Friday, June 29, 2018

What Are The Patterns In Your Trading?

Trading is based upon the notion of recurring patterns in markets.  These could be patterns of price behavior, patterns of response to world or economic events, or patterns that occur in the relationships among markets.  A common trading pitfall is perceiving patterns where none truly exist.  We can become anchored to recent occurrences and assume that these will recur.  We can overemphasize dramatic market occasions, such as large drops in prices, and look for similar "setups" going forward.  If we look at enough patterns, something by chance will appear to be significant.  Not all "overfitting" is performed by quants.

Just as there can be patterns--and false patterns--in markets, these can also exist in our trading.  One daytrader I worked with had flat results over several months.  When we dissected the P/L, it turned out that certain hours of the trading day (early morning) were consistently profitable.  Other hours were losers.  The patterns being traded, which involved momentum, were more likely to occur during periods of higher liquidity.

I also met with a portfolio manager who was having trouble making money.  When we examined his returns, it turned out that newly initiated positions were getting stopped out for losses unusually often.  This was because, in a lower volatility market, he was waiting for strength before going long and waiting for weakness before selling.  He kept stops tight and thus was whipsawed when the short-term price movement failed to extend.

There is tremendous benefit in dissecting your returns as a trader.  Yes, we can overinterpret and perceive patterns that do not exist.  Many times, however, there are rational explanations for why the returns are patterned.  Perhaps we're trading differently after having made versus lost money.  Perhaps we're trading differently as a function of market conditions.  Perhaps we're trading differently as a function of how we have prepared for the day or week.

I find it again and again:  Successful traders spend significant time not trading, studying their markets, and studying their performance.  Successful sports teams review game films to prepare for the next contest.  What is your review process, and how rigorous is it?

Further Reading: