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

The Right Tools for the Right Market

As a drywall contractor you don't show up to a drywall job with concrete cutting tools. As a trader we need to be congnizant of what tools we use on what market. And because in trading, as in construction, the tools often define the trader/contractor, it is important that you bid on the right job (i.e. participate in the right market).

A few years ago a fellow trader asked me what I was doing. He saw me using overbought/oversold indicators and other reversion to mean oscillators. And I was trading Forex. He told me "you gotta fit the right tool to the right market". If those were the tools I preferred then I was trading the wrong thing.

Needless to say that conversation prompted me to investigate the emini Futures (S&P 500, Dow, and Russell 2000). These markets respond well to reversion-to-mean indicators. Another lesson I learned is that what timeframe you trade also determines the right tools for the job. When you're scalping the Russell on a 52 tick chart (about 35 s - 1 m depending on the speed of the market) you need to have the 610 tick (about 5 m) chart up to keep you on the right side of the trend. Just cause you are reverting to the mean doesn't mean you want to ignore the big picture.

Today, whether I'm trading futures, forex or something else I know that I need to fit the right tool to the right market.

LT

Cut Your Losses and Add to Your Winners

You've heard it a thousand times before from experienced traders or even from yourself. Cut your losses short. It's hackneyed and frankly most traders feel they do cut their losses short. I certainly did. I use stop losses (and I don't move them away from my entry). I'm not a crazy man - or am I?

There is a great little ebook I read recently by the "Phantom of the Pits" that talks about this concept. Although there is a lot of fluff in my opinion there are several key points not to be missed:

1) Use a clock when you trade. In other words if you are in a trade you aren't waiting for the market to do "something" (usually take you out at your stop loss) but you are actively looking to exit the market if your trade idea doesn't immediately "prove it" to you. In other words don't sit there and wait until the market does something. Either your trade idea is a "winner" and it moves immediately and significantly in your favor or it is a "loser" and it either moves against you or doesn't move immediately and significantly in your favor. Every minute, hour, day you are in a trade that goes "nowhere" is just that much more likely to hit your stop loss. Don't wait for it - just get out.

2) There is a great quote in "Market Wizards" where Soroes says something to the effect of "when you're right you gotta be a pig - you can't own enough". The second major point of the Phantom of the Pits is that you need to add to a winning position when you are right. You gotta punish the market when you are right because otherwise you won't achieve much beyond break-even.

I have to admit when I originally heard the concepts of cutting your losses and adding to winners I didn't get it. I use a stop loss - isn't that cutting your losers? And adding to winners sounded dangerous - if I was making money the last thing I wanted to do was let it ride. I wanted to grab those profits quickly! So if you are looking for some ideas to increase your trading edge I strongly suggest looking into these. Especially for those folks who are trend traders this can really make or break you.

LT

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ER2 Migration and Re-defining the Edge

If any of you have read "Who Moved My Cheese" by Spencer Johnson then you'll have a bit of an idea of what it's been like for me over the past couple months (and incidentally why I haven't been posting in the blog much).

The long and the short of it is the emini-Russell contract or ER2 is moving exchanges from the CME to the ICE. So what you ask? Well the problem is several fold: 1) I'm not the only one abandoning the Russell and volume is down significantly, 2) the new exchange doesn't support limit orders. And the last CME contract of the ER2 is September 2008. So needless to say I have re-tweaking my short-term futures trading systems to work more effectively on markets that won't be undergoing such drastic measures - the emini-Dow and the emini-MidCap 400.

So what does all this have to do with the price of cheese? Well let's just say that it has reminded me of how traders must not only be able to find one market edge and exploit it but that they must be able to redefine their edge when market changes occur - such as this one. Brett Steinbarger of Trader's Feed has done an excellent job of describing this in his books and on his blog. Basically it means you have to always be hungry and never satisfied with yourself in the market. Never get too comfortable.

Back to re-defining myself.

LT

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