Friday, November 09, 2007

Test Before You Invest in a Trading Career

Contemplating this nugget of wisdom from
the wonderful site, I reflected upon all those traders who have described their competitive edge in the marketplace as "a passion for trading". Can you imagine asking your surgeon for his or her qualifications and receiving a similar reply? Not that there's anything wrong with passion, but one would like to see it backed up by a bit of training and skill!

So what is one's competitive edge in trading? If you're a systems trader, your edge comes from your trading rules: entries, exits, stops, and position sizing. That edge is documented through historical backtesting across a range of market conditions. Conducted properly, such testing shows precisely how much money you would have lost and won during various historical periods--the risk adjusted returns you can reasonably hope for going forward.

When you're a discretionary trader, your edge comes from your skill. Your ability to recognize market patterns, act on them with consistency, and effectively balance risk and reward provides your advantage in the marketplace. Your edge is documented through paper trading (or live trading of small positions) across a range of market conditions. Such a track record enables you to see how much money you won and lost during various historical periods--the risk adjusted returns you can anticipate in the future.

What is not a valid means for testing one's trading advantage is taking on faith that the methods have worked for others (including would-be gurus). "Other people use the X method," traders have told me. "It must be valid." But do you know that these methods are working for others? Do you know that you would have the same skills, risk tolerance, and consistency to exploit these methods?

Ultimately, a real time track record--for systems as well as discretionary traders--is the gold standard for estimating one's trading edge.

But if you haven't backtested your rules or diligently tracked your performance in real time, can you know you have an edge?

Moreover, if you don't know you have an edge, can you have full confidence in your trading?

When traders don't stick with their ideas, they call it lack of discipline. But perhaps lack of testing is the better term. Maybe traders don't stick to their ideas because they've never truly put those ideas to the test. Down deep, they lack the conviction that can only come from hard-won experience.

Would you invest in a car without giving it a road test? Would you buy a house without testing the mechanicals and inspecting the structure? A trading career is no less valuable: testing before investing in your trading is a great means for cultivating confidence--and, as we recently saw, confidence is a great step toward clarity in decision-making.


Understanding Lapses in Market Discipline

Top 10 Reasons Traders Lose Discipline