Tuesday, March 17, 2009

NCAA and Trading Upsets: Know Your Performance Profile

An excellent article in today's Wall St. Journal describes the science behind upsets in the NCAA tournaments. The article points out:

"Despite all the hunches about sleeper picks, teams often win basketball games at any level for a simple reason--they create more chances to score than their opponents do by forcing more turnovers and grabbing more rebounds. More shots at the basket usually generate more points."

The article later provides examples of teams that perform better or worse depending on the quality of their opponents. These statistical tendencies greatly alter the odds of tournament upsets.

The implications for trading are significant. Much of trading success boils down to consistency: being able to "score" against a variety of opponents (in different market conditions). Many times we see a trader make money, only to find that it's primarily made on the long side when buying the market. Little wonder that the trader experiences a tournament upset when the trend changes.

Similarly, just as basketball fundamentals--rebounding, limiting turnovers--alter the odds of winning, the fundamentals of trading affect profitability. Does the trader wait for weakness before buying or strength before selling, thereby improving the risk:reward profile for the trade? Does the trader limit losses promptly, using information from those losing trades to score with new, winning ideas? Does the trader take a level of risk in the trade commensurate with the trade's potential and uncertainty?

The most important implication of the article, however, is that many upsets are not really upsets, once we drill down to performance statistics. Most traders don't know how they perform in different market conditions; in their long vs. short trades; in their trades in different names or markets; in different times of day. It's difficult to improve yourself as a performer if you don't truly understand your strengths and weaknesses as a performer. Playing to your strengths and minimizing your exposure in weak areas can help ensure that you will be the one pulling off upsets in the markets, not the one who gets smoked in seemingly easy market conditions.