposure to efficient market states.
If you take the right side of the market during an inefficient state you will make money long-term. But when you initiate a trade in an efficient market your expected return is 0. And you still have to suffer through the volatility of each trade. It’s a waste of time, resources, and energy. You have to go through all of the work for no reward.
That’s why it’s important to think of trading episodically and not continuously. You don’t want to mix the good with the bad. Structure your trading similar to how a sniper goes about his business on the battlefield — a series of high impact and deadly episodic strikes.
The corollary to “high quality trading is episodic not continuous” is the rarer the market dislocation the greater the edge.
There’s a few reasons for this.
First off, an event that occurs seldomly is less understood than an event that happens frequently.
Uncertainty and confusion in the market is what creates an edge for the alpha players who are able to make sense of things.
Second, the professional quant community ignores rare events as sources of edge — which creates less competition.
Conventional quant techniques look for statistical significance. That means quants need to see lots of historical occurrence to prove that their trading methodology is legit. If there aren’t enough historical occurrences, they will write off the approach as spurious.
The ‘professional’ quant methodology guarantees that they won’t and can’t act on the highest alpha opportunities in the marketplace, leaving the lion’s share to human traders utilizing intuition and experience. Trader intuition and experience is powerful because it enables traders to identify rare alpha opportunities despite a low number of historical occurrences.
So if you’re an independent trader who
Believes that high alpha trading is episodic not continuous
The rarer the dislocation the more alpha
Here’s what you can do to shift your approach to produce better risk adjusted returns.
Start by weed wacking your trade “setups.”
Take the bottom 50% of your trading opportunities and cut them out. Then take the remaining trade setups and cut them by 50% again. This will align you with the philosophy of rare events (the most optimal setups) and make your trading episodic rather than continuous.
Then consider trades that make logical sense to you but don’t have many historical occurrences.
These trades will always have the fattest edge and the least amount of competition because other traders will pass them up.
Finally, expand your playing field as much as possible.
This is in line with our global macro approach at Macro Ops. Because high alpha opportunities are rare, a particular market will only generate a few quality signals a year. That puts a cap on your earning potential. The only way to make more money is to increase your discovery space. That means getting involved with other markets like currencies, rates, grains, meats, softs, volatility, crypto, energy, micro-caps and metals. Hopefully over the course of the year these markets will generate additional rare alpha opportunities that you can capitalize on.
So many people will quickly judge traders and investors as gamblers. In many families you can’t discuss trading openly without judgmental stares, rolling eyes, and disapproval. The general public does not understand that on a deeper level everyone is a trader in some way. We trade one thing in order to receive another thing. Not many people really judge if they are making a good trade in time, energy, effort, and stress for what they receive in return. Let’s think about this…
Employees get up before their shift begins, get ready for work, and drive to their employer. Then the work begins. It could be an 9am to 5pm job with a lunch or a long day as a salaried employee before being done and then driving back home. Employees must consider not just the time, but the energy and effort that it takes to earn a paycheck, not to mention the opportunity cost. Could you be doing something more profitable with your time? Does the pay from the job make up for the sacrifices? Most never examine if their job is worth it. They just feel they must have one and changing the current one is harder than sticking with it. Some people trade time for a paycheck.
Sometimes people stay in a terrible marriage for too long, stay connected to a dysfunctional family, or hang out with friends that are bad influences. Staying in a situation that makes them miserable is their path of least resistance instead of pursuing a path that could lead to a happier life. They trade a potentially better future for a known and familiar now. They prefer certainty with unhappiness for a different possibility with some life changes. Some trade happiness for security.
Many politicians only end game is votes and being elected. They are more actors than statesman. Their sponsors and donors get returns on their campaign contributions. They do what they must for the sake of success and power not what is right or fair. Some trade principles for politics.
There are people that have principles and then there are people that can be bought for a price. Greed and ego can lead people to do things for money that are illegal of immoral. Some people have morals and other have a price. Some trade ethics for cash.
Then there are financial traders. They trade money to buy things that could go up in value. They trade exposure to risk of their capital for the potential for capital gains. Some people trade risk for profits.
Everyone trades one thing for another, the question is whether the exchange is worth it. Everyone is a trader. The next time you are judged for being a trader with rolling eyes you can ask your judge: “What do you trade your time, money, and energy for?”
“There are loads of success stories from cryptocurrency investors that hit it big. However, where there are winners there are likely a lot of less fortunate investors too. Don’t become one of those statistics, prepare yourself! The infographic below is a good place to get started.”
“Trend following is a form of technical analysis. However, it is not predictive technical analysis, but rather it is reactive technical analysis. This is key to understand.” – Michael Covel
All that matters for a trader is what they are doing right now in the current moment. Their potential entry set ups, their stop losses, and what they should do about their current open positions. A trader has to focus on what is happening, not what they want to happen, think should happen, predict will happen, or hope will happen next. The past is over and the future does not exist yet, all that is left is the present moment and the actions that will be taken here. A lot of the stress a trader experiences is the intrusion of emotions that belong in a different space in time. No amount of regret brings back lost money and is a waste of precious energy and time. All that can be salvaged from past losses and mistakes is the lesson you paid the tuition to possess. You paid good money to learn these lessons and they should be quantified as rules in your trading plan so they are not repeated. Past emotional pain can be a great teacher if you are open to the lessons and willing to learn and change instead of repeating them.
No manner how much gurus want you to believe they can forecast the future, they can’t, why? Accurate predictions are not possible because the future does not exist. If a prediction is accurate it is more due to coincidence and chance than crystal balls or time travel. All that ever exists at any given time is the ever present moment of now. All that we can ever trade is the present price action and how it is acting based on our quantified methodology of entries and exits. Back testing of past price history and price targets for projected trends to key levels have their limitations as still the present price action is always moving and evolving in real time regardless of beliefs based on previous patterns or future potential.
I do believe in the study of past price history to observe emotional and technical trading patterns that repeat. I also believe that we can set potential targets to previous support or resistance on charts to give us a basis for risk/reward ratios and the probabilities for success. However I believe strongly that the keys to trading profitably is not found primarily in the back tests or the chart pattern projections but in our process. Successful trading is the process of flowing and reacting to current price action to capture trends, cut losses, and take trades with great risk/reward ratios with your stop loss close and your profit potential open ended. No matter the process we use for trading the market profitability only occurs in real time by following a robust process for entries, exits, and position sizing. There are many ways to develop a winning trading system but they all happen in the present moment of now.
There are two aspects of trading in the now. While the first is to react to price action as it occurs in the present moment taking entry signals without trying to predict what will happen next. When you enter a trade you do not know if your stop loss will be hit first or your trailing stop after a long profitable trade, your profitability lies in your flexibility to follow the price. The second crucial aspect of trading in the now is the dynamic of present moment mindfulness with a focus on how you feel, what you are thinking, and how that could affect your ability to make the right decisions for entries, exits, and position sizing. The ability to do the right things now is what makes all the difference not theory, or opinion, or predictions about the future.
What traders do to themselves is emotionally time travel to the past or future and experience feelings in the present moment that should have been resolved in the past or waited to be experienced until an imagined event really happens. The emotions of regret and dread should be experienced and decisions made on how to accept and manage them. You do not want unmanaged and unchecked emotions showing up in your trading and playing out as unresolved drama from your past. The future is great for goal setting and knowing the path you need to travel on to reach your destination but you can’t allow hope and fear about what will happen influence your current trading decisions. Your trading decisions have to be based on the right signals, position sizing, and trade management not your hope for a really big winning trade or your fear that you will lose stop you from even taking the entry when it is time.
The ability to follow your trading plan comes from the ability to act in the current moment and do what you planned to do regardless of how you feel. Present moment awareness allows you to overcome your emotions and trade in a disciplined manner. The more you focus your attention to being mindful of your thoughts and emotions in the present moment the better you will be able to execute your trading plan without internal obstacles.