The Trader Coach Project: Formulating the Focus

My last post regarding the coaching of Trader C featured an assessment of the trading problems that led him to seek assistance. Recall that Trader C is a professional trader at an established firm. He has a long track record of successfully trading for a living, but his results for 2007 have been subpar. He attributes these performance problems to being too aggressive in his trading. This, he feels, causes him to lose his discipline, costing him significant money. In his words:

"What I have been doing right is my feel for the turning point, or breakout, or direction of a group, but my drawback is the initial sizing in them."

What we know from research in psychology is that any kind of counseling is most likely to be effective--especially in a relatively short time frame--if it is highly focused. For that reason, it is important to move from an assessment of strengths and weaknesses to a specific set of targets for improvement. These targets must be jointly determined by trader and coach: they form the game plan for the work to come.

Many times the focus that coach and trader arrive at is different from the focus initially held by the trader. For example, Trader C might initially frame the focus in terms of "discipline problems". This definition of the problem has led Trader C to attempt a variety of solutions on his own, none of which have proven wholly satisfactory. An important--and rarely appreciated--function of the coach is to help traders in reframing problems, opening the door to fresh solutions.

In the case of Trader C, I do not share the view that he lacks discipline. Or, more specifically, I see any discipline problems in trading as the result--not the cause--of his concerns. Moreover, as I mentioned in my recent post, I see Trader C's strengths--not his weaknesses--as the source of many of his problems. Allow me to elaborate.

Trader C and I have now held several lengthy phone conversations to help us come to an understanding of his situation. He has evolved into a sophisticated trader, combining intermediate-term, theme-based trading with short-term scalping. For example, he will research and select individual stocks that he believes will benefit from current, fundamental trends (an example would be companies involved in oil services). These positions might be held for many days at a time. On the other hand, he began as a daytrader and has considerable market timing skills.

As I reflected in one of our conversations, Trader C has been making the transition from being a trader to being a portfolio manager. He is much more diversified in his positions, much more aware of the value of holding simultaneous long/short positions, and much broader in his thinking about risk management than he was when he first arrived at his firm. His success, in no small part, has been a function of this evolution.

But his firm has not evolved similarly. The firm emphasizes short-term trading and manages risk on very short time horizons. This makes it difficult for Trader C to fully exploit his longer-term ideas. Even when his entries are good, he can be stopped out of his positions because the firm's intra-day risk levels are exceeded. The result is an understandable frustration for Trader C. He is naturally aggressive in his trading style, and he has many positions worthy of pursuing at any given time. His firm, however, is managed quite conservatively and cannot provide him with a risk management framework that he might find, say, at a large hedge fund.

This is not to say that Trader C's firm is poorly run. Not at all. There is simply a mismatch between his evolved trading style and the trading framework supported by the firm. Unwilling to simply give up on his valuable ideas, Trader C has been struggling to stay underneath the risk radar for the firm. This, however, is a constant battle for him: it is like asking a competitive downhill skier to limit himself to cross-country skiing.

The obvious solution to the problem--for Trader C to pursue trading for a hedge fund or prop desk at a bank with wider risk parameters--is not so simple. Getting a foot in the door without a prior track record of successful portfolio management and/or a pedigreed finance MBA can be quite a challenge. And with Trader C's recent trading treading water, he is not exactly in the best position to be knocking on doors at the moment.

What I proposed to Trader C--and what seemed to make sense to him--was to turn his aggressiveness from the goal of making as much money as possible to the goal of becoming the best trader he can be in risk-adjusted terms. In other words, instead of grading himself by his P/L--which leads him to bump up against the risk parameters at his firm--we will grade him based upon his Sharpe Ratio and similar statistics that assess how much he makes as a function of the risk that he takes.

Once he achieves consistency in risk-adjusted terms, he will be highly marketable to other firms should he decide to pursue such a course. I gave him my assurance that I would use my industry contacts to help him open some doors once he reached his consistency goals.

What this will mean in practice is that Trader C will size his longer-term positions quite small in order to stay in the positions long enough to benefit from his ideas. He will also diversify his shorter-term positions so that he is not taking highly correlated risks when he has a directional bias. Finally, each of his positions will come with highly explicit position size limits and stops, so that he is not placing huge bets on any one idea.

All of these measures are simple extensions of the evolution he has already made as a trader. We are taking the aggressiveness that he has been channeling into trading and directing it toward risk management. If we're successful, his metrics will show a shift, such that the size of his average losing trade will not exceed his average winner.

Instead of working on a problem, we're working on extending a strength. We're going to make Trader C into the best portfolio manager he can be in his current setting. Once he succeeds at doing it small, he'll be positioned to manage more capital either at his present firm or elsewhere.

So how do we pursue this focus? That will be the topic for my next post in the series.

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