A Tale of Two Traders

Of all the incoming questions I get through our blog, I seldom get inquiries about the actual process of trading. It's always about how much money someone wants to make, how they love a special stock and "what I think" about this and that. Usually wanting to buy bust stocks and get me to validate their own assumptions.

It's honestly worrying because all of these questions lead me to believe most potential traders are doomed from the start. The focus is on money, lifestyle and the illusion of success perpetuated in society.

The questions people should ask themselves before they even start trading stocks should be:

1. Do I understand trading needs to be managed and treated like a business?
2. What type of time would I need to allocate to trading professionally or seriously?
3. Will trading stocks fit into my lifestyle and require much sacrifice?
4. How do I develop a profitable trading strategy and prove it works at least mathematically?
5. Does the mathematically sound strategy align with my personal beliefs about wealth creation?

I fell into the same traps for years until I had a real "Eureka" moment.

After taking another huge loss (at the time €550) which was like 10% of my account back then... I got so angry that I wanted to give up. A total "fuck this", "the market is manipulated", etc moment. So I got angry, I blamed everyone else but shortly afterwards hauled out excel and went through each trade I had ever made.

All I can say is what I saw, shocked, scared and excited me beyond all belief.

All the Makings of a Profitable Trader

My first exercise was to look at why my trades were going off course. It took a few seconds with a highlighter and notepad to realise almost instantly that I had pervasive and recurring issues that showed up like clock work in my trading. I found the following stats by marking up columns on my trading journal:

1. I was indecisive on over 30% of all my trades! - Fear of rejection
2. Almost 20% of my trades came from tips vs my formal trading criteria - Fear or missing out
3. Selling before my stop loss and choking off trades because of fear of losing money - irony at it's finest
4. Being scared of success and taking off big winners too soon - fear of being wrong or losing
5. Taking trades that were categorized as 'unclear entry' over 15% of the time - Fear of missing out
6. Position sizing was subjective, some positions where larger than others - Another form of fear of missing out
7. The positions themselves were too small in some cases and too large in others - Fear of loss

Two traits pervasive in ego driven decisions: i) Fear of losing or being wrong/rejected and ii) Fear of missing out and not being Mr. Perfect, #1 etc.

The biggest aha moment came about when I realized that these mistakes were all fixable with practice, repetition and positive re-enforcement. There was no ambiguity about why I wasn't hitting it out of the park - simple erroneous habits in my code I needed to resolve.

Phase 2 - Simulating Numbers

Taking these points into account, I took my trading journal and very systematically started taking away these errors in a parallel spreadsheet. I did the following:

1. Removed any F grade or non-conforming trades from the diary (which are objectively measured based on risk and other measures)
2. I made the position size and risk even for each and every trade to reduce ambiguity or 'how I feel' about the trade
3. The only entries taken in the simulated diary would have clear setups with distinguishable pivot areas - so no buying stocks below the 50MA
4. Stocks could only exit at the full loss amount (I could not take off a trade until the stop was hit)
5. Moving to break-even could only occur when the stock was up 2:1 it's initial risk - I still struggle with this.

After experimenting and going back to double check I wasn't subject to a number of potential biases, I ran the numbers in my actual account at the time, so I took my trades and plastered them with concealer.

I would like to take a moment to disclose I made sure to not curve fit at all.  The time frame used in this sample is 5 month duration from the beginning of last year (2019). Samples were also taken from other years to make sure the results would be comparable.

The Numbers

Needless to say, when the numbers came back, I had to double take, go back to the drawing board and make 100% sure I was not bending anything to my favor. After a few tweaks, they came back even better, so I used the worse of the two:

I called the imagined numbers a 'make-up' diary because we all sober up eventually. It's not that easy to switch off 30 years of hereditary programming and trade like a robot. The good thing though, it gives some really clear pointers of where your system is falling off the wagon. In fact, these could be the very thing that make you money or allow you to go bust.

As you would anticipate the comparable systems also create a similar stories with the % win distributions (graphs below) this reinforced:

1. Trading with poor discipline is the difference between profitable and professional trading.
2. Waiting for trades to play out allows your edge to roll over more frequently creating larger wins that more than make up for any losses you may have sustained

Perhaps the most important lesson here is - your assumptions and intuition does not have anything when objectively stacked against the numbers.

Taking poor quality trades just to be in the market may feel good at the time it will however be the difference between success and failure, in a massive way.

Expressed on a Distribution

If you look at the trades on a histogram, it also gives the impression of a bell curve. You can see where the real and ideal trades fall within these parameters to give you an idea of how you are trading:

Over time, the distribution and averages play out. This can't be done in a vacuum though as things can rapidly change in the stock market. If the market pulls in hard then you need to anticipate or at least expect a hiccup in your portfolio.

Two quick takeaways from this:

1. Trust the numbers more than your intuition - executing the strategy is your only job, stop thinking so much! There has to be set rules that have been tested and can be followed or automated.
2. Trying to outsmart the stock market is pointless. Our up and down emotional decision making that is acceptable in the outside world really has no weight in the market.
3. Taking low quality trades can lead to large losses as you can see in the red mark-up above. $GOSS - this was such an idiotic trade.

This is the same in "normal life", it's not what happens but how we adapt and react. This is something we all know and love as traders. The market is the ultimate objective mirror of who we are - that's why people fear it and we embrace it. The numbers don't lie.

Doing Some Results Based Abstraction

A good friend living and trading in Thailand (please follow him on Twitter) created a Monte Carlo simulator on his own blog. The basic premise of a Monte Carlo simulator is to take the known variable we have about our trading (making assumptions of course) and testing the probability over say 100 or 1000 trades.

It gives us an idea of whether or not our system will be profitable over the long term (statistically) and what our worst losses may be also based on the same assumptions. Below is a simulation of the winning diary compared to that of the less profitable one:

Make-Up journal variables entered into simulation:

Notice how:

1. The system does not dip below zero too frequently
2. Results are projected to the upside in terms of the normal distribution

Seeing what was possible by tweaking only 3 or 4 variables was mind blowing. I recall reading an interesting metaphor on this - If a ship sails towards an island and is off by only 1 degree, it could end up in a totally different part of the world. There are some very powerful lessons in how consistency and focus can move mountains.

No Make-Up Journal

The true power of compounding and having an edge are very obvious to see here:

1. The risk of ruin was far more real if I kept trading poorly
2. I was still trading quite well even for someone lacking discipline - this was a big confidence boost, some people are closer than they think.

The message became more and more obvious. Following the rules was the only way for me to make insane money in trading, rules based and systematic thinking was the only way for me to keep myself away from myself.

Make Sure to Run These Numbers

I highly suggest taking a trading journal and say 100 trades to try this out. If you need a template please subscribe or contact us directly. All you need is the winning trades % and other parameters above. Knowing these truths about your strategy could be the difference between doing well and going broke.

The Outcome

Plugging in my trading results and being brutally honest and accountable for my trading results forced me to start creating processes around my trading. Literal flow charts of my decisions and what I can and can't do. Below is an example of some simple screening or buy rules. I have a folder of these that I look at before the market to reinforce the truth - it's just a numbers game, stop being a slave to your emotions!

If at this point you are asking yourself about how much work trading takes if you really want to make it - this should give you a good idea. Yes it takes work but it is quite literally the most money you can make outside of owning a successful business or being famous. My goal is to be accountable to me and also stay off the radar. Fame is overrated and having employees to me seems like a massive responsibility.

To really emphasize the point, this is why trading is personal. Far too many people should just not trade at all, I came close to being one of them until documenting trades in depth.

What do Your Numbers Say?

So now my challenge to you is to run your own numbers and be 100% honest with yourself. Who gives a shit what people say about being wrong? Trading is all about being okay with failure. If you don't challenge yourself and learn how to be uncomfortable, don't trade! Invest in indexes, start a business or pursue another career. Trading is attainable and highly lucrative, if you know who you are. Knowing oneself is the easiest and hardest thing at the same time.

Once you've plugged in some trades I suggest doing a 'Make-Up' journal, take out the trades that did not confirm to your defined rules:

1. Is your system really profitable?
2. Is it risky, from a statistical point of view? What does the Monte Carlo simulator say?
3. What mistakes are repeating themselves and do you have a process to fix this? If not, how will you re-wire this part of your psyche?
4. Are there any subjective areas of your trading system that need to be ironed out?

Not having a clear map of what is happening is literally pointless. People do this every day with their life savings, some lose, some win. I would think that the odds using this approach are pretty abysmal.

If you don't have a trading journal, I can share my simplified XL version with you that gives all of the above info, win/loss ratio and distribution, just subscribe and drop me an email and I can share free of charge.

I don't mind giving all of my stuff away for free, I know how hard it is to find reliable information and have a passionate dislike for trader charlatans.

Use Journals to Test Ideas

A side note about trading journals is that they can be used to back-test hypothetical trading systems. If you are not sure of what an actual trading system is, please read this blog on what is required to create one. It really just involves a few major components that must be easily measurable.

If you have some objective entry and exit criteria, you can go back on charts and take 'fake' trades in line with the strategy as well. I did this a number of times and it's quite fun to increase the risk to 2 or 10x and find out you would have wiped out or been a trillionaire depending on which multiverse you live in.

If you do this over and over again you can get something statistically meaningful. The trick of course is to be objective, as mentioned in the blog on building a trading system - this is a fundamental requirement for any strategy.

Final Word

Using a trading journal and actively reflecting on my trading habits probably was the moment trading for a living became a reality. Once you see the objective evidence of attainable results that are realistic and not 'pie in the sky' numbers it's hard to look back. Make sure to print these and make them visible. Taking bad trades should be a very painful experience when you know it's going to guarantee failure.

The  constant reinforcement, visual and emotional gravity of these numbers should make it easier to incorporate good habits into your trading. The feeling of flow we get from trading in alignment with our strategy and who we are is something that can't be emulated or experienced by anyone other than you.  Only once you see the reality and rip out your ego and opinion can you free yourself of the mistakes playing on repeat.

Trading is just some basic probability amplitude and self-awareness converging on a screen. There is only one way to trade and make money. The above is the ultimate key which unlocks your potential. Reading something like this and not doing it separated the 80 from the 20.

Want an Excel to run the above tests? Subscribe and we'll fire this out to you! Happy Trading!