Newsletter
December 1, 2007
Surviving Chaos
Buyer Beware
Largest Changes In Raw Numbers (21 Days)
Surviving Chaos
Why is it that some people who are very successful in demanding professions have trouble gaining confidence as a trader? Why do some people buckle under pressure, yet others thrive on it? Perhaps because markets are often unpredictable and uncertain; causing some to act impulsively, abandoning their trading plans prematurely. Traders, who are able to weather the storm to make enormous profits, have a combination of characteristics that make them winning traders.
Of course there is no substitute for experience. The winning trader has experience with the markets and with his or her own personality. New traders are very much like beginners learning a new sport, such as skiing or tennis. They haven't experienced the variety of events that may come up. They see the market as a structure of random movements. The winning trader sees structure in what others see as chaos. Over time, comes an intuitive feel for the markets. They can sense when particular market conditions have emerged and they know that the odds of success are on their side.
Uncertainty is anxiety provoking and new traders succumb to the fear. When they are ready to put on trades, they aren't calm and focused; they are scattered and afraid. Winning traders, in contrast, have experience, and confidence. They know that the odds are in their favor, and that if they make enough trades under these ideal market conditions, they will come out ahead. Since they know that in all likelihood that they will succeed, they are calm and relaxed. Of course there are no guarantees, but they truly believe that it won't be the end of the world should they hit upon a series of losing trades. Should they encounter the worst-case scenario, they know they will live to trade another day and make the losses back.
When a trader has genuine trading skills, he or she knows that there is little to worry about in the long run. He or she is never stressed out. The uncertainty and unpredictability of the markets that produces stress in the new trader is seen as excitement and opportunity by the skilled, seasoned trader. The more trades you make, the more success you enjoy, the more likely you will gain experience and hone your trading skills. It will not happen over night, but it will happen eventually. In the meantime, you might as well accept your fate and patiently wait until you build up superior skills and confidence. If you stay optimistic, working hard, you will gain valuable market experience, and survive the chaos.
Buyer Beware
If you have been or go to an investment conference or read a magazine, you will see, even be bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an "exclusive" letter (Just you and a thousand other readers) which will give you a hot options or stock tips. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now!
Here's the reality. "If you could make 30% a year steady, in five years - ten at the most-- you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That's every year, of course. Why, in the world, would you sell that system?" - John Mauldin
Even very experienced traders often do not know why their system produces poorer results in actual trading than in historical back test situations. They do, however, know this condition exists and they compensate for it. Nevertheless they often do not understand the causes. There are four major sources of the discrepancies traders often find between historical simulation and what is encountered in actual trading.
In physics there is a term called the "observer effect" in which the act of observing and measuring a phenomenon sometimes affects that phenomenon; the observer disturbs the experiment by the act of observing. It is similar in trading. Almost anything that repeats with enough consistency is likely to be noticed by other traders and anything that is working particularly will is likely to be noticed by many traders. If enough traders begin trading the same setup, the same conditions, it will no longer work on a consistent basis. Why? Simply the professionals will also notice and begin to force the condition to happen and trade against it, thus changing the market conditions that made the setup work previously. The more liquid the stock or the market however, the less likely the professionals will be able to drive price and trade opposite.
If you have not read Nassem Talub's books "Fooled by Randomness" and "Black Swan" I suggest you do because that is the next factor to interfere with historical simulations as well as actual trading; Truly Random Events. There is no way of knowing in historical simulations just how many random events affected trading results both good and bad.
In today's world of powerful home computers and advanced software for historical simulations optimization is a fact of life. Optimization is the process of determining which particular numeric values for your indicators to use. A short moving average is a parameter in many trading systems, a long moving average is another, optimization is the process of choosing which is best. There are many, and I used to be one of them, that says optimization is bad because it leads to curve fitting which results in poor performance. Maybe, but not necessarily so.
Optimization can be good when it is done correctly because it is always better to understand the performance characteristics of changes to parameters than to be ignorant of them. For example let's say that you are entering and exiting trades based on a moving average crossover. Your currently using a 10 and a 20 day moving average, when the 10 day crosses above the 20 day you buy, when it crosses below the 20 day moving average you sell. You're somewhat pleased with your results but wouldn't you want to know that lets say a 13 day and a 21 day works better; or that the simple moving average works better than the exponential moving average or vice versa? I would! That is a reasonable optimization.
The problem that most object too is simply over-fitting or what is known as "curve fitting". Curve fitting occurs when systems become too complex. It's possible to add rules to a system that will improve its historical performance, but that happens only because those rules affect a very small number of important trades. Adding those rules can create over fitting. This is particularly true for trades that occur during critical periods in the equity curve for a system.
Sample size is another important issue that must be considered. If for example one tests for seasonal factors, such as sell in May and go away, over the last 10 years of data, there will at most be 10 instances where the phenomenon has taken place. There is very little statistical significance to a sample size of 10 and therefore any conclusion reached may not at all be predictive of future seasonal tendencies.
Designing usable working systems considering all the factors I've talked about during the last several weeks is not an easy task. One needs to avoid the many traps of misunderstandings of the statistical data and avoid over fitting. Design is a long and tedious process, do not treat it lightly.
Largest Changes In Raw Numbers (21 Days)
NOTE: The presentation of this report has now been changed to an excel spreadsheet format containing all Industry Groups, ETF's, and Indexes, allowing you to sort all from best to worst. In addition each weeks report will appear next to the last weeks report and so on, allowing I believe much easier research on your part.
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Have A Great Week!
Bill
Prudent Trader.com
Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.
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