Thursday, July 03, 2014

Hunter S. Thompson, Madness, and Trading

Yes, I was there for the infamous HST presentation at Duke University.  The backstory was that, after insulting his audience (he claims he hallucinated them as animated okra plants) , wrestling with his stage mike (he claims he hallucinated it as a snake), and tossing his bourbon onto the stage curtain, Mr. Thompson proceeded to meet with a smaller group of students on the university lawn and engage them in a completely sober and enlightening discussion.  Not all who rave are divinely inspired, but there was at least a touch of inspiration amidst the ravings that day.

Having an "edge" as a trader:  rarely has anything been so frequently discussed and so infrequently demonstrated.  We can demonstrate a trader's edge through a long-term, real-time track record of trading; we can demonstrate a strategy's edge through properly constructed backtests.  My preference is to trade a strategy that has displayed a historical edge and then let the track record display whether I have an edge in implementing it.  Like Hunter once said, it's fine to pray, but row away from the rocks.

Sometimes you don't really know where your edge lies until you go over it.  We like to think that trading what fits our personality will provide us with our edge, but that can be a socially acceptable way of justifying a failure to move outside our comfort zone.  Indeed, the whole reason psychologists get involved with traders is because trading one's natural predilections tends to mean trading one's perceptual and cognitive biases, acting out one's bad habits in markets, etc.

Getting on stage and imagining your audience consists of animated okra plants is considered crazy.  Sitting in front of a screen daily, trading away with no demonstrated edge, and justifying it all by "trading my personality" and "following my plan"...well, that's considered a career.  

Admittedly, going over your edge and seeing what lies on the other side is crazy.  It's a lack of discipline.  It's not trading your plan or being in your zone or beating one's breast with manly pronouncements of conviction.  And what if what lies over the edge is *not trading*?  Well, perish the thought: that would show a lack of passion for trading, and we all know how necessary that is for market success (and high commissions).

I once decided to play it brutally straight and, in a first meeting with a client, calmly explained that the strategy he was trading was based on randomness and a simple backtest would prove that.  That, I suggested--more than any psychological problem--was responsible for his trading woes.  Needless to say, the backtest was not requested and neither was my coaching.  Throwing bourbon on people's stage curtains is a great strategy for getting yourself ejected from the auditorium.

So what brought all this on?

Let's go out on the lawn and get back to basics.

The time series of any market consists of a linear component and one or more cyclical components.  When the linear component is near zero, we have a range-bound market.  When the linear component is very strong, we have a trending market.  When we have more than one significant cyclical component, we have a noisy, choppy market.

When we see a stable time series, what we're really seeing is consistency of linear and cyclical components.  When the world changes in material ways, those components change and we shift from one regime to another.  What makes trading so difficult is that the strategies that work well when linear components dominate are not those that work well when cyclical components dominate--and once a strategy works well, a shift of regime can undermine its efficacy.

Trends change their slope; cycles change their frequency and amplitude:  it's tough to trade your personality when the market is changing its own.  Trading fixed "setups" in changing markets is perhaps a setup in ways that are unintended.

In the current stock market, there is a strong positive linear component (uptrend) and a strong low-frequency cycle superimposed on it.  That regime has persisted for some time.  In such a regime, my "edge"--short-term trades of 1-3 days based on backtested predictors--has not been a particularly good edge when traded real time.  Why?  In essence, I'm trading a short-term cycle, when a short-term cycle is not dominant.  I'm trading my personality and my predilection, not what the market is giving me.  To borrow a phrase from a savvy trading friend, short-term strategies "get run over" when lower frequency cycles and strong trend components are highly dominant.

In other words, my dogma has been run over by my karma.

If I take what the market is giving me, I'd trade a helluva lot less often and align the trades with the most significant components of the present regime.  So, I've gone over my edge to see what's on the other side.  I'm trading the direction and time frame suggested by the components that account for the lion's share of market movement.  That means I'm not daytrading, I'm not swing trading, and I'm not watching screens nearly as much.  

I'm just making more money.

Further Reading:  Preparing to Win