Q&A The Thin Line

BarroMetrics Views: Q&A The Thin Line

Most of the questions can be classified under four headings:

Q1: What is the difference between a discretionary rule-based method and a rule-based method (mechanical system)?

A1: At the most basic level, the difference lies in the addition of one rule for the discretionary rule-based: “follow your trading rules but there will be times when you need not”.

This addition allows for intuition to play a role. The problem is, for novice traders, this additional rule allows not for intuition but for ‘into  wishing’ – they hang on to losing trades long after the used-by date. 

But, the difference can be much greater than merely adding one rule. To understand this difference, we need to be aware that technical analysis can be split broadly into two main camps:

  1. Richard Schabacker. Robert Edwards’ Uncle (Edwards was the co-author of Technical Analysis of Stock Trends). His approach was to categorise patterns and trade the patterns. Thomas Bulkowski has a site that tests the efficacy of patterns, Bulkowski’s Pattern Index.
  2. Richard Wyckoff. For Wyckoff, the principles of how markets operated came first. The model was an extension of the principles. If a model stopped working, the principles provided the answer to the question ‘why’. (NB: although I have used Dr. Gary Drayton’s introduction to Wyckoff, I rate the Wyckoff Stock Market Institute as the best source to secure a Wyckoff Education. Dr Drayton is the next choice).

Most Rule-based systems adopt Schabacker’s approach, very few adopt Wyckoff’s. As a result, most Rule-Based systems lack context, and do run into periods of lon drawdowns. Long drawdowns is one of the reasons I have preferred the Discretionary Rule-Based approach. Now thanks to my friends, Mic Lim and Joshua Fong, I have been able to develop a contextual Rule-based approach.

Q2: Since Discretionary Rule-Based trades are trader-dependent for their results, shouldn’t we expect to see different results for different traders, even if they trade the same instruments and use the same method?

I alluded to the answer in yesterday’s blog.

The question confuses ‘results’ with ”positive-expectancy’. ‘Results’ are the magnitude of the return; ‘positive-expectancy’ defines the robustness of the method.

Results will differ, of course. This is true of even Rule-Based (let’s call them mechanical) systems. The famed Turtle experiment produced a wide divergence of results among the traders. However, if a group of traders execute, with consistency, the rules of a robust method , the ‘expectancy return’ ought to be positive among all the members of the group. 

Q3: Why use stops?

A3: I am not sure how this question arose in the context of the discussion; but, since quite a few asked, I’ll answer it.

Long-time readers know that this issue has popped up from time to time in the blog. Some readers take the view that trading without stops is best. And they tend to equate ‘stops’ with exit strategy.

I take the opposite view.

I believe that you must always have an exit strategy – otherwise, one trade is may wipe you out. (For a more detailed view of my risk management principles see “Routines and Habits IV (B))”.  Figure 1 shows what I mean. The pair happens to be the AUDUSD, it could have been any instrument; it’s a daily chart, but it could have been any timeframe. Position sizes tend to be larger when traders day-trade. Depending on his size, a trader could have wiped out his profits and even his account on just one trade.

I use two types of exits:

  1. A hard stop i.e. a fixed price to exit – once the market hits the price, I exit and 
  2. A soft exit i.e. should certain conditions occur, I exit even if the hard stop is not hit. 

Q4: Would I be willing to make available an introduction to Ultimate?

A1: Not as a blog. But, I am considering a two or three video series. Let me see if I can organise that. I’ll let you know by Thursday or Friday.

exit-strategy.png

FIGURE 1 Exit Strategy

The Thin Line III

BarroMetrics Views:  The Thin Line III

The answer today. Let me first give credit to those in Ultimate who have diligently kept their journals (equity and psych, without which it would have been difficult, if not impossible, to track the reasons for the divergence).

Secondly, this is a long blog; so tomorrow, I’ll be answering the questions submitted in this forum and by email.

CONTEXT

Today, we are looking to identify the reasons why there was a divergence in expectancy returns….divergence in situations where method and instruments were similar.

Note, we are not talking about the results, but expectancy. Clearly results will differ for a variety of reasons. However,  we should see positive expectancy converge – if the method and money tactics are robust, and the traders are executing consistently. 

The givens are: we have a group of trader who……

  • Have a discretionary rule method that is based on the same theories; as a result, the core setups are identical. 
  • Have a set of money management rules.
  • Have a process by which they record their trades which provides the means to make the corrections for constant improvement. 
  • Execute consistently.
  • For the most part, trade the same instruments at any given moment. 

To trace the answer, I found I needed to return to our brain’s hard wiring. One aspect of the hiring is we humans, move towards pleasure and away from pain (i.e. ‘towards life’ and ‘away from death’).  And, it’s more the physical pain we move away from: anything we perceive as ‘pain’ is likely to cause discomfort and anxiety.

When trading we are constantly assailed by:

  • Uncertainty
  • Possibility of loss
  • Possibility of being wrong
  • Possibility of Missing Out
  • Possibility of Failing to Maximise the results of a trade.

And, they all cause cause discomfort and anxiety. Dr. Andrew Menaker calls these Pressure Points.

When we encounter Pressure Points we usually behave in one of two ways: we become aware and accept the discomfort: despite the anxiety, our response is based on reason (left brain) and intuition (right brain). Or, our response is shanghaied by ‘fear, freeze or flight’ (3 Fs) – what I call ‘impulse trading’.

(BTW, an aside……It’ s important to draw a distinction between behaviour resulting from an intuitive response and impulse behaviour. Both are emotionally based. Damasio and others have shown that emotions are essential to good decision-making. Decisions based solely on reason are not possible; and, if even they were possible, the decisions arrived at would be far less than optimal. It’s not emotional trading we need to manage; we need to manage impulse trading).

In short, in the context I described above (i.e. the ‘givens’), it is our response to Pressure Points that determines our results. 

Solution

The studies show that one way to reduce  the incidence of impulse trading is to have a plan that suits our personality. There are two types of plans:

  1. “A”: one with few decision-making parameters where the resulting action is specific e.g. If X happens, I go long with stops at ‘price a’ and a target at ‘price b’. Let’s call this a mechanical method.
  2. “B”: one with numerous decision-making inputs where the resulting action is probabilistic and constant verification is required. 

There is a gulf of difference between the two.  What I found was, those with negative expectancy returns were ‘type A’ personalities using a discretionary rule-based system i.e. their plan and personality failed to mesh. As a result, they constantly made poor decisions, usually involving where to enter and where to exit.

To test the idea that they could alter their expectancy by altering the form of the plan – from ‘B’ to ‘A’, I engage in the first of two tests. In fact, I found that by changing the type of plan,  the trader was able to change the expectancy from negative to positive. I am currently engaged in the second series of tests. 

Recommendations

What does this mean for you?

If your trading is not bringing the results you want. First ensure you have a robust method (positive expectancy), you have a money set of rules (at the minimum  have a set governing position sizing), and you are keeping an equity and psych journal.

Then seek to execute this simple strategy: do all you can to reduce the impact of Pressure Points that lead to impulse trading.  Some ways of doing this……..

1) Assess your personality. Are you better suited to a mechanical system or to a discretionary rule based? If you need assistance for the personality assessment, there are a couple of sites you can go to:

2) make sure your plan and personality mesh. If not, change the format of the plan.

3) Finally do what you can to make your analysis and execution, habitual.

For example, use a checklist for your analysis. Before executing, take a moment to visualise:

  • the trade being stopped out and 
  • exiting the trade at your profit target. 

The aim here is to make the loss and profit a reality in the mind – in this way you seek to exit as a matter of course – when the stop price is hit or the exit conditions occur.