LITMIR.BIZ

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      It makes sense from a purely evolutionary perspective that what has enabled us to survive would become our default mode, our status quo. Maxwell rationalized the decline in his profitability in many ways: as the result of stress, burnout, high-speed algorithms, and just pure bad luck. Each rationalization helped sustain the status quo. “Don't fix what isn't broken” is common advice. As long as we convince ourselves that we're not broken, we don't have to seek fixes.

      There is another reason, however, why traders don't quickly embrace change in the face of changing markets and opportunities. Even when we possess a distinct and consistent edge in markets, the paths of our profitability can be highly variable. Over the long haul – 100 or more trades – an edge tends to be apparent, particularly if one is not engaging in high hit rate/high blowup strategies, such as the naked selling of options. Over the course of any series of, say, 10 or 20 trades, there are random series of winning and losing bets that can play havoc with our psyches.

      Last year I wrote a blog post based on the P/L Forecaster that Henry Carstens posted to his Vertical Solutions site. In researching that post, I explored three profitability curves: one with no edge whatsoever (50 percent win rate; average win size equal to average loss size); one with a negative edge (50 percent win rate; average win size 90 percent of average loss size); and one with a positive edge (50 percent win rate; average win size 110 percent of average loss size). Over the course of 100 trades, we could see the edge – or lack of edge – play out. Along the way, however, were surprising ups and downs that were purely random. By running Henry's Forecaster many times, we can see how many ways it's possible to have a constant edge and end up at a relatively constant end point, but with extremely different paths along the way.

      Traders very often overinterpret these random ups and downs in the P/L curve. When they have strings of winning trades, they convince themselves that they are seeing markets well and increase their risk taking. When they encounter a series of losing trades, they become concerned about slumps and reduce their risk taking. Those adjustments ultimately cost the trader money. Imagine a baseball player who gauged his performance every 20 or so at-bats. When he gets a large number of hits, he considers himself to have a hot hand and swings even harder at pitches. When he strikes out a number of times, he talks himself into changing his swing to get out of his slump. Both adjustments take the batter out of his game. Ignoring short-term outcomes and focusing on the consistency of the swing is a far more promising approach to batting performance.

      So it is for traders. Someone like Maxwell is wise to not overinterpret daily, weekly, or monthly P/L. Rather, he should assess the elements of his trading process, from his generation of trade ideas to his trade execution, and seek to make incremental improvements. When the paradigm is working, the most constructive course of action is to steadily refine the paradigm.

      The problem is that, once in a while, 20 trades turn to 40 turn to 60, 80, and 100, and evidence accumulates that the trading paradigm is no longer viable. Even a small edge is apparent after enough instances: That's why it makes sense to keep betting in Vegas when the odds are with you. If you go all in on any single bet, you court risk of ruin: That randomness of the path can take you out of the game. But if you bet moderately with a constant edge, more bets allow the edge to overcome randomness. When randomness overwhelms an edge not just over a dozen or so trades, but over a great number of them, then we have evidence that something has changed. Still, a trader like Maxwell can convince himself that this, too, shall pass.

      Tracking your edge is relatively easy when you place several trades per day. What about less active investors and portfolio managers who might limit themselves to several trades per week or month? If trade frequency is low, an entire year of diminished performance could go by and represent nothing more than random bad luck in performance. Imagine, then, the trading firm that allocates more capital to the portfolio manager who has a good year and not to the one who underperforms. Those adjustments, no less than the hot hand/slump-inspired adjustments of individual traders, can drain performance over time.

      It's a genuine challenge to track edge and randomness over small sample sizes of trades. If a strategy can be backtested objectively without overfitting historical data, it is possible to generate a reasonable set of performance expectations in the absence of recent, real-time trading. For a purely discretionary strategy, however, the sobering truth is that, over the course of a limited number of trades, we cannot really know whether performance is due to luck or skill. Michael Mauboussin writes convincingly about this challenge in his book, The Success Equation (2012), pointing out that our failure to recognize luck makes it difficult to objectively evaluate performance. An overemphasis on recent performance leads traders to place too much significance on recent runs of winning and losing trades, not recognizing the important role that luck plays in those runs. Whenever Maxwell had gotten to the point of trying to make meaningful changes in his approach to markets, he would hit a winning series of trades and convince himself that “the market is coming back.” Only after hope was raised and dashed many times did he get to the point of seeking help. By that time, however, like our couple, Maxwell had gotten to the point of questioning whether he could, indeed, go forward.

      Maxwell was not broken, just as Gina and Chris weren't broken. Like them, he kept doing what worked and stayed confident in his course even after it ceased to take him where he wanted to go. But also like the couple, Maxwell was doing many things well. In avoiding consensus and the herd behavior of traders, he was able to sustain a high level of intellectual and behavioral independence. His ability to detect ebbs and flows in volume helped keep him out of trades going the wrong way, even if it was now far more difficult to anticipate the market's inflection points. In the old days, Maxwell used to be able to point to a chart level and anticipate how the market would behave once it touched that level. Those days, he realized, were long gone. There just weren't enough idiots left in the market to overreact to those chart levels!

      One of my favorite solution-focused exercises in such situations is to institute a review of winning trades. Much of the role of a trading coach consists of comforting the afflicted and afflicting the comfortable. When someone is afflicted like Chris and Gina or Maxwell, some comfort in the search for exceptions to problem patterns can be empowering. When traders are in denial, doing ever more of what hasn't worked, some affliction of comfort becomes useful. A review of best trades reminds discouraged traders that they are not wholly dysfunctional. Talents, skills, and experience remain – they just need to be redeployed.

      During Maxwell's trade review, we found an unusual number of winning trades held for a short time. He referred to these as scalp trades. “I see what's happening in the market and I jump on it,” Maxwell explained. It was when he tried to identify longer-term significant price levels and hold positions for hours or days that he was no longer able to make money. From the review, Maxwell and I could clearly see he had retained his reflexes – and his capacity for quickly sizing up markets. It was his thinking about markets and not his instinctive pattern recognition that was off. In scalping mode, he was all instinct – and he made money surprisingly consistently.

      Shortly after the review, Maxwell joked with me about an email he had gotten from a guru seeking to charge big bucks for sharing his wave-based trading secrets. He reminded me of my earlier blog post making fun of the “idiot wave” and shook his head at the foolishness of traders who believed such obvious sales hypes. I quickly saw my opening.

      “So, Max, if you don't use wave theory, how are you going to figure out where the market will be trading at 3:00 p.m. tomorrow?”

      Max laughed and joked that he already had too many crushed crystal balls and was not about to dine on more broken glass.

      “But aren't you doing the same thing with your levels that the Elliott guys are doing with their waves?” I challenged. “They're predicting the future and so are you.”

      Maxwell looked puzzled; he wasn't sure where I was going with this. “Besides,” I continued, “you don't need to predict markets to be successful. What the review of your trades told us is that you're plenty good at identifying

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