Saturday, April 12, 2014

How to Deal With the Uncertainty of Trading

Reader Eldad Nahmany asks the excellent question, "What if I can eliminate uncertainty by accepting the true range of results that can arise from each trade?  I guess everybody said it before: accept the loss before you even enter the same way you accept the winner, then I can become a true observer of information.  The question now is how do I accept the loss before i get involved? I need to believe in the trade, no?"

It's a dilemma on the surface:  how do you maintain confidence and conviction in a trade and, at the same time, embrace the trade's uncertainty by planning its failure?

If you were a retailer and you had perfect knowledge of demand, you would always order the right amount of product in each category and never maintain excess inventory.

Once we accept that we cannot have perfect foreknowledge, then we accept the necessity of inventory.  We order extra product, because we don't know if customer interest will expand or contract; if a particular offering will fly off the shelves or languish there.

Of course, you could ask the retailer, "How could you believe in your product and yet still plan for inventory?  Aren't you preparing for your own failure?"

The answer, of course, is that any specific product might succeed or fail.  If you are a good buyer and merchandiser, you succeed across a variety of products.  You carry enough different products and price them well enough to ensure that you'll have some hits as well as some duds.  The duds will lose you a limited amount of money; the hits will be restocked again and again and will make up for the duds--and then some.

So it is with trades.  You don't need blind confidence in each position.  You need enough confidence in your overall trading ability to put on a variety of trades.  Some will be duds, and you'll catch those quickly and minimize their losses.  Others will be hits and you'll add to those as they prove themselves.  Any particular trade can be a failure; it's the edge across trades that makes you successful.

When people wax poetic about their conviction in trades, my emotional reaction is:  Whatever.  A trade is a bet at the poker table.  Some bets will work, some won't; some you'll size up, some you'll fold.  Whatever.  Over time, if you play the odds, you'll do OK.  Beyond that, it doesn't make a lot of sense to beat the chest and invite overconfidence bias to replace normal confidence.

Every forecast of a statistical model can be wrong.  Every trading judgment is fallible.  If you have a 50% hit rate on your trades and you trade once a day, on average you're going to have an occasion in which you lose every day for a week during a trading year.  That doesn't mean you're in a slump; it doesn't mean you should change what you do.  It's going to happen and you can mentally prepare yourself--and size yourself in such a way that five consecutive losing days won't take you out of the game.

The goal is not to eliminate losses--that would require omniscience.  Rather, the goal is to  anticipate losses so that you're never surprised, never overwhelmed, never thrown onto the back foot.  True confidence comes, not from believing that you must be right, but from knowing that you can survive and even thrive if you're dead wrong.

Further Reading:  The Power of Uncertainty