Seven deadly sins of trading

I don't believe that trading and investing in the financial markets requires a huge amount of skill to do reasonably well. It's mostly avoiding making a series of typical mistakes. Here then are my Seven Deadly sins of trading to stay away from. Some of these will be familiar but others are often overlooked.

No system

True skill in trading is very rare in my opinion. Most traders would be better off sticking to a simple rule based trading strategy.

I've also noticed that the trading 'systems' in many books are vague and/or highly subjective and not really a set of rules but rather a set of guidelines. This could be because:

• The authors have a system but are unable to articulate exactly what it is.
• They do have a system, can articulate it, but choose not to so they can make some more money flogging expensive seminars or newsletters.
• They don't really have a system at all, but have tried to write down some rules ex-post on what they think they do.

In any case it doesn't set a very good example to the amateurs reading their books. If a system can't be written down in a precise algorithm that a computer could execute without any human input or judgement, it isn't a system.

Of course there is no point in having a system if you don't stick to it.

Not having, or not sticking to, stop losses

Even if you are a skilled trader who uses their own judgement rather than some strict rule based method for entering positions you must have strict rules for exiting your positions in the event of a loss occurring. Otherwise you won't know how much capital you have at risk on each trade.

Suppose you set up your stop loss so you would lose £10,000 if it was hit. The price then moves through the stop loss. Is your response:

• The fundamentals are good so I will hang on. Probably a good time to average down actually.
• Only an idiot would sell out here, this is just a short term blip
• The original stop loss made sense but now the Fibonacci retracements have shifted so a new lower level is in order.
• The short sellers are trying to take out the longs, once they've done that the price will rebound nicely.
• I can't afford to take the loss!
• I've already sold out. Why are we even discussing this?

If you picked any of the first five options, you are a danger to yourself and your bank account. You thought you had £10,000 at risk on the trade but now its actually much more than that.

Risking too much capital 

 

There are fancy mathematical models like the Kelly criteria and much simpler ways to decide how much to put on each trade.

(If you are interested in this subject then Fortunes Formula is a must read)

Behind the equations is a simple truth. No matter how good your trading is if you bet too much you will stand a chance of blowing up before your skill is translated into good performance.

Consider the genius who develops a trading system with a back tested Sharpe Ratio ratio of 2.0. Ignore the hype of anyone peddling anything better; this would be a really great system.  

To maximise your expected wealth if you had twenty thousand quid (bucks or euros....) of capital you should aim for an expected annualised standard deviation of returns of around forty thousand pounds a year. Or if you like around 95% of your daily profits should be between minus and plus 5,000.

The genius will do pretty well. On average if all goes well they will earn £80,000 a year pretax from their trading system, and more in later years if they can keep money in and compound their returns.

(Note to readers who still work in the financial markets. In case you didn't know to a normal person £80,000 is a lot of money)

If you adjust your risk according to any gains and losses then at that level you have around a 96% chance of keeping at least half your capital over a ten year period.

But a 2.0 Sharpe ratio in back test rarely materialises into reality. If you only managed a Sharpe Ratio of 1.0 (which is still very good indeed) then you only have a 50% chance of still having half your capital intact one decade later. And if you've really screwed up and get a SR of 0.5 then there's a very good chance (88%) that you will have wiped out at least 90% of your assets!

Most traders would do very well to expect a SR of 0.5. This means downsizing your bets to a quarter of what the 'genius' did. On average you'll make £5,000 a year at that level. Not enough? Then put up more cash. But only what you can afford to lose 90% of if things go wrong. Better still stick to trading part time job.

Setting stop losses according to money management rules

95% of trading books give lousy advice on position sizing by telling you to set your stop loss according to your capital.

So if you are trading crude oil futures and you have £10,000 or around $16,000, then you risk 3% or around $500 on your trade. Fine so far. Since NYMEX crude oil contracts are for 1000 barrels, your stop needs to be 50 cents per barrel below your entry. That means if you buy in at say $100 you will set your stop loss at $99.50.

On the other hand if you are a much wealthier person with £1,000,000 in trading capital then with $50,000 at risk your stop loss would be $50 below your entry, or at $50.

This doesn't make any sense. The oil market doesn't know or care how much trading capital you have. Since right now it moves roughly $2 a day or less two thirds of the time (one standard deviation of returns) the poor guy is probably going to get stopped out in hours, whilst the rich guy will be waiting months or even years.

Some books improve on things slightly by pointing out that the richer guy can trade more contracts. True, but how many more? And should he change his stop loss depending on that?

Fact is you should set your stop loss independently  of your wealth based only on the dynamics of the market and how long you want to hold positions for. Assuming the poor and the rich guy have the same opinion about these things their stops should be in the same place. Probably somewhere between $0.50 and $50... but lets call it $5 just for the sake of argument.

That means that both guys will have the same $5,000 per contract at risk for each trade.

You should then buy contracts according to how much money you want to risk on the trade, which of course is dependent on your wealth. That means the rich guy should pony up for 10 contracts. The poor guy shouldn't be in the market at all unless he can trade fractional contracts maybe through CFD's, or if he is going to day trade for which a much smaller stop loss might make sense.

Having profit targets and/or not using trailing stop losses

Again this is an error made time and time again by many books by 'experts'. Profit targets are pointless.

Why should you care about how much money you make on each trade? Isn't it better just to make as much as possible by using a trailing stop loss? Worst still if a profit target like the stop loss is set according to your capital.

Profit targets only make sense when they aren't profit targets, but part of your trade logic. So if you believe that a market is oscillating between £1 and £2 a share then of course it makes sense to sell at around £1.90. If you have evidence that trends collapse when they become overextended, and that equates to a level £5 above where you are now, then by all means sell out at this level.

This is all good but is completely different from a blanket 'Sell once you have a made a profit of £1000' rule which you apply to any market, regardless of it's dynamics or the reason why you put the trade on to begin with.

Trading too much

As well as risking too much capital nearly everyone out there is probably trading too much. I've seen it done by highly sophisticated institutional investors with complex models to optimise trading patterns versus costs. I've also seen it done by naive characters scalping in trading arcades being exploited to create commission flow for brokers.

From the maths above someone with £100,000 of capital can probably take a position in one crude oil future. It costs me around 100 cents in commission to trade one crude oil contract. But worst still the bid to ask on that crude oil future is 1 cent, or $10 of real money. So that's $12 per open and close trade if I have to pay the spread. If do ten of those a day I need to make $30,000 a year just to break even. On £100,000 of capital that means a reasonable Sharpe ratio of 0.5 will be pretty much halved.

To an extent the financial markets are a zero sum game. You can make reasonable pre-cost returns by not making mistakes. But only if you have a great deal of skill will you make enough to overcome the costs of trading this much (or another advantage like fast connections and a bent market).

Overfitting

 

This one only applies to the really smart people out there who have developed trading strategies through backtesting, data mining, call it what you will. As I said above a 2.0 Sharpe ratio in backtest really materialises into reality. Unless you have a really good grasp of statistical significance then don't even try to fit your trading models. Pick some really simple trading strategies, average them out, run them and stick to them; without going near any backtesting software. I almost guarantee you'll outperform any fancy machine learning / genetic algorithm / econometric magic you care to mention.

To conclude

 

We can't all be Lewis Hamilton (insert name of favourite professional driver). But we can drive safely and competently without having an accident. Only if you can do that should you even think about trying to go faster.

The same is true in trading. Yes it might be that you do have the rare ability to make significantly more than average traders do, but you will never find out if you don't get the basics right. On the other hand if you're just an ordinary person then you can steer clear of blowing up and do okay.

Be careful out there.

More publicity for LOBO scandal

Nice to see this blog quoted in private eye.

Why you shouldn't employ too many geniuses

"First class people hire first class people; second class people hire third class people" A famous quote, source unknown. Since presumably you are a first class person (otherwise you couldn't understand this blog) you must want to hire the smartest people you can? Right?

Wrong. I think there may be serious issues in hiring too many really smart people. This is especially the case if by 'smart' you mean 'academically gifted'.

Although these observations are based on working in the quantitative finance industry, to be precise a systematic hedge fund, they probably hold up elsewhere. This is especially true in similar industries where intellectual prowess is perceived to be particularly important.

First personal disclosure. I am pretty clever (137 Stanford-Binet if you care), but have had the experience of working with much cleverer people. Probably I would be lucky to be in the 25th percentile by IQ of the research and technology group where I was working (versus around 1st percentile in the general population). So I know exactly what I am talking about. Genius friends of mine reading this article will hopefully not be offended (and at least pleased I consider them to be geniuses). Of course since this article is full of gross generalizations it doesn't actually apply to you.

Now let's see why having too many super bright people is a problem.

Genius overconfidence

I am very interested in the cognitive biases that underpin the various facets of behavioral finance - the field which explains why people do not conform to rational economic behavior when trading and investing. The most potent behavioral bias in our brains is overconfidence. It leads to poor decision making, most markedly in decisions about money.

Now who is more likely to be overconfident, an average person or a genius? Ignoring delusions of grandeur  its probably going to be the genius. I have yet to meet a super bright person who is not aware of their high IQ, although many of them play it down in public so that some of their friends will continue to invite them to parties. Very clever people often have collections of academic qualifications and prizes that reinforce their self awareness of brilliance.

Most ironically are people who are extremely clever and also have advanced training in statistics or econometrics. This should lead to a deep suspicion of all statistically driven research as being potentially over fitted. Even when it does this suspicion rarely extends to their own research. Unfortunately most very able econometricians only gain in their ability to over fit in more complicated ways.

One way to combat genius overconfidence is to employ a range of abilities. Then at least the more stupid people (like myself) will have a stronger sense of their own deficiencies.

Genius group-think

When people go out and hire very clever people they tend to be fishing from a very small pool of graduates from elite universities. Elite universities at least in the social sciences have a habit of churning out people who all think in exactly the same way. Thus LTCM hired both Myron Scholes and Robert Merton - both geniuses. But that is like hiring the same person and paying them twice; when they might have been better off getting in some people with more heterodox views on financial economics.

Geniuses like other people also generally prefer to hire people with similar outlooks and prejudices.

The sense of collective brilliance can reinforce overconfidence when geniuses agree with each other; thus "We are all so clever that we must be right" (Thus the danger if you have all the smartest guys in the room in one room).

If you have some average people in the firm with your geniuses then you do have the problem that the mere mortals can be dazzled by the brainpower of the elite, leading them to agree with the most ridiculous notions just because someone very clever thought of them.

Geniuses are hard to manage

They refuse to do 'menial work'

Or in the words of Marvin, the paranoid android:
"Here I am, brain the size of a planet, and they ask me to take you to the bridge. Call that job satisfaction, 'cause I don't."

This is most usually a problem with very junior geniuses who think that their raw brain power should immediately put them in the job description of 'pure thinker'. They fail to realise they have to learn about the business and real life in general before their massive collection of neurons is likely to come up with any thoughts that are actually relevant or practical.

They go off on tangents

"Yes I know the client's project is late but I had some interesting ideas about solving the Riemann hypothesis using non Euclidean geometry and a Rubik's cube"

This is a difficult one because the only reason to employ geniuses (apart from gaining an edge in inter office quizzes) is often that they represent 'Out of the money options' - every now and then they will come up with some completely blinding off the wall idea that nobody else could think of. This one idea could easily pay the genius' salary for 1000 years. However you have to be able to spot it, and fend off the resentment from everyone else who is picking up the slack until it arrives.

They can't easily communicate with 'dumb' people

Geniuses find it difficult to articulate their ideas because it means slowing their brains down and trying to get the idea out before another one arrives. Its terribly boring trying to get some thicko to appreciate something that should be pretty obvious to any half intelligent person.

Note: This also makes it hard to distinguish geniuses from people who are just bluffing.

Genius support staff

All of the above means for every genius you need to hire three 'normals' - one relatively stupid person to do the menial work, one clever person to do the work the genius was supposed to do, and one person just below genius level to act as an interpreter.

Genius academic / theoretical bias

Geniuses tend to be attracted to paradigms that require high intelligence to understand. So highly complex models, academically 'sound', very theoretical ideas and anything with loads of unnecessary maths are all favored above more simplistic tools. Even if they are either pointless or downright dangerous.

Rewards to genius less than expected

In my previous career I was forced to repeatedly watch whilst sales people bragged about how many Phd's we employed (lots). This was a bit weird as I myself lack the crucial doctorate. But also as alluded to above I do not think that there is a direct correlation between having highly intelligent people and making profits.

Here is a quote from my current favorite book Daniel Kahneman's Thinking Fast and Slow:

'The most potent psychological cause of the illusion is certainly that people who pick stocks are exercising high level skills.... All this is serious work that requires extensive training... Unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock. Traders apparently lack the skill to answer this crucial question, but they appear to be ignorant of their ignorance.'

Or to put it another way just because you are highly trained / clever does not mean you will be a great stockpicker, or indeed create fantastic models to pick stocks.

As far as I can tell success in research often comes down to a combination of luck and effort, once you have researchers with a baseline level of intelligence, skills and knowledge (which admittedly could be quite a high baseline). In quantitative finance its probably even worse; putting more effort into research often just results in more finely over fitted models.

In my field of interest employing a bunch of moderately clever people is necessary to create a half decent basic trading model. But the marginal gains of then adding a series of very clever people is probably small and even negative. The business success of that model will depend on having less academically gifted people with a variety of skills. Sadly these kinds of people are often neglected in the hunt for academic rock stars that it is assumed bring success.

To conclude

Of course none of this means the optimal business strategy is to hire a bunch of stupid people who will obey and bow to your superior intellect. But a nice blend of street smart, and practical pragmatists (with perhaps just the one Nobel prize winner) is probably much better than a room full of Phd's.