Sunday, February 04, 2007

Six Keys to Trading Success: Lessons From a Successful Trader

In my last post, I mentioned that a generous blog reader shared his intraday trading approach with me last week. His ideas seemed sound, so I suggested that he contact Henry Carstens, an experienced systems developer. Henry, I told him, could test his trading ideas and perhaps suggest improvements, while avoiding the problem of curve-fitting. The reader, trusting that Henry and I would not divulge the particulars of his method, patiently explained his setups with numerous examples. Within a matter of hours, Henry had backtested the ideas over the past five years of trading. What Henry's report revealed tells us quite a bit about what it takes to be successful as an intraday trader. My subsequent conversations with the trader revealed yet more. Here are six lessons from our experience with a successful short-term trader:

1) The successful trader is selective. The trader's approach took about 1300 trades in a five-year period, or about one a day. It spent more time out of the market than in the market. As a result, it did not rack up huge commission overhead. Instead, it only took very high percentage trades. Without any optimization whatsoever on Henry's part, the system had almost 80% of trades as winners. This selectivity makes for very high risk-adjusted returns. Most of the time, the trader's capital was not at risk. He only entered the market when he could make money consistently. He had clear ideas regarding execution that enabled him to get into the market at favorable prices, minimizing losses when the trade didn't work out and maximizing gains when he got the moves to his target.

2) The successful trader has made the approach his or her own. When I talked with the trader by phone, I sometimes had trouble following his thinking. He spoke quickly about hitting the red line or the brown line on his charts and casually mentioned important trading ranges and levels. It was clear that this way of trading had become part of him. The way he set up his charts is the way he thinks. No doubt this internalization helps him see when the market is acting normally and when it is not, enabling him to quickly act upon opportunity or threat. Only considerable experience, watching markets day after day and studying charts upon charts, makes it possible to internalize a method to that degree.

3) The successful trader has found a niche. The trader did not just send me one or two charts illustrating his method; he sent dozens. On the phone, when he talked about his approach, there was real enthusiasm in his voice. It was clear that this kind of trading had captured his interests, skills, and talents. That creates a virtuous cycle in which success leads to more excitement which leads to more learning, which creates further success. He didn't try to trade instruments or time frames for which his approach--and his skills--were not suited. He focused on his strengths.

4) The successful trader is creative. I think it's fair to say that his approach is a short-term trend-following method. His way of evaluating the market trend, however, is unique. He is definitely not just looking at the same old 14-period oscillator that comes pre-programmed in most charting applications. Similarly, he has clear stop points and price targets, but these are defined in a unique way, based upon the market conditions he's observing. This "out-of-the-box" thinking style is common to successful traders, I've found. They look at markets in unique ways that help them capture shifts in supply and demand.

5) The successful trader is always seeking improvement. If our trader is already successful, why does he need to talk with Henry? He knew that, by sharing his ideas, he would learn a great deal about the strengths and weaknesses of his trading. Sure enough, Henry found that the average size of the trader's losers was larger than it needed to be. A simple modification of stop-loss rules improved the system's performance meaningfully. Similarly, by putting a filter on the system--only taking trades if certain conditions were met--the average profit per trade went up significantly. That could aid position sizing. The trader knew he had something good, but good wasn't good enough. He wanted better.

6) The successful trader is persistent. One thing I want to stress: the trader's methods were very sound--and Henry found ways to make them better--but they were not perfect. Out of about sixty months analyzed, fourteen were losers. The drawdowns were not hellacious, but there were periods of flat performance and drawdown. What that means is that a successful trader needs to have the confidence to ride out these periods of poorer performance to get to the periods of success. That is one reason why it's so important to find a way of trading that you can make your own. You're more likely to stick with a method that fits with how you think (and that fits with your skills) than if it's something you've blindly copied from others. Our trader believes in his method, and that gives him the brass ones to hang in there during relatively lean periods.

Note that our trader is not a mechanical systems trader. What Henry did was test out his major ideas and identify their strengths and weaknesses if they were traded consistently, with discipline, as if they were a system. If you are a successful trader, this is a valuable exercise. It will break your trading into components and show you how each component is contributing to profitability. It very often shows how the components can be slightly modified to produce even better results. By looking under the hood, so to speak, and making a couple of adjustments, we can meaningfully improve upon our success. There are very few trading strategies that cannot be programmed and tested, including complex chart and indicator patterns. The results can be most enlightening.


yinTrader said...

Hi Brett

A good reminder even to novice traders like me.

Thank you

Brett Steenbarger, Ph.D. said...

Thanks, Yin; I do think it's important for new traders to understand what it takes to be consistently profitable. It's quite a challenge!


Michele said...

Very interesting. One question though - how does one distinguish a "period of poorer performance" in a program trading system from a market which has fundamentally changed in some way as to invalidate the rules upon which the system was built?

In other words, when do you decide it's time to stop bailing and start lowering the life boats?

Brett Steenbarger, Ph.D. said...

Hi Michele,

That's a great question. There are two answers. The first is that you would need to see evidence of a shift in market trend and volatility to suspect that changing cycles might be affecting the system. Those shifts are typically preceded by fundamental shifts in interest rates, inflation, commodity prices, the dollar, etc. If you don't see those kinds of ongoing, fundamental shifts, it's less likely that a drawdown is attributable to drastically altered trading patterns in stocks.

The second answer is that historical testing will tell you what normal performance and normal drawdowns look like. If you see performance significantly outside those historical norms, that would have you questioning the system.

I don't think this issue is unique to trading systems. The patterns traded by discretionary traders also go through normal drawdowns and vulnerabilities to fundamental shifts. The momentum trading of the late 1990s is a great example.


Brandon Wilhite said...

Dr. Brett,

To maybe add a little more meat onto your post...

One of my foundational assumptions is that all systems eventually break (I act/plan as if this is true, even though there may be cases where it's not). So the question then is how to retain profits when the market starts to kill your system. I'd like to just point out that this assumption is actually quite contrary to a lot of available teaching about systems development out there.

One way to approach the problem of addressing the "poorer performance" vs. a fundamental shift is to set certain break-points for your systems. I.e. after x amount of drawdown decrease size, after y amount decrease even more and start to re-evaluate for fundamental changes in the market, after z amount of drawdown stop trading the system until you determine whether the system is broken or if it's just in a drawdown. You can base these numbers on some multiple of historical drawdown.

Also, you can have logical break-points based upon the fundamentals / market characteristics. It's hard to see these kinds of things in backtesting.

I hope this adds something to the discussion. :)


Brett Steenbarger, Ph.D. said...

Hi Brandon,

Thanks much for your addition to the discussion. The idea of break points for systems makes a lot of sense. I think, once again, the logic could apply to all traders, not just trading systems. If your methods are significantly underperforming their historical norms, it's worth pulling back from those methods and reassessing.


voodster said...


Could you feature more of these types of articles? I'd rather hear about what successful traders do to stay on top than attend webinars of people preaching what ought to work.

Also, I understand why this trader did not want his method revealed. Is it so rare for a successful daytrader to have something that actually works that he must be so protective of its secrets? With so many methods on the internet are you indirectly suggesting none of it works? Is this a case of what doesn't work in trading is in the public domain while the stuff that does work will continue to be guarded....but will later be for sale once it fails? I'm asking you because you are actively involved with many types of traders.

Brett Steenbarger, Ph.D. said...

Hi Voodster,

Thanks for the note. I do find that the more common a trading method is, the less likely it is to work. And I do find a high rate of performance degradation among whiz bang systems that are marketed to traders. A simple, robust method is better than something complex and curve fit.


denber said...

Hmm - this raises an interesting conundrum. The canonical wisdom is that widely disseminated techniques fail because if everyone can get in on a good thing, it ceases to be a good thing.

And yet, as a trader I watch Cramer every day, not because I think he's a genius but because I know everyone else is also watching him too and I can take advantage of this.

I have all the standard technical indicators up on my charts because I know everyone else does too. If everyone believes that support will come in at a certain level, it tends to become a self-fulfilling prophecy.

Maybe it's just too late at night, but I can't figure out why it is that widely available information helps in this case but is death to a program trading system.

Regarding the need to change failing programs, as a computer scientist let me point out that there is an extensive literature on dynamic planning in artificial intelligence, going back over 40 years. The bad news is that a lot of it is extremely tough to decipher. Still, there's no point reinventing the wheel when one can stand on the shoulders of giants, so to speak.

Mike_Trader said...

Dr Brett,
I'd like to comment on the term 'overtrading' as I think it's often mis-represented. If your system, discretionary or mechanical, yields positive avg/profit per trade (incuding trading costs) with a reasonable success rate and drawdown, then your goal should be to make as many trades as possible to maximize your advantage. Saying one trade per day is good because it's perceived as 'selective' is potentialy masking a situation where other quality opportunities are being missed. The number of trades is not the issue, it's the quality of the trades. As such, I believe the common use of the term 'overtrading' is mis-representing a situation better described as poor or inconsistent trade selection. Just as a business wants to sell more product to maximize profit, a trader using a system with a positive expectation should be looking for as many opportunites as possible to maximize his/her profit. Appreciate your comments.


Brett Steenbarger, Ph.D. said...

Hi Denber,

You raise great issues; thanks for the post. My sense is that the successful trading approaches and systems are not so much looking at totally different data, but they are assembling the data in unique ways. An example would be a chess grandmaster. He or she sees the same moves and pieces, but organizes the information differently--and more meaningfully. The ability to revise those organizational schemas is indeed quite difficult, which is why many more traders achieve initial success than sustained profitability.


Brett Steenbarger, Ph.D. said...

Hi Mike,

Great point. As long as you have the edge, you need to press it and take consistent advantage. When you test many systems or trading ideas, you find that more isn't necessarily better. The promising patterns are not present in all markets and at all times of day. But, you're right: if you find the signals are solid, you have to take them, whether that means taking 1 trade a day or 100.