Clustering and why trading can be difficult

If you have read my last article then the concept of system expectancy should have you in good spirits. Assume you can call the markets more than 50% of the time. Then, if your reward to risk is positive a kind fellow will write you a cheque for the rest of your days.

In a recent seminar I played the coin game with a 2 to 1 payoff. If they risked a fiver I would give them back 10 pounds. We started off with a pot of 100 pounds.

The room was full of CFA rated analysts and highly qualified people with little trading floor experience. They had a positive expectancy system but I have to report that the roomful of analysts went totally broke within 15 minutes of playing the game.

In trading there are two decisions at least in each trade.
1. Is the asset going up or down (long or short)?
2. How much do I bet?

The coin answers the first. I ask “Heads or Tails”?

Then I ask how much do you want to bet? The answer is varied but normally about 20%. I spin the coin and play the game. Let’s look at the probabilities. The latter are not as sexy as market direction but they will keep you alive.

In the coin game heads/tails has a probability of occurring 1 out of 2 coin spins.

Unfortunately there is a ¼ probability of two heads or two tails in a row and similarly a probability of 1/32 of 5 tails or heads in a row.

If you bet 20% of your loot on one trade then in a cluster of 5 poor trades then the game is over. That’s what happens to most traders. A run of poor trades takes them out prior to a run of winners starting even with a high expectancy system. Even if they have some cash left the drawdown will leave them scared and incapable of making a sound decision. The system will be long discarded.

Let’s think of some simple but robust answers

1. Resolve to not risk any more than 2% of your account in any 1 trade. If you have 5 bad trades in a row in a miserable market then the drawdown will be acceptable. If you think 10% is too high then scale back until it’s acceptable. At the institutional level 10% would mean getting fired.

2. Try and get your hit rate up from the 50% level. For me the VectorVest method of combining fundamental analysis and technical analysis has increased my hit well above the 50% level. My method of value momentum investing that I teach at the seminars has a hit rate of approaching 80% and I am very proud of it. It looks at the fundamentals of the share, the technical position of the shares and the technical position of the overall market. When all three are positive I can call the future with a probability that’s uncommon in this line of work.

3. Spend some time internalizing the concepts that Mark Douglas teaches in “Trading in the Zone” It’s not the easiest of reads but well worth the effort.

4. Buy a Backgammon set. Probabilities are easy at an intellectual level but few of us understand them at a gut level. Playing backgammon will develop an understanding of probabilities and that’s essential for those of you that wish to become short term swing traders.

Remember the objective of trading is to have some money left to trade with tomorrow.

David Paul
May 27 2014

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