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Feel like reading a PhD thesis?

PhDAt last!

On Wednesday my internal examiner approved the edits I did to my PhD thesis and I submitted it to the school’s online repository. That’s the last of the requirements on my end. All that’s left is for formal approval to be given by the Vice Chancellor’s Executive Group, which should happen this week (if it hasn’t already by the time you’re reading this). Then the long PhD process will truly be complete!

The title of my thesis is Trader Leverage Use and Social Interaction: The Performance Implications of Overconfidence and Social Network Participation on Retail Traders.

Here’s the abstract:

Overconfidence and its relationship to investor market participation is well established in the finance literature. The research into investors and social networks is only in its infancy, however. This thesis extends the literature by expanding on both subjects individually, then bringing them together.

Empirical work on individual investors in the existing literature links overconfidence and excess trading, resulting in impaired returns. The preferred activity metric, monthly account turnover, encapsulates two separate elements, though. One is trade frequency. The other is leverage use. Chapter 4 of this thesis theorizes based on the existing literature that in fact trade frequency is not a good measure of overconfidence. It then demonstrates through empirical analysis of a group of individual non-professional foreign exchange traders that leverage is much more suitable to that role.

Chapter 5 turns the focus to social networks, particularly with respect to information transfer. The literature in finance anticipates that network members benefit from their membership. Further, network position (social capital) enhances that benefit. This thesis challenges that expectation with respect to non-professional investors. Findings based on analysis of members of an online retail foreign exchange trader social network indicate that while there may be an educational benefit accruing to unsophisticated members, for more sophisticated ones membership appears to have a negative effect on returns.

One potential explanation for the negative impact of network membership is explored in Chapter 6 in the form of impression management. It is hypothesized that sophisticated investors are influenced in their behaviour by the realization they are being observed, and also the size of their audience. Analysis of foreign exchange traders indicates an increase in leverage use among sophisticated investors as their audience size increases, coinciding with a decline in trade excess returns, making the case for an observation-based rise in overconfidence.

Naturally, the thesis is heavily academic. I tried to make it as readable as possible, but you can only take things so far given expectations for language and style. If you want to have a look, you can get a PDF copy here.

The page count is 240, though there are a lot of tables. If you do actually read it, I’d be happy to hear what you think.

Trading Tips

Responding to a Forex Rant

What you are about to read below came from a comment that someone left. The spam filter caught it, and likely with good reason given the lack of a real name associated with it. Basically, it’s a rant against trading forex. There are some legitimate points made, but also so errors. I figure it represents some common thinking about the forex market, so I thought it worth addressing.

Playing Forex can appear alluring, but the majority of people who try it lose money. All you have to do is do a web search on the words Forex and lose to see this is the consensus.Forex is what we call a zero sum game. You are making a bet with someone else about whether a currency will rise or fall. For every winner there has to be a loser. If you are smarter than the average player, you may make money. If you are dumber than the average player, you are likely to lose money. Most of the people making the bets in Forex are highly trained professionals at banks and other institutions. You are unlikely to beat them at this game.Actually Forex is not quite a zero sum game. It’s a slightly negative sum game as the Forex broker takes a small percentage each time in the spread. It’s a small amount but over a hundred trades, it ends up being a considerable amount of money. So the average player is likely to lose money, and remember the average player is a highly trained professional and probably smarter than you.There is a lot of luck in Forex, and if you play it, you will have some periods of time where you make money. This is usually because you are having a lucky streak, not because you have suddenly become an expert Forex player. However, most people are unwilling to admit their success is due to luck. They become convinced they have a system that works, and lose a lot of money trying to refine it.

There’s more to the original, but I think the point is made with what’s above. Let me address the main ideas.

Yes, forex is a zero sum market – negative sum when factoring in the bid/ask spread and commissions (where applicable). I’ve addressed forex as a zero sum game before, so I won’t delve into that again here.

No, it is not true that most forex traders are highly trained professionals. The latest US forex broker profitability figures indicate that there are something approaching 100,000 active trading accounts (meaning did at least one trade in the last 3 months). There is absolutely no way you can claim most of those folks are pros. In fact, it is unlikely more than a very small percentage of them could be considered professional. Most of those accounts are individual non-professional types. The pros generally don’t trade through retail brokerage accounts.

That said, it is definitely true that most traders lose money. The figures generally show that only about 1 in 3 traders are profitable in a given three month period. In a lot of ways, forex trading can be looked at in a similar way as a game like poker. In the short run chance plays a big part in the outcome, but over the long run those with a higher level of skill will take money from those with less skill.

Trading Tips

Ten of the leading trader mistakes

Jim Wyckoff has a good article out which looks at the causes of trader failure.

  1. Failure to have a trading plan in place before a trade is executed.
  2. Inadequate trading assets or improper money management.
  3. Expectations that are too high, too soon.
  4. Failure to use protective stops.
  5. Lack of “patience” and “discipline.”
  6. Trading against the trend–or trying to pick tops and bottoms in markets.
  7. Letting losing positions ride too long.
  8. “Over-trading.”
  9. Failure to accept complete responsibility for your own actions.
  10. Not getting a bigger-picture perspective on a market.

I think this is a very good list. I dedicated a considerable amount of my book (and by extension my course) to developing a good trading plan, and many aspects of Jim’s list tie in with the things I talked about there. I have written previously on the subject of “protective stops“, so I won’t go into that again here. You can also see my recent post about traders letting losers run too long.

For me, #9 may be the biggest one of them all – at least for some people. Too many traders want to blame poor performance on someone else.

I will contend with Jim on the trading with/against the trend in #6 as there are systems that do quite well operating in a counter-trend (often called mean reversion) fashion. That, though, is different from trying to pick tops and bottoms, which usually ends in disaster.

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.

Reader Questions Answered

Penny Stocks or Forex for the new trader

I had an email come in with a set of questions from one of my newsletter subscribers yesterday.

Two weeks ago yesterday, I began my venture into learning how to day trade. Expect to start in Penny Stocks &/or Forex. Here’s my Q’s…

1. Which one do you suggest I try first, Penny Stocks or Forex? Penny Stocks I’ve studied the most already.

2. How do I open a paper account, (to practice what I’ve been studying about Penny Stocks) the same Broker I plan to open my actual trading account with later, or somewhere else?

3. I like what I see at Peter Leeds web site… the list of Brokers he recommends, (as choices for opening our 1st trading account) and system he’s developed for picking stocks he recommends to those who subscribe to his newsletter. What do you think of his expertise?

Any suggestions for helping us get started, are greatly appreciated.

Let me start with the last question first. I don’t know Mr. Leeds, nor am I familiar with his website, system for picking stocks, or his newsletter. As a result, I cannot speak to his expertise or the value of what he does.

When I am confronted with questions like this my standard response is that you need to make sure whatever product or service you’re contemplating investing your money and/or time in is what you need right now to either further your trader development or to improve the efficiency and effectiveness of your work developing trade ideas and/or managing positions. Way too much money and effort are invested into things which don’t fulfill those criteria. This is largely because the person in question hasn’t taken the time to build up their foundational knowledge and worked through the process of understanding how they need to approach the markets and their own trading. Helping them do that is the major driving focus of what I am trying to do with this site and my various educational efforts.

Getting back to the other two questions…

Penny Stocks vs. Forex
I cannot tell you penny stocks or forex is better. Both have their strengths and weaknesses. A major factor in the decision, though, is time. You won’t be able to trade penny stocks outside exchange hours, so if that is something important then you’ll have to go with forex. On the flip side, there are only a limited number of really tradable currency pairs, so if working with a broad array of potential trading vehicles is important for your strategy, then penny stocks would be the better choice.

One thing I would note here is that penny stocks tend to attract low-capital traders because of their lower cash requirements. This is not a good reason to opt for penny stocks, though, because their lower liquidity tends to mean higher bid/ask spreads than in higher-cap stocks and commissions have a higher negative impact on a smaller account than on a bigger one. You will likely find if you are a very low capitalized trader that transaction costs in forex are smaller.

If you’re new to trading, my advice is to pick one or the other. Working on learning two quite different markets when you’re trading to develop your knowledge and skills will be problematic.

Picking a demo platform
In an ideal world, you’d go with the demo platform of the broker you plan on trading through when you go live. That said, part of the demoing process is also finding a broker whose platform you like. Also, if you’re planning on doing an extended period of demo trading you may be constrained by the time limits that some demo platforms have.

The Basics

What do you trade and why?

A question came up on Trade2Win recently on a new thread. It asked the question of the membership, what do you trade and why? In many ways this is a fundamental question that every trader needs to have a strong answer to in order to be on the right track. So to that end, let me address it for myself.

I have traded just about everything you could think of a retail trader trading. Basically, it’s about finding good opportunities. I’m primarily a technically driven trader who operates mainly in the swing to position time frames, so I don’t need to have the narrower focus of someone who trades in the shorter time frames.

That said, stocks and forex are my two main markets.

In the case of stocks, that’s what I came up following. Back in the 80s when I got started it was still the main market available to retail market participants. I didn’t have the funding to effectively play in the futures market (there were no mini contracts back then). Also, when I read [easyazon-link asin=”0132825244″]How to Make Money in Stocks[/easyazon-link] it really resonated with me in terms of approaching the market. The strategies I use to this day have a foundation in what I learned from that book.

I got active in forex in the early 2000s. This was as online trading was really starting to develop and I was covering the forex market professionally at the time (as I am today). I liked that I could trade at any time of day or night, which you couldn’t really do in other markets at that time. I also liked how technical the forex market was. It suited my trading orientation very nicely.

These days my #3 is stock indices. I go through periods where I will lock in and fairly actively trade the likes of the mini S&P 500 futures. It’s very much a market conditions and available focus sort of thing, though.

What about you? What market(s) do you trade and why?

Reader Questions Answered

Trader looking for angel investors

A recent site visitor sent me a question via the contact form. It brings up something I’m sure quite a few others have at least thought about at times in their trading development and/or career. After all, who wouldn’t want the opportunity to trade with a larger stake?

Hi John,

I’ve been reading your blog for a while and I have a question to ask. Do you know about angel investors for traders?

I traded with my own money before (6 years ago) but lost a sizable chunk of it. I want to get back in the game and currently trade stocks and options on a demo account.

I practice good risk and money management and try to chose only trades with the highest probability of success and minimum risk. I treat my demo account with all respect as it was real money. I feel that it holds a key to my financial independence.

I intend to continue to do so until I reach a constant 1%/week average gains. (As of now, I am up 5% since inception 2.5 months ago).

Then I will feel confident enough to start trading with real money.
However, there lies a problem. My demo account is $100K and I use strategies suitable for this account size. Unfortunately, I don’t have that much real money to trade (only trade what you can afford to lose, right?). The best number I can come up with is $10K. I am afraid that with this size of account I am doomed to fail.

So, I plan to present my entire track record (including some really dumb trades that I did in the beginning) to someone who would be willing to “buy” equity in me.

They would open a real account and let me trade it for, say, a year. They would keep 90% of profits if I am profitable (I hope I will be) but assume all losses. If I end up losing, they would take the account away. If I keep winning they may add to it and so on.

Once my profit share reaches $100K I plan to trade on my own. That would be money I could afford to lose.

Do you know if these people exist at all and if so, how do I get in touch with them?
I need someone for whom $100K would feel like a small change.



My first question for Nikolay would be why he thinks that the strategy he’s using in demo trading wouldn’t work with a $10,000 account? I can guess at potential answers, but I would also want to take a look at things to see if there could be ways to adjust the strategy to employ less capital.

As for whether there are these “angel investors” out there, I’m sure there are some. I couldn’t say how to find them, though. Also, a 2.5 month positive track record against a 6 year negative one isn’t likely to inspire much in the way of confidence in a prospective investor.

An option to consider may be a prop trading operation. This is not a subject I am well educated on, but Brett Steenbarger posted on the subject fairly regularly, so you can search through his blog (he also talks about it in the Trading FAQ).

If any reader has a suggestion for Nikolay, definitely leave a comment below.