Developing a Trading Strategy

We are preparing to move into some specific types of investing that you may or may not want to consider (most of them not).  Most people simply don’t have the time or the drive to master the art of trading, and that is a prerequisite for moving forward with more active investment strategies.  The old adage “she knows just enough to be dangerous” definitely applies to this situation.  My advice is to read and study the following chapters and explore what mastery entails.  I only provide a basic overview of the process of market investing.  This will provide you with just enough information (as the saying goes) to be dangerous to your wealth.

If you find that you become both intrigued and excited about the prospect, perhaps your personality will allow you to pursue trading as a second vocation.  I strongly advise that if you do decide on this path that you dedicate the time and energy to really learn how markets work and how to profit from within them.  All too often, people get excited about making big money based more on a sense of euphoria than a workable plan.  Anyone with a few thousand dollars and an internet connection can trade, but very few people have what it takes to be a profitable trader.

By “have what it takes” I don’t mean superior intelligence or preternatural skills.  I mean a fierce dedication to mastery.  Beyond having the “grit” to dedicate yourself to lifelong learning with mastery as your goal, you must develop the intellectual discipline to develop a detailed trading plan and the emotional discipline to stick to the plan.  Many people don’t have the stomach for trading because markets don’t work according to neat, linear functions.  Markets are multivariate and highly probabilistic.  The problem with probabilistic phenomena is that they cannot be predicted with perfect (any?) accuracy.  Individual trades will fail.  To win at this game, you have to step into the mind of the gambler yet never gamble.

As you may have surmised by reading all that came before the current discussion, I believe that there is a distinct difference between an investor and a trader.  The only path suitable for the vast majority of people is investing.  I also believe that there is a distinct and critical difference between a trader and a gambler.  Gamblers are defined by a penchant for risk, and will frequently make bets when they do not have an edge in the hope of realizing oversized gains.  The waters become murky because so many people are dishonest with themselves about this distinction.

When it comes to casinos, the lottery, and racetracks, most people will tell you that they are gambling.  For some reason, people doing their gambling within a brokerage account almost always call themselves “investors.”  You are an investor when you seek to profit from economic growth, and such growth only happens over protracted timeframes.  Profits are circumscribed for even the world’s best investors, and the magic of compounding is the investor’s edge.

The trader, on the other hand, has not such perfect edge.  Traders, no matter how skilled, have an imperfect edge.  Successful traders must master the art of assessing the probabilities associated with particular outcomes while also mastering the art of safe capital allocation (sizing bets).  Probability assessment sounds rather technical, and many successful traders would say that they don’t know what you are talking about.  Traders often assess risk intuitively and use strategies that have high probabilities of success.

We could develop a long list of strategies and tactics that attempt to build high probability trades without ever using the term “probability.”  If a trader says that “I am a momentum” trader, they are attempting to profit from the fact that trends have a high probability of continuation in the short term.  They may not think of the way that they trade in those terms, however.  A technical trader may enter a trade because an oscillator crossed over a threshold.  She may not be able to articulate the precise probability of a change in direction associated with that crossover, but she intuitively understands that when such as event occurs that the probabilities shift such that she has an edge.

The reasons that most people fail to become profitable traders even when they use a probability-based strategy is that they are using a univariate model to predict a multivariate outcome.  Many traders recognize this problem intuitively (they likely do not think in terms of probability and variables), and they develop systems that have many steps, each aimed at assessing and tweaking probability levels.  Often, they end up measuring the same thing in several different ways (a problem researchers call collinearity) and fail to improve their prediction models meaningfully.  A trading system that actually works will use several indicators (e.g., buy signals and sell signals) that provide a unique contribution to the probability assessment equation.

Occam’s Razor

Occam’s Razor is a problem-solving principle attributed to the English theologian and philosopher William of Occam.  Also known as the “law of parsimony,” the principle states that when all thing are equal, the simplest solution is the best one.  When it comes to applying the principle to a trading plan, it means that we want to include anything that provides a substantial advantage in terms of accuracy (as evidenced by it generating profitable trades).  We want to exclude everything that doesn’t improve our chance of success.  This is accomplished by eliminating indicators that don’t have much predictive power and ones that provide redundant information.  Many stock “signals,” for example, get at the same thing in slightly different ways.

 

Perhaps the rarest breed of trader is the scientifically minded individual that seeks to determine actual probabilities of success empirically.  This is usually impossible in the day-to-day reality of executing trades for the retail trader because of the time involved.  Smart Money traders can accomplish this feat because they have vast resources such as mathematicians to develop the algorithms, programmers to set them up within supercomputers, and blazing fast network connections to execute high probability trades in a matter of nanoseconds.

For the retail trader, the best method of developing a high probability strategy involves considering an adequate number of indicators and establishing an action plan based on the specific conditions of those indicators that suggest the trader has an edge.  The strategy can be tested (and backtested) using historical data and paper trades to assess the strategy, adjust the strategy, and reevaluate the strategy.  The key to success always boils down to identifying, entering, and exiting trades in such a way that realized profits exceed realized losses.  If you enter trades without such a system in place, you are a gambler and not a trader.

The average person can build wealth with a supremely simple strategy as long as the trading plan is geared toward the long term.  This is what I strongly suggest (and earlier advocated) that you do with your retirement account.  Your health and well-being in retirement are just too important to accept any probability of success less than 100%.  With your “mad money,” you can afford to accept some risk.  The key to this strategy is to define that risk.  Part of that is learning techniques to limit losses and insure against them.

The other side of that coin is to have a system where you only enter into a trade when you have a probability of winning that is acceptably high.  To meet this criterion, the probability of success has to be known.  This can be accomplished by using a constellation of indicators that provide the requisite edge, albeit in an imprecise way.  You will be able to make profits in a more predictable and consistent way if you can translate imprecise statements of probability (.e.g., “highly likely”) into precise statements such as “a 70% chance” of making a profit.  Such specificity is difficult to achieve with most investments.  (The mysterious world of options trading provides traders with a relatively easy way to accomplish this potentially profitable task).

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