Sunday, July 31, 2016

How to Evaluate and Improve Yourself as a Trader

Physicians are taught that diagnosis precedes treatment:  you have to identify and understand a problem before you prescribe medications or initiate procedures.  Many symptoms can have multiple underlying causes.  Is an abdominal pain related to an ulcer, might it reflect an inflammatory bowel condition, or might it be an early sign of appendicitis?  Location matters.  Type of pain matters.  Timing of the pain matters.  Before you initiate treatment, you gather information:  a history and physical, blood tests, imaging studies.  Only after thorough evaluation do you intervene.  That is because treatments themselves carry risks.  Physicians know that their job is to "above all else, do no harm."  If you don't understand a problem, don't begin surgery; don't prescribe a medication with side effects.

The process of evaluating and gathering information before taking action is very relevant for traders.  When we act as our own trading coaches, in a sense we act as our own physicians.  If our trading results are not so healthy, our task is to understand why, so that we can initiate the right corrective measures.  To change our trading when we don't truly understand the problems we're facing is to run the risk of doing further harm.  Alterations of our trading can bring side effects and complications as well as solutions.

So how can we accurately diagnose the problems that we encounter in running a trading business?  I propose that the great majority of trading problems fall into one of three categories.  Knowing which category is relevant to your problem is an important step in identifying potential solutions.

1)  The trading problem is a business problem - A while back, a trader reported to me that his trading was not making the kind of money that he had hoped.  We examined his performance statistics and it indeed seemed as though he was making money.  His hit rate on trades was favorable and he was making more money on winning trades than losing ones.  His Sharpe ratio--the amount of money he was making per unit of risk taken--was solid.  So what was the issue?  Quite simply, he had a small trading account.  He could not make significant money because he started from a small capital base.  If he leveraged his account too much, his drawdowns would eventually place him in a risk-of-ruin situation even though his overall trading was sound.  What he needed was greater access to capital.  The answer wasn't a psychological technique; nor was the answer to change his trading.  The answer was to gain greater access to capital.  I helped him identify a proprietary trading firm that fronted his trading and he found far greater monetary success.  This was a business problem, pure and simple.  A different trader was struggling because he was following too many markets and tracking too much information.  Our evaluation found that tracking all this information did help his trading.  What the trader needed was an assistant to help him sift through information.  His trading had grown to the point where he needed to build out a team.  That's a business problem, requiring a business plan and a new business direction.

2)  The trading problem is truly a trading problem - One of the best diagnostic processes for any trader is to take an inventory of winning and losing trades and identify potential patterns of strength and weakness.  A trader I met with conducted such an assessment and found that he consistently lost money in low volatility, rangebound markets.  This was because he was trading momentum patterns.  His problem was that he lacked reliable and valid tools for identifying market regimes.  Once he developed a couple of screening tools, he could then focus on only those markets that were trading with higher volume and volatility and ignore the ones that were slow.  He also learned to pull back from trading when markets overall were slow and to take proper risk when his reliable breakout patterns were triggered.  His trading problem was creating frustration and discouragement, but it would have been a mistake to focus on emotions alone.  He needed to better identify and adapt to changing market conditions.  No amount of psychological, self-help methods could have solved his problem.

3)  The trading problem reflects a psychological problem - Sometimes the patterns of winning and losing trades have less to do with market conditions than with the condition of the trader.  One trader I knew had trouble accepting losses and became angry and frustrated after drawdowns.  This led to classic revenge trading to make the money back.  Of course, such reactive trades only further served to deepen the losses and increase the frustration.  The underlying problem was that the trader could not emotionally distinguish between losing on trades and being a loser.  He viewed losses as failures and took those personally.  Other times, traders may find themselves making poor decisions out of boredom or overconfidence.  The answer to these situations is to recognize one's "triggers"--the situations that set off the poor trading--so that those can be processed in a different fashion.  The trader who became angry when losing engaged in ongoing visualization exercises where he rehearsed a different kind of self-talk during drawdowns.  Eventually he internalized this new self-talk and was able to not take losses so personally and even learn from them.

Too often traders fiddle with their trading and make large changes in their risk taking without properly going through a self-evaluation.  Successful traders spend as much time studying themselves and their trading as studying markets.  In the patterns of your best and worst trades is the information that can make you the best trader you can be.

Further Reading:  Evaluating Yourself as a Trader