Trading Tips

From the data: One reason traders struggle

Over the last couple of weeks I’ve been working with the forex trader data I’m going to be using in my PhD research. I included some of the figures I’d pulled out in one of my recent newsletters, but I thought I’d share some additional stuff here.

I’ve pull the following set of numbers on trades which include USD pairs (no crosses), of which my data contains over 2 million records.

Winners: 1,280,459
Average Profit: $60.03
Average Pip Profit: 28.20

Losers: 752,614
Average Loss: $105.14
Average Pip Profit: 63.88

Notice there are many more winners than losers. They represent 63% of all trades. These are retail traders, so it just goes to show that you don’t want to get too crazy about looking to trade against the collective.

Notice also that the average loss is about 75% higher than the average profit. That completely offsets the 63% win rate and results in a negative overall expectancy for the group.

It must be noted, however, that that average loss appears to be due to holding on to losers too long rather than risking too much money. Notice how the average loss in pip terms is more than double the average gain. Traders actually had lower pip values on their losing trades than on the winning ones (on average). They just held on too long.

Here is the problem is for most traders. They are quick to take profits and slow to take losses. This is referred to as the Disposition Effect in Behavioral Finance research.

Much more analysis of the data needs to be done, but these results are very interesting nevertheless.


Doing a PhD to study all you crazy traders

Over the last couple of years I have been researching PhD programs with an eye toward taking that final step in my academic career (having already done an MBA). I’ve had a former professor of mine pushing me in this direction just about ever since I finished my undergraduate studies oh so many years ago. I resisted for many reasons, but a couple years back it occurred to me that one of my major excuses – lack of shareable experience to bring into the classroom – wasn’t really valid any longer. That started the process.

This week I was offered a PhD studentship by the business school at the University of Exeter in England and have accepted. I still have to be offered and accept admission by the university proper, but that is just a formality and should happen shortly. The business school wouldn’t offer me the funding if they weren’t going to accept me, after all.

That means I’ll be leaving my current position as a professional analyst, but it most certainly doesn’t mean I’ll be leaving the markets or trading. In fact, that will be the focus of my dissertation. My research proposal for admission was on the subject of individual retail forex trader profitability and performance. It fits into the general area of Behavioral Finance, which is basically the counter-point field to classic efficient markets theory.

I’m really looking forward to delving into the data (I’ll be using a big set of trader transactional and performance data for my studies) and the sort of results that come from it. As much as this will be academically oriented work, I see lots of opportunity for it to be applied in the practical arena.

Do you like Doctor of Trading or Trading Doctor better? ­čÖé

Trading Tips

Lessons for traders from neurofinance research

Neurofinance is one of the sub-fields in the area of Behavioral Finance research. It’s the area which focuses on how out brain works. During the conference I attended last week there was a set of presentations on the subject that were very interesting. I thought they would be well worth sharing here.

The impact of learning
One of the papers presented was titled “Brain, Financial Market Bubbles, and Investing” by Dr. Paul Zak from Claremont Graduate University. Basically, Dr. Zak described an experiment he was part of running in which the impact of learning was gauged in terms of the actions of “traders” in the formation of bubbles. The conclusions were interesting.

The bubble experiment is one where a group of people are given the opportunity to trade a fictional market for a depreciating asset. By definition, this is a market that must eventually go to zero, yet consistently through these sorts of experiments there are clear bubbles being formed in the markets (meaning prices go well above fundamental value). Research has found, however, that as participants repeat the experiment the bubbles tend to become less extreme, indicating a learning aspect.

The experiment about which the Zak paper was written was an effort to see just how significant that learning factor is in bubble formation. Using drugs, the researchers impaired the learning facility of about a third of participants. The result was that those traders did not learn as quickly as the others, and thus it took longer to see the same reduction in bubble formation than in the non-drugged group (actually, the non-drugged group was 50% on a placebo and 50% on caffeine pills, but there was no significant difference in performance).

Zak’s conclusions were three-fold. First, market participants must learn market history so they know what the market has done before. Second, learning must be “salient”, meaning it involves actually risk and reward (in other words real money trading, not demo trading, as I have suggested on many occasions). The last was that trading frequency relates inversely to the potential for a market to form a bubble (think real estate as a prime example).

Understanding your brain
[easyazon-link asin=”0470543582″][/easyazon-link]The other key presentation in this area was from Richard Peterson, co-author with Frank Murtha of [easyazon-link asin=”0470543582″]MarketPsych: How to Manage Fear and Build Your Investor Identity[/easyazon-link]. Peterson made two really interesting points that I think traders should latch on to as part of their development.

First, from a real neuro perspective, he noted that greed actually turns off the fear centers in the brain. This is scientific evidence of what many traders already know – that when we start thinking overly much above what we could make in the market it shorts out the part of our brain where we process the risk. As a result, we take too much risk and otherwise act stupidly.

The other point Richardson made was that we are naturally inclined to want to “do something” in times of stress. This is where a good trading plan comes in (see my series of trading plan posts). It gives us specific action items to do so that our natural instincts – which rarely work in our favor when trading – don’t override our ability to do what needs to be done, even if that is actually nothing at all.

News & Updates

Back from the world of Academia

I’m back in the real world again today after having attended my first academic conference last week. It was the annual conference for the Academy of Behavioral Finance and Economics that took place at UCLA (which, if you’ve never been, is massive – and I’m not even really talking about acreage). It was definitely an interesting experience and a good opportunity to hear where the current state of academic research is in terms of trading.

To that end, here are some of the high points:

– One of the papers presented looked at trading in Taiwan stock index futures. It looked at whether traders made good decisions in terms of adding to positions. Not surprisingly, the authors found that profitable traders do a good job of adding to positions (or perhaps better stated, building positions) than losing traders.

– During the keynote address from Dr. Vernon Smith (Nobel Laureate) he brought up the fact that participants in behavioral experiments (pay-off games, etc.) have to be compensated because results are different when there is no monetary factor involved. This fits in very well with the view among traders that demo trading is very different than live trading.

– There was a really interesting panel discussion which featured fund managers who focus on using signals generated by news and social media (Twitter, etc.) content analysis.

– From the neurofinance side of things, which focuses on how our brains work in relation to trading and investing, there were a couple of interesting takeaways. I’ll follow up on this particular subject in a future post. As I noted the other day, I found Advances in Behavioral Finance, Volume II to be an excellent study in the history and current state of the field of Behavioral Finance.

Of course there were some dud papers as well. Overall, though, I found it interesting how the focus of the conference seemed to be much more toward exchange of ideas and furthering the research, which is different from my experience at trading conferences. The latter seem to be much more information presentation and socializing.

News & Updates

Going academic next week

Next week I’m attending a conference in L.A. I’ve been to conferences before, of course, but this is going to be something new. It will be my first academic conference. This is the 2011 Annual Meeting of the Academy of Behavioral Finance & Economics. It’s taking place at UCLA, which provides a very convenient excuse for me to visit Southern California again. This is a great time of year for that.

Traders tend not to think all that much of academic financial theory, especially that bit about efficient markets, but the area of Behavioral Finance is one that I think a lot of traders can find considerable value in. It covers a number of specific subject areas, but where the financial markets are concerned a major point is the challenging of the efficient market premise and taking a closer look at how market participants actually make decision. Prospect Theory, for example, takes a hard look at risk aversion. Distribution effects, which are the tendency of traders and investors to hold losers and sell winners, are studied. Overconfidence is also a key consideration with the idea that it drives overtrading, and a considerable amount of research has been done on the idea of markets over- or under-reacting, among other subjects.

In other words, a substantial portion of Behavioral Finance is dedicated to the study of trading and traders. I found [easyazon-link asin=”0691121753″]Advances in Behavioral Finance, Volume II[/easyazon-link] to be an excellent study in the current state of the field, by the way.

I’m looking forward to this conference, not just because it’s my first academic event, but because some of the presentations sound like they could be quite interesting.

  • The Financial Crisis, Risk-Taking, and Active Investing
  • Individual Investors and Option Trading: Attention Grabbing versus Long-term Strategies
  • Risk-Taking Behavior and Profitability: A Trade-by-Trade Examination of Retail Traders in Futures Market
  • Emotional Investing and Performance
  • Investor Behavior, Hedge Fund Returns and Strategies
  • What Drives the Herding Behavior of Individual Investors?
  • Behavioral Trading Strategies

That’s just a selection. There are loads more that caught my attention. I may have some hard decisions to make.

Not that this will be all work. As long-time readers will recall, I use to coach college volleyball. I haven’t been to a match since I “retired” at the end of the 2006 season (though I’ve watched on TV). That might change, though. Conveniently, UCLA is hosting Stanford the last night of the conference. Both teams are in the Top 10, so it would be a great match to watch. I think my exile will be ending! ­čÖé

Trader Resources

Video Review: Mind Over Money

The other day I watched the PBS documentary Mind Over Money├é┬á(which is available streaming for Netflix subscribers). It’s a very good compare-and-contrast discussion of two primary sides of the academic view of markets – the efficient market side and the behavioral side. It was released in 2010, so the financial crisis was included in the film’s coverage,├é┬áalong with a look at historical market bubbles.├é┬á├é┬áNumerous interview clips of some of the most prominent proponents of each side├é┬áare included (Eugene Fama and Robert Shiller being two of the highest profile).

Overall, the documentary leans toward favoring the behavioral argument. The film provides a lot of evidence that we humans do not act rationally, especially where money is concerned. One of the more interesting experiments shown was how bubbles are created in the lab with experiment participants trading a depreciating asset. The video, though, does a good job of including contrary arguments as well.

Definitely worth viewing.

Make sure to check out all my trading book reviews.