Sunday, October 18, 2015

Why So Many Traders Lose

Here are a few observations on why so many traders fail.  It's not because of psychology:

1)  The majority of traders think directionally, and they think linearly.  That has them trading momentum and that has them trading trends.  Even the traders who look for reversals look for momentum and trend, just in a different direction.

2)  Market behavior can be described as a combination of cyclical and linear (trend) components over any particular time frame.  As markets become more crowded, cyclical components dominate over time, reducing the Sharpe ratio of those markets.

3)  Traders fail because they are thinking in straight lines when they should be thinking in cycles.  They think of cycles as sources of choppiness and noise, not as sources of signals that are different from linear, trending ones.

4)  Any market cycle consists of mean-reverting behavior at cycle peaks and troughs and trending behavior between peaks and troughs.  This ensures that any single approach to trading markets (looking for trend/momentum; looking for reversal/mean reversion) will draw down substantially over many cycles.

5)  When the Earth was found to be round and not flat, that opened the door to exploration and development of new lands.  When markets are viewed as cyclical and not linear, that opens the door to promising trading strategies.

6)  A great deal of the emotional frustration and disruption of trading that traders encounter is the result of trying to fit markets into a preferred framework, rather than discovering the framework that best describes market behavior.  

7)  Becoming more disciplined in applying inappropriate models to markets leads to greater consistency in losing.  If a ladder is leaning against the wrong building, becoming a better climber won't get you to your destination.

In short, traders lose, not because they're bad at the game, but because they are playing the wrong game.

Further Reading:  Finding Opportunity in Cycles