Friday, February 15, 2008

Trading Logic and Trading Edge: Accuracy, Execution, and Position Sizing

I've emphasized elsewhere that every trade is a hypothesis. I find this to be a very useful framework for thinking about the logic of trading.

The specific conceptual schemes we use (technical analysis, reading market depth, historical models, Market Profile, etc.) help us frame our trading ideas. Certain schemes may be more or less helpful in the context of particular markets and time frames; the most important aspect of a conceptual scheme is that it make sense to the user and generate reliable and valid trading decisions.

When all is said and done, however, every directional trade idea boils down to a very simple proposition: "We will hit *this* price before we hit *that* price". In other words, we are placing bets that the stock, futures contract, or ETF will hit a target price level before it hits the level that stops us out and tells us we're wrong.

Viewing trading logic in this simple fashion, we can see three sources of "edge" in trading:

1) We are right more than we're wrong - In other words, we are good at generating promising hypotheses. Here the core skill is anticipating market moves. Our methods for reading supply and demand in the markets are so good that we are accurate in assessing direction.

2) We make more when we're right than when we're wrong for a given position - We may not be right more than we're wrong, but we are good at framing hypotheses with a favorable ratio of reward to risk. That is, we will make more money if we're right than if we're wrong because there is an asymmetry between the loss we'll take if we're stopped out and the gain we'll achieve if we hit our target. Here the core skill is execution: getting into ideas at such good prices that risk/reward is in our favor.

3) We are bigger when we're right than when we're wrong - We may not be right more often than we're wrong, and we may have a relatively even balance of risk/reward. If, however, we are good at recognizing when we're right *as the trade is progressing*, we can then add to our size when we're right and keep size small when we're not. Here the core skill is sizing (position management): adding to winners and keeping losers modest.

When we lay out sources of edge in this manner, it becomes possible to ask: What is your core competency as a trader, and where can you make your greatest improvements?

My experience is that too many beginning traders shoot for number one--trying to be right most the time--when in fact the majority of profitable traders fall into the latter two categories (and often both). Execution and sizing may not offer the ego rewards of being right and outsmarting the market, but they embody a kind of reasoning that is essential to success, regardless of one's market, strategy, or time frame. The implications for self-coaching are profound: This post lays out many of the mistakes traders make as a result of faulty trading logic.