Saturday, May 03, 2014

Honing Your Trading Process - Part One

We often hear of the importance of having a "trading process".  But what goes into such a process and what is it so important to be process-driven?  This two-part series will offer perspectives.

In such fields as manufacturing and health care, a process orientation is essential to quality control.  Surgeons, for example, operate under the guidelines of best practice routines to reduce complications and maximize outcomes.  Reliance upon a standard set of procedures reduces the variability of outcomes.

When Margie and I visited the Two Roads brewery in Stratford, CT, we were surprised to see how few people were involved in the brewing process.  Almost everything was computerized and automated.  This automation ensured that each step of the brewing occurred at exactly the right temperature, for exactly the right amount of time, with exactly the right amount of ingredients.  Once the brewer has the desired recipe, the key to successful production is standardization:  making the same excellent product every single time.

From a quality control vantage point, replacing subjectivity with objectivity is generally a desirable outcome.  The expert chef can get away with estimating ingredients by adding "a pinch here", but most of us are not experts.  If a machine can add the precise pinch, a potential source of error is removed.

In an activity such as trading, where emotions in the heat of battle can introduce wild elements of subjectivity, a process orientation is essential to success.  Algorithmic trading is the Two Roads version of money management, where every decision is precalculated and automated.  Yet even discretionary trading can be made rule-governed and process-guided.  An analogy would be playing poker or chess:  there are rules for making good and bad bets and good or bad moves on the board, even as there is considerable room for individual judgment.  Similarly, a football quarterback may call an audible at the line of scrimmage to take advantage of a defensive alignment, but the play called will have been pre-structured and well rehearsed.

The areas of trading that can typically be made more process-driven include:

1)  Research and idea generation:  Procedures for coming up with good trade ideas and investment theses;

2)  Trade expression:  How to structure the trade to achieve optimal reward to risk;

3)  Risk management:  How to bet enough on the idea to achieve a desired return on capital, but also to avoid an undesired drawdown;

4)  Trade management:  How to handle the position once it is on, including points to stop out, scale in, scale out, and take profits;

5)  Portfolio management:  How to allocate capital across trades to diversify returns and optimize equity curves;

6)  Self-management:  Procedures you implement to keep yourself in an optimal state for recognizing opportunity/threat and making decisions under time and emotional pressure.

Each of these areas can be mapped out and distilled into principles and checklists.  The checklist for an equity long/short investor will necessarily differ from that of the daytrader, but the categories will be similar.

If you are a process-driven trader, you can write a substantial essay for each one of those categories.  Indeed, if you were seeking capital for your trading, questions about each of the six categories above, along with detailed examples, would anchor an effective interview.

If your essay or interview responses would consist of a few sentences of generalizations, you know that your processes can be elaborated and tightened up.  Ultimately, your responses to the above should map to a distinctive and demonstrable edge in the marketplace. 

The goal is to figure out your best trading and then help you become as consistent as possible in enacting what you do best.  Your process should be the distilled essence and procedural expression of your greatest strengths.

In the next post in this series, we'll take a look at how you can elaborate your processes and make them more robust.

Further Reading:  Reflections on Trading Process