Friday, November 25, 2022

The expectancy gap and performance leaks

When trading, you are free to construct your own methodology and set of rules to use - what markets to trade, triggers for entries and exits, how much equity to risk etc. That's the easy part.
For the majority of us, the difficult bit is ensuring you keep operating within that framework.

Building your own approach to the markets and the decisions and actions you take are entirely within your own control. But you have no control over what the markets do. Ideally, you want to react to the market's price movements, and trade within the confines of your carefully constructed framework.

In Trading In The Zone, Mark Douglas stated that 95% of a traders' issues come from the following 
four fears: 

  • Fear of being wrong;
  • Fear of losing money:
  • Fear of missing out; and
  • Fear of leaving money on the table.

All of these issues are within your own control, and relate to the compatibility with, and / or your ability to follow your own method or rules.

Several years ago, I was mentoring a trader who kept detailed logs comparing his real results against the theoretical results he should have achieved by executing his entries and exits strictly in accordance with his rules.

He was astonished when he could see the accumulated differences building up over time - and of course, it quickly became clear that his attempts to act 'smart' and override the rules had such a negative effect on his actual results. 

I refer to this difference as the 'expectancy gap'.

You can quantify this (as he did) in terms of R. Providing the basic method you are using has a positive expectancy, the closer your actual results get to the theoretical ideal, the more efficient (and profitable) trader you will become.

With trendfollowing, the biggest 'performance leaks' I've seen causing an expectancy gap is the fixation over win rate and the fear of losing open profits, where people don't let winners run. This often increases after a run of losing trades - anxiety often makes people snatch a small profit for fear of it turning into a loss.

As Jesse Livermore said:

"They say you never go broke taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market…  I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out."
It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!"

But that is the very nature of the method we use, giving us the 'lumpy' returns.
I've also seen people hesitate or pass up acting on valid signals for fear of being wrong or losing more money. And lo and behold, those very signals end up generating decent sized profits. One trader I know suffered this, meaning he missed out on what would have been his most profitable trade of the year!

I've previously mentioned this example, but in his book Way of The Turtle, Curtis Faith talked about a series of cocoa trades where this recency bias could have caused a trader to miss out on decent profits after a series of losing trades in that market.

If you do not take a valid entry signal, then you do not lose any money. But the loss of the potential gain far outweighs this.
It is my belief that focusing on increasing your ability to perform efficiently within the confines of your own method will yield the biggest improvement in your performance.

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