Sunday, April 30, 2017

A Simple Mistake Traders Make

Here's an interesting informal experiment I recently conducted:

Select an entry point on a chart and a direction for the trade.  Based on the chart (and the chart patterns perceived), select the target point at which you would exit and the stop point you would honor.  In other words, estimate how far the market will move in your favor and how much it could move against you.

My experience is that successful traders are more realistic in the setting of those targets and stops.  In other words, they don't place targets unrealistically far away, and they don't place stops unrealistically close.  When I've polled newer traders and then actually calculated the odds of hitting the price targets within a given holding period, the odds were much less than 50%.  In other words, the less experienced traders overestimated the directional movement possible within their holding period.

Conversely, those less experienced traders underestimated the odds of getting stopped out.  Those odds, for a given holding period, well exceeded 50%.  The net result was that traders were getting stopped out well before reaching their targets and then becoming frustrated at "choppy" markets.  That's bullshit, however.  It's not that the market is choppy; it's that the trader's estimations of price movement are unrealistic.

I find this dynamic to be especially prevalent among those who trade over longer time horizons based upon fundamental criteria.  They set price targets with those fundamentals in mind, but over the course of their anticipated holding period, volatility would have to spike for them to hit those targets.  They are implicitly trading a volatility view, and that's been lethal in recent low volatility markets.

Interestingly, I recently observed a trader who was experiencing consistent success, with profitability every month this year and most trading days.  When we discussed what the trader was doing well, it turned out that he was patient in his entries and *very* realistic in his price targets.  When others were seeing price make a local new high or low and getting excited about the "move", he was already taking profits.  Because of his conservatism in taking profits, he implicitly was expecting reversals--a dampened volatility view.

To cement these observations, I went back to my recent trades and calculated my typical holding period.  I then went back to historical prices and examined the expectable directional price movement during that holding period.  In many cases, my targets were not well aligned with the movement that could be expected.  If I had taken profits halfway to my target instead of waiting for the target, I would have been much more profitable, with a higher hit rate.

As a result, I created a measure of microvolatility:  the amount of movement expectable over intraday time periods.  When targets were adjusted for microvolatility, the hit rate and profitability soared.

Traders--and I include myself here--lose money because we are stupid.  We impose our needs/desires/expectations onto markets rather than adjust to the actual behavior of markets.  If I operated in such a manner in my social life--or as a psychologist!--I would alienate quite a few people.  The socially skilled person reads the verbal and nonverbal behavior of others and is sensitive to that when responding and conversing.  The skilled trader similarly reads the behavior of markets and trades within the framework of what markets provide.

Anything else is stupid--and unprofitable.

Further Reading:  The Actual Relationship Between Volume and Volatility