Main Source of Trading Losses

It's not extremely hard to find things that work on the market. The hardest thing is to make them work properly and make you money in the long run.

The main problem why you not perform may be not that you trade things that do not work. You may have decent setups or strategies or vision, but still, struggle to turn all this into consistent money flow.

The reason is that you over-react on the dynamics of your performance equity. When everything goes well, you scale up, when you hit by a drawdown, you scale down. That may seem perfectly reasonable practice, but in the long run, it may become a serious burden dragging your performance down if you're too fast scaling up and down.

Your psychology is pressing you to do it fast. When you're growing, you want this to be as fast as possible. When you're hit by a drawdown, you want to protect whatever rest of your profits at all cost. All this seem so reasonable!

The problem is that many conditions on the market tend to be clusterized. When you hit the sweet spot of market state, you may locally have a boost in performance. When you're in a bad spot, it may seem a stroke of bad luck. In other words, trading "luck" tends to be kind of cyclical.

The pro-cyclical pressure of your performance makes you over-invest into your trading right before your good luck is over. And under-invest (or even quit) right before your good luck is about to start.



I believe this is the main source of long-term trading under-performance.

Control your scaling practice.

Up or Down? Is this the Right Question?

The common belief is that it is possible to have reasoning about price direction at any moment. At least this is seen as a final point of your progress if you're into chart interpreting. People expect that if you're good, you have a vision "up or down" at any moment.

But from what I've learned: you, in fact, can have this kind of answer only in a particular moment of time, where the local situation loses stability and undergo some critical shift. This is just a quick moment, and it is usually wrong to be too fast or too slow using it. After that moment everything happens very fast because next moment the whole market sees this piece of information and act accordingly. So you have to enter just in time.

So I don't know how people can have an opinion about price movement direction at any moment of time. It looks to me that this kind of opinion on average will be extremely poor. If you want a quality of decision good enough to bet your money on it, you have to accept that good enough reasoning will appear only in sparse moments. The rest of the time, 99% of it, you just don't have enough information to answer "up or down" question.

I suspect, that many people just can't accept the fact that they there's no answer 99% of the time. People just like having an opinion. It may be ok to discuss "up or down" just for fun, but if you want to bet your money on your opinion, that's different. You have to understand the level where "for fun" becomes "good enough to bet money", and to have the courage to admit that this level is very high.

So many players are over-concentrated on "up or down" question because they believe that this is what the game is about. And they make decisions not having enough information to do so on a decent level. This situation looks like an opportunity. You just have to understand where a massive failure of that kind of players happens.

Who is the Paying Side in Trading?

If you want to consistently stay on the winning side, you'd better know who are the people that will pay you and what is their problem, why would they act so unreasonably.

They make decisions. If you play the people vs people game (which is what trading essentially is) you have to be well trained to stay on the winning side. What that training means is that you have to make thousands of decisions and take a lot of beating during this process. That training at some point may turn you into a pro (not necessarily, though).

But there is a lot of people (if not most of them) who make decisions not being a pro. They use all kinds of mental tricks to persuade themselves that in this particular case you don't have to be a pro to make this particular decision about this particular trade. It can be done relying on what I call "external insight". It may be an opinion of some guy on TV or Youtube or trading community guru. Or it may be a product of some scientifically-looking algo-shmalgo thing that you don't really know how it works. Whatever makes you think your ass is covered.

Yes, this is the mass of people who create patterns, because the difference between "nonpro" and "pro" ways of action has some structure. This structure is created by behavioral patterns of people acting "naturally".

This structure is what you want to exploit.

Where the Trading Edge Really is

Many people are concentrated on the question "where the price is going - up or down?". And you may think that the edge in the trading game is about the correct answer on this question. But I want to give you a different look at this.

Let's take a roulette.

Is it possible to have an edge in the roulette game? If you're playing against the casino, obviously not, you have a fixed math expectation which is against you.

But what if this is the kind of roulette where winners share money of losers? This fact changes the situation more than you might think.

Now you may have an edge consistently betting against the majority. Because if the majority fails, the minority of winners take excess profits on their risks. This creates the edge in the game. You still can't guess the right outcome because it's random, but when you're right - you make more money than you lose when you're wrong.

Most people in this kind of game anyway will concentrate on the "red or black" question. This will create the necessary disbalance of bets in the game. And this gives you an opportunity to play the game against this bet disbalance.

The trading game is an example of this kind of roulette. Winners take money of losers, minus transaction costs. Most people are concentrated on guessing where the price is going.

So maybe it's a good idea to stop being overly concentrated on the "up or down" question (it may be random, after all), and start being concentrated on people making bets. If you find a way to be there when the big chunk of bets fails, you will have your edge.

Explanations

Secret of High Sharpe Trading

The Source of Market Inefficiency

It is customary to believe that main source of market pricing inefficiency are emotions of discretionary traders.

But I think that most inefficiency today, at least on shorter time-frames, is created by actions of "naive" systematic traders, implementing excessively simple and straightforward approaches. They over-backtest, over-fit, and then over-invest into whatever they found. Then at some point they get ruined by the market game logic, creating shocks, jumps and other kinds of impact sophisticated traders love to exploit.

The problem with the systematic approaches is that they seem so scientific and reliable, that you just can't find enough reasons to doubt the promise you see behind them.

But they are not in fact as reliable as it seems, because the market is not a physical object with fixed properties. It is an interactive game, which adapts so the less sophisticated participants loose money (mostly to transaction costs, though). It doesn't really make a difference are those participants discretionary or systematic, if they are not good enough to adapt faster than the environment changes or see the gameplay deeper than the average participant, they pay.

So if you search for the market inefficiency spots, you may start with a question: "what would a simple minded systematic trader NOT do?"

Another consequence is that this situation is probably not going to change as more and more technology comes into the gameplay.

We all expect the AI to come to the market. The common idea is that it makes all the market inefficiency disappear, eliminating traders as a class.

But again, there will be no AI not linked with the particular person making some decisions about that AI. That means we will have over-simplistic approaches all over the place and over-investments into whatever AI may seem to promise. Which will be breaking at some point, creating shocks and jumps.

So inefficiency is here to stay as long as we have at least some humans involved in the gameplay.