Sunday, May 05, 2019

Trading Psychology Techniques 2: Testing Your Trading Ideas

In the first post in this series, we took a look at the do's and don'ts of keeping a trading journal.  This post tackles a very different skill essential to trading success:  testing your trading ideas.

You might be asking WTF?!.  How is testing trading ideas a trading psychology technique?

The sad truth is that a substantial portion of trading (and trading psychology) problems stems from trading sheer randomness.  Traders convince themselves they see a pattern in price action, earnings, macroeconomic data releases, indicators, etc. and they act upon that pattern without testing its validity in any fashion whatsoever.

I recently met with a trader who was frustrated over losing money.  The trader described a trade where one price bar made a lower high and lower low than the bar previous on increased volume.  He inferred that a decline was underway, waited for an uptick to enter, and then stopped out when his entry bar took out the highs of the previous two bars.  He complimented himself on his risk management (i.e., honoring his stop out level), but said he was frustrated because his "setup" didn't work.  He concluded that he needed to be more "patient" with his entry and wait for weakness within the current bar before entering his position.

My approach to helping the trader was a bit unorthodox.  I downloaded data for his symbol and created a database in Excel.  I coded with 1's versus 0's all instances in which the current bar made a lower high and lower low than the bar previous on increased volume.  I then assessed the forward returns (over the next 1-10 bars) for the "setup" group versus all other occasions.

There was no difference whatsoever.

The pattern being traded was not predictive.

So here we have a situation where the trader is diligently working on his trading psychology (keeping a journal, observing his losing trades, making plans for improvement), but his psychology is not the primary problem.  His  frustration and discouragement stem from the fact that the ideas he is trading lack a foundation in objective reality.  Imagine if a person played roulette at a casino and placed bets on numbers corresponding to the birth dates of family members.  That person then becomes frustrated and stressed because his system is not working!

(To take the analogy further, imagine a "gambling coach" who emphasizes to the roulette player that he needs to maintain a calm focus and stick with his system in a disciplined manner.)

How many traders trade sheer randomness, only to have mentors and coaches insist that there is an "edge" and that the key to success is faithfully following the system?

That is not just bad trading.  It is a clear waste of time, energy, and resources.  When someone trades randomness and can't obtain results, they *should* get upset!  What is delusional is continually getting one's hopes and confidence up and "working on trading" by tweaking utter randomness.

There is, however, a more subtle problem associated with the lack of testing for ideas.  The great majority of traders aren't really crazy, though I may occasionally question their sanity.  They realize that their ideas are untested, and they can't truly explain *why* the patterns they trade should produce an objective edge in the marketplace.  As a result, they never develop confidence in what they do, even when the ideas are seemingly working out.  It is the cognitive grasp of why trading signals are valid that leads to the development of true conviction.

There are two ways of testing trading ideas:  1)  backtesting over multiple independent data samples (to make sure any single backtest isn't spurious) and 2)  establishing an objective track record in simulated and real-time trading that demonstrates, over multiple time periods and market conditions, results significantly better than random.  Ideally, the first way of establishing the value of an edge leads to the second, so that backtests are validated in real time.  

The bottom line is trading ideas that you've worked with and tested provides an unparalleled--and reality-based--foundation for your trading psychology.  Testing also tells you what doesn't work--and that can lead to a deeper understanding of hidden edges.  Sadly, there are many traders who insist that they will succeed in their trading through sheer passion and willpower, when in fact they display all the signs of a trading addiction.  You would never purchase a car without giving it a test drive; your trading deserves nothing less.  It is not enough to rely on the promises and claims of peddlers offering the next best trading scheme.  Test before you invest your precious time and money.

Further Reading: