Monday, October 08, 2007

Trading Success: A Perspective From Wonderland

It's a particular joy for me when the comments to my blog posts are every bit as good--if not better--than the posts themselves. Such has been the case with my recent post on finding an edge in the currency markets. I heartily recommend that you read the comments to my post--particularly those of Ziad and Brandon (BW).

When I visit different proprietary trading firms, investment banks, and hedge funds, I feel a bit like Alice in Wonderland. The reality I experience at these firms is nothing like the one that is portrayed in the popular trading literature.

Trendlines? Oscillators? Chart patterns? Wave formations? Angles? All of those figure prominently in the books, seminars, and magazine articles that dominate the mass market.

Yet I have yet to see a successful trader at any of these firms use these tools. You would think, by sheer chance, having worked with well over 100 traders personally and closely, I'd find *someone* who trades the way the books and magazines describe.

But no. I have found none.

Rather, what I find is a kind of reasoning that might best be called "relational". The traders who are doing this for a living and making a successful living year after year invariably relate the instrument(s) they are trading to a broader network of market events.

This can take the form of intermarket analysis (i.e., developing a view on currencies based on interest rate differentials and yield curve dynamics across countries), but can take other forms as well. For instance, I notice short-term S&P traders at prop firms looking at what is happening in related markets (NQ, for example) and sectors (financial stocks) to get a handle on what their market is up to.

Somewhat defensively, a few readers have replied that it *is* possible to make money trading simple market patterns. To clarify (and also to apologize if I was unclear): I never meant to say that it is *impossible* to succeed without relational reasoning. Rather, I was passing along my observations over the last two years that I have not encountered a consistently successful professional trader who trades simple, linear relationships limited to their trading market.

It was not always thus. When I first came to Chicago, I saw many traders thrive simply by trading patterns in the depth-of-market displays for their instruments. As an increasing proportion of that trade became automated (and the automation exploited mispricings across instruments), that trade went away. It is now rare to see a highly successful short-term trader in Chicago trade in that market-making style.

Similarly, in the late 1990s, it was common to see traders thrive by trading momentum patterns among NASDAQ stocks. That trade also dried up as we moved to record low volatility. It doesn't mean that someone, somewhere *can't* make a living by trading short-term momentum, but the opportunity is not what it once was.

There is much to be said for trading a style that is congenial with your talents, skills, and interests. Still, such a style must be consistent with objective opportunity if it is to yield enduring success. Many of the trading approaches described by the popular trading literature (such as buying strength and selling weakness) not only have no edge in short-term trading of stock indexes, but actually run counter to objective opportunity.

I'll state my position baldly and take the heat as it comes: I think the individual, independent trader is being sold a bill of goods. There are firms that have a vested interest in making traders believe that success is easy and that the simple patterns offered by their software, trading courses, and publications will provide a road to riches.

It's no different from the "no-money down" real estate seminars or the pyramid marketing schemes. All promise great returns with little effort or knowledge.

The irony is that traders would love for me to validate their fantasies and tell them that untold wealth is around the corner if they just follow a particular set of indicators or self-help methods.

But I can't do that. I visit the traders who are truly successful--and whose success I can personally verify--and I see them doing something very different from what the seminars and magazines describe. Similarly, when I look at who is truly successful in real estate and in business, I find entrepreneurs who study and master their markets--not people who are acting upon a seminar, a wing, and a prayer.

Success *is* possible for the individual trader; I've seen it happen. But it's the result of a developmental process that includes a kind of cognitive development that transcends simplistic reasoning. More on that cognitive development in my next post.


Ziad said...

Dr. Brett,

I'll make a relatively brief (for once) comment.
I think the argument the other readers and I were making was not that "it *is* possible to make money trading simple patterns", but rather that focusing only on your market does not necessarily imply simple linear thinking. One can have very deep 'relational' thinking even when only looking at their market, where the relational aspect has to do with price and a host of reference points as opposed to other markets (as I described in the previous post comment). I for one actually don't think that one can hope to make consistent high-level returns from simple linear analysis as the media suggests, but I also don't think relational beneath-the-surface thinking necessarily needs to imply looking at inter-market or sector relationships.

Having said that, there is much to be said about "Having a style that is consistent with objective opportunity", but the question then becomes can a trader who builds expertise at a non-linear reading of his market be aware of and exploit this opportunity without necessarily being aware of its inter-market fundamental causes?

Thanks again, for the thought-provoking posts.


Brett Steenbarger, Ph.D. said...

Hi Ziad,

Great point; thanks. You're absolutely correct. One need not reason across markets/asset classes to embody deep relational thinking. A good example would be a trader who fades a new high in the market because a majority of stocks are not making new highs and the new high is occurring on below average relative volume.

Similarly, it's very common for scalpers to notice order flow or volume patterns in one index (say, NQ) and key off that to place a trade in a related index (ES).

Market Profile involves relational thinking by coordinating price/volume relationships across different time frames.

Thanks for the great posts and thoughtful insights. Best of luck in your trading--


mdbllbr said...

I think it's really difficult to understand how things work inside a large trading firm. Some facts that we should know are:

1 - The trading environment is ruled by the law of natural selection. Good traders survive and bad traders are fired.

2 - Traders are evaluated by their risk adjusted return. They tend to work hard to sharp their skills and their knowledge to do that. They go after everything that can improve their return reducing the risk.

3 - They must make money efficiently... Only efficient strategies survive...

4 - To be a professional trader you must have skills and knowledges that is determined by the natural evolution. If you don't fit you are not choosen. In order to trade using other's people money you should really be prepared to do that. You can't start trading for them because you want to do that.

5 - They trade in a different scale and timeframe. Large positions and long timeframe require a better prediction skill than daytrading few contracts.

6 - When trader loose money they must explain why and must be really convincing otherwise management will think you are doing something wrong... They can't make any mistake... When you loose you must loose correctly...

7 - In currency markets you have different ways to implement the same strategy, for instance they look for the cheapest way using different kind of instruments...

Anatrader said...


If I may add a simple observation of the market price movements.

Although we ignore, or do not look at inter-market fundamental news, prices of instruments such as currency pairs will have such fundamental news factored into their price movements.

So if some traders ignore inter-market relationships, the prices in a way have taken into account such economic news without our conscious efforts to consider them.

In that sense, some find it is not necessary to factor in inter-market relationships.

Hope this makes sense?

Brett Steenbarger, Ph.D. said...


This curious idea has come up a couple of times: That price already factors in fundamental news and factors and therefore no consideration of such factors need be made by traders. But if this were the case, there would be no behavioral finance literature. The entire thrust of behavioral finance is that price diverges from value due to information processing biases that we possess. An example would be initial underreaction to earnings surprises, but overreaction to series of such earnings events. Did price factor in fundamentals during the Internet stock craze? Markets are efficient, but it's divergences from efficiency that create trading opportunities.


CrossProfit said...

Great article.

lobagola said...

Dr Brett,
Exactly! You have just confirm what Anatrader had said. To further elaborate, not only has Fundamentals being priced in but any divergence or dislocation as well. Are you going to trade with what the Market is telling you or because relational markets is saying otherwise?

Remember why LTCM fail? In normal conditions, relational theory works fine but when co-relation or dislocation occurs then what are you going to base on?

Btw, I'm not saying relational theory does not work. I do look at it but only to confirm my trade plan. In the end, that particular Market I'm looking at is what's going to be the final deciding factor.

Also, I do agree with what Ziad and you said that relational reasoning need not occur across markets and assets classes.

NQTrader said...


I have 3 insights to share.

1. You are one of the very few trading 'coaches' who actually takes the time to put effort into educating traders about finding an edge that can pull them out of their psychological difficulties. A recurring theme in your books (which I both own) and articles is that a solid/non surface/rich reasoning/approach to market analysis is the horse that will eventually pull the cart forward (the struggling trader who mistakenly believes his problems are related to his mind rather than his lack of a real edge) You put in a heck of a lot of effort towards educating people towards that end and I, as I'm sure others, are very very thankful and appreciative of that.

2. Yet, at the same time, I see a HUGE GAP crater sized, in the trading and trading psychology literature that sadly goes unaddressed....namely, there seems to be complete and utter silence regarding the issue of defining and validating an EDGE. Precisely, the criticism I have is at the core, an epistemological one. How does a trader KNOW he has an EDGE? Does the trader even understand what an EDGE is? I personally define an EDGE as a statistical advantage, identical to the statistical advantage that a casino operates on.

Why am I getting into this? I am because I strongly feel that regardless of what the method of analysis, whether relational, surface technical, deep technical, quant, hardcore fundamental or other, traders NEED to KNOW that their EDGE is real and not the result of random luck. While Jim Simons has revealed that he doesn't necessarily use super advanced math in his work, he did say that it is his sophisticated statistical work gives him huge confidence that his edges are based on reality and not luck. He is less likely to be led into a deathly trap of false confidence by data that is generated in a faulty and analyzed in a dangerous manner, no matter what the nature of the data. (a particular hedge fund operator who has blown up for the 3rd or 4th time comes to mind...)

3. Now, once a trader has convinced himself that he does indeed have an EDGE (and hopefully he has evidence to back his belief), he needs to work on the mountain like obstacle of learning to accept the risk of trading and think in probabilities. Because I don't care your good your edge is, if you have mental hangups that are preventing you from taking each and every single trade your method dictates you should be taking, you will NEVER be in a position to enjoy your equity curve.

So in summary, here are my 3 thoughts:
1. Use all the resources you can find to develop an EDGE. Look everywhere and leave no stone unturned.

2. Make sure you KNOW that your EDGE is real and is backed by evidence, not dogma.

3. Learn to think in probabilities so you can actually exploit your EDGE and reap the fruits of your hard work.

Dr Brett, if you could also address steps 2 and 3 in your future work in addition to step 1 which you are doing so well, I am sure there would be many traders who could greatly benefit.

Brett Steenbarger, Ph.D. said...

Hi NQ Trader,

That is a great comment, and you make an excellent point. I will devote a blog post in response. Thanks to all for very enlightening comments to the posts. The comments have been outshining the posts!


bzak said...

I disagree with the idea "That price already factors in fundamental news and factors and therefore no consideration of such factors need be made by traders."

While the fundamentals are influenced in the price, they aren't always accurately reflected the true value of the stock. Investors can be overly optomisitc or fearful when it comes to assesing the information.

This can give a trader an edge if they understand the psychology behind the market behavior and their own behavior.

When new fundamental information comes in, instead of assuming that it is already reflected in the price, I see if the price change accurately reflected the news.

SerpentMage said...

I think there is a really big difference between what you see and what regular people see.

You see the professionals, and regular people see Jim Cramer and people asking on TV, "So what's your latest stock pick."

The problem here is that people are not willing to learn the basics or can learn the basics. I have been getting into this and have learned you need to read books like Hull, and Taleb to get a feeling of what is going on.

The market is a place for financial engineers. I am not talking about creating structured products. I am talking about understanding what the markets are about.

JohnDiddler said...

i bet you're right about "systems". here's an idea i've been struggling with (i bet it reveals where i am in the intellectual trading growth process): i find it easy to achieve a "break even" trade technique... i am able to set stops and sells such that basically i do no better than owning an index fund. it seems to me it is not an automated mechanism i need, but rather the determination of conviction based on deep analysis and ultimately based on my individual judgement, and not on any mechanical decisionmaking. given all the factual information and meta-information i can gather, i'm struggling to know what constitutes conviction within myself.