Monday, July 16, 2007

Do Traders Prefer Winning Trades or Making Money?

It seems like a strange question to ask: Would traders rather make winning trades, or would they rather make money in the market?

As the Dr. Mezmer blog nicely outlines, people tend to prefer the positive: they preselect samples so that they can make positive predictions about the future and they gravitate toward positive short-term outcomes when given the chance.

Consider the situation in which people face two situations:

1) A majority of their bets win money, but occasional large losing bets cause them to lose money overall;

2) A majority of their bets lose money, but occasional large gains cause them to make money overall.

As the good Dr. Mezmer notes, nearly half of participants in such an experiment choose the first option--even when they know the negative expected returns. When they don't know the odds in advance, a larger proportion of subjects select the first condition. That is, they prefer winning in the short run to making money over the long haul. (See this study for a fascinating discussion of the preference for short-term wins over longer-term success in a card game).

Is it any surprise that traders have difficulty letting profits run and containing losses? The desire for frequent wins causes traders to take profits quickly; the aversion to losing leads to holding losers in hopes of converting them to winners.

The culprit, perhaps, is our preference for good moods. Frequent wins make us feel good momentarily, even though they might not be in our best interest in the long run. (A trend following style of trading--and the difficulties sticking with such a style--is a good case in point). An interesting post from Dr. Richard Peterson supports the Wall St. adage "sell in May and go away" and suggests that seasonal shifts in moods might be responsible for the pattern. Indeed, he cites research that finds greater evidence of seasonal patterns in higher latitude markets (such as Scandinavia)--and that finds opposite patterns in southern hemisphere markets (where seasons are reversed).

Does it make sense that returns could actually be superior when people are risk-averse and in bad moods (as the "sell in May" pattern would suggest)? Peterson quantified negative and positive words in the transcripts for the Nightly Business Report and found a significant correlation between the number of negative words in the show and stock market returns over the following week. Returns were best when the news was most negative.

It is only natural to gravitate toward the positive and shun the negative. Traders do not simply trade to make money; they inevitably trade to maximize their positive moods. This is why sentiment measures--from the options premiums (VIX) to put-call ratios to the predilection to transact at the market bid vs. offer (NYSE TICK)--can be powerful tools for understanding market behavior.

RELATED POSTS:

What Drives Investor Sentiment?

A Different Way to Measure Market Sentiment
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11 comments:

Flatwallet said...

Dr. Brett,

I did a study on all my trades. When I scale out, I have more wins than losses. It's around 65-70% win percentage. However, if I didn't scale out my win percentage would drop to 45 -50%, but my P&L would be around 33% - 50% higher. Does this sound correct to you?

Lots of people say you need to scale out all the time, but does it make sense to get out all at once? Could it be that scaling out leads to higher win percentage and thus we feel we are doing the right thing?

LP

Henrik said...

There are two very good books on this subject that I would recommend - The Disciplined Trader and Trading in the Zone, both written by Mark Douglas. Thanks for the article, tho.

bzbtrader said...

Curtis Faith was 19 when he was selected to be one of the legendary Turtles in 1983. The most successful of the Turtles, he racked up profits of over $ 30 million in the next four years and then basically retired from trading. In his new book, THE WAY OF THE TURTLE. Faith believes most of the Turtles failed to achieve good results because they could not or would not follow the trading plan rules which they were provided. Primary violation: other Turtles exited their positions too soon, missing the big moves (and profits) that followed. (They also avoided the 70% drawdowns -that's not a misprint- that Faith sustained.)

heywally said...

On the scaling out idea - I think it depends on how large of a position size you have and whether you have enough left over after scaling to be able to ride a trend up/down with a wide enough trailing stop. For me, anyway.

Feanen said...

My backtesting has shown that placing stops always reduces system profitability. I haven't adjusted for risk in most of my studies, so it is possible that stops do improve returns for a fixed risk level (max drawdown or some other measure of risk) with varying leverage. But everyone says you should always have stops (at least mentally). This is possibly another case of people preferring to never lose much rather than making more money overall.

MrPaul said...

Excellent post Dr. Brett!!

What can we do if we are trading for mood instead of profit?

Brett Steenbarger, Ph.D. said...

Hi LP,

Great observations on your trading. Scaling out can definitely reduce opportunity as well as risk. Where I've found scaling out to be helpful is if I have a high probability profit target (e.g., R1 or S1 pivot level) and a lower probability secondary target (R2 or S2). I'll take some profits at the first target and let a smaller portion of the position ride. I also find it helpful to scale into trades when I have a longer-term idea; I'll then scale out when hitting an intraday profit target, but might leave a piece on overnight.

Brett

Brett Steenbarger, Ph.D. said...

Hello Henrik,

Thanks for those recommendations!

Brett

Brett Steenbarger, Ph.D. said...

Hi BZB Trader,

Yes, the Turtle Trading is a perfect example of the challenges inherent in trading an approach that can have positive expectancy with low win %. Thanks for the note--

Brett

Brett Steenbarger, Ph.D. said...

Yes, Feanan, thanks for your observation. I think price based stops are often based more on traders' pain thresholds than on well-grounded criteria of risk management. Many of my stops are either time-based or indicator based (e.g., I'm out if we get a certain threshold volume at bid or offer), and I find those work better for my trading. I also do better when I trade smaller and trade with wider stops.

Brett

Brett Steenbarger, Ph.D. said...

Good question, Mr. Paul. I find that trading mood often begins with trading size that is too large for one's account. This exaggerates swings and emotional reactions to those. I find that having certain rules for my trading (e.g., trading in the direction of the cumulative volume at bid vs offer; not trading when we go below a certain level of volume) helps me avoid mood-based trading.

Brett