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.

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Brian C. Lund

Brian C. Lund

Great father. Good friend. Decent trader/writer. Lacking husband. Solid drummer. Sometimes funny. Often A-hole. Terrible poker player. Too smart. Punk rock. Work in an ice cream shop.

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