Saturday, May 20, 2017

How Expectations Poison Our Trading

A while back I worked with a trader who was the most calm, balanced trader I had ever met.  He went through losses and drawdowns and I never saw his demeanor change.  During one particular drawdown that would have frustrated most traders--he went from up on the year to slightly down--I asked him why he didn't seem particularly upset.  He then quoted to me his lifetime Sharpe ratio (his profitability as a function of the variability of his returns) and explained the amount of risk that he was taking to make his desired return and explained that these statistics guaranteed that he would have such drawdowns at least once every year or two.  Tolerating the drawdowns was part of sticking with a process that had proven itself over many years.

This trader also explained why he did not size up particular trades relative to others.  He believed that having an edge in the market was a matter of probabilities.  He felt that he did not have a crystal ball that reliably predicted which trades would work.  If he were to size up particular trades based upon a false confidence, this would change his P/L dynamics, potentially creating drawdowns larger than those expectable based upon his historical Sharpe.  His goal was to trade consistently and let odds work in his favor over time.  Psychologically, he placed little expectation on each individual trade; probabilistically it might work out, it might not.  By reducing his expectations for each trade, he avoided frustration and trading reactively out of emotional reaction.

When we become frustrated and then either miss trades or overtrade out of that frustration, the problem quite often is with our expectations.  When we turn a trade into an issue of "conviction"--when we *need* for a trade to work out--we set ourselves up for disappointment.  Our job is to trade with the odds and accept the probabilities that the odds may not play out on any particular occasion.  Confidence in trading comes from the cultivation of a set of robust processes for identifying opportunity, expressing that opportunity as trades, and managing the risks associated with those trades.  

Can you imagine having a great romantic relationship if you kept score each day on the "performance" of your partner and became happy or disappointed based on that day's score?  How would you feel if your partner kept scores on your daily behaviors?  It does make sense to assess a relationship, but you do so over time by stepping back and making sure things are good in the big picture.  That is exactly how we should assess our trading.