Saturday, April 18, 2015

What I Learned By Studying My Exits

An interesting question posed on the Tradeciety site asks the one thing you wish you had known when you started your trading career--and gives the responses of a number of experienced traders.  Most of those responses focus on sound trading practices and ways of learning trading--sound universal lessons.

A worthwhile variant of that question is:  what's the one thing you wish you had known at the start of the year?  In other words, what have you been missing in the last few months of trading?

I recently conducted my own trading inventory and examined in detail what has worked and not worked.  The results were illuminating.

My exits have been bad.  In some cases, they've been really bad.  What I mean by that is that:  a) they've been less rigorously thought through than the entries; b) they've been reactive to the pain of drawdown and not the risk/reward at that moment; and c) they've been at poor locations.  A surprising proportion of my trades would have been profitable had I held the position with a wider stop.  The seemingly good risk management significantly hurt profitability.

The problem--and I see it with traders I work with--is the misalignment of goals for the upside and risk management on the downside.  At a given, reasonable, but positive Sharpe ratio, a trader seeking X% returns is going to draw down a meaningful percentage of X% at some time.  Traders--including myself--feel the desire for the X% upside, but cannot psychologically or practically tolerate the accompanying drawdown.  It is not coincidence that my hit rate on trades placed with smaller size (less risk) has been quite good.

Ultimately this is a problem of lack of diversification.  A well constructed portfolio consists of many relatively independent bets, each with positive expected return.  This smooths the equity curve while allowing the trader to place a higher proportion of capital at work.  Diversification requires ongoing research and development--and the ability to see multiple edges in the market.  It is much easier to allow trades to breathe and hit relatively wide stops when there are multiple trades working for you.  A great deal of the challenge of dealing with emotions in trading is a function of poor money management.  It's tough to trade dispassionately when all your eggs are in one basket.

Further Reading:  Diversifying Your Emotional Portfolio