Saturday, July 25, 2015

Lessons From My Trading: Turning Trading Into Learning

Back in May, I wrote about an experiment I was conducting in my trading.  Since that time, I've made mistakes and learned valuable lessons.  Out of those has emerged a promising consistency in my profitability.  I am quite confident that I have many more lessons to learn and mistakes to make.  So far, however, those lessons have been constructive ones, so I thought I'd share the most important ones:

1)  Since May, I have returned to my daytrading roots.  In that May post, I outlined three patterns that anchored my trading.  My trading consistency (hit rate) and profitability increased dramatically when my trading of those patterns was intraday.  When I focused on the larger picture--patterns and price projections from those patterns--I lost my feel for the market and became ill-prepared for variations in price paths.  When I used the patterns as context but focused on the moment to moment flow of market behavior, I could actually feel whether or not patterns were playing out.  This has become important, not only in terms of managing risk proactively (exiting trades when the flow of volume is diminishing in my direction; not when prices have reversed and hit my stop), but also in terms of opportunity management (sizing up trades in which flows line up with the patterns).  Fast pattern-recognition is my greatest cognitive strength as a trader.  By focusing on longer-term market behavior and patterns, I was neglecting this strength and that led to trading that was not consistently profitable.  It's been a great reminder for the psychologist:  success comes from leveraging who we are at our best.

2)  Since May, I have refined quantitative models that forecast ES prices 3-5 days forward.  The greatest refinement has been to model non-linearities in the data:  situations in which the relationships among predictors and outcomes are different at extremes of the distributions.  For instance, it's not too unusual for average values of an indicator to be unrelated to future price action, but extreme values to have predictive significance.  Modeling those non-linearities has led to better models.  (They actually are quantifications of the patterns mentioned in the May post).  Per the first point above, however, my trading has been best when these model forecasts act as background and context.  The successful trading comes from seeing order/trade flow line up with the forecasts.  Even the best forecasts predict only a modest fraction of total variation in forward prices; trading only when flows line up with forecasts has greatly improved the hit rate.

3)  I review every trade and what I've done right and wrong.  It is no exaggeration to say that I spend much more time reviewing trade results, reverse-engineering success and failure, and researching the lessons from those than actually trading.  The intensity of this deliberate practice has greatly accelerated my learning curve.  Increasing the selectivity of the trades I take (per the two points above) and maximizing my review process has been much more successful than spending a lot of time in front of the screen and less time in review.

4)  The number one psychological predictor of the success of my trades is my cognitive state while putting the trades on.  If I am highly focused and have a clear sense of both larger picture and moment-to-moment flows, the trade is much more likely to be successful than if I lack that quiet sense of understanding and mastery.  A great example of a trade lacking that sense would be one where I am entering because I'm concerned about missing a move.  Almost invariably, the timing on such a trade will be poor.  It's in the quiet, focused state that the pattern recognition will kick in and I will have a much better feel for when flows are turning in the expected direction.  Eliminating distractions while trading has been crucial for me. 

5)  Where I have the greatest progress to make from here is in proper trade sizing and position management.  What I'm finding is that it is much better to limit the number of trades taken based upon the above four criteria and sizing those trades up, rather than taking more trades and sizing them moderately.  I'm also finding it helpful to use this increased sizing to facilitate a scaling out of positions, so that the portfolio can benefit from both short-term price reversals and ongoing trend behavior.  Because I only trade one instrument, my diversification comes from differentiating time frames.  This requires separate planning and review for the short and longer trades, and that is a work in progress for me.  The challenge is to ensure that the longer-term planning and trading process does not bleed over into the flexible management of the shorter-term positions mentioned above.

My hope is that this self-reflection can serve as a kind of model for your own trading.  Your lessons will be different from mine, because you are different from me and your trading is different from mine.  The overlap will be in the process sense:  by treating your trading as a performance activity, learning from mistakes and successes, and feeding those lessons forward into your future trading, you can evolve dramatically.  If you write a blog and thoughtfully review your lessons learned, by all means let me know and I will be happy to link in the spirit of mutual learning!

Further Reading:  Turning Setbacks Into Wins