Saturday, December 09, 2006

Trading's Mid-Life Crisis: Getting Bigger Vs. Getting Broader

Well, my trading mid-life crisis is nowhere near as dire as Santa's (thanks to the usually off-color Moohead for the cartoon link), but it's surprisingly common--and yet rarely discussed by trading coach/psych types.

The crisis arrives when you've hit a level of relatively consistent success in your trading. You're at an equity curve high; you're not taking large drawdowns; you're following your game plan; and you're comfortable.

Now what do you do? Do you get bigger (do more of what's working in larger size), or do you get broader (find non-correlated markets and time frames to exercise your edge)?

The reason we don't hear too much from the trading coaches and psychologists on this topic is that they tend to address that portion of the trading public that *isn't* successful: those who are not following their discipline and those who, perhaps, have not yet found their edge.

The successful trader has an edge and has the discipline to utilize it. The question becomes how to take maximum advantage.

It truly is a mid-life crisis for traders. In the mid-life crisis we normally think about, we get to the point where we're established in a career field and in a marriage/family. We realize that either we're going to coast to the finish line or tackle something new and challenging while we still have enough time and youthful energy to see it through. That 's really the same issue facing the successful trader.

And, in life as in trading, we facing the issue of getting bigger vs. getting broader. Do I build on success by growing my company and doing more of what is working, or do I begin to develop other aspects of my life and use this success as an opportunity to widen my horizons?

The problem with getting bigger is that you're bound to be at your maximum size when markets change and your edge erodes. I have seen this occur with many very successful traders at prop firms. In a sense, they were one-trick ponies and all their eggs were in the basket of that one trick. In my latest book, I refer to this as "first-order competence": the ability to master a particular market. "Second-order competence" is the ability to master markets as they change. Second-order competence requires going broader, not just bigger.

Systems developer and successful trader Henry Carstens weighs in on this issue with his most recent post. His point is that there is a limit to which you can keep doing more of the same thing. Eventually, you run into problems of collinearity: the overlap among trades. You're not just increasing your size, but your risk. Going broad by trading other time frames or other instruments diversifies risk. That strategy, we might say, is getting broader before you get bigger.

And, you know, that's what the great artists do. They don't just paint, write, or sing in the same style the same way throughout their careers. They remake themselves and keep their work fresh. Read the early biography of rocker John Mellencamp and then his latest bio. He has never stayed still. He was already successful when he announced to his band that everyone, for the next album, would have to learn a new instrument--himself included. Out of that emerged the folk/Appalachian style that made "Lonesome Jubilee" a hit. More recently, he has spent time atop the blues charts.

The time to get broader, I suspect, is when you're on top of your game, not when a shifting market forces you to adapt. It's time for me to learn a couple of new instruments. Too much of my profit has come from short-term countertrend (mean reversion) trades. In that sense, I'm no different from the momentum traders of the late 1990s. Feeling good and feeling flush, doing the same thing over and over. That, too, shall pass.

The explosion of ETFs has made it easier than ever for individual traders to get broader. Different time frames, different markets: when one strategy is drawing down, others are making money. Getting bigger without expanding risk: that's the goal of getting broader.

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