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.

Trading Tips

Gauging trading performance

There’s a recent post from the SMB blog that brings up an issue a lot of traders have – or at least think they have. Namely, they want to know how they are doing with their trading in terms of when they’ve reached a degrees of success. Here’s the main part of the query that came in from the trader asking the question:

I have been profitable every month since and including August of this year. Month to date December I am profitable as well. Before that I saw trickles of black but was always losing on balance and never had two consecutive profitable months until recently. I would greatly appreciate if you could shed some perspective on how I am doing based on my results. I am taking the money up every month so the only way to assess my results is based on percentage gains for a given month based on the account size traded that month. 2011 is my 4th year as a developing trader. For August through December (MTD) I sat down to trade 76 days and took 118 trades averaging 1.55 trades per day. My win ratio is 55.78% excluding scratches. My winners are 43% larger than my losers on average. I am in my winners 2.68:1 longer than my losers. My average risk per trade is 1.02% of the account size for a given month. The max risk I took on a trade was 1.65% of the account size. Nothing crazy risk wise. I always have a hard stop in the machine -always…and I never ever cancel it. For the 4 months August through November (2011), I have an average gain of 2.32% of the account total for that month. (6.7% the best/August -3.3% worst/September)

There are a few things that can be extracted from this:

  1. This trader has been going at it for several years and only now is finding his feet as a profitable trader. This is very common because the majority of folks who start trading really have no idea where they are going or what they need to do to get there. Figuring that out (usually through trial and error) often takes literally years.
  2. The trader had spells of profits, but was generally losing until the last few months. This is the standard pattern because consistency is lacking and developing traders often don’t know why they are struggling. And even when they figure it out, they still have to consistently implement the required change to get things sorted out.
  3. The trader understands the value of keeping track of his performance statistics, which too few traders do. The step he’s lacking here is the objective benchmark against which to measure his performance – at least so far as he’s communicated.

What this person is looking for from evaluators is whether he’s making enough from the markets – and also whether his performance has reached a level of predictability to suggest that it’s OK to add money to his account (that’s a separate part of the email). The numbers certainly look good. The problem is, though. we don’t have any way to tell him whether his results are good in the context of his trading method/system and repeatable or not.

Just as a start, we don’t know whether he’s trading a consistent system or multiple different ones. We also don’t know whether he’s being consistent in the application of his system or methodology. An additional question is why he’s only traded 70 days during the period in question. What’s the cause for not trading on the other days and does that have an implications for his performance?

I can also think of these other questions:

  • Do you ever have multiple positions on at a time?
  • If you’re risking about 1% per trade, why are only only making about 2.3%/mo given the number of trades done per month?
  • How much time is being put into the trading?
  • Given the numbers provided, the trade expectancy is about 0.355%. How does that compare to prior performance of the system/method employed, or to how the system should have been employed over the time period in question?
  • Can the system/method be used in a more frequent fashion to produce higher returns?

There’s a lot that has to go into actually judge trading performance. Just looking at the return figures isn’t going to be enough in a case like this. The best approach for any trader in this kind of condition is to try to figure out how they could/should have traded their system or methodology over the period in question and compare that to how they actually did. If the two are a close match, then you’re at least doing that part of it right. It then becomes a question of whether the system’s performance can be sustained and scaled up.

Trading Tips

Traders can do what athletes can’t

There’s a post on one of the BabyPips blogs which discusses the comparisons between elite athletes and successful traders. I will definitely not deny that there’s a lot in athletics which carries over well into trading. The aforementioned post mentions some of them:

  • Competitiveness
  • Solid “fundamentals”
  • Emotional toughness
  • Focus on continuous improvement

Here’s where the author comes up a bit short in his analysis, though.

In sports the thing which tends to differentiate elite athletes from the rest is physical. The author uses basketball in his examples. Let’s face it, though. You can be the fiercest competitor, have rock solid fundamentals, be emotionally tough, and constantly work to improve your skills, but if you’re short with no jump and slow afoot you’re not going to make the NBA. Flipping that around, if you’re 7’+ you can get away with short-comings in many other areas and still have a good career.

I bring this up because the features noted above can be found in athletes at all levels. I certainly saw them in college volleyball players I coached, though none of them had the physical tools to be All Americans or National Teamers. That doesn’t mean they did not have enjoyable, satisfying careers, though. They just had to focus on getting the most out of what they had in the context of their limitations. In sports the mental stuff can separate an individual from others with comparable physical tools, just as superior physical abilities can separate an individual from peers with similar mental abilities.

This can apply to trading as well. We just need to replace the physical element with the financial one. After all, if you have a lot of money you’re able to make a lot of money from the markets, even if your rate of return isn’t very good. Flipping that around, if you’ve only got $1000 you’re not going to be able to make enough money to live on – at least not consistently or without being constantly on the edge of complete ruin.

Of course the difference in trading is that you can save up and use compounding to increase your account and maybe eventually become that 7-footer, though it takes a lot of time and effort is you’re only starting off as a 1-footer. 🙂

Trading Tips

Looking at 97 Trading Mistakes

There’s a post up on the Winner’s Trading Edge site that purports to list the 97 top forex mistakes. Most of the 97 are equally applicable to trading basically any market, not just forex. Most of the list I definitely agree with, though there’s a bit of redundancy in places. Some of the best ones are:

Not having a life: Balance is key.

Thinking the market is wrong: Your opinions of what should happen are just that, opinions.

Failure to take responsibility: This is huge. I can’t stand it when traders blame everything but themselves for their failures.

There are also a few I definitely think are problematic. They include:

Not having a profit target: This is only applicable if a system is designed to use a target. Not all trading methods and systems work optimally with them (like many trend-following approaches).

Cutting winning trades too quickly: This is basically a contradiction to the prior one in that it suggests letting winning trades run. Again, whether you let them run or have a profit target depends on the system or method you use.

Trading with fear: A little fear is healthy. It makes you respect the markets and not get carried away with risk-taking. Too much fear, though, is a problem.

Trading with the crowd: Folks get carried away with thinking they need to trade against the crowd. The problem is the crowd is often right and potentially is driving the market. It’s just when things get extreme that you want to be cautious.

Not having fun: I think most long-term successful traders will shy away from calling trading fun. It certainly isn’t drudgery, but it’s not viewed at as a game. It’s a business, not a leisure activity.

Give the list a look and let me know which ones you’ve fallen victim to and/or have had the biggest impact on you.

Trading Tips

Comparing Your Trading to the Alternatives

I wrote the original version of this for the Currensee blog, but it has a broad based focus, so I wanted to post it here as well.

A thread was begun by a member of the BabyPips community on the subject of measuring and comparing trading system performance. The author had earlier initiated a discussion as to whether active portfolio management (in this case specifically talking about forex trading systems, but the same ideas apply across markets and methods) was of any value given the Efficient Market and Random Walk premises. That latter subject matter predictably generated a rather intense debate. I won’t take that up here, but I do want to discuss the upshot of it. Forum members wanted to know on what basis a system could be judged as to whether it was better than a passive approach. The performance measurement thread took that up.

Here’s the premise.

Performance of any active approach to taking on the markets must be measured against performance of a passive approach. I did a hatchet job on the original poster’s primary recommended metric because it was mathematically flawed, but his overall idea is legitimate. If you’re going to actively play the markets, then it needs to make sense doing so.

Volatility of Performance
Now, this isn’t quite so simple as comparing your own trading returns to that of the S&P 500, or sets of system returns against each other. This is where “risk-adjusted” comes in. The various markets have different levels of volatility (see Looking at Volatility Across Markets), and the same can be said of trading and investing methods. Volatility is the standard measure of risk, so we need to incorporate that into our comparative analysis.

How you measure volatility varies. In academia it’s common to measure the variation of period returns over time. That tends to focus on the consistency of performance. You could, however, use a measure of the size and/or length of drawdowns, which more focuses on the impact of adverse periods. There are other metrics as well. The important thing is identifying the one that makes the most sense for your objectives.

With a metric in place, you can then assess the performance of different approaches to the market on a risk-adjusted return basis. That would let you know that System A, with a 15% annualized average return and a 7% average drawdown, is probably better than System B, with its 16% annualized return and a 10% average drawdown. And then you can look at where System A falls within the sweep of potential uses of your money which runs from low return/low risk (like T-Bills) to high return/high risk (like penny stocks).

The Cost of Time
Assessing a given approach to employing your money is more than just looking at risk-adjusted returns, though. You must also account for the amount of time and effort you put into the process. For something like sticking your money in CDs or investing in an index fund, the time element will be small. For an active day trading strategy the time element is going to be high.

For that reason, it’s worth having a separate metric for looking at this time element. A simple $/hr calculation will suffice. Once you’ve figured out the hourly return of your trading/investment activities, you’ve got another basis for comparison – and for looking at the best application of your time overall.

But beware that the time element of trading/investing cannot just be viewed in cost terms because things like entertainment and education value come in to play. For example, when I first started coaching volleyball I calculated what my hourly rate was when factoring in all the time I was putting in to it. The result was below $1/hr. It bothered me not one bit, however, because I enjoyed the work and was developing myself as a coach such that I could increase my effective hourly rate moving forward. This is a particularly important consideration for new traders – otherwise no one would ever even think about getting into trading!

To Go Active or Passive
The bottom line here is that you need to look at whether being an active trader or investor makes sense in terms of risk-adjusted returns and the amount of time you have to put in to it all. If it’s not, then you’re going to want to look in to a passive approach.

The Basics

Positive Points, Negative Profits

A subject of conversation in the blogosphere in recent weeks has been the idea that you can have a positive point or pip (I’ll use points for simplicity from now on) balance from your trading, but end up with a negative net P&L. This may sound like an impossibility, but I assure you, it isn’t. Let me provide an example.

Let’s say you do 10 trades. You have a 60% win rate and make 50 points on average for those winners while suffering 30 point losses on the other 40% of trades. That tallies up to a total gain of 120 points (6 x 40 – 4 x 30). This looks like a pretty good result, right?

The problem with the above is that it assumes all of the trades are the same size, the same value per point gained or lost. As soon as you start including trades of different sizes you cause problems with using point accounting to gauge performance. All I have to do is change the size of one of those losers to make something that looks quite positive into something with a negative bottom line.

Let’s say for 90% of your trades each point is worth $10, all of the winners and three of the losers. That translates into a net profit of $1500 (6 x 40 x $10 – 3 x 30 x $10). If, however, you had a really good feeling about the last trade and put on a position ten times the size you normally traded ($100/pt), then the 30 point loss for that final position would wipe out all the net gains from the other 9 trades and end up $1500 down ($1500 – $100 x 30pts). Suddenly the total point gain figure doesn’t seem so good anymore, does it?

You may be thinking you’d never trade 10 times your normal size, but that’s not really the point. You can create any number of scenarios in which the point tally is positive and the actually profits are negative or break-even or decidedly unimpressive because of variation in position size between trades (or just as easily the other way around where it results in much more impressive performance than the point tally suggests). That means unless you always trade the exact same point value, counting points doesn’t tell the real story of your trading.

This is exactly the reason why I’ve been a proponent of using other measure to gauge performance. Obviously, % return is a good one, though that doesn’t factor in risk. Using R is a good way to incorporate risk into comparative performance measurement. Whatever you use, though, just make sure to be aware of both its benefits and short-comings.

Trading Tips

Top 10 Ways New Traders Lose Money

If you frequent trading oriented websites you’ll probably have notice ads from the forex broker Oanda. Those familiar with Oanda know this is something very new. Unlike most retail forex brokers, they have never been big marketers, preferring instead to allow word-of-mouth to grow their customer base. It worked pretty well, as they are right there among the biggest global retail forex brokers.

A short while ago, however, Oanda finally started a real advertising campaign. The most prominent of those ads features a “Top 10 Ways New Forex Traders Lose Money” theme. Most of their top 10 are fairly universal, so I present them here for discussion.

1.  Lack of Experience
2.  Unreasonable Expectations
3.  Absence of a Sound Trading Plan
4.  Lack of Discipline
5.  Failure to Include Stop-Loss and Take-Profit Instructions
6.  Excessive Leverage
7.  Holding Too Many Open Trades
8.  Holding Losing Positions Too Long
9.  Ignoring Rate Spread Fluctuations and the Impact Spreads Have on Profitability
10. Thinking About the “Big Win” More Than Effective Cash Management (AKA Greed)

I think #2 and #10 are at least very closely related, #6 and #7 both fall under the “trading too big” theme, and it seems to me that #5 really is part of #3, so we could probably cut this list down via consolidation. Beyond that, most of the ideas broached are common ones, and in some cases link closely to my 8 Ways to Limit Your Trading Education Tuition. The spread fluctuation discussion in #9 is certainly an interesting addition to the topic, though.