Contemplating this nugget of wisdom from the wonderful Despair.com site, I reflected upon all those traders who have described their competitive edge in the marketplace as "a passion for trading". Can you imagine asking your surgeon for his or her qualifications and receiving a similar reply? Not that there's anything wrong with passion, but one would like to see it backed up by a bit of training and skill!
So what is one's competitive edge in trading? If you're a systems trader, your edge comes from your trading rules: entries, exits, stops, and position sizing. That edge is documented through historical backtesting across a range of market conditions. Conducted properly, such testing shows precisely how much money you would have lost and won during various historical periods--the risk adjusted returns you can reasonably hope for going forward.
When you're a discretionary trader, your edge comes from your skill. Your ability to recognize market patterns, act on them with consistency, and effectively balance risk and reward provides your advantage in the marketplace. Your edge is documented through paper trading (or live trading of small positions) across a range of market conditions. Such a track record enables you to see how much money you won and lost during various historical periods--the risk adjusted returns you can anticipate in the future.
What is not a valid means for testing one's trading advantage is taking on faith that the methods have worked for others (including would-be gurus). "Other people use the X method," traders have told me. "It must be valid." But do you know that these methods are working for others? Do you know that you would have the same skills, risk tolerance, and consistency to exploit these methods?
Ultimately, a real time track record--for systems as well as discretionary traders--is the gold standard for estimating one's trading edge.
But if you haven't backtested your rules or diligently tracked your performance in real time, can you know you have an edge?
Moreover, if you don't know you have an edge, can you have full confidence in your trading?
When traders don't stick with their ideas, they call it lack of discipline. But perhaps lack of testing is the better term. Maybe traders don't stick to their ideas because they've never truly put those ideas to the test. Down deep, they lack the conviction that can only come from hard-won experience.
Would you invest in a car without giving it a road test? Would you buy a house without testing the mechanicals and inspecting the structure? A trading career is no less valuable: testing before investing in your trading is a great means for cultivating confidence--and, as we recently saw, confidence is a great step toward clarity in decision-making.
RELEVANT POSTS:
Understanding Lapses in Market Discipline
Top 10 Reasons Traders Lose Discipline
.
Posts
8 comments:
Excellent advice, I wish there were an equal number of people offering to teach computerized back-testing as there are willing to teach you to trade.
Somewhere around October 10 you said that:
"One of my priorities on the "to do" list is to conduct a seminar on the topic of how to use Excel to identify historical patterns. More on this to come!"
Did I miss the event or do you just have a lot of higher priorities? :) Considering your prolific output, I wouldn't doubt it.
Hi Elegy,
Thanks for the nudge and reminder. It's not that I have higher priorities, just a lack of time to properly organize and conduct an online workshop. I'm currently working with traders in NY, CT, Chicago, and London and am on the road every week. At some point the schedule will moderate and I promise to get to the Excel seminar!!
Brett
Hi Brett,
Talking of London do you have any plans to speak / present when over here in the UK? Would be great to say hello after following this blog for some time.
Ryan
Hi Ryan,
Thanks for the interest! I won't be presenting in London (all my time will be with traders), but if you email me, maybe we can arrange a Sunday meeting over coffee--
Brett
Dr. Steenbarger,
When I saw this post, I was deeply moved. I felt as though I had just been hit--by a hammer!
As a full-time occupation, I've played around in the markets for close to ten years. However, I'm not ready to call myself a trader, for reasons you have clearly hit upon in this post and in other pieces of your insightful work.
In the past, people have asked me for advice on trading; a few people have asked me for advice on what it means to be a trader. I knew before where to direct these people--this blog; I now also know which particular post to direct them to first--this post.
Thanks for making things clear.
--Troy
Thanks so much, Troy. That's exactly the goal of the post: to afflict the comfortable, even as other posts hopefully comfort the afflicted. :-)
Brett
Is there a particular software program you would recommend for backtesting, particularly if I'm not too savvy when it comes to programming?
The critique could apply to almost any endeavor, including, especially, the related skills of portfolio management, security analysis and asset allocation.
I find, however, that there is so much noise in most of these that unless you are incredibly superior to others, it will take a LONG time to detect skill levels that are worth documenting. An old Journal of Portfolio Management article (if memory serves), said 94 years. Those assumptions are pessimistic, but extrapolating from shorter periods of high success leads to a string of successes followed by blowups like this summer's.
You really need some very sophisticated understanding of why your approach should work, the market environments in which it will work better or worse, and a good way to predict that those conditions will obtain in the future.
A lot of work. Maybe it's better to just have fun doing what you like, and not treating yourself as too smart, reining in the hubris that might bankrupt you.
Post a Comment