Saturday, June 07, 2008

Getting Off the Performance Roller Coaster

A surprising number of traders I hear from and work with experience what might be called a performance roller-coaster. They make money for a while, then become sloppy and overly aggressive in their trading. This leads to harrowing and frustrating losses, which in turn force them to focus their efforts and resume trading well. Not infrequently, these traders experience several boom-and-bust cycles before they reach out to seek help.

The culprit in this scenario is overconfidence. Trading gains lead to heightened expectations, which in turn facilitate overtrading. These changed expectations, ironically, lead traders to change how they're trading right at the time they're trading at their best! Instead of being satisfied with their gains, they press to achieve more. This leads to crippling drawdowns, because they're trading most aggressively even as they've strayed from their best trading.

My recent post focused on the importance of self-management in trading. A very perceptive reader who had experienced some of these trading ups and downs wrote to me recently and described a scoring system that he implemented for his trading. The system gave him points each day based upon his preparation for the day, the quality of his trading ideas; his execution of those ideas; and his management of the trades. Instead of focusing on his P/L each day, he has been emphasizing keeping his trading score high. This has aided his consistency, and that has paid off in profitability.

Another savvy trader wrote to me and described how he used visualization techniques each day to convince himself that he was coming back from a drawdown--regardless where his actual equity curve stood. By mentally rehearsing this "coming back from drawdown" mode, he also kept the focus on the *process* of trading, resulting in his best and most consistent profitability to date.

That is the paradox at the heart of trading and many other performance activities. The goal is profitability, but the best practice is to not focus on the goal. By staying connected to the processes that lead to the goal, we maintain consistency in our expectations, mood, and outlook--and that pays off in consistent performance.


Overconfidence in Trading

Top Reasons Traders Lose Their Discipline


Globetrader said...

Hi Brett,
yes you hit the nail on the head (AGAIN). After 3 months of fine trading earlier this year I find myself in a consolidation. My trading results going up, then down, then big down, then up again. As if something in me has changed. And reading your article I think I found what was going wrong. Overconfidence in my ability to read the longer term market direction correctly. Going so far that I no longer cared where my entry really was, as the contracts I traded were showing such a high volatility, that nearly all trades would show me a profit sometime after my entry. But I coupled that with a desire to squeeze more and more ticks out of the individual trade seeing 50 to 100 tick moves and thinking, that I should be able to get more than 30% out of these moves. Therefore, even with a bad entry I stayed in trades longer than warranted and I did not take the chance to exit when it was offered as I expected follow-through which never materialized as I traded against a longer term trend.

The first time in my trading career I'm going through such a consolidation and I'm not standing with my back at the cliff, where one misstep will throw me in the broken account chasm. And by chance I followed the link you posted to Henry Carstens in your other article. In his "Introduction to Testing Trading Ideas" article I found something extremely valuable:

A formula to calculate the Minimum Margin you should apply to all your trades.

You need to know the maximum loss sustained in one individual trade and your Win% and Loss% numbers. I've taken the numbers for 2008, but that's up to you of course. Just make sure, that the number of trades done within the time selected is high enough to give an accurate picture of your trading.

Minimum Margin = (Largest Loss) / (((( 1 + (W% / L%))*W%) - 1) / (W% / L%))

My largest loss this year so far was 5812$, my Win% rate is 63% and my Loss% rate is 12%, the remainder are breakeven trades. I made 377 trades which is high enough to give me statistically meaningful results for my Win% and Loss% rate.

So my Minimum Margin calculates as:
MM = 5812$/((((1+(63%/12%))*63%)-1)/(63%/12%)
MM = 10347$

I always knew, I should not use less than 10k$ margin / contract traded and I did so for 3 months, but I violated that rule during the last 4 weeks, when I tried to convince myself to increase size.
I did not feel comfortable, but I couldn't put my finger on it, telling myself that I'm just anxious to increase size. Now I have something measurable, something which tells me when it is ok to increase size and when I should still wait.

Best regards,


Brett Steenbarger, Ph.D. said...

Great observations, and a great model for other traders, Chris; thanks for sharing--


Dominic Di Bernardo said...

In the minimum margin calculation, is this the amount or position size in dollars that you should not exceed. Or every position I put on should be this dollar amount or greater? I have all the data points and have done the calculation but I am a little fuzzy as to what the result is telling me.