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The psychology of stop loss

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Diets don’t work. There has never been as many methods in the history of mankind. Meanwhile, we are all getting fatter year after year. Diets just solve the wrong problem. The issue is not the food we ingest; it is how we relate to it. If instead of juicy, delicious, melting, tender, we associated beefsteaks with increased risks of coronary and cardiovascular accidents, reduced life expectancy, arteriosclerosis, high cancer risk, we might be less inclined to partake in the consumption of the flesh of the holy cow.
Stop losses are like diet. Every knows the recipe: “cut your losers, ride your winners”. Everyone also knows the way to accomplish this as well: stop loss losers. So, why do we all fail ? This is not a statistical problem about calculating optimum stop loss. The issue is the associations we make about closing positions. Stop Loss is an identity issue.
The topic of “stop Loss” deserves a book. This article merely scratches the surface. Yet, You will find powerful tools to reframe your stories and practical tools to set and honour stop losses
The interesting twist on stop loss is even though we intellectually know that we are wrong at least 50% of the time, our ego has us still behave as if we have to be right 100%.

Part 1: Making money on the markets goes against nature

 “Hope is a mistake”, Mad Max, Aussie Philosopher
When people say I don’t believe in stop loss,…
… What they actually mean is I don’t like to admit I am wrong. They are often acutely aware that there is something wrong. Yet, they are willing to take on more pain and more uncertainty hoping that things will turn around and that they will be vindicated. This phenomenon has been studied by Nobel laureates Daniel Kahneman and Amos Tversky and known as risk seeking with losses and risk aversion with profits.justice-for-children
At the heart of this lies a confusion between outcome, i-e making/losing money, and process, i-e investment discipline. If being profitable equals being right, then logically losing money means being wrong. Any loss is therefore a direct attack on the self-image constructed by the ego. Since the ego wants to be right, and will always protect itself at any cost, we will sacrifice profits, endure excruciating pain for long stretches of time, jeopardise our jobs, our reputation even our families. The objective is no longer to be profitable but to validate the ego.
In Jungian archetype, the ego is an unhealthy version of the orphan. It is an early version of our personality, developed during the formative years of childhood. The image of the orphan, abandoned and mistreated, is actually a good metaphor.
Deep inside, the orphan’s intentions are good, he means well. He yearns for love and validation. Yet, as a child, he does not know how to handle situations gone out of control. His natural defense mechanism is denial and deflection. He will delay admission that something is wrong only to preserve ego driven self-image. He will pretend it did not happen. He will rationalise. Since he does not have better problem resolution method, he will show extraordinary resilience and wait until wrong turns back to right, until losses turn back into profits.
Do not underestimate the toxicity of a stubborn ego. Reputations and jobs have gone before egos surrender. Examples of pointless wars, companies run into the ground by narcissistic top management.
Bottom line: we are naturally inclined to let our losers run.

Why we cut our winners

We are not born eager to take profits early, quite the contrary in fact. “Beginners luck” stands for taking big risks on a low probability events, something no seasoned player would never dare. We become risk adverse after a few painful losses. We see profits evaporate before our eyes and want to keep some of it next time. If we never experienced losses, we would not feel the need to be risk adverse with profits. We would gladly embrace the riskiest strategies if it was not for the painful lessons we have learned through losses.
Bottom line: it is in our nature to run losers and then cut winners. Making money in the markets goes therefore against our nature

Part 2 How to re-write the story of stop loss

 

1. Accountability: take responsibility

The job of the ego is to protect itself at all cost, at all times. By now, You have probably concluded that this toxic form of ego has happened to people You know, but that You are immune to it. This makes for (hopefully) a nice read, but there is no need to change. Well, if that thought just crossed your mind, Your ego is playing tricks on You. Self-deception covers is a built-in feature that covers its own tracks. Try those exercise and see for yourself how good You are at deceiving yourself.
Exercise 1: Business is a form of procrastination
What do You do when there are uncomfortably large losses festering in your portfolio ? Do You read every analyst report ? Do You call companies, experts, read every article ? Or do You simply clean your desk ?
Chen & al asked students preparing for exams to grade their assiduity as well as break down their daily activities. Students who put off studying were also found more diligent at cleaning their desk , calling their parents. They were engaging in useful activities as a way to rationalise the guilt of not performing essential duties.
Exercise 2: The naked truth of numbers
In one of my previous jobs, i was fortunate enough to analyse the performance of managers stock by stock. If the three worst performing stocks had been removed from every portfolio, all managers would have outperformed their benchmark (before cost) every single year for the entire sampled period.
So, analyse all your trades and compare the bottom 5th percentile to the top 95th percentile. Download the trading edge vizualiser and run the numbers.
Calculate a 5th percentile tail ratio.
 
Your ego might have tricked You into believing You are rational. It might even have tricked You into believing You were doing the right due diligence, but in the end numbers don’t lie.
 

2. Reframing stop losses

If someone handed You the keys to the sexiest car on the planet, but whispered “brakes don’t work”, would You still take it for a spin ? Stop losses are like brakes. You may not like them, but they will keep You alive.
That simple metaphor is called reframing. It translates an abstract concept like stop loss into something we can relate to. Even though the absolute, imperative, non-negotiable necessity of a stop loss imposes itself beyond any beginning of dispute, we are still unlikely to execute, simply because enforcing them still conflicts our sense of identity. Bottom line, Stop loss is an identity issue.

3. Identity association

For example, diets are healthy, we know that. Yet, the overwhelming majority of people who have successfully lost weight end up putting it back on within a year. They have gone through the physical part, but they maintain unhealthy identity associations with food. Food is not the problem, how we associate to it is.DietsGone wrong
As long as we associate profitability with self worth on a trade-by-trade basis, the ego will trick us into skipping stop losses. We need to consciously associate being right with adherence to an investment process. This shifts focus from outcome (profitability) to process: being right is executing the plan.
This accomplishes two things:
  1. It becomes quantifiable and measurable: one trade is random. 100 trades are a data sample.
  2. It removes the incentive to cheat: being right is no longer an individual trade decision. You can lose money and be right. In fact, this association is stronger than the outcome orientation. It involves the neo-cortex in relationship to the dorso-lateral cortex (siege of identity). It literally rewrite the neural pathways to your identity

4. Clarity: Stop loss is a price, not a fundamental story, not a valuation exercise

Fairness is a trait common to all infants around the world. It manifests itself even before toddlers can speak. The orphan likes boundaries. He likes fairness. He does not like ambiguity. He hates favoritism.
Some people make the mistake of associating stop loss with change in fundamental story or valuation.
  1. Stories: prior to becoming a superstar with Emotional Intelligence, Daniel Goleman wrote an even more interesting book about the lies we tell ourselves. He argued that self deception is a built-in feature that covers its own tracks. We rationalise our bad choices. We will change our beliefs in order to match our actions. If You find excuses to avoid the gym, then You will fabricate excuses to allow losers in your portfolio.
  2. Valuations: Earnings estimates are notoriously inaccurate and jumpy. Forecast accuracy for analysts earnings estimates 1 year out within +/-10% range peaks at 25%, half a coin toss !
If a trade goes sour, You do not lose an investment thesis. You do not lose a P/E, DCF or some Frankenstein sum of the parts valuation either. You do not lose things that were outside your control in the first place.
You objectively lose two things: money and time. Risk is a number: this is how much You can afford to lose
5. When to set a stop loss
The best time to set a stop loss is … 5 minutes before entering a position. Stop losses must imperatively be set before entry
  1. Stop losses are necessary to calculate position sizes. If You do not set a limit on how much You can afford to lose, You may fail to appreciate what the market has in store for You
  2. Emotional interference: Once we enter a position, emotions kick in. Think of it as a prenuptial agreement. Commit to a price in writing, write it close to entry cost and price. Do not trust your brain with some abstract stop loss price. Your brain will renegotiate and it will trick You into a suboptimal decision (marketing buzzword for stupid mistake).
Stop Losses are necessary. We need to know when something is wrong, cut it out and move on for three reasons

6. Pre-mortem: enter each as if You expect them to fail

Everyone knows about post-mortem: this is the quarterly ritual when someone in management goes through your trading decisions with the benefit of hindsight…Grief
Pre-Mortem is a technique invented by Gary Klein: fast forward in time and visualise the decision You are about to make as if it was a failure.
For example, optimism usually peaks before entry. Even though our long term win rate is around 40%, we behave as if every trade was a winner. Consequently, we tend to oversize positions and delay stop loss.
Practice this powerful exercise for a month: just before entering a trade, imagine it will be loser that will have to be stopped out. Visualise yourself closing the trade at a loss, use the present tense. It may seem crazy but it accomplishes two things:
  1. Conservative position size: if you enter a trade expecting it to be a stopped out, You will naturally take smaller bets. You will stay out of illiquid issues
  2. Pre-packaged grief: we normally expect trades to work. When they don’t, we grieve our way to stop loss (Kubler-Ross). We negotiate with the inevitable. Now, if we expect every trade to fail, those which work will be good surprises. That do not perform as expected. It removes the emotional toll.

7. Execute the stop loss: re-parenting

A stop loss is just like any other trade. The difference is the meaning we assign to it can be potentially devastating.
The paradox is that beating ourselves up over losses reinforces the ego. Think of it as an orphan. Children have superb natural resilience. Beat the orphan, shame him, and he will retreat further, deeper. He will drape himself in the warm mantle of anger and call upon his resilience to endure the hardship. The orphan will endure but the child will yearn for forgiveness and love.
There is a link between self-forgiving and learning. Students at U-Penn who were taught to forgive themselves for their lack of assiduity have shparent4own 10% additional retention and 15% better grades than those who were instructed to enforce rigorous discipline. People who forgive and love themselves when they have trespassed their own boundaries tend to learn from their mistakes. In Jungian archetypes, this is the Ruler bringing back the orphan to the committee of the mind and thanking him for his protection. In other words, soothe yourself as if You were talking to your child. This is called re-parenting the orphan.
So, the more You forgive yourself, the less daunting stop loss becomes
The easier it is to execute stop losses, the easier to take new trades
The smoother the execution, the better the performance
Bottom line, forgive yourself for your mistakes and You will become a better portfolio manager.
In conclusion, watch this excellent video from Nobel laureate Daniel Kahneman on mistakes and pre-mortem

Better System Trader: Questions from the audience

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These are questions from the audience on the Better System Trader podcast with Andrew Swanscott. I am honored and humbled by the interest of listeners. We did not have time to cover all questions, so here are some written answers. If You have questions, please feel free to ask

Trading Psychology

From: Jim

The mind plays tricks on us, even with a successful system, as a system trader, what methods to use for the mental part of the system trading?  So meditation, journaling but how to implement them in one overall plan?

EXCELLENT QUESTION: Part 2 of the book will focus on this

  1. You cannot trust your mind. Michael Gazzanikas 1964 split brain theory. Self-deception: (Daniel Goleman) is a built-in feature. It happens automatically and covers its own tracks and designed to deceive us.
  2. Accountability: simple exercise to test validity of prediction and convince us we are unable to predict.
  3. Reframe from outcome to process: develop a system, account for signals generation and be honest about signal execution
  4. Daily market journal: write what You think markets, thoughts, things that happen, small comments, ideas, formulas. Do the James Altucher method: keep a moleskin with You at all times. Deliberate practice: activates the Default Modal Network (Olivia Fox Cabane)
  5. Write about the thoughts that cross your mind:
    1. dreams and aspirations when making money, why You keep doing that, why You like it. How does it manifest in the body
    2. fears, pains, detail, reflexes (ex: read the press, look for expert opinions): be specific and commit to writing or dictating. Very important
  6. Walk through your fears: meditate and manifest your fears. Seneca was history’s first investment banker. He also happened to be the founder of stoicism school of philosophy. He advocated one day a month of living frugally as a form of inoculation.

The view from the short-side: how we process emotions and the market signature of the 5 stages of grief

Another post on the topic:

Amygdala and the neurophysiology of Greed and Fear

From: @trader1970

So far as a Trader what is the biggest fear that you have not been able to overcome?  How do you manage this situation?

  • My father had a hemiplegia (brain stroke) when i was 7. He never regained motor skills and speech ability. We fell into severe poverty. As a result, I have a deep seated fear of becoming handicapped and not being able to feed my family anymore. Personal and vulnerable. Markets related fears I can deal with, I am a short seller, this is a versatile skill
  • How does it manifest itself in trading:
    1. Diversify sources of revenue: we have a real estate business that generates enough to cover our primary needs. That provides peace of mind. My family is safe from harm
    2. Frugal lifestyle
    3. Systematically take less risk: when making sizing arbitrage ask yourself, would You be satisfied with earning a little less than You could or losing a lot more than You should ?

 

Position sizing

From: Bass

Tell us more about risk management, Volatility based Stops and position sizing.

  • It really depends on your customers: Investors are like teenage girls: Teenage girls say they want a nice guy and they fall for bad boys. Investors say they want returns but they react to drawdowns:
    1. Magnitude: never lose than what investors are willing to tolerate
    2. Frequency: never be the last person investors think about before going to sleep
    3. Period of recovery: never test the patience of investors
  • Risk is not a story, risk is a hard number: it manifests itself in individual trade risk per trade (RPT), in aggregates exposures. Example: Long small caps / short futures is synthetically residually Long large caps as the index is primarily composed of large caps
  • Volatility stops: swings +/- 3 ATR. Volatility is as welcome as Kanye West at an award ceremony. Bad news, volatility is like Monsieur Kardashian bad manners: it is here to stay. Your job is to ride it and the way to do so is position sizing. For example, biotech and internet stocks are more volatile than department stores for example. So, size them accordingly.
  • used in position sizing. Rank trades by size (bigger first) so as to go for better volatility signature

 

From: Derek

Hi Laurent,

I have been following your website ASC for quite some time and also your answers on quora. I have something related to an answer you had to a quora question In investments, does more risk really equal more return, in the long haul? Your answer immediately clicked with me and it logically made sense to me. Laurent – you may want to quickly summarize what the answer was before we move on to the next part of the question. I’ll ask you what the answer was.

 Would you please elaborate on your convex position sizing method for a risk per trade and draw down module. This was discussed as an answer on Quora. I understand that as you make money you will allocate a larger risk budget using a convex surface with a max risk budget of -0.30. But i do not understand the reverse side of this, the draw down part.  As we get more draw down we should decrease our risk budget again using a convex surface. It starts at 100 and bottoms out at around 35. I do not understand how that part works.

 Also how did you come up with this method? Can you give a practical example of when you used this both for drawdown and additional risk scenarios?

Thank you very much

Derek

Here is a complete article on the topic. Thank You very much for asking

Convex position sizing algorithm: something your brain can trade through euphoria and depression

  1. Long Side: people add risk. Short side; frequent squeezes, start from manageable risk then reduce
  2. Metaphor of accelerator and brakes. Optimum fuel consumption happens when You do not solicit brakes. It clicked while listening to Larry Williams interview on the famous Better System Trader after bringing my daughter to the Hoikuen (crèche in Japanese)
  3. Market Value (MV) = AUM * Risk Per Trade (RPT)
  4. Most position sizing formulas will use one side RPT usually to calculate risk. In my case, this is convex so as we make money take more risk. This is accelerator. You want this to be responsive and nervous so to re-accelerate quickly after drawdown
  5. Meanwhile, when strategy stops working, You need to trade minimum risk. The problem with conventional formulas is that brakes are spongy and re-acceleration slow. You can get whipsawed. Which then erodes emotional capital, which leads to downward spiral. (Feedback loop between emotional and financial capital). By allocating a convex surface, AUM drops dramatically very quickly but then re-accelerates as there are signs of life
  6. Practical example: ETF. At the moment squeeze so drawdown, then surface immediately reacts and I naturally trade smaller. Residual open risk in my latest short entry was -0.12%, down from min risk at -0.25%

Trading Edge

From: Marcia

During your interview in episode 32 you talked about the “Edge” formula, which is, I think, ” (%wins X Average Win) – (%Losses X Average Loss) “? Would you talk more about that and what number you are looking for, or, what insights the number gives YOU?  thank you

Thank You very much. I am writing a book on short selling. Part 1 is about how to build a statistical trading edge. Part 2 is about building a mental trading edge. Part 3 is about constructing a portfolio with a positive trading edge. On the Long side, the market does the heavy lifting. On the short side, the market does not cooperate, so building a trading edge is critical

  • I am looking for positive number. I have never looked for a specific number, thank You for the suggestion
  • Use as asset allocation tool:
    • Plot trading edge by side and strategy
    • Pro-rate trading edge
    • Allocate resources (trading AUM or surface) based on trading edge, with floor and ceiling
  • This is useful for multistrats portfolios where You would systematically allocate resources to the best performing strategy

Shorting strategies

From: Adonis

What are the 3 most successful triggers he uses in going short? Does he use daily or weekly charts?

There were originally several variations on two strategies (mean reversion and trend following). Over time i have managed to merge them into one.

  1. Define trend: lower highs, lower highs
  2. Wait for roll-over: maximum information: volatility, swing high
  3. Enter on next bar

Exits:

  1. stop loss: full
  2. trend reversal (logical time exit): entry qualified on the other side happens within stop loss
  3. partial exit: risk reduction, take profit objective is to break even

Now, the delicate part is not in the signal module. Trading suspension for example is not a signal issue but a position size one. If sizes are too small, then trades are rejected. For example, sometimes currency pairs flip-flops between bull and bear. So, we count entries and add penalty for each full exit. This reduces risk per trade. If the overall equity is ain a drawdown, then position sizes get smaller. If they are too small, they are automatically rejected. This allows us to trade more pairs as some of them stop trading.

 

From: Graham

How do you simulate borrowing costs when testing a shorting strategy?

Everything at General Collateral (GC) +0,15% added to slippage. The question is probably related to hard to source issues or crowded shorts.

Do not short issues with borrow >5%, except on the Long side: squeeze box. Do not squeeze people: it is bad karma

 

From: Nikhil

1)  Majority of ideas for a short strategies seem to fail rigorous testing on larger time frames so one should focus on more active time frames [5min to 2H based data] instead of passive time frames [Daily to Monthly based data]  ?

Assumption: Nikhil may trade breakdowns, because this is a classic symptom or rebound higher than entry which leads to false positives.

Solution is not in better entry signal, but in partial exit and better money management, Trading system has 3 components: exit/entry, money management and mental.

 

2) Can you highlight a basic idea on a short strategies variable for further research for those struggling with constructing a short only strategy ?

JNK Short

Sure, check post on JNK attached. It is a scale-out/scale-in system.

There are 2 certainties in life: death and short squeeze. Use squeezes to your advantage

3) What opportunities do you see in the financial industry going forward for new generation of entrepreneurs (non trading/investing related) coming up ?

At the moment, everyone wants to be in the HF game. I entered the HF game in 2003 when it was still in infancy: a bunch of cowboys blowing stuff up in their kitchen. HF is bound for yet another healthy correction.

I believe the future to be threefold:

  1. Algorithmic assets allocation: fire your financial advisor. If You don’t know why, he probably does. Machines do a better job and they don’t get kickbacks…
  2. Separately managed accounts (SMA): open a brokerage account and let algo do the heavy lifting. Funds running costs are prohibitive. Besides, there is a proliferation of single brain cells parasites called compliance. They are the TSA (US airports officers) of finance: utterly useless at catching problems but extremely annoying
  3. Active management “soft patch”: SPIVA.com. The overwhelming majority of funds underperform the index and they are more expensive than ETFs. There is a gambler’s fallacy going on: ETFs have outperformed active managers so far, but the latter will be better equipped to navigate volatility and downturns. That is gambler’s fallacy: if managers failed to outperform during easy times, why would they even succeed during hard times ?

As for non-investment profession, I honestly don’t know

 

From: Ola

I am using market filters to keep me out of bear markets for my long only strategies for stocks, and I’m cashed up for periods of time. I find this a bit boring. What type of indicators or price action should I look for to create a short strategy to complement the long strategies? I’m looking for something simple and robust to be used on the daily time frame.

Best regards,

Ola

Check JNK trade attached. 1 Define trend, 2, enter on counter-trend move 3 exit partially as rebound comes

 

General trading

From: Bengt

Hello, it is often said that short trading is very difficult to make money off: Do you agree with this? If so, do you think it is a matter of the odds not being on your side or is it too much to handle mentally?

EXCELLENT QUESTION: “This is space, the environment does not cooperate… You solve one problem after another, and if You solve enough problems, You get to come home”, The Martian.

Andrew, Allow me to explain why people fail on the short side: they think from a Long perspective. This is deep shit that no-one has ever explained in statistical and psychological terms. Fascinating theme, I am writing the book on the topic and how to build a sustainable short selling practice

Example: 4 stocks: A,B Long C,D short, all start at 100

Start: Long exposure 200%, Short exposure: 200%, Gross exposure: 400% , Net exposure 0%,

A goes up by 10%, B drops by 5%. C drops by 10% and D goes up by 5%

End: Long exposure 205%, Short exposure: 195%, Gross exposure: 400% , Net exposure +10%,

Bottom line:

  1. On the long side, the market does the heavy lifting for You. There is a bigger bet on something good
  2. On the short side, the market does not cooperate: there is a bigger bet of something that does not work
  3. Net exposure is +10%. The main reason why people fail is that they want to short a throw away the key when they should be working more on the short than the long book. Just to stand still they should keep running: this is a Sherlock Versus the Red Queen effect

 

On the other end of the spectrum: is there an outer limit, odds-wise, for profitable long term trading, or is an 800-day breakout tougher to handle mentally than a 2 day breakout?

Best regards: Bengt

The problem is false positives: You will have many more false positives because of poor trend formation with shorter periodicity. You will deal with being systematically late. A more robust statistical approach is to deal with exits so as to move the needle from “near win” (false positive) to “near miss” (partial win)

 

From: Rob

Please ask for the following:

1) What works better in the forex market – momentum or mean reversion?

Mean reversion works until trend following works. It is a question of periodicity and tolerance for stop loss.

My strategy is a combination of both.

Post about two types of strategies:

Regardless of the Asset Class, There Are Only Two Types of Strategies

2) If you had to start over from the beginning with the knowledge you have now where would you focus on and what would you throw away?

  1. Psychology: clarity about beliefs. 90% of trading is mental, the other half is good math
  2. Trading edge is not a marketing gimmick: it is a number
    1. Money management: example of convexity
    2. Exits: stop loss is the 2nd most important variable

3) You have said in the past to focus on exits and not entries – but how exactly do you do this? Is it a matter of thinking about when you will exit if you are right or wrong?

Never think about right or wrong, it is the wrong mental association that will lead to death. Think about profitable. I am writing something on the psychology of stop loss. This article is potentially the most or second most important post I have ever written.

The best analogy is diet. Diets don’t work. We are all getting fatter and there has never been as much information on diet. Diets fix the wrong thing. The problem is not what we eat. The problem is how we think about we eat. Same goes with stop loss and exit.

This is not a mathematical problem. This is a psychological issue about the meaning we ascribe to closing positions. If we associate stop loss with being wrong, the ego will revolt.

IAU option trade anecdote funny and excellent example to talk about emotional capital and Zibbibo viognier white wine blend from Etna

4) What do you think about fixed fractional position sizing

it is a good basis of any position sizing algorithm. Now, it is a bit simplistic for 2 reasons:

  1. Uniform risk taking through the cycle: think of it as a car. Sometimes it is good to accelerate, sometimes You need to decelerate. Win rate changes through the cycle and so should risk
  2. Dissociation: Long and short sides rarely work well at the same time. Since they have different win rate, they should have different risk numbers

Dissociation by side of the book, strategy using trading edge or win rate. Please check my post on convex position sizing

5) Please talk more about stops. you said in the past your stops have a large impact on your P&L – but how do you calculate your stops. What are the considerations when using a mean reversion vs momentum strategy and type of market forex vs futures.

Sure, happy to explain the equation

The game of two halves: an elegant two-step process designed to cut losers, run winners, while maintaining conviction

Now, for mean reversion strategies, the equation includes another variable: frequency. Let me give You a simple example. If you clock +0.5% per month and then have -6% month, it will take roughly a year to make that back if everything else works. So, a simple idea is to empirically come up with a patience factor. Example: never allow losses to be greater than 4 months of average profit. The difficulty though is correlation. Accidents travel in group.

Another important point on mean reversion, never trade open risk strategies. Example: short naked gamma. I was having dinner with some options portfolio managers friends. Short OTM gamma is still marketed to unsuspecting investors. Those are scams: they show consistent returns until they blow up

From: John D

I trade a long term trend following (trade every 1-3 months) system on stocks indices currencies and commodities. What type of exits would you use on this type of system?

Trailing ATR stop? Time stop? Both?

John D, You are right on all of them

Three stops:

I have developed something called box concept. Once in a trade, there are three possible scenarios:

  1. It does not work and needs to be stopped out. That is a floor or ceiling depending on whether You are Long or Short
  2. It works well and warrants some de-risking: take money off the table and leave a portion for the long right tail
  3. It goes nowhere: this immobilizes resources and needs to be dealt with

The concept is that whatever happens, it will trip one of the mines and will be dealt with. This is how it is done in practice

  1. Isometric staircase stop loss: swing +/– allowance for volatility. Markets do not go up in straight lines. They go up or down, retrace and resume their course. This method allows markets to breathe
  2. Partial trailing stop loss: take some money off the table so as to reduce risk, but leave a residual for the big trend. After taking some money off the table, it makes sense to re-enter and a add a little bit more risk.GBPJPY
  3. Time stop: buying power and trading frequency. Some stocks do not move enough to warrant either a stop loss or a risk reduction. These are the harder ones to spot. The solution is to timestamp them.

About timestamp:

A powerful two step process to deal with the endowment effect: The game of two thirds, or how to deal with free loaders in your portfolio

 

How do I overcome an addiction to forex trading?

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My answer to How do I overcome an addiction to forex trading?

Answer by Laurent Bernut:

Addiction to Forex trading has all the symptoms of alcohol or drug addiction. It is deceivingly easy. It is accessible. It does not require large amount of capital. It can be done anywhere on a smart phone. It gives immediate feedback.

Alacoholic anonymous:
welcome to addictive personnalities. The best thing You can do is attend Alcoholic anonymous and substitute everything that mentions alcohol with Forex

In fact, I cannot recommend their program highly enough to overcome over-trading.

A. How the brain works:
The reason You want to stop is most likely because You are not about to buy that private jet You saw on the advertisement.
Here is the interesting distinction between gambling addicts and recreational players.

    1. Illusion of success
Forex brokers do an exceptional job at giving the illusion of success. Anyone can open an account with almost no capital and start commanding vast amounts of money. It is so easy, yet it is anything but simple.
This is a form of video games, except this time You can make money. The worst thing that can happen is that You make money initially. The best outcome is You lose and wisely conclude it is not for You.
So, You probably made a bit of money, got hooked and then started losing

    1, The curse of near miss
The brain does not process information the same way. Three outcomes:

  1. Win: addicts and civilians process wins the same way, that is they attribute it to their skills (believe it or not, we attribute wins to our skills even in roulette)
  2. Clear loss: addicts and civilians process clear losses the exact same way
  3. Near miss: civilians process near misses as losses, the same way a clear loss is processed. Addicts process near-misses as if they were wins: it activates the dopamine reward circuit (Nucleus Accumbens NaC)


    2. The dopamine reward circuit and “your brain on porn”
The meso-limbic circuitry is also referred to as the dopamine reward circuit.  At its core, the reward circuit is a primitive guide that will psuh You away from pain and toward pleasure. It had a vital role for our ancestors: eat the wrong berry and You will be someone else’s dinner. Fats forward tot he modern world, this is how addicitons are formed: NaC gets activated, releases dopamine and memories are formed.

The best explanation of this cycle is in this medical video. I understand people would be put off, but everyone should watch this video, especially if You are a parent: Your brain on porn

   3. Beginner’s luck neurosciences and statistics
From the above paragraph, it is easy to understand how people can be driven to play again and again. If they win, they will continue. If they lose a little bit, they will play again to make it back and if they lose, they will attribute to bad luck. There is no losing combination. You are bound to play until You throw the towel

Now, if You are a recreational trader, near-misses will be magnified losses and You are likely to trade more conservatively as a result. In the end, You will make money and everyone will call t beginner’s luck.
No, your brain responded to objective (loss) and subjective (fear of loss) stimuli by adequately reducing risk, which increased your trading edge (gain expectancy)

On the other hand, if You are a junkie, You will overtrade, lose and revenge trade to make it back, which will invariably dig the hole a bit further.

The subtle statistical difference is in the treatment of the near miss. For example, imagine payoff equals loss. If the objective win rate is 48% but You think You win half the time, what do You think happens in the end ?

You are not as good as You think You are, You are just as good as your trading edge and here is the formula:
Trading edge = Win% *Avg Win% – Loss% * Avg Loss%

B. How to cure addiction

Alcoholic anonymous
They have an impressive track record. Their method works.

The habit loop301043
Once an alcoholic, always an alcoholic. Neural pathways of addictions are almost permanent.The brain loves habits. More than 45% of daily activities (a bit more if You work for CNBC) are spent in automatic unconscious mode
Mechanism is simple:

  1. Cue/Stimulus
  2. Routine
  3. Reward

The habit loop is unlikely to change. Whenever the stimulus is triggered, the urge will itch, and the loop will be activated. Rings a (Pavlovian) bell ?

The brain craves its reward and, despite all your best efforts, it will get it. How many people who You know who can’t quit smoking ?

So, the trick is to reverse engineer the habit loop. Substitute the bad routine with a good one, and gradually habits will form. The key here is to identify the cue that triggers the routine.

Whenever the cue happens, don’t fight it, use it. Example, I used to smoke 1 cigarette around 10 am and 1 around 3:15 pm after market close. I changed my routine to inserting two 5 mn Calm.com meditations on my iPhone.

Cold turkey and study
Personally, I would not hire someone who has a tendency to over-trade. This is usually symptomatic of deeper issues: perfectionism, dissonant self-esteem, poor discipline, addictive personality etc.

It does not mean that compulsive traders don’t make it. It means they have a few more demons than regular people.

There is one silver ling about being compulsive. Those traders are more attune to risk. It is easier to teach them stuff like gain expectancy. BTW, go to my website and download your free copy of trading edge visualiser (http://alphasecurecapital.com/?p=521
). The intellectual part comes naturally, that’s the mental part that they need to keep in tight check.

It is hard to fight an addiction, but those who are admirable

Use this tool, it is 100% free and it will help You visualise, analyse and then overcome your trading addiction
http://alphasecurecapital.com/?p=521

How do I overcome an addiction to forex trading?

Convex position sizing algorithm: something your brain can trade through euphoria and depression

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Introduction

There are two position sizes: too little or too much. Too little when it is working and too much when it is not. Of course, our inner idiot compels us to take too little risk when we should be bold and vice versa when we should be prudent.

Position sizing is this critical juncture between financial and emotional capital. Deplete the former and it will take effort to rebuild. It is a complicated problem, but not a complex one. Break the latter and “Game Over”.

On the short side, position sizing is even more critical: failures get bigger and painful, while successes shrink away. Over the years, I have experimented with many position sizing algorithms. Many of them were brilliant, but I would always drift away and abandon each one of them after a while. Then, I realised I looked at the problem from the wrong angle. Convex position sizing is the story of my journey

If You have encountered “fear of pulling the trigger” or if You routinely take too much/too little risk at precisely the wrong time, then this position sizing algorithm might be for You.

 

Part 1: The correct mathematical answer may not be the right one

The first part of the journey was to find out why I consistently drifted from conventional algorithms.

  1. Short selling is not a stock picking contest, it is a position sizing exercise

On the short side, the market does not cooperate:

  1. Volatility is elevated: that rules out systems like equal weight.
  2. Concentrated bets is a bad idea, as their volatility drives the short book and consequently the entire book
  3. Short squeezes are frequent: expect all shorts to rally >10% over 5 trading days
  4. During bear phases, correlation goes to 1. Expect Longs and Shorts to go against You at once
  5. Unprofitable trades balloon rapidly. So, the natural tendency is to be conservative and take small risks.
  6. Unlike the long side, there are no 2-3 baggers. Winners shrink and contribute less. So, there is an opposite tendency to oversize positions.

Bottom line: the short side is less a stock picking contest than a position sizing exercise. Winners get smaller and loser get bigger. The difficulty is to size positions so that they contribute when successful, but do not torpedo performance when unsuccessful.

 

  1. Two types of algorithms and two types of people

There are two types of position sizing algorithms: aggressive or conservative. Risk seeking systems will have You bet beyond your comfort zone, and sometimes lose more than You should. System failure means cumulative losses have permanently damaged your ability to bounce back.

Conservative systems will have You bet small and earn less than You could. Failure means returns are not attractive enough, and/or period of recovery after a big loss is too long.

There are also two types of people when it comes to risk: risk seeking or risk adverse. Risk seeking people have higher tolerance for the volatility that comes with bold choices. If they go too far, they may no longer have the resources to bounce back.

Risk adverse people accept underwhelming returns in exchange for low volatility. Their downfall is they are sometimes conservative to the point of being risk seeking. Failure does not mean they aim too high and miss their target. Failure means they aim too low and succeed.

 

  1. Regime Change, transition and drift

Now, the world is not Manichean. There are times when it is wise to be conservative, settle for a risk adverse system, accept to earn a little less than You could.

There are also times when it pays off to be aggressive, ride a risk seeking system, but potentially lose a lot more than You should.

The problem is that most position sizing algorithms are good at either one or the other. They are not equipped to transition smoothly from equity growth to capital preservation. A core principle is that systems must be followed throughout a cycle in order to achieve predicted results.

 

  1. The correct mathematical answer may not be the right one

The problem with many position sizing algorithms is not to find the optimal size that will achieve desired geometric returns. The difficulty is keeping executing through euphoria and depression. Of course, optimal f is the correct position sizing algorithm. The problem is my inner idiot thinks he knows better.

For example, “fear of pulling the trigger” is simply the inner idiot (often referred to as amygdala) saying those bets are too big. This fear gets reinforced after every loss in the thalamus. It eventually gets to the point where the brain overrides the algorithm, but rationalises decisions. Self-deception is insidious, it covers its own tracks.

I did not abandon any of the position sizing all at once. I just gradually drifted away. I failed because my inner idiot constantly second guessed what the algorithms suggested. Discipline is futile. It’s like diet: everyone puts those kilos back on in the end.

I therefore realised that the only way to makes more sense to build a position sizing algorithm that the brain can embrace and then figure out the math.

 

Part 2: Convex position sizing

  1. Philosophy of the convex position sizing

Convex position sizing algorithm was conceived backward. Math is subservient to the brain. It may not be the optimal mathematical solution, but it is one my inner idiot will have no problem executing during triumph and disaster.

So, I started out with a list of demands

  1. Trade at optimum risk: (accelerator)
    1. Accelerate to maximum risk during run-ups, but
    2. Decelerate quickly as soon as there is a drawdown
  2. Absorb volatility: (brakes)
    1. allocate maximum equity, but
    2. reduce risk drastically during severe drawdowns
    3. Avoid whipsaws due to premature re-acceleration
  3. Reduce risk for each new re-entry: (trend maturity)
  4. Simple input variables (risk appetite)

The best analogy is fuel efficiency. Flooring the accelerator and then slamming the brakes is not a fuel efficient way to drive. These are aggressive systems like Kelly criterion, optimal f and Fixed Ratio Position Sizing (FRPS). Driving like Mrs Daisy is lovely, but not necessarily the most competitive style. These are systems like constant Fixed Fractional Position Sizing (FFPS), equal weight.

Convex position sizing algorithm runs at optimum acceleration. It will take on risk as equity curves rises and reduce as it comes down. It will slam the brakes to avert accidents and then re-accelerate smoothly. Risk Per Trade is the accelerator and Equity would be the brakes.

One of the strengths of the algorithm is smooth transition from risk seeking to risk adverse. The algorithm focuses on drawdowns. As soon as there is a drawdown, risk is reduced. Conventional position sizing algorithms focus on winning streaks and thresholds. They are therefore slow to react.

 

  1. Fixed Fractional Position Sizing revisited

Fixed Fractional Position Sizing algorithm basic formula is:

Market Value = Risk Per Trade / Distance to Stop Loss * Equity

Most formulas focus exclusively on Risk Per Trade (RPT). With the notable exception of Market’s Money, few of them consider Equity (capital allocation or surface). The idea became clear to use both sides, one for acceleration, the other for deceleration.

 

  1. Convex Risk Per Trade

In practice, this is what Risk per trade looks like:image (1)

Risk per trade oscillates between a minimum and maximum. Trends mature, so risk per trade is reduced for each re-entry. Convexity comes from the ratio of min/max risk. In this example, min risk is set at -0.25% and max risk at -1%. The bigger the ratio the steeper the acceleration.

How to calculate min and max risk per trade

  1. Max Risk per Trade: Risk Appetite / [AVG number of positions * (Long Term Loss Rate + 2 STDEV(Loss Rate)]
    1. Risk appetite: is not a mathematical number. It is the drawdown investors are willing to stomach before redeeming. Whatever You think that number is, divide it by 2. This is a clear case where You do not want to be right !!!
    2. Long Term Loss Rate: ideally, this is the win rate through the entire cycle. When there is not enough sample data, default to a conservative 2/3. That means 2 trades out 3 will fail. 51% Win rate is for fairy tales, and Prince charming is not coming
  2. Min Risk per Trade: this is the minimum RPT that would still allow trading during drawdowns
  3. Position count: Trends mature. Risk should therefore be reduced after each entry so as to avoid giving back profit on last entries

Risk appetite is one of the two input variable of the entire posSizer algo. Everything else is calculated.

 

  1. Drawdon module

image (4)This is the equity allocated to each trade. The objective of this component is to absorb small daily volatility. As a drawdown becomes severe, surface is exponentially reduced so as to collapse residual risk. Note the slope of the curve. Small recovery results in rapid increase of the surface.

Trading floor: this is the second input variable. This is a percentage of equity balance that will be allocated if drawdown exceeds tolerance. A good example here is Millennium partners. After a drawdown of 5%, equity is automatically reduced to 50% of initial capital.

When investors say they can stomach a 20% drawdown, what they mean is they will think about redeeming after a 10% drawdown. So, it is wise to cushion the blow with this drawdown module.

 

Part 3: Convex position sizing in action

This posSizer runs on auto-trade Metatrader MT4. We trade closer to 30 currency pairs, leveraged at 100:1 on 15 minutes periodicity. This is probably as aggressive as it can be.

It feels like being in a driverless Formula 1, without a steering wheel, pedals for accelerator and brakes. Yet, thanks to this algo, there is no need to stay glued to a screen all day. This posSizer provides priceless comfort when most needed. It will smoothly handle trouble: reduce risk, collapse it if necessary and then re-accelerate rapidly.

This is what it looks like in practice. Below is a hypothetical equity curve (GS stock price). The real equity curve does not have those big drawdowns, so it is harder to distinguish.image

Blue and pink lines are min and max market values per trade (MVPT). Green lines are market values for each position n1 to n4. Orange line is first entry without the drawdown module.

As equity curve rises, MVPT rises in unison. MVPT reacts rapidly to each drawdown but still remains closer to the upper bound until a more pronounced drawdown happens. Risk is reduced for each new tranche.

The drawdown module kicks in during severe drawdowns. This is the difference between the orange and green dotted line. MVPT goes down even further than minimum risk. There are times when even small positions seem too big. This ensures trades go through but at bare minimum risk. This reduces concentration, which in turn sets the stage for a rebound.

One of the problems of FFPS is premature re-acceleration after a drawdown. This leads to whipsaw in sideways markets. This is again a potential reason to drift from suggested positions. After a severe drawdown, the orange line rises faster, while the dotted line adjust re-acceleration to the speed of recovery. For example, the first drop below min risk was followed by a prompt recovery. The second one was more gradual.

 

Conclusion:

Under extreme stress, every degree of freedom, every bit left to interpretation has the potential for costly human error.

Position sizing often overlook the most important component in any trading system: our inner idiot. This algorithm reconciles math and affective neurosciences. It helps us “meet with Triumph and Disaster, and treat those two impostors just the same”, extract from Rudyard Kipling, “If”

Better System Trader 2nd Interview:

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Andrew Swanscott has one of the best podcasts on trading out there. He has brilliantly interviewed world trading champions, legends such as Van Tharp, Larry Williams, Jerry Parker, Perry Kaufman etc. In each episode, there is a nugget of wisdom. One word of caution though: Better System Trader is more addictive than chocolate.BetterSystemTrader

It was an honour to be interviewed on episode 32.

With the recent “soft patch” in global markets, Andrew decided it was time to catch up and go deeper into topics such as psychology. Markets are stressful on the long side already. On the short side, pressure is something else entirely.

Thank You very much for all the questions and comments on the website. If You have questions You would like to ask on the podcast, please go to the link below:

http://bettersystemtrader.com/ask-laurent-bernut/

 

Topics covered this time will probably be:

  1. How to improve your trading edge ? (This is a question from a reader, thank You). A post will follow shortly
  2. Sherlock Vs the Red Queen: why people fail at short selling ? You will understand the trappings in which people coming from the Long side fall. This topic has never been approached from a statistical perspective.
  3. The psychology of Stop Loss: did You notice that your desk is cleaner when You can’t close a bad trade ? We all know that cutting losses and riding winners is the key to success. We will go through evolutionary psychology, affective neurosciences. We will teach You how to reframe stop loss and trade like a psychopath
  4. Jedi trading: if You want to be the iceman on the trading floor and if You want to switch from fight, freeze or flight syndrome to flow state in less than 2 minutes, then practice this technique
  5. if we have time: why You should not be afraid of this bear market, Einstein and monkeys and the importance of Chuck Norris

 

@Quora: In trading, how can I stop getting emotional?

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Answer by Laurent Bernut: @Quora: In trading, how can I stop getting emotional?

Excellent answer from @Nate Anderson. Viktor Frankl (Man’s search for a meaning) survived both Auschwitz and Dachau. One of his most profound lessons was that: “between stimulus and response, there is a space called freedom”. You cannot control what is happening to You, but You can control your response.

The paradox of systematic traders and psychology

Every systematic trader who writes about building trading system devotes a lengthy chapter on psychology. Meanwhile fundamentalist hardly ever talk about psychology. You would think that mechanical traders would care less about psychology and people who rely on their judgement talk more about it.
book_buy_sell_sell_new_1024x1024
My theory is that systematic traders experienced mentally devastating losses which prompted them to develop systems so as to remove emotions. Along the way, they managed to quantify their systems and realised that after all is said and done: 90% of trading is mental, the other half is good maths.
Bottom line: Your emotional hijack means You do not have system yet

The counter-intuitive trick about system development

Most people who develop systems fail to execute. There are two reasons: they focus on the wrong thing and they don’t have faith in their system.

Wrong focus: the only soldiers who do not have exit strategy are kamikaze

People focus exclusively on entry and consider exits as an after thought. They have it completely backward. Entry is a choice, exit is a necessity. Emotions kick in once a position is in the portfolio, not before.
Real life example: Long IAU strike 11 April 2016 options at 0.20 on entry date. Actually, I had my eye on the 12 strike but a fat fingered Viognier Zibibbo called Abraxas (how can You not surrender to that deadly combination ?) got in the way of trading. I felt bad for a couple of days and then moved on, c’est la vie.
Now, let’s say i would have bought in the chrematocoulrophony (financial jesters) and sold the same option on that day. Current value is 1.20 with 2 months time value left. That is -500%. This thing would have drilled a hole in my portfolio through the center of the earth and pop out somewhere in Antarctica. It would have drilled a hole in my brain. I would feel trapped without a way out.
Bottom line: system development starts with the exit in mind.

Corollary: Peace of mind

Before: no clear exit strategy. I used to read every single news, check prices 2-3-5-10 times a day. I was always torn between running positions a bit longer (greed) and taking money off the table (fear).
After: exit strategy for every contingency: It brought immense peace of mind. There were three booby traps: stop loss, profit target and on the time axis trend reversal. I knew that unless an exit condition was tripped, positions would run their course. I had harnessed volatility. I checked price once a day, the rest of the time, I was one of the heaviest users of  YouTube on earth. This lead to surreal conversations with my boss:
– “What ! Are You watching another Shaolin flick ?”, he laughed
– “Why ? You are not ?”, I replied vaguely outraged by his lack of cultural curiosity “Time for some off-site (code word for plundering the Roppongi Enoteca wine shop) ?”
– “it’s only 4:00 pm”, he said looking for a feeble excuse
– “Yeah, I know late start, let’s get into position for the happy hour”, with high conviction for the day

Systematic execution and pregnancy

Developing a system that works is the hard part. And then executing it day in day out is the hard part. This is where a lot of guys trip in the carpet. They spend considerable time developing a strategy that they run until it stops working. Then, it is back to the drawing board, tweaking endlessly, waterboarding it until it confesses. Two reasons:
  1. Complexity is a form of laziness: I have seen a lot of systematic strategies. The most fragile ones are always the most complex ones. Optimisation is the poor brain solution
  2. Faith: We trade our beliefs. The best example is Markowitz, the father of the half century old modern portfolio theory (MPT). At the end of his career, a journalist asked him the composition of his portfolio. The inventor of the efficient frontier candidly replied: 50% stocks, 50% bonds. I rest my case
Bottom line: systematic trading is like pregnancy. Either You are pregnant, either You are not. Sorry, but You can’t be un-pregnant on ladies night.

Trading is 90% mental, the other half is good math

Mindfulness:

Ray Dalio meditates, twice a day. I rest my case. I meditate every day, sometimes twice during rough markets. Before trading, I seat in silence 2 to 5 minutes until presence.
Check Rande Howell at Trader State of Mind. His work is unique and transformative. He works on the Pearson Marr or Jungian archetypes. I cannot recommend his work highly enough.
I would highly recommend the App called Calm.com. It is reasonably priced and has excellent guided meditation.

Journal your journey:

Journal your journey through the markets. Journal your emotions, when You are making money and when You aren’t. Pay particular attention to your fears when losing money.
I am working on a format that could be useful and meaningful using Google sheets and Evernote. There are some elements of Nathaniel Branden’s stem sentence completion exercise. Mr Branden is famous for his work on self-esteem and deep belief elicitation. There are also elements of Byron Katie’s work. Finally, it is brought together in a quantitative format using Google Sheets.

Trade with fear

Some charlatans recommend to trade without fear. That is not how the brain works, at all. Tell the antelope that a lion is just a confused cat. Fear is a signal. Fear is an evolutionary mechanism that has kept You alive to this day. Ignore it, it grows and soon enough it infiltrates your trading, it cripples your action.
Fear exists in the shadow. Name it, face it, and then physically walk through it. This is why it important to journal your experience.
Fear is vastly underrated. It keeps You sharp. Size your positions as though You expected them to fail.

Visualisation

Athletes train to visualize their performance. There are clinical studies that show that athletes who visualize their performance have more muscle mass than those who don’t. Surprisingly enough, those who simply visualise without physical effort have higher muscle density than those who neither train nor visualise.

Visualisation does not mean seeing oneself on the podium with a gold medal, laughing under the cameras. That is wishful thinking. Visualisation is rehearsing procedures to overcome obstacles, feeling fear arousal and bringing calm response. It is about setting anchors that will trigger neuro-physiological responses.

At elite level, athletes are in similar physical shape. The difference that makes the difference is mental preparation. Best example is Conor Mc Gregor versus Chad Mendes. He won the fight mentally before he won it physically. He was on the ground, pummeled by some severe elbows to the head. Meanwhile, he was laughing: “is that all You got ?”

 

THE POWER OF CHECKLISTS

Airplane pilots have checklists. Firefighters have checklists. Surgeons have checklists (read Atul Gawande’s “Checklist manifesto”). Bottom line: these are highly skilled, highly trained professionals who have responsibility for human lives. They swear by checklists.
Meanwhile, finance people believe it is beneath them. Investing is supposedly an art. Checklists free up some precious bandwidth that can be used for thinking. In this ultra competitive sport called trading, every extra bit of mental bandwidth spared is a competitive advantage over emotional traders.
Great investors are not smarter, they have smarter habits. Break all your tasks in small specific checklists.
Example: my short sell checklist
  1. Check risk per trade and lots: if position small (i-e too volatile), then reject
  2. Check exposures & balances: if trade exceed risk, then reject
  3. Check borrow cost and availability: if expensive, then reject
  4. Set Stop Loss on platform GTC
  5. Sell Shares at Limit validity 1 day
  6. Take break, do something else: cool down and refresh (2-5 mn)
  7. Verify one last time and send
My entire workflow is broken down into small checklists: Buy to Cover, Buy Long, Sell Long, trade reconciliations, trading signals, portfolio management system update, etc. This helps a lot during stressful times.

 Conclusion

When we are on the bus in a new city, we check every stop, every building. We are afraid of missing our stop. Before getting on the bus, our stress hormones are mildly activated. Once in, stress hormones go up. Bottom line, exit matters. Think about them before entry

Success is habit. Unfortunately, so is failure. They have the best habits.

Trading is mental: profits are a side effect of inner alignment between deep seated beliefs all the way to daily routines.

In trading, how can I stop getting emotional?

Quora.com: What-do-the-fund-managers-that-consistently-beat-the-market-do-differently-when-picking-stocks-than-those-who-cant-beat-the-market

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https://www.quora.com/What-do-the-fund-managers-that-consistently-beat-the-market-do-differently-when-picking-stocks-than-those-who-cant-beat-the-market
Great fund managers are not smarter, they have smarter portfolio management habits. Making money is not about trying to be right, it is about accepting to be wrong and move on. That is much easier for married men…

Portfolio Manager serenity prayer

No manager consistently beats the markets. Every style has its peaks and valleys. The difference is how managers weather those periods. Profits look big only to the extent losses are kept small. If You know when your style is out of favour, then fold, take less risk. Making money is about accepting to be wrong and move on.

Risk and trading edges are not stories, they are numbers

Finance is the only industry where science fiction is smack in the middle of the marketing pitch and nobody calls the bluff. Ask any manager what their trading edge is and they will weave some positive science fiction story that would put LafayetteRon Hubbard to shame.
Read Jack Schwager’s and Mike Covel’s books and the common thing between all market wizards is their understanding of risk. Risk management is not part of the business. It is the business.
You just cannot meditate enough on this formula
Stop Loss is the 2nd most important variable
Look at the above formula. Stop has a direct impact on the following variables in your system :
  1. Win%: the tighter the stop loss, the lower the win rate
  2. Loss% (1 -Win%): and vice versa from above
  3. Avg Loss %: stop losses cap your losses. BTW
  4.  You can’t buy if You are fully invested
  5. Position sizing: anchor your stop loss and limit prices for position size
Many books were written about cutting losses short and running winners. Very few were written about riding losers and cutting winners.

90% of trading is mental, the other 50% is good math

Making money in the markets is like diet: simple but not easy: eat less, exercise more. Simple, yet the number of obese people continues to go up, not easy. Making money in the market is simple: buy stuff that goes up and short stuff that goes down.
The difficult part is the inner chatter, the beliefs we hold. Great managers have exceptional inner alignment from deep subconscious beliefs to daily routines and habits. Setting a stop loss and honoring it is not a debate: it is a habit.
Some people have subconscious beliefs that they are not worthy of the money they make. So, they sabotage. Some people have fairness as a core value, so stocks should revert because they are too expensive or too cheap. Well, life is unfair and so are markets. Fairness is hardwired in us, It is also a destructive belief.
I have an exercise about eliciting deep habits, but it is a daily struggle.

Complexity is a form of laziness

Long term performing managers have worked hard to simplify their process. Complexity is fragile.
Stress is designed to de-activate the thinking brain. It is an evolutionary built-in feature. If You start thinking that the lion chasing You is in fact a confused cat with some unresolved oedipian complex, then You are lunch.
Markets are stressful. So, it is impossible to execute complex sequences under heavy stress. This is why people make stupid (referred to as sub-optimal) decisions under stress.
Fear makes anyone piss their pants. Fortitude is the ability to work with wet pants.

Grandmother’s advice on advises

Only take advises from people You want to look like. That just took care of 95% of glorified journalists otherwise referred to as experts and market gurus.
You are 100% responsible for your own decisions.
The attitude towards mistakes is fundamentally different. I worked with one fund manager who one day called me to his office to talk about a stock he had some loss. This stock was literally the best performer that year (pure veteran’s luck). After being told that I should have insisted, I finally answered: “R…, if we are here having this conversation, it is because 1) i told You to buy 2) You did not and thought it was a stupid idea 3) You watched it go up 4) You felt frustrated 5) You bought at the peak 6) Now You nurse a loss, feel frustrated and want to blame somebody.”
There is an interesting book called mindset about fixed versus growth mindsets. Finger pointing is a classic fixed mindset attribute, quite destructive in trading

Why is humility an essential trait of profitable short-sellers ?

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January 2016 was a difficult month for investors. According to Barry Ritholtz:s, 93% of investors lost money. Feeling helpless and crushed while watching your investments melt away is a terrible feeling that takes a devastating toll on emotional capital. There can’t possibly be anything worse feeling, except perhaps a skill aspiring short sellers have to master, humility.

If You want to profit from a bear market and if You want to hold your short positions long term, then You probably should read this article.

Turning away from the gates of Valhalla

In January, my performance roared out of the gate. i was up at around +5.9% mid-month. i was timidly positioned for a cautious slow start with a gross around 150% and -0.12% risk per trade. Despite being ridiculously conservative and vastlyunder-participating, performance was there day after day. Returns were not only one-sided either. It was quality performance : Longs pulled their weight too: sugar, gold, Fixed income, Forex USD Bull. This is the stuff hedge funds are made off. i have long argued that the secret to AUM is to perform when no-one else does. This was it. And then, i saw it coming. i even wrote a post about it on the first day it happened, January 20th . A short-squeeze was under way. At this point, i could have closed all positions, walk away with +5.9% and be the one who closed right at the bottom. The gates of heaven were opening: Valhalla, shiny and chrome.

But then, i did the unthinkable. i went to work, methodically reducing bet sizes. i chose to take as little profit as necessary. i chose to forfeit all those profits and promises and then sat by the side of the road, waiting for the market to humble me all over again. And sure enough it did. It peeled off rock star returns, money for my family, fame, marketability, anything anyone would have aspired for. By the time Mrs Market was done with me, i had lost 90% of my gains: i went from +5.9% to +0.59% in less than a week. i was humbled alright, but i ended up profitable still. More importantly, I am better positioned now for round 2. Humility is a critical skill and below are the lessons from my journey

Two certainties in life: death and short squeezes

There are two certainties in life: death and short squeezes. There is no way to predict how long, how brutal short squeezes will turn. Why they happen is irrelevant: exhaustion of selling pressure, irrelevant but reassuring good news, government gesticulation, monetary intervention. Whatever the reasons, short squeezes are part of the short landscape and i have to deal with them.

Someone told me that short selling a stock at $1 can still yield a juicy 50% return if it drops to 50 c. True, at least in theory. The real question is would he still be there after price rallied from 52 c. to 70 c., or 30% in 4 days ? Very few people have the testicular fortitude to hold steady. i don’t, and this is why i have developed a methodology that enables to ride short squeezes.

The triple R methodology to weather a short squeeze

Short squeezes happen with 100% certainty. It is not about if, only about when. Rather than thinking of them as pestilence, i came to appreciate them and make good use of them. After all, they provide good entry points, plentiful borrow and flush amateurs (it is hard to feel sympathy for impatient people who jump in the water after vaporetti). Without further ado, here is the triple R methodology:

  1. Reduce: bet sizes as soon as You perceive a short squeeze
  2. Ride the squeeze. Do not short sell on the way up, but trim Longs that got clobbered in the downturn
  3. Reload: once the squeeze fades: lower stop losses and top-up existing positions

In practice, it looks like the chart below:

​Reduce

i am a trend follower. My objective is to ride positions as long as trends are valid. So, as soon as i see a squeeze coming, i reduce risk. i cannot control how vicious and how long they will last, but i can control how much damage they will inflict to the portfolio. So, the first step it to reduce bet sizes, so as to capture some profit and reduce subsequent potential damage.

Whether You trade German Bunds, US equities or colorful language with your significant other, You deal in one thing: risk. Risk is not a story. Risk is number. Since there is no way to predict how unpleasant a squeeze will be, it is prudent to bring risk to neutral as soon as You see it happening

Above is a picture of my portfolio in late January:

  1. Open Risk (pink bars) = Shares * (Cost – Stop Loss) / NAV
  2. CTR (Contribution, light green) = [Shares * (Price – Cost) + Realised P&L] / NAV (Scale out model, hence realised P&L)
  3. Weight (blue bars) = Market Value / NAV
  4. Weight at risk (orange bars) is weight (blue) where Open Risk (pink) is still negative

In simple terms, i try to bring the orange bars to neutral. At the onset of a squeeze, my objective is to have as many positions as possible with a neutral or positive risk carry. There are several ways to do it, but if You are new to the method, just halve your positions. Example: if You have -0.50% open risk and +0.25% profit, halving the position will reduce risk by a factor of 4: from -0.50% to -0.125%.

Important: make a note of the mental chatter while You are closing your positions. Which side wins: fear with “close it all, You don’t know what tomorrow is made off” or greed “just one lot, and leave everything on the table, that’s the way to get rich”. This mental chatter is an important window into your psychological market make-up. Journal your thoughts and emotions, You will find treasures

Ride

“Everybody’s got a plan until they get punched in the teeth”, ​Mike T​yson Mysteries

Now that all the hatches are closed, that i am safe and sound in the cockpit, time to find this bottle of stiff spirit and roll with the storm. The only permissible trades are Longs: close poor performers during squeezes and buy resilient stocks as they underperform.

The hard part is to accept to let go of your paper profits. You have to accept that short squeezes will come and go, that they will wreck your portfolio and that You will have to watch it happening and keep calm. This is part of the game. Roll with the punches.

Important: Journal your fears. There is a tremendous wealth of information here. This is an exceptional opportunity to learn about what makes You tick.

Reload

“it is not about how about hard You can punch, It is about how hard You can get punched and keep coming back”, Rocky Balboa

The whole purpose of the method is to go past the squeeze and reload. Alright, i got humbled, but i am still standing and now it is my turn to hit back. In the above chart, the positions with long green bars have gone through multiple stages of reduce/reload. Australia, Junk bonds, oil, natural gas and Jim O’Neil’s BRICs have delivered over time.

Once the squeeze is over and stocks start to roll over again, it is time to:

  1. Reset the stop losses lower: swing high + n * ATR
  2. ​Reload existing positions
  3. Reallocate resources to new promising shorts

Example: SPY was entered at 202. It represented -3.8% of the portfolio. Only 0.8% was necessary to cover so as to ensure break even on the remainder position. Previous stop loss was at 209.92. Current stop loss is at 201.23, below cost. This gives +0.15% of positive risk carry to be deployed to another tranche of SPY.

​Short-selling is not like Long buying: You cannot buy once and throw away the key. Shorts shrink, so You have to keep topping them up. Every time a stop loss is lowered, residual risk decreases. This goes far beyond eliminating risk. Positions continue to accumulate positive carry along the trend. This gives a distribution like the chart below where best performers have 5:1 reward to risk.

The -1 peak stands for positions being stopped out. Failure is the primary ingredient of success.

-2 and below positions are positions that woke up way below their stop losses. EWM was a good case in point: i closed a Short, open a Long and a week later the position lost 30% overnight. Volatility was high, so size was small anyhow. It was unpleasant but not hurtful.

As You can see, the methodology is simple: reduce risk, ride the storm and reload. Yet time and again, i have failed to execute and in the beginning at least so will You. Now, would You like to know why ?

Marshmallows, or why i used to fail to execute a simple methodology as the triple R

90% of trading is mental, the other half is just good maths. The triple R methodology relies on three principles

  1. Commitment: this methodology only works if i am committed to hold your positions long term. If i just want quick gratification, i will take profit too early and never allow them to fully mature. Similarly, i would never have the stamina to be slapped around so much
  2. Clear trading plan: commitment is directly proportional to the clarity of the trading plan. People don’t fail because they don’t have a plan. They stumble because they have complex ambiguous ones.
  3. Mental reframing: We are hardwired to do the exact opposite of the triple R​Loss aversion: Kahneman Tsversky have demonstrated that we are risk adverse with profits and risk seeking with losses (i am writing an awesome must-read & practical post about this + Jungian archetypes and neuro-chemistry BTW, so stay tuned)Process versus outcome: performance is the outcome of a good process. ​​delayed gratification: the single predictor of success in life is whether You will eat the marshmallow. Behind the adorable cruelty there is a profound principle Faith: it is simply the perseverance to trust and execute a plan. In the Jungian archetypes, those are the resilience of the orphan combined with the vision of the magician and the discipline of the ruler

Beyond the fascinating academic research on the brain, i came to find a simple conclusion. The reason why i failed was poor habits. As soon as i became conscious of my habits, i became able to fashion new ones. A simple habit is to reset stop loss. Another is to take profit at the onset of a rally. A third one is strict position sizing. All those habits have fashioned my investing style.

So, when the short squeeze was upon us, it was not hard to step aside and let it pass, however petulant it could be. It is a habit now.

Conclusion

“if You can meet triumph and disaster, And treat those impostors just the same”, Rudyard Kipling

The short side is the Antarctica of the markets. It is out there, not too far from civilization, but vastly unexplored at the same time. My stance on short selling is simple: if You think a stock is short, don’t fool people with writing a book about companies fooling people, don’t talk your book to Bloomberg reporters, don’t sue companies. Just locate some borrow, place the trade and let the market give its verdict. Those are no market wizards strategies, those are marketing wizard gimmicks.

Being a good short seller requires a lot of humility. A short squeeze is always around the corner. It takes a lot of strength to forego instant gratification for the sake of long term rewards. So, when the month ended at +0.59% instead of +5.9%, did i feel bad ? Of course, it hurt, but then: Mr Short Squeeze, is that all You got ? Now, my turn…

 

 

What are your best short selling ideas right now?

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Answer by Laurent Bernut:

This is answer to a question on Quora.com

Lifeisunfair

Life is unfair, so are markets, get used to it

This is a novice question that lead to two unprofitable biases: fairness bias and confirmation bias

When new to the fascinating short world, we want to short overvalued stocks. They believe that this has gone too far and that it “should” go down (same grammatical “should” as there “should” be peace on earth BTW).
We are hard wired for fairness. Even before speaking toddlers understand fairness. One of the subconscious beliefs behind this reversion to the mean is fairness.
Well, life is unfair, markets are unfair, let’s just get used to it. Overvalued stuff  often becomes ridiculously overvalued. Remember this please: pioneers are the ones with arrows in their backs

2nd stage, when we have lost enough money playing vigilante, we often turn ultraconsetvative. We want every box to be ticked, every fact confirmed. Every bit of information has a price tag in the markets. So stocks drop like stone, waiting for confirmation is an expensive habits.

If you want to be consistently profitable in the short selling world, change your mindset from outcome (need to be right bias) to process (probabilities). Probabilities are calculated risk assuming <50% hit ratio.
Short selling is a psychological & probabilistic game

What are your best short selling ideas right now?

Why do 100% of economists say that it’s hard to predict stock prices?

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amygdalaAnswer by Laurent Bernut:

“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher
Economists are extraordinarily helpful at predicting … the past. They will give today a savant explanation as to why their predictions for last week did not pan out. Economists gather some attention during bear markets when all predictions turned out be wrong anyways and investors want to gauge the “real economy”. Now, not only economists are wrong. Analysts are appalling and strategists are laughable. We, as a species, are biologically incapable of forecasting anything.
Experts cannot predict
In early 2008, before the GFC, my friend Marco Dion, quants guru at JP Morgan, wrote a piece about analysts earnings forecast accuracy 1 year out.
The probability of being spot on is a whooping 2%. The correct terminology for such low percentage is statistical error: “oops, I got it right”…
The probability of being +/-10% was 25%. That is half a coin-toss.
I used to compile strategists’ predictions published in Barrons and measure forecast accuracy twice a year. Fasten your seatbelt. If You thought analysts were bad, You haven’t seen anything yet. Forecast accuracy of Barrons roundtable was 17%. That is simply a few notches below useless, that is laughable.
(The primary reason why strategists were so low is primarily the broad range of questions from interest rates to currency, S&P levels. Within their domain of competence (fixed income, equities or currencies), they were relatively OK  but were tragic everywhere else)
Why we can’t predict 
Our “ability to predict” is located in the prefrontal cortex. It is the siege of our thinking brain. Now, within that brain, there are several regions invoked every time we make a prediction.
“High conviction” predictions trigger a zone called the ventro-median prefrontal cortex. The interesting part is the dorsolateral cortex, where our ego and identity gets activated. Hal Hershfield has observed through fMRI dual activation in those regions when subjects asked to make projections about their financial well being claimed to have good financial literacy. In other words, people who claimed they knew something about the subject were also more prone to overconfidence. Our forecasts are contextual.
A third thing that makes it even more interesting is something called recency bias. We extrapolate tomorrow based on what we know today. Have You ever wondered why analysts earnings prediction go in straight line up through the next 20 years ? It does not even dawn upon them there could be a dip.
Maybe we asked the wrong question in the first place
Back in the 60s, there were a series of studies conducted at Yale University where subjects were asked to send electric shocks to test subjects if they answered wrong (Milgram experiment )Milgram_Experiment_advertising. Of course, test subjects were actors and no shocks were sent, but the interesting part was that few people rebelled. The objective was to measure compliance to authority, specifically how could people obey nazi orders and send victims to a certain death. We are conditioned to respect figures of authority and experts.
Yet, in finance, we still avidly seek the opinions of experts who continue to prove time and again that they are hopeless at it: they are still several standard deviations below a coin-toss. So, why do we still rely on them ?
Rather than running an ugly contest on who’s worse at forecasting, maybe we should ask ourselves a better question: despite overwhelming evidence that we are hopeless at forecasting, why do we keep doing it ?
Our fear receptor is a region in our brain called the amygdala. These are two glands in the center or our brain. They are our fear receptors. The amygdala has helped our ancestors survive saber tooth tigers. It has not evolved for thousands of years. In the Jungian and later Pearson Marr archetypes, amygdala could be compared to the orphan.
Now, our primitive brain does not know the difference between a saber tooth in the bush and a news headline. Uncertainty triggers fear. This fear activates the amygdala.
So, we rely on “experts” who know better and can reassure us and soothe our uncertainty. In other words, we delegate our fear management to experts.
Is there a better way then ?
Uncertainty is not going away anytime soon. Uncertainty and risk are part of life. Rather than delegating fear management, maybe we should learn to live with it, to make peace with it. Fear exists in the shadow and evaporates when brought to light.
  1. Mindful meditation: There are several techniques designed to reduce fear, one of the best being “mindfulness meditation”. I would also recommend the work of my trading coach Rande Howell (trader’s state of mind).
  2. Risk is a number: The second way is to quantify risk and stop loss. Risk is not a paragraph at the end of a dissertation called investment thesis. Risk is a number: know how much you are willing to risk and can afford to lose before entering any trade.
Conclusion
“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher
We are hopeless at forecasting. Forecasts have been wrong and no matter how technology evolves, they are likely to be wrong in the future as well. (I had this conversation with Nate Silver in Hong Kong actually). Even if forecasts accuracy doubled, it would still be below a coin toss. So rather than trying to improve them, how about learning to live without them ? How about growing comfortable without discomfort ?
If You are interested in how “Greed and Fear” tricks our brain: Amygdala and the neurophysiology of Greed and Fear. and, don’t forget to sign-up if You want to receive free bonus material

Why do 100% of economists say that it’s hard to predict stock prices?