Wednesday, April 08, 2015

The Importance of Understanding WTF We're Doing as Traders

I noticed that Bruce Bower, via SMB, has posted on the topic of what a winning trading methodology looks like and has released an e-book on the topic.  Bruce emphasizes that a methodology must be grounded in a replicable process and that this process must fit well with the personality and skill sets of the trader.  A very important observation from Jack Schwager in his Market Wizards series is that successful money managers have quite different skills, personalities, and workstyles.  These result in very different trading styles.  What creates success is not adherence to a particular style, but the ability to exploit market inefficiencies in a manner consistent with one's own abilities.

Replicability as a process and fit with a trader's skills and personality are necessary for a successful trading methodology, but not sufficient.  Bruce points out that the method must also manage risk effectively and filter the many possible decisions into ones that offer a reward that is superior to the risk incurred.  In short, a successful method must possess an "edge":  positive expected returns over time that justify the risks incurred.

But there is one other ingredient in a successful methodology that tends to be overlooked:  understanding.  

If you think of a trading methodology as a core aspect of a business plan, the element of understanding becomes clear.  A good business plan doesn't just describe a business with a process and a fit with the owner.  Nor does it simply limit risks and pursue greater rewards.  The good business plan starts with an understanding of the consumer and the drivers of demand in the marketplace.  A startup business meets an identified need.  Entrepreneurs must understand their markets.

Too often I see trading plans/methods that describe "setups" that are devoid of market understanding:  a shape on a chart, a reading on an indicator, a news development, a data release, etc.  Missing from such an approach is a clear identification of what drives prices and how one's methodology will uniquely exploit such drivers.

A very worthwhile text is this regard is Expected Returns from Antti Ilmanen.  Ilmanen identifies specific factors that uniquely impact the pricing of markets, such as value, momentum/trend, carry/roll, volatility, seasonality, liquidity, and the like.  Bender and colleagues break down factors into value, size, volatility, yield, quality, and momentum.  If we think of trading methodologies as business plans and factors as defining opportunity sets, then the solid methodology should be grounded in an explicit understanding of the factors  being targeted and the ways in which the trading approach uniquely exploits those factors.

A simple example would be a breakout trading style that defines periods of market balance and pursues directional moves that emerge from this balance.  That would be a strategy for exploiting momentum and possibly trend.  That would be quite different from a value-oriented long/short strategy that buys undervalued companies and sells stocks of similar companies that are more richly valued.

Three simple tests for a sound trading methodology would be:

1)  Can you clearly identify the factors that your methods/plans will be exploiting?
2)  Can you clearly explain why your methods uniquely exploit these factors?
3)  Can you demonstrate with research or trading evidence that the methods you're trading indeed do uniquely exploit the factors targeted?

If you were investing in a business as a potential venture capitalist, you'd ask those questions of anyone pitching their business to you:  Can you identify the business opportunity?  Can you clearly explain how your proposed business exploits that opportunity?  Can you produce evidence that your business indeed does exploit that opportunity?

If you wouldn't invest in a business plan that lacked clear answers to these questions, why would you invest in a trading plan similarly devoid of understanding?

Traders are entrepreneurs:  We're most likely to trade with confidence and conviction when we possess a deep understanding and belief in what we're doing.

Further Reading:  The Proactive Personality of the Trader