Zen and the Art of Trading 2

Discussion in 'Trading' started by neutrino, Dec 8, 2008.

  1. Zen and the Art of Trading

    I haven't been around ET for a couple of years but I've been trading and reading from time to time. I often read about the importance of psychology against the importance of having a profitable trading strategy. Some say the psychology is more important, others hold that it is often the strategy the reason for losses and not the psychological factor.

    After some thinking I came to the conclusion that they are both equally important, in fact they are part of the same thing. Here is why...

    As far as strategy is concerned, I am convinced that whatever strategy you are using at the moment, be it mechanical or discretionary, it will certainly STOP working at some point in the future. No matter how well tested, flexible and robust, it is always based on past data which is available to everybody else and the competition will sooner or later discover it and eventually destroy it. Noone can say when. But it will start losing money. Competition destroys everything. This has happened a million times in the past. Whether you were a dinosaur, or an individual who was very skilled at killing with a sword or a gun, a small business, a large company (like IBM or Microsoft or Google or CitiGroup), which had network effects, a know-how, a brand, a patent or whatever ”economic moat” you come up with, a king, a dictator or even a country or empire, eventually things change, competition catches up with you, in a way you could have never ever expected, and you go down. It can happen slowly or it can happen fast, but it will happen. Same thing in the financial market - evolution catches up with everyone. We are now worried that bots or algorithms will change the landscape of the markets – that they can either reduce or increase volatility and bring more chaos and efficiency in the system. That will happen and whatever works now, will not work in the future precisely because it has worked now – because more and more people will start using it. You can have a nice trend following system, which can work like magic for the next 5 or even 10 years. But such system has always built in systematic risk - if you continue using this system in the future, at some point it will simply collapse. You will have a large drawdown which will tell you to replace that system. People following the same system, will start placing their stops and targets at the same levels, and eventually the price will reach just enough to hit the stops or almost to the target and then back. Even if you have an adaptive generator of trend following systems that updates in real time, such algorithmic generator will be discovered by someone else, become mainstream and get destroyed.

    So, what’s the conclusion of all this? The conclusion, of course, is that you should keep observing, researching and coming with new and improved strategies. This will help you survive long enough to hopefully become rich enough, so when the big blow comes, you will have enough millions to live buy. However, this is not a process over which you have much control. And this leads me to my second point – the importance of psychology and how does this translate to your trading decisions.

    In order to be flexible enough to recognize when the conditions have changed and you have to abandon what you have been doing up to this moment, you must be in a certain state of mind. Now whether you operate in that state of mind when you execute a single trade, if you are a discretionary trader, or when you execute certain mechanical strategies, if you are a systems trader, this is important just the same. That state of mind as you all know is called “Zen”. It means you must “empty your mind, be formless, shapeless, like water…” as Bruce Lee explained it. You must allow yourself to relax and react adequately to whatever change or opponent you have to deal with. The past will not exist, the future will not exist, just here and now.

    Now where is the link between strategy and psychology? It should be obvious by now. Creating profitable strategies (or single trading decisions) in real time, can only be done when you are in this state of mind. Simply put, if you are not in a stable, detached psychological state, by definition you are not creating the optimal strategies. You can only be sure that you will survive tomorrow, if you know that tomorrow, when the market changes, you will be able to adapt and come up with a better way to profit from it. So you must ensure, that the decisions you make today, will not impair your state of mind tomorrow. So your long term success does not depend as much on what strategy you are using today, but on your psychological balance tomorrow, when you have to change that strategy.

    This brings me to my final point. If success is so ephemeral in this business, as Paul Tudor Jones put it, your last weapon to beat the competition, which always comes up with new and more effective strategies, is to ensure that you will always be in the Zen state of mind, which will allow you to adapt and evolve a little bit better than the competition. There is one single way I know how to do this, and this has been said numerous times, but is never ever followed by anyone is to UNDERTRADE. Always bet LESS that you want to bet. Never get leveraged to the point where your emotions can play dangerous games on your mind. When I say leveraged, this is relative. For someone it may be 100% of the S&P500 volatility, for others it can only be 25%, and yet others (quite an exception though) can withstand 200% of the S&p500 volatility on their capital. But once you put the foot on the gas, there is no going back. The spiral of mistakes and regret and losses and more leverage to get out of the losses and more losses, is activated. One prominent example – Long Term Capital Management. They were smart and they had the best model in the world that you could possibly have. It did work like magic for four years and they made billions. However, their model did not predict one thing – it could not have – that their fund will at some point become the market, and when you are the market, you are bound to lose. Could they have prevented the collapse of the strategy and the fund? I think they could have. Even if they didn’t know how big they have become and that the smaller fish (Goldman and the other counter parties) started copying their “secret” strategy, once they had a 500 million dollar loss in a single day, something should have clicked and they should have started thinking that something has changed. Something, whatever it is, has changed. They were however leveraged to the hilt, and I think they were not in the right state of mind to recognize that change. If they did undertrade, they might have seen it and reacted in a better way. May be they could have avoided the coming crash. In fact, if they had made 10% a year, instead of 30%, they might still be around instead of becoming a distressed seller. By the way, Buffett said that he never felt necessary to use leverage in his operations, and this is probably one of the reasons he still has tens of billions of dollars. The small fish however, always wants to make something with nothing, they want to make it big and leverage, like alcohol, makes them weak hands. So… once again, cut your trade size in half, and you have a much bigger chance to retire a rich trader :)

    PS. Sorry for the long post guys, I hate to read long posts, but that’s what happens when you don’t write often :)

    Edit: I do not in any way advocate, that you should just sit around, meditate and hope that you have a good strategy. Far from that. Of course a good strategy requires a lot of thought and dedication and noone can do the homework for you.
  2. Good psychology comes from a successful strategy.

    Your entire thread can be reduced to one sentence. Figure out a profitable strategy.

    Of course thats what thousands of aspiring traders come here to do instead of using their own minds.

    Throw yourself on a deserted island with only real time charts and you will undoubtably come up with something profitable.

    Hardly anyone is even willing to sacrifice half that though.
  3. I do not in any way advocate, that you should just sit around, meditate and hope that you have a good strategy. Far from that. Of course a good strategy requires a lot of thought and dedication and noone can do the homework for you.

    But you have to prepare for the moment when your strategy starts losing money. From what you say, it follows that as long as you make money you will be in a good state of mind. But what happens when your successful strategy starts losing money and you have a 40% drawdown because of big bets? Will you be able to adapt, come up with something better, or you will dig a deeper hole and you give back all those profits from the once successful strategy?
  4. Funny thing is I had a very hard time today and yesterday to follow my own advice and not overtrade. I felt I had a slightly bigger position than I normally should have, and after many hours of thinking about my own post, I finally forced myself to trim it by 25% to my comfort level :)