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

His philosophy basically boiled down to “buy on the dips.”  This was something he would call out from time to time, saying things such as, “I am 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 make it as a trader was that he did not have a sound methodology in his trading.  He may have thought that “buy on the dip” was a sound method based upon his success in the past, but he made the same mistake that many others traders make; he used outcome to validate his method.  Now that your eyes are rolling back in your head, let me tell you 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 giant plastic Eiffel Tower mug or maybe you split a brewzooka, it really doesn’t matter. Now that you are 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” on the roulette wheel.

If you in fact hit “red”, it was still a bad decision.  The reason is, even though you won, the methodology you were using, “everything on red”, was flawed.  Eventually it would not work (actually 50% of the time), and the one time it didn’t work, the downside is so large that it would wipe you out and you would not be able to play in the game anymore.

He’s Dalton. He’s the Cooler DAMMIT….!!!

Trader1 was fooled into thinking that his method worked, because in the two years that he had been trading, the market had in fact rebounded after every dip.  The problem was that Trader1’s method did not have any contingency in case the market didn’t rebound after each dip.  It was basically based on a consistent “one-sided” outcome, something that never happens in the world of trading.

The most obvious way that Trader1 could have improved his methodology would have been to incorporate a stop-loss rule.  In addition, he could have had a “target” rule, where he would take some or all of his profit when a position hit 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 then refine his rules until he found a method that was consistently profitable, and then evaluated the “success “ of his trading not by the outcome of his trades, but by the adherence to his trading rules.

You can read more about flawed methodology and fooling yourself into thinking your “system” works by reading Fooled by Randomness and The Black Swan by Nassim Taleb.

Buy the dips working…..

Now…..not so much!

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