The Importance Of A Trading Methodology

Back in 2008, in one of the more active chat rooms I frequented, I came across an interesting character that went by the name of “Trader1”.  Despite having perhaps the most unoriginal screen name in history, he seemed to be a nice guy and was always chatting about the markets and the trades he was making.

His trading method was simple – buy on the dips.

This was something he would announce from time to time, calling out, “I’m buying more XYZ on this dip”, or “this dip is a great place to buy more XYZ.”

He bought a lot of stocks on the dip like CFC, LEH, and BSC.  Don’t try and look these symbols up because the companies don’t exist anymore.

Trader1 eventually disappeared from the chat room and I suspect that the call out he makes most now is, “would you like fries with that?”

The reason Trader1 didn’t succeed was that he did not have a sound methodology.  He may have thought that buying on the dip was a sound method based on his success in the past, but he made the same mistake that many others make – he used outcome bias to validate his method.

Now that your eyes are rolling back in your head, let me explain what I mean.

Say you go to Las Vegas, and you and your buddies go out and get shitty-drunk. Maybe you drink one of those margaritas in a giant plastic Eiffel Tower, or maybe you split a brewzooka, it really doesn’t matter.

Now that you’re fully lit, you take everything you own – your car, your house, your life savings, your autographed picture of Patrick Swayze from Roadhouse – everything, and put it all on red at the roulette wheel.

Even if you hit red, it was still a terrible bet because though you won, the methodology you used – everything on red – was flawed.  Eventually, it will fail (actually, a little more than 50% of the time due to the green “0”).  And when it does, the downside is so huge that you’d be wiped out and no longer able to play the game.

He’s Dalton. He’s the Cooler dammit!

Trader1 fooled himself into thinking that his method worked because in the two years that he had been trading, the market had rebounded after every dip.

The problem was that Trader1’s method did not have any contingency in case the market didn’t rebound.  It was based on a consistent one-sided outcome, something that never happens in the real world, and certainly not in trading.

The most obvious way Trader1 could have improved his methodology would have been to incorporate a stop-loss rule.  In addition, he could have had a target rule, one that would take some or all of the profits when a position hits a certain level.

But perhaps the best way he could have improved his trading was to create a rules-based methodology.  If his trading was not initially profitable, he could refine his rules until he found a method that was consistently profitable and then evaluated the success of his trading – not based on outcome – but on adherence to his trading rules.

You can read more about flawed methodologies and fooling yourself into thinking your system works by reading Fooled by Randomness and The Black Swan.

How to Explain Short Selling to Your Mother

Occasionally, at a social function or while scrounging through a dumpster in back of Arby’s, I’m asked the question “What do you do for a living?”

Sometimes I’ll just say that I work in an ice cream shop or huck a handful of soggy curly fries at them.  But if pressed, I will cop to the fact that my work is related to the stock market.

This revelation usually prompts looks ranging from excitement to Schadenfreude, depending of course on what phase the market is currently in.  If it happens to be in a downtrend they’ll usually give me a pitying look, saying something like “wow, things must be pretty tough, huh?”  I, of course, respond that I am doing fine because you can make money when stocks move down.

(insert glazed look in conversationalist’s eyes).

My mother actually thinks I’m describing something illegal when I tell her money can be made by shorting a stock. She’s convinced that it must be some evil endeavor created by a Satan/Hitler/Beiber-type troika.  Personally, I’ve never had an issue with the concept of shorting, which is probably why I’ve traded for over 30 years.  But for others who don’t quite understand the concept, I’ve developed a simple way to explain it.  It goes like this;

A share of stock is a standardized instrument just like a book or a DVD, meaning every share of Apple is the same as every other share of Apple, just like every DVD of Harry Potter and the Deathly Hallows is the same as every other.

So let’s say your best friend just bought a brand new copy of Harry Potter and brings it over to show you.  The first thing you should do is ask yourself is why you have a 13yr old as your best friend, but after that, let’s say you immediately ask to borrow the DVD before it’s even unwrapped.

At some point you will have to return it to your friend — I mean, not really since you can probably beat up a 13yr old — but assuming you’re a decent person you’ll eventually give it back.

Now, let’s say that you take the copy you borrowed and sell it.  Maybe you sell it on Ebay, maybe at a garage sale, maybe to an individual, it doesn’t matter where, but you get $25.00 when you do. However, you still owe your friend one copy of Harry Potter, so you order a copy on-line from a discount DVD liquidator that only costs you $19.95.

When the DVD arrives you return it to your friend, keeping the difference between what you sold it for ($25.00), and what you bought it back for ($19.95).  Thus you’ve made money by selling something you did not own and then buying it back (and replacing it) for less that you sold it for.

Short selling is the same concept; you just replace a share of stock in XYZ company for the copy of the Harry Potter DVD.

In the above example, the venue where you sell the DVD could be anywhere, but with stocks, it’s the open market.  If you were unable to buy the DVD back for the $25.00 or less that you sold it for you would have had to cover the difference out of your own pocket making it a money-losing trade.  Or you could just tell your friend you lost the DVD and say “what the fuck you gonna do about it punk?”

The same concept applies for the stock market example as well (minus the “punk” part).