Practicing with Probabilities: Outcome Simulator

I struggle with really internalizing probabilistic thinking, especially when trading live. I can understand the math and the reasoning–I’m a freaking rocket scientist after all. However, a rocket scientist is trained to NEVER be wrong. A trader must be trained to be “wrong” quickly and relatively often, and accept it and move on with their system. Staring a loss in the face (or even worse a string of losses) shakes your ability to believe in it. You doubt your system, and you doubt yourself, and that’s when impulsive revenge trades can come in and you blow yourself up. It takes practice to overcome your emotions, at least for me.

Assuming that you have researched a strategy, know when it should work and when it doesn’t, and are consistent in applying it, if you stick with your plan then the law of large numbers can come into play and your edge can pay off. But how do you know if the edge has changed? If you usually win 70% of the time, but start to win only about 30% for a few days, do you pack it in, or keep going? What if you start a new system? How many trades are enough for your hoped-for edge to show up in your outcomes? How many are too few to call it quits?

I created a tool to help myself practice these things. My Outcome Simulator lets you make simulated “trades” by clicking a button, and see how the results come in based on different probability settings. Hit the “Reset” button to start over. There are three modes to use it in:

1. Targeted distribution–you put in a desired win percentage for a group of 100 trades. A possible distribution is created that is close to your target. The wins/losses are assigned to each of 100 toggle buttons. As you click, they show if you won or lost, and your realized outcome distribution is shown. If you click all 100, your realized actual outcome will match the possible distribution, but for the first few trades the realized outcomes can be far different, as these screenshots show:

2. Random distribution–this mode creates a distribution at random between 0% wins and 100% wins. You can then see how the realized outcomes roll in with those kinds of rates.

3. Hidden distribution–In this mode, a distribution is chosen either targeted or at random, but it is hidden from you (targeted is kind of pointless running hidden, since you put in the number, but oh well). You could be looking at a net winning set, or a net losing set. Click to see outcomes, and try to decide from those if it’s a winner or a loser distribution. Then click the “show” button to pretend that you are quitting trading, and to see what the actual distribution was. When you click show, if the true distribution was below your actual results, then you made the right call, and quit while you were ahead of the possible. Even if you were a net loser on outcomes, if you did better than the true distribution you made the right decision to stop! Conversely, if you were a net winner, but the true distribution was better than your outcomes, you should have kept pressing. It was the wrong decision to quit. You should begin to learn to value the rightness of a decision based on what you knew at the time and in aggregate rather than what the individual outcomes of each “trade” are. It can also tell you a lot about yourself. If you have a run of 5 losses, do you get impatient and start clicking like mad? Revenge trader. If you have a string of wins, do you get fearful and hesitate to click more?

Using the hidden distribution mode can simulate what it’s like to start trading a new system. You don’t really know what actual outcomes you are going to get when you start. In the markets, there is no set “true” distribution. The odds are always changing. But this simulator can give you practice in coming to the decision to stick with a system or bail on it, as well as a feel for how many trades it takes to get a reasonable level of confidence in a system’s viability. For the chronically conservative, this can give you practice at sticking with a well reasoned concept even if you see a string of losses right out of the gate. Then you should be able to get over the hump instead of going back to the drawing board and tweaking setup parameters ad infinitum looking to filter out all losses. This tool is more about training your brain and emotions than predicting or modeling the markets, which I would argue is the most important foundational thing to do before any trade system work.

Of course, the emotional side of being wrong is not really present in a simulation. I can arrange for you to pay me every time the tool beats you if you need me to 😉 But seriously, if you do this enough times, it can help condition your mind to think this way and accept outcomes as they happen under your larger system goals.

This tool is freely available under “Released Tools” at my Google site. If you feel this is valuable to you, please consider a donation to my blog.

Thanks!

Greed and Fear Revisited: Outcome vs. Opportunity

In trading, Greed and Fear are often condemned by many people. Greed is thought of as a companion of Fear, and both are considered to be bad when found in traders. I want to propose a different way to think about Greed and Fear. I agree with Mr. Gekko, that Greed is good, and I will go even further to add that Fear is good, also. However, they are only good for you if you are greedy and fearful of the right things. Otherwise, they are vices and not virtues.

My trading psychology in the past has always been this:

A mindset of maximizing my profits (or winning trades) and minimizing my losses (or losing trades) right now on THIS trade.

This mindset is focused on the outcome of the current trade. I believe that an outcome-based mindset (whether it’s P&L focused or win/loss focused) is where Greed and Fear cause us to fail as traders. The flipside is that this same mindset is also the source of profit for many successful traders, as they fade the losers.

I submit that traders SHOULD be greedy and fearful, and that the following should be the mindset for a successful trader’s Greed and Fear:

A mindset of maximizing your exposure to profit opportunities (Greed), and minimizing your exposure to loss opportunities (Fear) at all times and in all trades.

Surfing The Markets, or Quit Trying So Hard To Be Right

This is another chapter in the continuing saga of my recent ponderings of how to understand and approach the markets. Again, more of a journal of thoughts and ideas than any kind of hard statistics or methodology. However, it does constitute part of the foundation on which I am building those things for myself.

•Being Right vs. Trading Right

My past trading lives have been fraught with various psychological maladies. One is a need for each trade to be a winner. I blame the SEC and the pattern daytrader rule. When you only have three round-trip daytrades in a week, they HAVE to count. When I would choose one trade to take, I was already biased into making sure this one worked out. The result? I stayed in poor trades for the full 1R loss, even if the trade immediately went against me, hoping that the market would reverse and bail me out. I would also take profits (when I got them) far too early out of fear of “wasting” a daytrade and not having a winner. Of course, a need to always be right and overanalysis have also plagued me.

The Phantom of the Pits has a rule that he calls “Rule #1”. It says to get out of a trade if it is not proven correct. To me, this means that if the trade doesn’t work according to the thesis that your setup is based on, you cut it fast. PotP says “Don’t wait for the market to tell you that you are wrong. You decide if you are wrong!”

•Swimming vs. Surfing

This need to be right and trying to force a particular idea onto the market is like a person swimming through a rough sea among large rocks and strong currents. You will get battered as you try to plow your way to the other side, or wherever it is that you want to go to. A lot of traders make the analogy that good trading is like surfing, and I am beginning to agree. While I am no surfing expert (any surfing readers feel free to chime in), I can understand the idea: ride the wave. You go with it. You don’t try so hard to force a particular course or outcome, you just go where it takes you. No two waves are the same, just as no two market moves are the same, but you don’t need to understand or predict the wave to ride it. You just need to time your entry to the wave pattern, and go with it as long as the wave stays intact. It’s a really simple idea, which is one reason why I think it can work. This means that your job as a trader is to watch the wave and flow with it, period. Your job is not to create the wave, to understand the wave, to predict the full extent that it will last, or to enter the wave out at sea at the exact beginning. You see it, you time it, and you just go while it lasts. You ride a portion of the wave. And sometimes you will get in right at the end and get wiped out. Sometimes you will try to get in before it really moves and get stopped out (go nowhere). It’s okay; it’s all part of the surfing experience. This generality and $3.50 will buy you a grande latte, though. The hard part is making a defined framework to recognize the always changing wave pattern.

•Knowing When to Trade and When NOT to Trade is Half the Battle

Knowing when to avoid trading is probably more important than your actual trading setups. Expecting trends at the open of normal days, expecting chop on low volume days and over lunch time–these are the kinds of things to know before looking for a trading theme or strategy during those times. Einstein tried to come up with a grand unified theory of mechanics, but he never found it. It could be that there isn’t one. There is also no grand unified market setup! Different trades for different times. Don’t buy strength during choppy markets. Don’t fade moves in strong ones.

The Wisdom of An Experienced Trader

I recently got this communcation from an experienced trader. I thought it was very wise and worth sharing. There’s a lot of very good advice in here, and it is especially applicable to me:

“I have traded for over 30 years. Some of those were a struggle but many of them were great. In my first trading job I sat on a trading desk at a primary dealer in Chicago. I had been on the floor learning the business and was a broker. I kept talking to guys and finally met the head trader at that primary dealer. Over time, he liked me and gave me my first trading job. Before that I had traded customer money and my own small account. There were over 30 guys who traded for a living on the desk at the primary dealer. Each one traded a little differently. I tried to learn a little from each one of them. I was successful but just barely for a few years. I never could get over the hump and make real money. I went to Mark Douglas, who ran a trading psychology business. After talking to him, I realized that I was trading to make a certain amount of money and no more. I was effectively limiting how much I made by my trading decisions. I was undercutting myself without knowing it. He suggested that I set up a foundation and put a % of my winnings in that. That way I was not just trading for myself but also for the people who would benefit by my foundation. As silly as it seems, it worked. I just had to understand what my motivations for trading were. I already had the tools. I just needed to learn how to use them more effectively.

Over the years, I have traded on many trading desks, from hedge funds to prop desks to CTA’s. The guys who made it were the ones who learned what worked for them. See what your risk parameters are first. Learn money management. That is more important than anything else. Determine a trading style that works for you. Make sure your money management will keep you in the game. Take the emotion out of the equation. That is what people mean by saying making money is boring. If you trade for the thrill of it, you will lose. Play the odds and stick to your game plan. Don’t second guess yourself. Learn to control your emotions but use your gut when it is working for you. When you are hot trade more aggressively. When you are cold, trade conservatively and patiently. Limit your losses each day to a set amount. If you lose that stop trading. Watch the markets. They will tell you when conditions are ripe and when they aren’t.

You learn about yourself first and then you learn the markets. Find what works for you. Ignore the rest. Keep it simple and add things that seem to work for you. Try different styles and methods. See what works for you and incorporate that into your trading style. Watch and learn the markets. They change over time and you must change as well. Remember that there are millions of ways to make money. Successful traders learn what time frames work for them.

I wound up being an event trader. I traded when the conditions in the markets were ripe for me. I traded technically also. The hardest thing for me to do was to stay with my winners. I tended to want to fade markets, but finally learned that I could make more money if I traded longer term in options along with trading short term in futures and cash Treasuries. I wound up trading differently for each time frame. I kept them separate. Once in a while a short term trade was a winner and I moved it into my long term trading drawer. If my gut changed, I would move some of my long term trades back into my short term drawer.

I hope that helps some. Remember that the first thing you must do is understand yourself. Then look to the money management side of things. That will take some of the emotion out of it. Then try to understand the markets as well as you can, both technically and fundamentally. Look for trading methods that fit your risk parameters. If they work, add them to your repertoire. Keep learning more things to add to your trading basket. Eventually, you will be able to compartmentalize things and be confident in your methods and money management tools. Then just do it!

Markets go in rhythms. Trading can be easier if there is a group of people who are giving money away. That has happened over periods of time in the past. In the 1980’s the Japanese started to trade Treasuries. They traded in herds. They all got in at the same time and had the same positions on and also got out at the same time. Many traders made a lot of money trading at that time. Later the S&L’s were having troubles and firms took advantage of that to profit from trading. Recently both hedge funds and quant firms had troubles that created large profitable situations for certain traders. The sub-prime troubles created a situation for some traders to greatly profit.

One of the keys to trading is to try to understand which groups are losing money and to adapt your trading to take advantage of those groups. Realize that there are traders who trade different time frames and thus have different risk parameters. Markets have a way of finding the weak hands. Try to understand who are the weak hands and try to take advantage of them..

You should also chart your trading. See which types of trades are making you money. See if you are exiting well. See how many days you are profitable and how many days you are very profitable. Look at your risk parameters for all your trades but also look at your daily risk parameters. Make sure you are winning more days than you are losing.”