Saturday, November 03, 2018

Recency bias, and labelling markets as easy or hard

I've seen it said that one of the goals you should have as a trader is to try and make money when things are easy, and that you should be more defensive and protect what you have when things are hard.

That is all very laudable, but from a trend follower's perspective there is a problem with that.

The point is, you can generally only see when things have been easy or hard after the event, with the benefit of hindsight, and quite often your own interpretation of what is easy or hard is solely dependent on whether you made a profit or a loss.

Your goal as a trend follower is simply to trade well (i.e. take trades which meet your criteria), and that you faithfully follow your process in terms of entries, exits, risk, position size etc. 

Everything that happens to price subsequent to you entering a trade is outside of your control.

If you are trading in the moment of now, you can only react to what you are seeing at that point in time. To say "things are easy" or "things are hard" is putting your own recency bias on current market action.

What if you see a valid price set up in a stock, forex pair or commodity which meets your criteria, but you've suffered a run of losing trades?

You maybe thinking "Things are hard at the moment - I've had a run of losses, and the market is chewing me up. I'm going to pass on the trade".

That would be completely the wrong thing to do. If there is a valid signal, it should unquestionably be taken. 

In Way of The Turtle, Curtis Faith set out a schedule of the trades taken in Cocoa in from April 1998 through to early 1999. Up to the end of October, there were 17 trade entries taken - ALL of them generated losses!

You can therefore probably guess what happened with the 18th trade - a trend took hold and the resultant profit covered all the losses from the previous 17 trades and had some residual profit left over.

Then there followed another three losing trades, before the next signal generated another profit. Over the whole period, a total of 28 trades were taken, of which only 4 were profitable. Yet solely trading cocoa over that period you would have made a handsome profit.

The critical question though, is how may people would have carried on taking all those valid signals? What if the voice in your head had said "Things are hard at the moment", and you didn't take the 18th trade?

What would you have done? I dare say many would have stopped taking the signals after three or four consecutive losses.

That is an extreme example, but I have had to deal with this in my own trading. I have attempted to trade a particular stock, got stopped out two or three times, and then missed the subsequent price move. Sometimes, I have kept taking the signals as they came and was able to cover my previous losses and make an overall profit.

My own thinking on this has evolved over time, to the point that the only element which can make things "harder" (i.e. more difficult from an emotional point of view) is the current level of volatility. 

To me, a valid signal is a valid signal - end of. And using volatility based position sizing helps address the volatility issue. 

In an ideal world, the mindset of a trend follower would be to simply see price action for what it is, not what you think it may (or may not) be. And if a price signal is generated which meets your criteria, it should be your job to take that signal, irrespective of any emotions or misgivings  you may have.

The only thing that can determine whether you make a profit or a loss is price action subsequent to your entry into a market. What you feel about what has previously happened, or what is currently happening, or what may happen in the future, is irrelevant.

I'm not saying its easy by any means, but once you can grasp that, things do become a lot more straightforward.

If you truly believe that anything can happen in the markets, at anytime, which includes changes in market state or levels of volatility, then you need to avoid falling into the trap of giving labels to any market based on your recency bias.

And if you get a valid entry signal, make sure you take it!

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