The Real Reason 95% of Traders Fail

You’ve all seen this statistics that are anecdotally given out at trading forums, seminars and the like. And I’ve always thought to myself, wow, is it really that bad? I mean I’m not that smart and I don’t work that hard that I should be in the top 5% right?

This Saturday I had an interesting discussion with a fellow trader who’s been successfully trading the markets for longer than I have. He told me that he’s had guys come to him for help before (having heard that he knows how to trade) and he will ask them to please read a certain trading book. The next time that person talks to him they tell him that they purchased the trading book and are reading it. And so he asks them, “Do you have the book right in front of you?” When they invariably say yes he says, “So on page 114 paragraph 2 what does it say?” 9 times out of 10 they log off IM and he never hears from them again.

To me this is an incredible story. The “average trader” doesn’t have the commitment to go purchase and read a book that is $15 and then has the audacity to lie about it. What does this say about the “average trader”? In my mind they are a total joke. No wonder 95% fail if this is the pool of “average traders” that exists. I mean how is that trader going to actually test a methodology if they can’t commit to something so simple? How will they ever endure the painful and psychologically debilitating process that is a prolonged drawdown? The answer, I believe, is that they cannot. And that is why 95% fail.

But for those of you who are capable of the blood, sweat, and tears that are required to learn about, create, and test trading systems I feel very confident that 95% of you will succeed. Where did I get this statistic from? I just made it up. But seriously, I have never met a trader that has done his homework for 3-5 years who hasn’t been successful. Thus, in my mind the only trader that I ever have to really compete against are the 5% that can actually do their homework.

For myself I have my own litmus test as to the longevity of a potential trader. Can you commit to testing your trading idea (either candle by candle, backtest, or forward test) for at least 60 trades? If you cannot do this simple exercise then quit now, for you will never succeed. If you can then congratulations! Welcome to the 5% club.

LT

Trading Wife

No I’m not trading in my wife. (She’s irreplaceable). She’s expressed an interest in learning to trade. All these years I thought she was absolutely uninterested in trading, but actually she was interested yet worried about taking over “my thing”. I guess I understand that. But trading isn’t exactly like a bachelor’s party…

So I’m having her start off learning the important things (many of which I did learn in the early years), without all the fluff and snake oil (which is almost impossible to avoid). I’m having her start with Forex because it was what I started with and because I still think in many ways it’s the easiest to trade (yes I’m sure some of you disagree with that statement). Also it has the advantage of having its best trading hours during the late P.M. early A.M. our time which is most conducive to her schedule (since she is still working during the day). We will split the trading duties into roughly 4 hour blocks and basically trade from about 12:00 a.m. our time to about 8:00 a.m.

We’re going to trade an old favorite of mine – Phil McGrew’s dots. And for the first time in a long time I’ll (actually we’ll) be able to trade on the 15 minute timeframe (which is what Phil himself trades). I’ve not been able to juggle this and trade other markets like the eminis so it had been put aside for the last couple years (which is too bad since it is a great methodology). I think this system will be a good one for her to learn on since it is not entirely mechanical or discretionary but a little bit of both. It’s mechanical enough that someone new to the markets isn’t overwhelmed with information, but discretionary enough to take advantage of intelligent insight.

So for the next 4-6 months I’m having her learn the basics plus get familiar with the dots (Phil has a wonderful 100 page + manual that I deeply admire). Also during that time I’ll have her start testing the system the same way I do (candle by candle) to gain confidence in trading it and understand how drawdowns work. After that we’ll have her start with a demo account for another 3 months to understand mechanical execution, and then we’ll start with a small account trading live and see where things go from there.

The best part about all of this? I can talk about trading with her now and not receive the glassy eyed look. Priceless :)

LT

PS The picture is of a week I traded the 15 min dots back in April 2006. Good then, still good now. That's a robust system IMHO.

The Frugal Trader

Protecting your assets doesn’t seem a foregone conclusion as it did even a year ago. Iceberg risk isn’t just a theory anymore. Unfortunately your money isn’t safe.

Several frugal blogs have described some ideas to conserve money for the upcoming Great Depression Part II. I have several ideas on how we as traders can reduce (but never eliminate) our personal portfolio risk.

1) Set aside at least 2 years (better if you can do 5) of your total free capital. Put this capital in government backed savings accounts. In at least 3 banks worldwide. I recommend 1 U.S. bank, 1 European bank (Swiss Bank is good), and 1 Asian bank (Singapore or Hong Kong). Want to be even more secure? Put at least half of it in gold – jewelry, coins, etc.

2) If you are Forex trader, split your account between Spot FX and Currency Futures. Remember that the 6E and the EUR/USD trade in a very similar fashion and Futures are regulated and often insured (check with your broker).

3) Have at least 3 or 4 brokerages (as reputable as you can find) as possible. Make sure they don’t all clear from the same clearing firm.

4) Get your family on a budget. Tell me you already have one. Monitor that budget at least monthly.

5) Reduce all debts to zero – that includes your house. Can’t afford to pay all cash for your house? Get a condo.

6) De-leverage your trading as much as possible. Are you currently risking 3% per trade? Get it down to 1% - or less if possible.

7) No lattes! Reduce your latte and eating out habits. Eat at home. You will lose weight, save money, and help the environment. See if you can cut your total food costs in half. It isn’t that hard.

8) Grow your own food. There are several urban homesteaders who feed their family entirely from 1/10 of an acre. You might have to become vegetarian to make it happen (yep I hate veggies too – get over it). Get into gardening. Re-invent the Victory Garden for your home. WWII rationing may seem quite pleasant compared to the upcoming storm.

9) Kill your T.V. If you subscribe to cable cancel your subscription. T.V. rots your brain anyway.

10) Kill your cell phone. Do you remember when you were a kid? There were no cell phones. It’s a waste of money; nobody really cares about your 100 texts per day anyway. It will relieve stress and help you disconnect from unnecessary distractions. Still can’t live without it? Any disconnected cell phone is still able to dial 911 (the only number you really need in an emergency).

Some of this might seem a little over the top. Didn't we all get into trading so that we could live the Lifestyles of the Rich and Famous? That may be true for some, but for me it's about personal and financial freedom. How can we be free when an iceberg could put us underwater at any time? Remember, just because you're paranoid doesn't mean the market isn't out to get you.

LT

Advice to My Younger Self

Recently I have been discussing optimal f and appropriate risk over at Phil McGrew's forum. Below is some information I posted to a young trader (in his twenties) that sounds like advice I wish I had listened to when I was getting into trading.

I'm glad to hear that you'll be starting off slowly and on the right foot. All of us make lots of mistakes in the beginning and one of the most dangerous is wanting to do too much too fast (I want to grow my $5k account to $500k in 2 years lol). Imagine if a medical intern wanted to perform complex brain surgery in their first week. Obviously complex brain surgery (ala trading a large % risk) is possible, but not safe for beginning interns.

Remember that trading is a great career/business (not fad or get rich scheme) and that you want to be enjoying it for many years to come. Just like a great surgeon it will take you many years to become proficient and even more years to become a master. Try not to think of this as a bad thing - but rather as job security. Remember, the rewards are exponential. It may seem like a long time but imagine the trader you will be when you are 30 or 40. Ten or twenty years may seem like a very long time to you right now but it is not. And because you are young you have the time to enjoy the rest of your life doing something you love (hopefully you love trading or will grow to love it) it is important to build your skills and set your goals with the long term in mind.

To give you an idea of what goals you should be thinking about, consider this. 9 out of 10 of the top CTA funds listed at Attain Capital have not made more than 15% this year with a max DD of 25%. Each of these funds manages well over $50 million. If you could put together a live account track record for 5 years that beat these numbers (or even met them) then you could manage $10 million or more and make in excess of $500K per year (assuming a profitable year). Obviously this is not the only way to make money as a trader but it is a very viable one for those who do not have many thousands of dollars to trade but DO have a reliable low risk track record.

Alternatively, consider this scenario. Start with $10k. Making only 75% per year (with a max DD of 25%) in 10 years you could be making in excess of $250k per year (assuming you can mentally survive 25% drawdowns on a million dollar account). Welcome to the top 1% income earners in the U.S. This would include paying your taxes (can't avoid that silly). I chose 75% because most of the successful traders I personally know and many of those interviewed in market wizards can average at least 50-75% per year. The advantage of this method is that you only have to deal with the psychological pressure of risking your own money (which is easier for some people), however, the downside is that you cannot start withdrawing funds in year 1. It will take at least 5 years before you can start withdrawing anything. So don't quit your day job.

Remember that although these returns are very possible, they are not linear. Consider the fact that it is entirely possible to make no money (or even lose money) for a year or more (this is mentioned in the track records of several successful market wizards) and hence having emergency savings (that is not traded) is a very wise choice. I am personally working up to having about 2 years of saved income and adding to it during the good years.

So why is it at every beginners forum (such as ForexFactory, EliteTrader, etc.) they are talking about making 300-700% per year? I don't know. Of course making that much is possible, but sustaining that year after year is highly unlikely. Also most traders attempting to make that much put too much financial and pyschological pressure on themselves to do so. There is a LOT of obfuscation of this fact in the beginners forums.

In conclusion, if I knew then what I know now I would have spent more time building confidence with either a demo account or preferably a very lightly leveraged real account (say 1% risk). 6 months to a year is the minimium to tell you anything in my humble opinion. Don't change ANYTHING during that period (of course you better test your ideas thoroughly beforehand and challenge your assumptions). Experience counts for so much in this business (same as brain surgery).

Hopefully this isn't too preachy or too long. Just some straight talk I wished I had listened to a few years ago (yeah I was told).

P.S. Although I ignored this until fairly recently, consider the fact that most of the people who become wealthy (not inherit it) are very frugal. Learn to live frugally. You will appreciate the wealth you make that much more and you will aquire it at an amazing pace. This is an often discounted tidbit of wisdom in the trading world, but take it to heart. When we are young we live happily on little money (I wish I could live as carefree as I did when I was 20). As we get older we buy toys, cars, houses, etc. We become more trapped in our job. We have less freedom, less happiness. This is a trap. Learn to escape it. Money will not make you happy. Only you can do that. Check out Get Rich Slowly for more frugal ideas.

LT

More on Optimal Trading Size

So if Optimal f is less than optimal how much should a trader risk on a per trade basis?

Although there are many ways to trade the market, I've never heard of any successful trader who risks more than 5% of their account at a time no matter the market, timeframe or anything else. In fact of the pros I know the vast majority risk 1-2% of their account. I'm guessing there is a reason for that.

In my view here is the problem with risking anything close optimal f or kelly criterion. If you test your system for 30 trades that gives you about a 90% confidence level, 100 trades about a 95% confidence level, 1000 trades about a 97.5% confidence level. It would take well over 10000 trades tested to reach a 99% confidence level. That means that even if you could be 99% sure that your expectancy was accurate (within a margin of error) you still would bust your account at least 1 out of every 100 trades with an optimal f risk. Now that might sound like a good gamble to you until you consider this - it is virtually impossible to reach a 99% confidence level because once you test over about 150-300 trades the market makes earlier trades irrelevant.

In other words - the market always is changing. I've known folks to test systems of thousands of trades over decades only to find that the system will break (after being robust for over a decade) and the expectancy will shift (even if the system bounces back eventually). In reality I've found it impractical to achieve much more than a 95% confidence level. That means if we push "the optimal solution" we will go bust 5% of the time. Now I don't know about you but to me that is not the optimal solution. That is the gamblers folly.

So let me define for you what I believe is the optimal risk solution. To trade with as low a risk as possible (thus smoothing my equity curve to as close to a straight line as possible) and still achieve gains that exceed the industry standard (about 25% per yer with no more than a 25% drawdown). And for those of you who aren't impressed with those sort of gains consider the fact that if you can achieve those numbers you could manage other people's millions. Hence we are back to risking less than 5%. I actually prefer about 2-3% for my systems. Of course if I had a million dollar account I might risk 1% or even 0.5%.

Obviously we can certainly do better than the "industry standard" as small traders. However, most of the beginning traders I know are trading too small and want to make 1000% per year. They end up over optimizing everything about their system, taking too many trades, taking trades not in the plan etc. Their own boredom and fears and greed overwhelm them.

The best words that any trader (Phil McGrew) has ever said to me, "Good trading is boring". So be bored. Make 50%-100% per year (instead of dreaming of making 500-1000%). Take so little a risk on each trade that you absolutely don't care about the result of that single trade. Think in terms of at least 30-50 trades at a time. Evaluate your results quarterly or annually instead of weekly or monthly. In 5 years you will be the millionaire you wish to be.

LT

Figure Note: The curved lines are "efficient frontiers" showing the most optimal risk-return values for different two assets portfolios against the variation in return. Each curve represents a different correlation ρ between the two assets. The minimum variation (point MV) represents an example of a minimum variance portfolio (Ross et al. 2002). The figure shows that past a certain point risk and return are exponentially positively correllated.

Optimal f - Betting the Farm

Optimal f is the optimal % risk that can be applied to a fixed fractional money management scheme that will yield the greatest net profit. Of course for the net profit of optimal f to be positive the expectancy of the strategy must be positive. This method is also known as the Kelly criterion.

The primary disadvantage of optimizing our risk parameters in this fashion is the high degree of volatility that this will incur in your account. As such, this method utilizes no limiting factors to account for things such as margin calls. Also, it fails to keep risk within human psychological boundaries as when a trader experiences an 95% draw down (which could occur in 5% of all trade sequences) it is unlikely they will be able to keep trading in this fashion. Lastly, and if the above reasons were not sufficient, this methodology assumes a constant statistically verifiable expectancy. In other words - in the real world where trading expectancy is not constant, optimal f is not constant either. Which in layman's terms means that you are constantly trying to catch a falling dagger - drunk, blindfolded, and missing 3 fingers. Hence, it is an interesting theory but of little practical relevance.

LT