Perversion in odds and values

Dan Gilbert talks about mistaken expectations. What he talks about have everything to do with trading. Our innate tendency to misjudge odds and values is one of the reasons why I use a statistical approach to assess market anomalies.

The Power of Tangential Learning

According to Wikipedia,

tangential learning is the process by which some portion of people will self-educate if a topic is exposed to them in something that they already enjoy.

I was just organizing my bookshelf the other day and is surprised by how fast my collection of statistics books have grown. I studied statistics back in school as a stepping stone to learning stochastic process for wireless communication theories (e.g. CDMA). Detecting radio-frequency and resolving wireless signals to meaningful messages is fundamentally about assessing the state of random processes. I hated statistics back then because I didn’t get it and did poorly in those courses. It is ironic that years later I would realize how much I have grown to rely and love the little p‘s and q‘s in my little hobby of quantitative trading.

I still don’t like statistics (or theoretical math), per se. I just love applying them in my trading and quant programs. The more that I learn about statistics, the more that I realize how powerful they can be and how ignorant I am. For example, in my clinical study days I used either t-test or ANOVA for everything under the sun. Now that I’ve come to understanding about inferential statistics, I am aware of the assumptions and pitfalls such as the assumption of t-tests of homogeneity of variance between the two samples tested. If this assumption is violated, then the unequal variance t-test should be used.

Finer points like these are routinely ignored in practice because many clinical studies are inherently designed in the experiment to meet these criteria. However, that’s not the case when I am making creative use of statistics in my trading. I don’t have a clinical study committee watching over my back. If I make a false or weaker-than-expected claim and don’t know better, then it is my bank account that will suffer the consequences.

Learning statistics was initially due to this got-to-know-better necessity. However, the more that I learn about statistics, the more that I appreciate it. If used correctly, statistics can provide a new dimension to the scientific assessment of your trading performance and market data.

3 reasons why I even bother trading a small account

If you look closely at my trade log, you will see that the amount that I trade is small. I am not going to get rich anytime soon even if I can maintain my 10% return or so every half a year. My wife was asking me the other day why I don’t plunk in more money to my trading accounts since I have even won a trading contest and all.

With accounts and trading sizes so small, I am appearing to be just wasting my time. For example, it took 2 to 3 hours of research and analysis the night before this recent trade in gold and then just to see it make $35. At least it’s slightly better than the minimum wage here.

The real trial though, is in facing a losing streak. Imagine spending hours and hours pouring over price charts, economic news, and financial data only to see your account shrink and shrink. Those are the times when you wonder why you even bother putting in the hours. It just won’t make a difference, right?

Well, here are my three motivations for trading a small account.

1. Slow and steady. The fact is, trading is about aiming for consistency and not scoring that one-in-a-lifetime trade that’ll make you rich. That took me a few years to realize. It is a lot easier to make pocket change than score a jackpot. Don’t make trading harder on yourself.
2. Trading comfortably. Hey, this is a hobby. I wouldn’t last too long in this game if I’m sweating my palms with every position. If I bet my farm often, either my account will go broke or my sanity will. I prefer to keep my risk small enough to lasts and make trading enjoyable. If I want thrills, I go to a casino (there is actually a big casino 15 min. from my house).
3. Walk before you run. Eventually though, as I become consistently profitable, I increase my risk ever so slightly step by step. Couple that with the effect of compounding, I may eventually be able to replace my salary with my trading income. That is probably still years away for me, but as people say, everybody has to start somewhere.

So no, I don’t think trading a small size is a waste of my time. It is a good risk management, psychological mediation, and learning technique for amateur traders such as myself.

Work harder, trade fewer in a long and excruciating trading drawdown

I write this as I am in my first trading drawdown of 2010. As I said previously, I find that I am still ill-trained to respond to big drawdowns. I caught myself over trading again hoping to rake in a few quick paper bucks in my demo account to get myself out. However, the ability to maintain discipline and performance under stress is what separate the pros from newbies like me. I know what I must do at the back of my head but I took the easy way. This trading drawdown is definitely bringing the worst trader in me.

As Dr. Steenbarger wrote in his post on Stress and Performance in Trading,

“… one reason stress might affect performance among traders is by skewing their assessments of risk and reward. Under pressure, traders may narrow their cognitive scope to only the information most salient to them (availability bias) or relevant to their expectations (confirmation bias); focus only on superficial qualities of observations (representativeness heuristic); or become more likely to take profits than losses (disposition effect). In other words, stress disrupts performance by altering normal, sound information processing.”

In addition to a narrowed mindset, the cause of my bad habit to over trade during a big drawdown is that I subconciously associate the need to recover my account balance with the need to trade. Nothing will happen if you don’t trade, right? Well, at least you won’t lose anymore than you have. That would have been a good start.

So I considered to ease back on trading by focusing on my quant work. Then I realized this is yet another misconception. I was merely walking away from my problem. What I needed to do is to face it, not with mindless trading though.

During a stressful drawdown, work harder and think plenty about the market, not about recovering from your drawdown. In the mean time, only trade your best strategy to reap the best probability of profits.

At the end of the day, nobody can dig yourself out of an account drawdown but you. Something must have been wrong with your trading or your current perception of the market to get you in a drawdown. Or, it could very well be just plain old bad luck. In any case, take a step back from trading and use the opportunity to realign yourself with the market or wait for market conditions to sync back with you.

This is a forgotten lesson that I have wrote about in a previous drawdown. I have since added an additional section in my trading rules to impose it upon myself with this re-ocurring problem.

I can never get rid of large drawdowns completely because they are a regular part of trading. This particular one has been a great self-discovering experience. Ultimately, learning to cope with trading under stress is one of my top training priorities to achieve before moving on to trading a live account with real money.

Early bird does not get the worm in forex trading

[This post was updated on January 13, see addendum below.]

I have discussed my enthusiasm in shorting the Aussie a few times this week. First trade was shorting AUD/JPY at 84.53. After that got stopped out, I re-tried at the same level the next day. My trade history in this currency pair is shown in Figure 1 below. Evidently, I am early in my trades as the recent upward momentum is still going. But that’s just speaking from hindsight advantage. What is actually wrong with this play is that I was too eager at the first entry when the price was just at a minor resistance (short-term trendline of Fig 1). In turn, that caused me to lose my confidence and not be as aggressive as I should be when the price reached a major resistance at 85.50.

Referring to Fig. 1, I made 5 attempts on the minor resistance below 84.60 in the first round. What’s worse is that I didn’t have enough patience to wait after these shorts failed and I tried again at 84.52. Even though that resistance level is voided already.

But here comes the kicker. I actually noted the important 85.50 level before my first attempt. It was clearly on the chart and I even mentioned about its significance. I just figured that it wouldn’t be touched. How wrong I was.

As I said, another problem with being early in a trade is that it stripe you of your confidence prematurely in a good setup. My setup to short AUD/JPY is as good as ever now. I am drooling over that negative RSI divergence shown in Fig. 1… But since I’ve already taken a beating in this pair this week, my account drawdown dictates that I limit my risk. As such, I can’t back up the truck to pile in on this trade at this point. But why not?

I won’t break one rule to compensate for another. Although I am light in this trade now, I will not compromise my risk management rules to compensate for my own mistakes. That would just open a whole new can of worm. Besides, I can’t say this often enough — risk management is always the top priority in trading.

In any case, there will always be other opportunities.

The moral of the story is this. Do not be too eager to get into a trade. Secondly, adjust your position size accordingly to the significance of the setup in play.

AUD/JPY, 3-hour

Update January 13:

Figure 2 below shows an updated view of AUD/JPY a week later. The red dot on the 9th was my last stopped out entry. As you can see, I missed the smooth 200 pips ride down. This experience is proving to be better than I expected to illustrate how being early in a trade can really hurt your account.

A week later in AUD/JPY, 3-hour chart