EP148: Seeding Your Subconscious (Part 2 of 2)

In this second part of a two-part episode of 2Traders Podcast, Darren and Walter talk about what discretion, intuition and large winning trades all have in common (this may be surprising). You will also learn about how the godfather of automated trading taught at a community college (!) and has since inspired traders like Richard Denis of the Turtle experiment and Ed Seykota of Market Wizards fame.

This trader (do you know who he is?) is considered by many as one of the most influential traders over the past hundred years.

Also, how to tell if the system works with Darren’s simple hack. The weirdest currency trader you’ll ever hear about down under (and how he spends time thinking about an aspect of trading most traders never consider). You’ll be laughed off the “free factory forums” if you adopt his trading technique. And what do winning traders do differently from the crowd (you must pay close attention to see this).

Did you also know that there’s an antidote for this common trading mistake? Find out what it is in this episode.

Finally, you’ll get why most trading systems don’t need to be fixed (and how fixing them can be dangerous – do this instead). All this, and more in this episode of the 2 Traders Podcast.

Download (Duration: 27:26 / 62.8 MB)

In this episode:

00:39 – how to infuse creativity?
02:20 – machine to beat humans
04:21 – machine learning
06:35 – a good tip
08:38 – seed your subconscious
10:43 – put systems in place
12:49 – perfect system
14:24 – cash register
16:36 – behavioral edges
18:34 – radical change
20:52 – chugging along
22:04 – adjust your rules
24:05 – single perfect strategy
26:05 – different fields

Tweetables:
Our lives are in autopilot [Click To Tweet].
Change your conscious thinking pattern [Click To Tweet].
It’s about testing and tweaking [Click To Tweet].

Download The Full Episode 147 Transcript Here

Walter: The thing about doing that when you’re conscious in your everyday going through life, it’s great. It’s great but it’s a lot better and it’s a lot more powerful if you can do this and put it in your subconscious with something like hypnosis or when you’re going in a hypnagogic state. So, that’s when you want to really focus in on it…

Announcer: Two Traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.

Walter: Welcome back to Two Traders. In this Episode, you are going to hear about how you can infuse more creativity into your trading systems. The secrets to building profitable artificial intelligence based trading systems. How your subconscious mind directs your trading behavior and the best time of the day to seed your subconscious to profitable trading thoughts.

Also, you’ll get the two biases you must be aware of if you want to trade successfully for a long time. And really, how loose should your trading be. All these and more in this Episode of the Two Traders.

Darren: Good morning, Walter. Very good, thank you.

Walter: I think if you start with the end in mind like, what do I want to get? There are different ways to get that, right?

Darren: Yeah, definitely.

Walter: Adding things from other completely outside the box fields and things. I was listening to an interview with the guy who’s like a computer scientist and he programs, the big thing in trading is like AI and Machine Learning. Used to be Neural Networks. It’s moved on, it’s AI and Machine Learning. 

Basically there are a couple of issues that have come up but he basically said, “The financial markets are swimming with all of these very intelligent people who’ve come over from other fields and have a computer background and they just think, we just have to let the computer figure out what the trading system is. What is going to make money and they find that it is much more difficult than they thought. It’s a lot easier in other areas.”

For example like building an AI machine to play chess and to beat a human. That is much easier because that is a closed system. You know what all the pieces can do, you know how big a board is and all that. In trading he was saying that what happens is, it changes because when you create a machine learning based strategy and then you start trading it, that changes the whole dynamic of the market.

He said, “one of the biggest issues was” — it’s fascinating — “one of the biggest issues with these systems when they’ve created it is, when you’ve put too much data in, what happens is you get basically like a middling system that will kinda do like, not kind of okay kind of plug along in all kinds of markets.” It’s like a Jack of all trades, Master of None sort of thing.

He said, “But really what you want to do is you want to look at a small chunk of data to create, let the machine create the system based on a really small set of data.” Which is completely different to the normal thinking. If you listen to people who are into automated trading, they are always talking about the importance of data. You need big large data sets.

What he said was, “No. you want a small data set and then you keep tweaking it and you keep adjusting the system by feeding it more new data as you go.” So you’re always kind of tweaking it rather than setting it a bit.

It makes sense because if you’ll think about the markets , we know that the markets go from constricted quiet markets that aren’t really going anywhere to trending markets to swing markets or very volatile but not going anywhere or very quiet trending market where it’s trending really hard and hardly retracing at all. There’s all these sorts of phases that the market goes through. 

Like from abroad from a general sense and you can see where one’s strategy would work in one of those markets but totally fall apart in another one, it makes sense but I just find it fascinating how these people who are really good at Machine Learning and AI, when they’ve come to trading they don’t realize that it is completely different game because it is not a closed system, basically. The rules are always changing.

Darren: I imagine they come with this idea that the answer is to win consistently and all the time. 

Walter: Yes, of course. They are always in the lower timeframe, quick profit. Exactly.

Darren: Which again, I suppose where our subconscious takes us. That’s the solution. This is about making money and people would want to make money everyday, every hour, every week. They don’t want to consider losing money.

Whereas, what you find in trading is the people who make the most money are comfortable with losing.

Walter: Yeah, no doubt. 

Darren: That is really a hard idea to take on. Going back to the poker analogy, you’ll find the best poker players they’re not concerned with winning every hand. They are concerned with winning the best hands. The hands where they make big money.

It’s really a hard idea to take on and it is especially hard if you’ll just stay in this trading world because when you’ll go into forums, everybody is winning everyday. That is the story that you’re told.

Walter: Yeah.

Darren: Every now and then, you get one thread on there where a guy says, “Been trading for ten years, I’ve never made a penny. What am I doing wrong?” These are the threads where you’ll actually learn something. You learn about losing. 

I think going back to this idea of seeding your subconscious, that’s what we should be looking for. We should be looking to seed our subconscious with the ideas that are not popular but still work. Go and look for those in other fields. There’s a lot of them out there, if you say that’s what your goal is, to find those.

Walter: Yeah and a good tip for people who are listening is to use that state when you are going to sleep. So the hypnagogic state is when you’re falling asleep. That’s when you can place things into your subconscious.

You hear a lot about positive thinking or mantras or stating all these things over and over again and all that. I even have a friend in highschool. I went over to his house and there’s all these you know those post-it notes, they’re all over the house and I’m like, “Woah! What is going on here?” Everywhere I look, I see these post-its with positive messages. I was like, “What the heck?” He’s like, “Oh! my dad wrote a book about positive thinking and he’s totally into them.” I said, “Oh, okay.” It was confronting to see all these messages.

The thing about doing that when your conscious in your everyday going through life, it’s great but it’s a lot better and it’s a lot more powerful if you can do this and put it in your subconscious with something like hypnosis or when you’re going in a hypnagogic state. So that’s when you want to really focusing on.

It could be as simple as, “I’m trying to workout the best exit strategy for my trading system and in the morning when I wake up, I will have an answer.” You can just kind of let it percolate and you could say, “Subconscious, tomorrow let me know what is the best solution is for this exit strategy.” 

You could also put a positive message in there but you want to make sure it’s in an active voice. You don’t want to say, you don’t ever want to tell your subconscious, “I will start making money consistently.” That’s the last thing you want to do because it’s always going to be in the future for your literal subconscious. It’s sort of, “I am” as something happening right now.

So, that is another thing that you can do. You can solve a problem or a challenge or you can just seed your subconscious as you’re falling asleep. Just keep repeating it as you’re falling asleep. It’s a great time to do that. 

So Darren, to me, you could still have a challenge as a trader, you still have these issues that keep cropping up in your trading but it’s sort of like the old Whack-a-Mole. Do you know the whack-a-mole game is?

Darren: I do, yes.

Walter: Yeah, they keep popping up. So it’s kind of like this where I think in trading especially if it is not clicking for you and you have these issues that keep creeping up. It’s like, you whack one and then another one pops up and it could even be the same one sort of disguised. So, what do we do there?

What do we do if we know it’s something subconsciously that’s happening? Do you have any ideas on that? What would you do? For example, let’s say a trader keeps moving his stops. So he doesn’t want to take the loss so he says, “Look, this is still a good trade. I’m just going to move my stop, give it a little bit more room and see how it’ll go.” 

Of course the trade goes further against him. He said, “Ahh, I’ll just push that a little bit further because I know it’s going to turn around here. Here’s where the support is going to come in so I’ll be fine. I’ll just move my stop.”

And so what ends up happening is he takes in the mother of all losses. His big losers keep attacking his account and he knows this but he keeps doing it over and over again. How do you deal with something like that?

Darren: I think the hardest thing is actually knowing it and accepting it, that’s the hardest thing because generally they’ll cover it up with something else. They’ll make a story that didn’t involve them. I think if you know that you are making this mistake, I still think that and a lot of research backs this up, the best way to trade is to go systematic as much as possible. 

Put systems in place for you to follow and then try and break those mistakes that you’re making. All of the research suggests that in a field like trading, systematic wins out. Now, that doesn’t mean intuition and using discretion has no value at all.

Generally, we’re better off staying in within a systematic approach. And so, imagine if you are a trader that has recognized that you’ve got a problem and whatever you do makes no difference then look at how you can become more systematic.

I see a lot of the time the decisions people are using to, the intuitive decisions they’re leaving without a strict rules set, they believe they’re performing better because of that. I think you really need to examine and find out whether that’s true. Wrap some strict rules around it and see if it still performs well.

Walter: Yeah, right.

Darren: I know it’s a [11:13 inaudible]debate this but I used to be using a lot of discretion in my trading. Purely because I believed it was the way to trade but when I tested the idea, I found that my beliefs are wrong or not.

Walter: It’s optimism bias and hindsight bias, right? We feel like, you look at the chart and say, “I wouldn’t have taken that one because of blah, blah, blah” you’ve concede it could’ve been a loser or whatever.

Darren: Yeah. I’ve got a good question from someone in my trading group, this week. So we trade a specific system and he has seen something and had an idea about kind of using some more discretion on the exit and I said, “Well, you know the system works well based on the backtesting and forward testing is going well. The system is making profit. Rather than this approach of trying to optimize one system to be the perfect system, take that idea and have a separate account and diversify. Run both strategy.”

Walter: Yeah, of course. You run a race basically. See what’s going to happen. I think we can trick ourselves into overestimating, how well things are going to work out.

Darren: We’re amazingly good at it. I mean, it can literally be, you could have traded  the system for 6 months and then Monday, Tuesday you’ve spotted something that have happened and you want to change the whole system. That emotion is so powerful that it could make you do that.

It can make that small rate of data because it’s so current and particularly if you’ve taken a couple of losses on your system, you could see this tweak would have saved you those losses. It just completely squashes that data.

Walter: It’s so tempting though. When you have that creep up, it’s so tempting to modify everything and change it so that that won’t happen in the future. In life, that’s the way everything is run. You know like, “Well, my kid fell over here because he was wearing these shoes and he cut his lip. So he’s not going to wear these shoes anymore” or whatever.

Same thing with businesses, you’ll see the same thing. “Somebody stole money out of the cash register. So from now on, everyone is going to type in their code every time you’ll get into the cash register so we’ll know who’s in.” This is what happens in life.

The crazy thing is if you’ve fallen into the same trap as a trader, it’s a trap. Most of the time, it’s a trap. It’s not going to help you at all.

Darren: Is this “hot hand fallacy”? 

Walter: Right.

Darren: I was doing really well at the moment. You jump on board with that and then you know, you see the EUR/JPY is moving so I’m going to jump over to EUR/JPY. Mike Bousson did a lot of research on this with fund managers.

They found that, the fund manager who did really well last year, everyone piles into that fund manager. And then, he doesn’t do so well this year, what they found is, it’s much better off to just stick with the fund managers that got average performance than jumping to the new star in the market.  

Walter: I think you can also anticipate when the markets really going to trend because all of these articles come out especially in these Finance magazines and newspapers. They’ll come out and they’ll talk about how like, trend following is dead. It happens all the time.

You’ll see all these articles and they’ll bring up the famous trend followers that you follow like those Brothers in Florida, the Dunn. They’ll talk about how they’re just doing terrible and has been terrible for the last two and a half years or whatever. It’s so awkward.

You’ll see these articles come out and then boom! The next twelve months are amazing. It’s so funny how that happens. I know some traders that actually look at the cover of the Economist. 

They used the cover of the Economist. Whatever is on the front cover of the Economist every week, they’ll watch it and they’ll see. A lot of times, the Economist is really good at calling market bottoms and tops because they’ll run the future story in the exact opposite. It’s crazy.

Darren: This is why I’m always saying you should look for behavioral edges and not information edges which are really hard to get. Or technical edges which are really hard to get because behavioral edges, they don’t change. They stay the same. 

Walter: Yeah, it’s a lot less work isn’t it? Just try to figure out few behavioral edges than trying to keep ahead of the algos.

Darren: Definitely and if everyone is coming out saying that trend trading is dead, I’d be loading up before I was a trend trader.

Walter: Exactly.

Darren: Because the whole reason that trend trading works is that sometimes it doesn’t work. That’s the edge. Price does not trend all the time but then when it does, it trends really strongly for longer than you’d expect.

Walter: So true. The Computer Scientist guy who I was listening to the other day, he eventually came to the conclusion, it’s kind of along the lines of what you’ve just said, Darren.  Because he’s saying, he was trying to figure out how the best go build these trading strategies using Machine Learning and finally he came to the conclusion that he should study fundamental analysis.

So he was throwing everything in the kitchen sink into building these algos and then he was like, he shifted gears. He started reading and learning everything he could about fundamental analysis. 

Which is really almost about it as far as you can get from the algo world but that’s where he finally learned how to make his algos go. When he made that shift and kind of took a step back, look at the macro picture. 

Darren: Definitely. I try to encourage people to do this all the time. If you’re stuck in this loop of doing the same thing over and essentially looking at the same thing and just tweaking the parameters, you’re not really going to make any radical change. It’s crazy to think that just by tweaking the parameters, all of the sudden you’ll just kind of hit this gold mine and it will completely change. You need bigger, more radical ideas.  

Walter: That is right. So instead of changing from a 21 moving average to a 30 or something like that, what about scaling in positions? Or instead of taking, like you said, a 2R target and moving it to a 3R target, what about shifting it to a 12R target? What will happen there?

What would happen if you had a 6R target and a 12R target and split your positions out that way or use a trailing exit plus a big, fat 10R target? Here’s an interesting one. So I had a friend and he created an automated strategy. It’s basically based on this idea, during the interbank period.

So he would only trade during the interbank period which is fascinating to me. What that meant was, he was trading in the most eliquid time of the day essentially. The widest spreads, basically the period when nobody wants to trade because it’s so tough. 

The market does not go anywhere. The spread is wide and that was his sweet spot, that is where he found his little edge. I think that, that’s the kind of thing we should probably look for.

If you’ll look at the numbers on the open position ratios — which I’m a big fan of watching — just to get a sense of the trend, what you’ll notice is that almost everyone is a reversal trader.

So all of these retail forex traders, they’re all basically selling uptrends and buying downtrends. They’re all trying to catch a falling knife. It’s ridiculous but it’s true. So what it does that tell you? 

Like you’ve been saying, Darren. “Okay, how do I do something different to what they’re doing?” They’re all piling in, they all say, “Okay, this trend is going to be over. It’s been going for too long.” Well, that’s probably a sign that the trend is going to keep chugging along.

Darren: Yeah, definitely. I do this all the time. Think about what’s most popular with the people most likely to be losing money. Those are the things I don’t want to be doing. You can reverse that and say, “Find the people that we know are making money. What is popular amongst them and is there a complete mismatch there?” Do a crossover and things jump out [2048 inaudible] but you have to start thinking outside the box.

When I look at trading forums and the strategy pages, you can literally go from page after page after page and see no discussion on trade management at all. It’s a one-liner at the bottom of the twelve-page strategy and it’s not popular. So there’s a clue for a start.

Walter: Yeah, exactly. See how your equity curve changes if you are backtesting something. See how your equity curve changes as you adjust your rules in an area like, do you move to breakeven? Do you not move to breakeven? Do you have a looser trailing exit that lets the market jiggle around more or tighter one? Do you start off with a really lose stop or really tight one? All these things that Darren just hit to that, these are really, really fertile areas to look into.

Darren: Yeah. I see real radical change in the performance of simple systems by playing with the trade management. Real radical difference there but it’s very hard to take on board. You kind of have to work on yourself to sort of take that because it’s not natural to look into those areas.

Walter: Do you think that there is a different mindset between the average forex trader and the average share trader or stock trader?

Darren: Possibly but only because when, if you go on YouTube and you do a search on forex trading and do a search on investment in the stock market, the information, the seeds that are first planted tend to be different.   

Walter: I agree. I think that the typical approach is fundamental approach for share investors and the typical approach for futures or forex traders is a technical approach. 

Darren: Yeah and it tends to be much more long term in the investing world and more short term in the trading world. I’ve been studying investing quite a lot recently and I find that thing, that’s the one sort of gem I’m taking away from it. This idea of diversifying. It’s very hard in the forex world to see retail traders talk about diversifying. They tend to have this single perfect strategy idea. It’s very hard to find that in the investing world.

Walter: That’s right and a lot of technical traders will assume that if they’re trading different markets, they are diversifying, which is not. I think when I first started to get into trading, it was more kind of investing, sort of short term investing and the books I’ve read, they were all talking about how to pick good companies. 

And then there was another book, that some of you might have read, the William J. O’Neil book How To Make Money Trading Stocks and that was kind of different because he had a little bit of an approach where you would look for certain fundamental factors but then you would also look at the chart. 

So that’s kind of my introduction to chart reading and we used to get this big book called, Daily Graphs. It would come in on Friday. This was during the early to mid ‘90’s and you had this booming stock market in the States. The NASDAQ Market was taking off. You get this big telephone book size, these green books that would come on Friday and they were the daily graphs, the daily charts.

You go through there and see all these, it was like this filtering process of finding the right ones to buy. We didn’t hold them very long. Sometimes we’ll hold them for a couple of months or whatever but it wasn’t. There were a lot of genius traders back then. Kind of reminded me again of that one when Bitcoin has it’s big run up. There’s a lot of similar sort of things going on, there were a lot of geniuses out there.

Darren: Yeah, definitely. 

Walter: Cool. Thanks for your time Darren. Is there anything you want to end with, sort of enclosing here?

Darren: Just really, perhaps consider some of the things we’ve talked about today and think about this idea of  looking in different fields to how problems are dealt with there and applying that to trading. So if you’ve kind of been studying and working to be a successful trader for a couple of years and you perhaps hit a brick wall, stop looking at forex for a bit and have a look at some other fields.

Walter: Good advice. You can look into cognitive biases. You can look into Physics. You can look into different fields. There’s a book called Thinkertoys. It’s a really good book about trying to pull from other areas, other fields. Thinkertoys by Michael Michalko. I’ll put a link in the show notes. The idea is you just bring things from totally different fields and see how can we make this, how can we meld this to what we’re doing here, in the trading world or whatever you’re working on. It’s really a good way to mix it up a bit.

Thanks for your time, Darren. I really appreciate it.

Darren: Nice to chat with you again, Walter and I’ll see you next week.
Walter: See you next week!

EP147: Seeding Your Subconscious (Part 1 of 2)

Can you program your subconscious for trading success?

Walter and Darren look into your subconscious mind in this episode. What does your subconscious really do and how does it effect your life?

Walter sheds light on forming the correct patterns today to shape your future decisions. According to him, most traders need to tweak this one thing when they first start out trading. Is trading success due to “cracking the code” or something else? He also talks about The Myth of Gann and living in a fishbowl.

Darren talks about the loops inside your brain and why looking at the markets from one point of view can lead to a particular trading result. Can ideas from forex trading be transferred into stock trading? Darren also talks about trailing stops, triggers, and why you should consider “being an expert” for your trading. You will also hear about Annie and similarities between traders and poker players…

All these and more in this first half of a two-part episode of 2Traders Podcast.

Download (Duration: 26:43 / 64.1 MB)

In this episode:

00:42 – interesting perspective
02:12 – viable career
04:27 – stuck in a loop
06:02 – thinking pattern
08:22 – magic wall
10:40 – pattern loop
12:16 – learn to lose
14:00 – a broader knowledge
16:30 – treasure chest
18:45 – locus of control
20:18 – planting seeds
22:13 – unique experience
24:05 – fishbowl
25:58 – sphere of comfort

Tweetables:
Our lives are in autopilot [Click To Tweet].
Change your conscious thinking pattern [Click To Tweet].
It’s about testing and tweaking [Click To Tweet].

Download The Full Episode 147 Transcript Here

Darren: Sometimes we’re taking a hammer when we need a screwdriver because we’re stuck in this loop, we don’t realize that that is what we are doing…

Announcer: Two Traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.

Walter: Welcome to Two Traders. It’s Walter here. Hi, Darren. How are you doing? 

Darren: Good morning, Walter. Very good, thank you.

Walter: Great! Great to hear you again. So I’ve been thinking about this and apparently you’re thinking about this as well which is really cool. Hopefully, we’ll have different interesting perspective on this. 

I’ve been looking into research along the lines of how you can achieve your goals or perform better based on seeding your subconscious. There’s a pretty good literature out there behind this idea of if you want to do better at something and there’s also anecdotal evidence going back centuries. 

Inventors and people like these who’ve used their subconscious as a tool for solving problems, overcoming challenges along the way that obviously come across. Inventors have this issue all the time. They know what they want to do but they’re just not sure exactly how to do it. How to create that product or that thing, to solve that problem.

I’m just kind of thinking from a trader’s point of view, how important is it for us to be aware of the fact that it is possible to do better and achieve, get a better hit rate I suppose, at trying to succeed and reach your goals if you employ the power of your subconscious.

I think this is something that is important especially if you are surrounded by a lot of influences that are adjusting what you believe is possible. If you are around a lot of people, I’m thinking about traders that I know who’ve been in a situation where some of their family members, people close to them, do not believe that trading is like a viable career or whatever. They don’t believe that it is something that they should really be spending their time on. It’s a waste of time.

You know, these can kind of pull you down psychologically and so one of the things that I think a lot about is how you can counteract to these things that come up. How do you deal with these things? I think the subconscious is a great place to start. What are some of the things that you’ve been thinking along these lines? 

Darren: When we’re talking about the subconscious, in layman’s terms, what do we mean by that? Are we talking about beliefs, basically? Is that another way of describing?

Walter: To me, the subconscious is the driving force behind most of our behaviors because we pretty much live life on autopilot and so our conscious minds just like when we do things, our conscious minds will say, “I did that. The reason why I drove that way to the party  was because I always do this and I just thought today is Saturday. It’s going to be busier or whatever.”

When really what’s going on is our subconscious is making the decisions for most of the things we do in life. Our conscious mind is just kind of covering and saying, “This is really what I was thinking” and basically making us look a little bit smarter than we really are. That is how I look at it anyway. 

It is sort of the driver of all of our…  

Darren: Would you say it’s kind of like actions we take without really considering them? 

Walter: Absolutely. Same page.

Darren: Okay, cool. Well, I’ve been sort of looking at this idea myself and I’ve been looking at this idea of thinking patterns. With regards to trading, this is the idea that when we’re faced with a problem, we kind of have a pattern of how we deal with that problem. We re-apply that pattern and if it doesn’t work out, what we tend to do is we do the same pattern again but we just tweak things around a little bit. And we feel like we’re trying new ideas and coming at stuff from different angles but, essentially, we are stuck in a loop and we are just really repeating the same thing again. 

The idea is that these loops we kind of learned when we’re young. When we first have a success dealing with a problem or a challenge we’ve learned a pattern of how we dealt with that problem and then when we find similar problems going forward we tend to revert to that pattern.

I suppose you could say that is kind of a subconscious thing and this bit of research I’ve been looking at is this idea of rather than doing that. What we do is we look at how people deal with problems in other areas and then try and apply those patterns of thinking to the problem we are stuck with.

You try to breakout of that subconscious which is kind of similar to what you are saying. You are trying to seed your subconscious with seeds from different areas. That is something that I’ve been having quite a bit of a success.

For instance, I’ve been studying investing in the stock market a lot which is very similar to trading. What I’ve learned from that is perhaps some of the techniques they’ve used there which is really popular and worked well, that might be shunned in a sort of day trading, forex trading world, actually do lay bear fruit switching them over. It is about changing that thinking pattern, your conscious thinking pattern. 

Walter: What do you mean by that? So you’re kind of see the markets from one point of view and you have to switch that up when you get into the share world, the stock world?

Darren: Yeah. To give an example, in the day trading of forex trading world, people tend to be very focused on having high win rates and having these kind of linear returns and being so short term seems very popular.

Whereas, when you look at investors, they’re much less concerned with individual trades and short term. They tend to be much more long term, not completely but so it’s like saying, “Do those ideas transfer? Is that a better way to think in forex trading where the consensus tends to be the other way. Can those ideas transfer over?”

It doesn’t have to be just from investing in forex trading but it’s just this idea of if you’re approaching a problem using the same thinking patterns all the time, then perhaps change your pattern of entry or your candlesticks pattern and you’ll think you are kind of coming at it from a different point of view. Whereas, really you’re just stuck in a loop.  

Walter: Yeah, I agree. I think those being stuck in a loop sort of things are often come from things we learn in life and are kind of incorporated. For example, let’s say that you are a trader who, growing up as a child, you had some sort of event where somebody told you as a child, “You are not worth it. You’ll never going to amount to anything” or something horrible like that. Says to a child,  “You’ll never going to make it. You’ll never amount to anything” something like that.

And then as a trader, you get to this point — I know this is really a simple example but you get to the point — where you’re able to build your account to a certain level and then boom! You can’t get it beyond that. It’s like this magic wall, boom!

It could be something like that in your head, you might not even be aware of that. It might take a lot of work to pull that out and say, “Okay! Oh yes! I remember my Auntie told me that when I was 8 years old” or whatever, something like that.

We get these patterns, things like that that keep coming up. Like you’re saying. Let’s say, you’re a scalper. You like to take 10 pip profits and you understand that your reward to risk ratio is all upside down and you have to be really careful about cutting your losses quickly and all these sorts of things. But, you keep making the same mistakes and you keep letting these losing trades totally impact your account.

So then, what do you do? You might decide, “You know what? This Stochastics is not working for me anymore. I want to move to Momentum.” You feel like you’re changing it but you’re actually doing the same thing. You are making the same mistake in terms of not letting go of those losing trades but to you it’s a whole new system because you’ve got a new indicator on there or something. I know these are really simple ideas but they happen all the time with traders.

Darren: Exactly what I am talking about. I think a lot of the time, we’re focusing on details that don’t really matter because we have this pattern of dealing with the problem. Sometimes we’re taking a hammer when we need a screwdriver because we’re stuck in this loop. We don’t realize that that’s what we’re doing. You have to kind of have come at it from a more radical approach.

Like for instance, I’m talking about trailing stops and I’ll give suggestions of the way that a strategy or my particular approach. Most of the questions will be about what is the specific level where I start to trail. And really, that isn’t the question you should be asking. You should be asking why a trailing stop is better than a fixed stop if it is.

I think in trading we focused on the precision because there’s some sort of pattern loop generally in our subconscious that focuses on that. I think it’s about moving the focus away from that and away from the precision. Is this is a subconscious thing, is what I’m saying.

Walter: Yeah. I think we have certain desires. To me, this side of trading there’s two levels. There’s the conscious level that we’re aware of the cognitive biases, hindsight bias, optimism bias, all of these sorts of things that come into trading. And then there’s the subconscious level which we’re sort of tackling today and that’s the idea that there are these drivers inside of us that have come from different places. Oftentimes, we don’t know where they’ve come from.

If you’ll look at a computer program, there are certain rules that the computer runs by and that’s kind of how we are. We have these certain rules that we used consciously, those are called cognitive biases and subconsciously. These are the repeating patterns. Our patterns of behavior that we do over and over again.

One of the obvious ones for trading is that we want to win. When you start playing soccer as a kid, you’re trained to have desire to win. You want to win. The paradox of trading is that oftentimes, breaking that down and sort of disintegrating that real desire that we have in trading can help a lot. Because if you’ll let go of that and you learn to lose and accept losing, oftentimes that can improve your profitability greatly.

Everybody wants to win. Everyone wants to take the quick win and for a lot of people that is the road to losing as traders and we know this. You’ve pointed this out, Darren. This is basically the big error that a lot of forex traders make. It’s trying to take really small profits. Unfortunately, even though they are right more often than not, they’re more often right than wrong because these are really small profits, their bigger losses eat up all of those wins.

Darren: This has kind of to me, suggest that the idea with trading is you really need to study one field and become an expert in it. This is suggesting really that, that probably isn’t the way to go because you have a limited array of thinking patterns that then you can apply to the problem.

This to me says really, what we should be studying is more fields outside of trading and get a general idea of how to deal with problems. What sort of problems are best dealt with this way and what sort of problems are best dealt with that way.

Because we’ve kind of all have the same triggers, don’t we? We generally all go through the same sort of education system. I imagine sort of globally. Where you grew up would make a slight difference as well but it’s suggesting that a broader knowledge would help you as a trader. Would you agree with that? 

Walter: A broader knowledge, yeah. I would say so a broader knowledge. I don’t think that you necessarily needed to dig into one thing.

Darren: Would you say if you want to be a great trader and you want to be a swing trader and you want to use price action then the best thing to do is for the next two years, just study price action.

Walter: Yeah.

Darren: And just study trading. We already know the importance of Psychology. So, perhaps you want to apply Psychology to it as well and it’ll be hard to deny that.

Walter: Or game theory. 

Darren: Game theory. You know I’ve learned a lot from studying poker players, really good take advice.

Walter: Exactly. I know you’re going to say that, Darren. 

Darren: Annie Duke now who is really big in the trading investing world was an amazing poker player. And Psychology as well, everyone is quoting there and with good reason because it is a slightly different field. How you deal being a really good poker player is slightly different to how you deal with being a good trader but the stuff that we can learn from both sides is the same.

You could say with sport, we could learn a lot from great sportsmen about performance and we can also learn a lot from sport about how skill and luck are important in achieving good results.

I like this idea of studying how problems are dealt within other fields and then considering how you deal with the problems with trading. It opens up, it seed your subconscious with these different ideas, these different approaches.

Walter: I feel like when we first, like when you first get into trading, we see it from the wrong way. We feel like you just needed to dig into that one area. For me it was about technical analysis when I first started trading or learning about trading. I read everything I could get my hands on in terms of technical analysis.

Darren: But why was that? Why do you think it was technical analysis?

Walter: Because I thought the key was to crack the code. That you need to crack the code, you crack the code to the markets and then boom! You’ve unlocked the treasure chest. That was my thinking. You need to figure it out.

Darren: You’re suggesting that it was in your subconscious. You didn’t know what planted that seed in your subconscious, that technical analysis was the way to go, something primed it.

Walter: Probably Gann. Probably reading about Gann like a lot of traders do. The Myth of Gann. I don’t know. I have no idea if it is true but the story goes — everyone has probably heard it — that there was a Journalist  for the New York Times or something like this who’ve followed this W.D Gann fellow for a month or two recorded all of his trades and he claimed to have sort of figured it out the harmonics of the universe. And he had two losing trades out of 38 losing trades and he built up this many empires.

And then he wrote a book and he said that the key is in the book. But the book was like some sort of a weird fiction book. All of these people have either claimed to have cracked the code of Gann or have wanted to crack the code of the Great Gann. I think that’s probably what sent me down that rabbit hole.

I was just thinking, “Okay, somebody obviously had figured it out.” I feel like when you get into trading, you’ll almost have to decide like either there is, and I know this is simplifying like it’s the 80/20 rule. 

80% of the traders who come into trading, I think go down to one of these two paths. They either think, “You know what? It’s all rigged. The banks and the funds and the trading robots and algorithms, those guys have got it all rigged. It’s rigged. It is not going to work. It’s really hard. You just have to join them basically”

Or, a lot of traders think, “No. There’s actually a way to do this. You just have to do X” and X could be learned fundamental analysis or learned technical analysis or study under somebody who you think is really good and learned how to scalp or order flow analysis like he does.

Whatever it is but usually either it’s under your control. It’s internal locus of control which is I control my destiny. So I just have to learn this thing then I’ll crack the code and I’ll be able to make money in the markets.

Or, it’s external locus of control. “I can’t do this. It’s the big boys who are able to do this” and then you have to decide are you just going to go work with them because they’re the ones obviously that have the game rigged.

I feel like that’s the and I could be wrong about it but I feel that most traders, when we first get into it, we kind of fall into one of those categories. What do you think?

Darren: My suspicion is it is the easiest and most available information that surround that you get when you start. If that fits with what you want to believe trading is about then that’s what people grab into. 

I just think now, technical analysis is the big bus thing. If you put forex trading into Google, you’re just going to get a load of technical analysis stuff. And that just kind of fits what most people want to believe. It’s that, “I just need to learn this thing and I’ve got to crack” that is what everyone comes with. 

It is how readily available that information is and how appealing it is that plants the seed. It seems to me that once that seed is planted, it is really hard to break from that and look for ideas out there. Especially if it instantly matches in your head what you’d like to believe trading is about.

I think that this idea of planting seed is really going into levels because if you agree with what I’m saying and you think that, “Okay, that is possibly what happens” it does suggest that it’s fairly easy to find an edge over the masses, over the majority because really you just have to look for new seeds to plant. That should be your study.

Your study shouldn’t be to just continue looking at charts and looking for patterns there. Unless you’ve happen to approach trading that way and you’re extremely successful doing that but if you’re not, I think you need to take this idea of planting new seeds in your subconscious. 

Walter: I think part of it is becoming aware what do you do to become aware of what is going on in there right now. For example, you want to plant tomatoes in the garden, do you have to first eradicate the weeds? Is that what you have to do first? Do you have to go in and just kill all the weeds before you plant the tomatoes or is it like, “Oh, it doesn’t really matter what’s back there. I’m just going to start planting tomatoes.”

Darren: You do definitely but it easy to spot that there’s a problem there. The one that wakes me up to myself was this, I had an idea, so I did the backtest. The backtest looks really good. Now I did live trading and the live trading was terrible. 

I went through that thinking pattern. I repeated that process over and over again for a really long time to a point where I said, “What is going wrong here?” Eventually, I found out that it was me that was going wrong and then I could start to plant new seeds.

I am guessing that is not a unique experience for traders. I had a good strategy but I was making mistakes when I took that strategy live. So, it was me that was the problem. That made me start to look at my processes, my Psychology and my beliefs to try and find out why my performance was not matching my backtest performance. 

Walter: Did you identify a mistake or a challenge? Like a challenge that you felt that you had to overcome? Was it like, “Oh, I remember when I was a kid, we always did this so that’s why I am doing this” or was it just something more sort of Monday, “Oh I keep taking wrong trades because I keep doing this and I just need to stop doing that.”

Darren: I really didn’t go back to find the deep psychological root cause of why I was making these mistakes. I just basically realized that I had two options. I could continue on doing what I was doing and basically lose all my money or I could make a change but that seed had been planted in my subconscious then that I needed to actually make a change if I wanted to achieve my goals. I think then it’s fairly easy really but you can put some persistence in place then to help you deal with the problem

Walter: No doubt.

Darren: If you followed your system and you try to replicate your backtest and you did everything right then obviously it wasn’t you. But in my case, it was definitely me that was the problem.

Walter: I feel like sometimes as traders, we live in a fishbowl sort of thing. We don’t see the water. We’re restricted, we’re in this little domain, we can’t see outside of it. We’re almost like it’s hard for us to break outside of what we consider possible or normal.

Darren: Definitely. This is why I am suggesting kind of looking if you’re trying to deal with the problem and you just keep going on forex forums and reading about traders and reading technical analysis book and that is not working for you then a good way to start is to start looking outside of that domain.

It is the same I think with this idea of staying in your comfort zone as well. We tend to trade a system and we’ll say, “Perhaps, I need to hold my trades longer” so you’re going to aim for 2 to 1 or 3 to 1 and you’ll feel like you are making this radical change to how you are trading. But really, you’ve just tweaked it out a little bit and that doesn’t work either. 

Holding trades longer, that doesn’t work you’ve dismissed that idea as well. I’ve done a few experiments where I’ve said, “Okay, we’ve got this simple system with a single  moving average.” 200 period moving average and people will argue, “Ow, shouldn’t it be the 180, the 150, the 210?” I said, “Okay, make it a 4,000. Make a radical change to test that belief that around the 200 is so important. Try making real radical changes.”

Instead of going for a 2 to 1 risk/reward to 3 to 1, how about going for a 10 or a 20 and test those. It is about where your sphere of comfort is. It is about testing those areas and tweaking them. I think form there you’ll get new ideas and new approaches and new ways of thinking about a problem.

Walter: That’s all the time we have for Part One. In Part Two, you are going to hear about how to infuse more creativity into your trading. The secrets to building artificial intelligence-based trading systems that work. How your subconscious mind directs your trading behavior and how you can change this to improve your trading.

The best time of the day to seed your subconscious to profitable thoughts. Two biases you must be aware of if you want to trade successfully for a long time. And really how loose should your trading be.

All these and more in Part Two. We’ll see you next time. Happy Trading!

EP146: The Mathematics of Trading (Part 2 of 2)

In this second part of a two-part episode of 2Traders Podcast, Darren and Walter talk about what discretion, intuition and large winning trades all have in common (this may be surprising). You will also learn about how the godfather of automated trading taught at a community college (!) and has since inspired traders like Richard Denis of the Turtle experiment and Ed Seykota of Market Wizards fame.

This trader (do you know who he is?) is considered by many as one of the most influential traders over the past hundred years.

Also, how to tell if the system works with Darren’s simple hack. The weirdest currency trader you’ll ever hear about down under (and how he spends time thinking about an aspect of trading most traders never consider). You’ll be laughed off the “free factory forums” if you adopt his trading technique. And what do winning traders do differently from the crowd (you must pay close attention to see this).

Did you also know that there’s an antidote for this common trading mistake? Find out what it is in this episode.

Finally, you’ll get why most trading systems don’t need to be fixed (and how fixing them can be dangerous – do this instead). All this, and more in this episode of the 2 Traders Podcast.

Download (Duration: 26:43 / 64.1 MB)

In this episode:

00:42 – discretion and intuition
02:29 – butterflies and unicorns
04:24 – gut pattern recognition
06:55 – smart approach
08:00 – naturally hardwired
10:30 – pick what you fancy
12:42 – a radical change
14:12 – is the majority winning?
16:55 – assumptions
18:05 – less uncertainty
20:07 – extra layer
22:30 – building up resilience
24:43 – the right thing
26:21 – engine in a car
28:04 – genes aren’t destiny

Tweetables:
Be open-minded [Click To Tweet].
Stick to your rules [Click To Tweet].
Trading shouldn’t be complex [Click To Tweet].

Download The Full Episode 146 Transcript Here

Darren: Are you going to take that as being more important from guys who’ve been around 40 years and make an average 20% a year and have never blown up and are managing millions of money and there is a huge group of them with which one do you want to believe? Which group of people do you want to believe?

Announcer: Two Traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.

Walter: In this episode of the Two Traders Podcast, you’re going to hear about trading discretion, intuition and large winning trades. What do they all have in common? Also, we’ll talk about Richard Donchian. A Community College Instructor and probably one of the most influential traders of the last hundred years. 

People such as Ed Seykota from the Market Wizards and Richard Denis of the Turtles fame have all been very influenced by the Donchian. Which instincts traders must overcome to make consistent profits. Find out in this Episode.

Also, Darren offers his simple hack for how to tell if the system works or not. You will hear about the weirdest currency trader down under. You’ll be laughed off the free factory forums if you’ll explain how he traded and he manages money. He’s been doing it for a long time.

What winning traders do differently from the crowd. Blink and you’ll miss it. The trader with thousands of trading systems and why he rarely trades them. Also, a simple forex system, Darren will all lay that out for you. The antidote for trading mistakes. These are too common amongst traders but you don’t have to make them.

Finally, why most trading systems don’t need to be fixed and how fixing them can be dangerous. All these and more in this episode of the Two Traders Podcast.

…If I tell a story to you and then I tell a story to my daughter for example. And the story that I tell you, is all about how this man searched high and low and collected the data then figured out this is the way that you can make money in the markets. You might think that’s really great because that’s your approach, that’s your orientation.

If I tell that story to my daughter, she’s going to be like, “Whatever, I want to hear about butterflies and unicorns. I want to hear about their friends and how they play.” Some people are more on the right brain side and some people are more on the left brain side. Some people lean towards Science and others kind of lean towards creativity and mixing things up. I wonder if that doesn’t sort of direct the style of trading that you’d be able to adapt.

I guess, for traders out there maybe asking the question: are you saying that if you’re going to trade, you’ve got to go based on data? Or, is it possible for some people to simply look at the charts and notice something and go like, “You know what? It seems like this is happening. This is what I see and it usually does this. Should I test that out and see if that is true or not?”

Darren: It’s kind of a deep pattern recognition skills that we have.

Walter: Sure, yeah. Something like that as an example.

Darren: I think so to a point. I like the Interviews with Poetry to Jones when he’s  used a lot of kind of intuition, if you want to call it that and discretion in some of his biggest trades. And when the interviewer asked him why he’s being so successful, he tends to kind of think about it for a bit and he’s not a 100% sure.

He’s had some gut feeling and it worked out for him but at the same time he also says, “If I wanted to give advice to anyone I’d say, just use a 200 period moving average and have a 5 to 1 risk/reward.”

There’s somebody that’s kind of playing both sides of the game. They understand that both sides of the game, just the data and this kind of gut pattern recognition, intuition side can both be useful.

I think really perhaps it comes down to doing that. Having an open mind that both of these things can be useful. So really, if I want to give myself the best advantage, I really need to understand both of these factors that are at play. And then, perhaps develop my trading strategy around that.

So, you might take all this information in and think, “You know what? I am just actually really good at picking when the trends are right and the right entry. So I want to build my trading strategy around that but I am not going to discount the fact that data are important as well. So I am going to take that and use elements of data and see if I can make my strategy a bit more robust.”

You have to be open-minded. I think the best traders are able to push themselves into the field that they are not comfortable in or where they are not an expert and use that data as well.

Walter: Yeah.

Darren: I don’t know if you agree. Don’t you agree with that?

Walter: This is what I think. Let’s just start with somebody who is new to trading. It gets a little bit complex as you do this longer but when you first start out, I think the best thing that you can do is figure out what makes sense to you and then start there. The next thing you need to do is convince yourself that it works.

Do you know the story about Richard Donchian. Obviously the Turtles, traded the  Donchian channels and all that, I think Emmanuel in our forum did a Donchian presentation for everyone, which is interesting. He uses them totally different to the way that the Turtles do.

What’s interesting about Richard Donchian is this: reportedly he taught this class like in some community college or something. And the whole class is about trading the markets. I think this must have been back in the  ‘60 ́s or something.

It was a 12-week class. He spent the first two weeks explaining to the students what the trading system was and the remaining 10 weeks, convincing them that they should take every single signal. 

When you’re thinking about trading I think, that is a pretty smart approach because he understood that a lot of people would just give up after so many losses. When you determine as a trader, you ́re new, you ́re trying to figure out, how am I going to quit this first system.

I think once you figure out what you believe in and what makes sense to you then what you needed to do is convince yourself that it works. I think that you are right that data is one way to do it. I think that data in a simulator is one way to do it.

I think that you can have the computer spit out some numbers. Have someone code i in for you if you don’t ́t do that or use a software that makes it easy to do that, just spit out some numbers. I think that, that ́s a distant second to actually getting your hands dirty and trading the system and taking the trade yourself. Because I think you get more out of that but that’s just my personal opinion. Some people like to code it in and I think there’s a whole bunch of pitfalls there when you do that

Darren: Here’s where I have a slight problem with that idea. Are we naturally hard wired to be attracted to the things that do not work when it comes to trading? Aren’t most traders going to come in and what they feel works is hard wired to be wrong and then what we do is we use biases to find information to back up that belief. 

Then we get kind of fenced in with this kind of belief system where everyone on the forum is saying this works, this is what I believe. This is what my gut tells me works and so I ́m just going to keep tweaking this and eventually I’ll get there. Is it our natural intuition to look for the wrong things? 

Walter: Yes, it is. I think that when you do your testing, when you go to your simulator that is when you learn how to tweak it. What I ́ve noticed is that the easiest way tweak to make, to make something better is to basically change the way that you get out of your trades. That is usually the easiest way to do that.

If you are trading a system and you want to trade the 5-minute charts and you want to get a one-to-one reward to risk ratio or whatever or even less. A .8 to 1 or something like that. We have these 15 pip losses and these 11 pips winners or whatever it is on average. 

You can do that and then when you go through the simulator and you start taking the trades, the idea here is you say, “You know what? Maybe I should give it a little bit more” I mean, I’ve just recently talked to a trader in England about this exact thing. He was saying that he was really trying to get to the point where he could push his targets up further because he understood that it would take the pressure off. It would make it easier for him to, it is a little bit of a cushion if he’ll do that. If you change your system from one-to-one reward to risk ratio to two-to-one, it changes the whole dynamics of how important the execution basically is.

Darren: I pretty much benchmark traders and strategies that I look at now by how much emphasis they put on how the trades are managed.

Walter: Right.

Darren: So, if this is really a great, if I’m reading a strategy like a thread about strategy and there’s all these information about how they are picking out the charts and how they are timing their entry and then at the end, it’s just one sentence that says, “Exit when you want. Pick what you fancy” at the end. 

This is just one line after sort of 12-pages talking about the entry. Then I can pretty much, my gut feeling is that’s probably missing the point because that’s the one consistent thing I find when I build this evidence of traders who’ve been successful. They all bang on a lot about how they manage their trades.

Walter: So let me ask you a question because this is something that I still don’t know. I know the easy way out but this is one thing I’ve been thinking about ever since I read the Scott Barlow interview in the — I’ll put the book in the show notes for you guys if you want to read it — the Nick Radge book “Every-day Traders” where he interviews a bunch of traders. 

Scott Barlow is the only forex trader in there and I mentioned him before. Basically he gets a subscription to this bank’s currency recommendations. The bank tells him which currency to buy and when to buy them and all that. He just manages the exits and he just goes for 3 to 1 target.

And so all of his trades basically have either it hit a 3 to 1 target or they get stopped out and they lose 1R and that’s it. In the bank signals that he subscribes to, he doesn’t listen to their exit. He hasn’t care why they say to buy the Euro and sell the Aussie or whatever. He doesn’t care about any of that stuff. All he wants to do is outsource the signals. 

Now, here is the question Darren. If you have a trade that goes 2.9R in your favor but never hits the 3R target and then comes back and reverses and stops you out at negative 1R, are you a good trader if you allow that to happen?

Darren: Are you a good trader if you allow that to happen?

Walter: I think he is a good trader because he is sticking to his rules. His rules are: this trade will be a 3R trade or it’ll be a negative 1R trade and that’s it.

Darren: Yeah. I mean, if he is sticking to his rules and he’s got evidence to back up that management, over a long period, his work did in the past and he’s got belief that it will take a radical change in the way that market moves for it to stop working and has set his position size correctly then certainly, yes.

Walter: If he goes to one of the forums, the free forex forums out there and he posted that and this guy manages his own money. He’s been doing it for a long time. So, if he goes out there and he posted this in the forum, he’ll be laughed off in the internet.

People will laugh because as you say and you’re right, our instincts are wrong. So people will look at that and go, “Dude, what are you doing? You’re taking these signals from some bank? Are you kidding me? Maybe they’re good but you are not even listening to their exits, their targets and you are letting these trades go 280 pips in your favor and then reverse and stop you out at a 100 pips. That’s crazy. What are you doing?”

I can tell you like people will look at that and say, “You are making a mistake. At least move to breakeven or at least take profit when it goes 2.9R.” All these sorts of things, that is what people will say and they will say that he is the village idiot. But he is following his system and the system works.

Darren: Yeah and you have to ask yourself: Are a group of people who are saying it is wrong profitable and are making a lot of money from trading? Is the majority winning? Are most people winning? 

No. It’s the people that are behaving slightly differently that are winning. It’s the small percentage and they are doing something different to the majority. That’s their edge. If everyone is jumping out of their trades early, then that is probably giving him his edge because they’re adding liquidity to the people who are still holding their trades.

Walter: Yeah. It’s crazy to me that people will overlook a profitable approach because it does not make sense. But, it is true. That’s pretty normal. It’s pretty normal that people look at something that is profitable and they’ll talk themselves out of it because they’ll say, “That’s wrong. It doesn’t make sense”.

Darren: I think a lot of the time, it does make sense to them but it doesn’t feel right.

Walter: Yes. There’s another guy who runs these thousands, he uses a machine learning and so he’ll run through the data and every week he’ll get thousands and thousands of trading system and he´ll rank them. He’ll be like, “Okay, this ones are performing well right now. So on Monday, those are the ones that I am going to fire up and start using on my live accounts.”

What’s interesting about that is the machine learning is like, you would think the sort of systems that it spits out are these really complex moving averages and bollinger bands and all these things like ADX or whatever. All of these sorts of indicators would be the backbone of the strategies but they are not. What ends up happening is, it says things like, “Buy the Euro on Wednesday at 4 pm”. That is the strategy. That’s what it gets like these are the things that come out. 

To me, I think, if we’re relying on these computers, on machine learning and neural networks and all these advanced tools to tell us what to do. Because the markets are so complex and they’re so efficient we really need to rely on computers. If we don’t do that, we’ll never make it work. And then the computers are turning around and giving us these answers. To me, what is that telling you?

Darren: It’s telling you that what you feel shouldn’t necessarily be what you believe.

Walter: Yeah, it doesn’t have to be that complex. You think it should be complex. You think you need a computer to tell you what to do. These are all the assumptions but really it doesn’t have to be that complex. You can literally have a strategy where you buy at 4pm on Wednesday.

Darren: And what you’ll find is when that rule becomes more extreme when uncertainty becomes more extreme.

Walter: What do you mean by that?

Darren: If you’ll compare say, the EUR/USD and the S&P 500. Over the last sort of 30 years, the S&P 500 is generally being one direction. It is generally being going up. So, if you are trading like a simple trend trading strategy with the S&P 500, let’s say you have a strategy where if the previous day close up, you bought. If the previous day close down, you sold.

And then you had a second strategy where you said, if it’s above the 200-period moving average and the previous day is up, you are going to buy and if it is below the 200-period and the precious day is down, you are going to sell. 

Now because there’s less uncertainty in the movement of S&P 500, it’s generally going in one direction. Whereas, the EUR/USD as being much more up and down, the more complex entry is more likely to work well in the S&P 500.

Whereas, the very simple just the previous day’s direction is more likely to work well on the EUR/USD because there’s more uncertainty in the actual overall direction. Does that make sense?    

Walter: I hear what you’re saying.

Darren: So basically, I have a very simple trend trading system that I trade in forex. One of the rules I use is, if I’m trading intraday, I use the previous days close for my direction to trade the next day.

So if yesterday closed down, I’m just going to look to short today. Now, you’d think, “That’s pretty good. That works.” So I’d do a backtest on my system and that works. That is a pretty solid way of trading. Sooner or later you’re going to get 4 or 5 days in a row and you’re just going to be trading long. You’re going to be in line with the market movement.

If the direction changes one day, my strategy changes direction fairly quickly. Now you’re going to think, “What if I add a long term trend to that as well” is definitely going to make it more accurate. That is your natural belief is but the data does not back that up.

It might have a slightly higher win rate but I missed out on more opportunities because of so much uncertainty in the direction and the movement that adding that extra layer. Just that one little extra bit of complexity to the entry actually reduces the performance.

The important thing is, that is the odds of what you believe. You naturally believe that adding that 200-period moving average is what everyone uses. I’ll add an extra layer to it is definitely going to improve it but I’ve tried a gazillion of these added layers and none of them actually improve the performance, quite the opposite.

Walter: Yes you are right, in the bulk. If you’ll look at the whole of the data but the sexiness to it is this, is that people will go, “Ohh! I just had a second loser, if I had used the 200 moving average on these last two trades, that would have saved me and I wouldn’t have these losers.” That to me, that is the big trap in trading.

Darren: Yeah, definitely. Or you have a really good strategy and you backtest it for a year and it’s brilliant. And you backtested the year before that and it’s brilliant and the year before that, it was brilliant as well. And then the fourth year back, it made a drawdown over the whole year.

So then they’ll go back and find the tweak that made that year profitable and then they’ll realize that they’ve just reduced all of the other years in their profit. Rather than just saying, “Okay, that’s fine. If I have one losing year out of every four years, that is a pretty good ratio. I can compound that up”. 

Walter: Yes.

Darren: But, it’s the obsession with the short term results. You want every day to be a winner. You want every week to be a winner and every month to be a winner. Whereas, actually a really good approach is just to say, “You know what? If I trade a whole year, what is the likelihood of that year being profitable? And if I could do, if there is a high probability of that, I could just compound that reasonable return over five, ten years and it’s really robust, I could be really successful doing this”.

But that requires you to have really horrible periods where my last three weeks had been losing weeks and I posted it on my Facebook group and some were saying, “How you’re coping with three losing weeks on the trough?” I said, “Well, if you’ll look at my results based on weeks, my weekly win rate is only 50%. So having three on the trough is not unusual.”

Walter: But the antidote for that is just building up your resilience. And so for you that might be data. You might like data is what, well actually you just cited the data, didn’t you? When you said 50%.

I believe that that is the key. How do we deal with those losing periods? How do we wait through those? If the more resilient traders are the ones that stick around long enough to see the next lucky streak or winning streak. And, the less resilient of us are the ones that kind of fall by the wayside.

There are many ways to do that. You can quit trading altogether or you can go and find a new system or you can tweak your existing system or whatever but you still kind of starting over again no matter what you do.

Darren: Yeah. I know you’re much more into this idea of people’s personality. I completely believe this that people’s personality should decide where they’ll go to trading but maybe it’s that personality trait to be able to kind of notice when your beliefs are wrong or you need to question them.

That ability to do some analysis on yourself on how you are behaving and step back and say, “Look, you’re being a bit overconfident here”. You’ve got this really strong belief in this approach but what are your results saying?” You’re not doing that well at all.

In fact, you are pretty much breaking even for the last three years but you still got this belief that this is going to make insane returns. The two aren’t matching up here. Maybe I need to step back and say, “Okay, let’s reexamine this and be a bit more honest with myself.”

Walter: Yes, and the opposite of that also holds which is we catastrophize and we say, “Oh my God! I had three losing weeks in a row. This is it. My trading is going to fall apart. I’m never going to make this work. I can’t believe this is happening to me. What am I going to do?” It works both ways, doesn’t it?

Darren: It does. There’s data out there even in retail forums. Everybody is saying the right thing.

Walter: What do you mean, saying the right thing? What do you mean?

Darren: Well, everyone is saying you’re going to have to accept losers. Everyone is saying that you need to stick to it in the long run. These aren’t unique or new ideas. This idea is everywhere about how to trade the right approach but clearly people aren’t, they’re saying it but they’re not doing it.

Walter: Right of course because people want to be right. People want to fix things. Like, Darren if you are driving your car and you hear some weird noise, that doesn’t seem right to you and the car doesn’t seem to have as much get up and go that it used to, I think that is an American term. What would you do? What will you do if that happens? 

Darren: I’m terrible with that. If anything is broken or looks like a little leak, I need to fix it right straight away and I need to fix it myself as well.

Walter: Exactly. It’s the same thing with trading. We do the same thing, don’t we? When really the deal with the trading, a lot of time is nothing is broken. It is just bad luck. You have three weeks of bad luck, that’s all it is.

In fact, it’s not really bad luck. It’s actually normal luck. It is a normal result of wins and losses. There’s really nothing there to see. There’s nothing to fix. The engine is not broken.

Darren: It is also important to appreciate that an engine in a car is not trading. An engine in a car is kind of a closed circuit and if something is not right then it is quite easy to work down the line. Pick the element that is not right and replaces it. 

When it comes to trading, you need to see yourself as the engine, the market, and the trading as being the environment that it is working in. So you are much better off to look at how you are performing in accounts by journaling and saying, “Am I following my system? Am I doing it correctly? Am I risking the right amount or sum planned out?”

That is the engine that you need to fix for trading and the bit that you don’t have control over, which is basically your results or your system performance, that is the bit that you have to see in a different light.

Walter: Yes, exactly. The key really is this I think as you’re saying is, is to be self-aware. You can become self-aware when you write. When you write down your thoughts especially if you write them out longhand and not type them into a computer.

If you write out your thoughts, you can become more self-aware. Really what you want to do here is you want to be aware of when you are becoming overconfident or when you are catastrophizing, when you are doing these things. That is the key here.

People talked about personality as if it is set in stone, that is not true. If you are not very self-aware, you can teach yourself to be self-aware. Just as if, if you’re an introvert today, you can learn to be more extroverted. All of these are true.

Those old ideas in Psychology that came from Freud were wrong. We know that. I think that people shouldn’t feel like you’re destined to you know, your genes aren’t your destiny. This whole thing in Science is swinging back the other way with Epigenetics. 

It is not true that your genes determine who you are and what you are going to do. As a trader, if you find yourself feeling like you are not very self-aware, you might feel like you are fooling yourself or you are catastrophizing or making any of these sorts of mistakes that we all make, depending on our circumstances and where we are in the equity curve, you can change that. It is possible.

I just want people to know that because this trading thing is not necessarily easy. It can be very simple but you’ve got to let it be simple. You do not have to overcomplicate it. I strongly believe in 80/20 in trading.

I think that most of the time, you can get 80% of your results. 80% of your profits from a very few number of things. One of those things is definitely being self-aware as Darren has highlighted today.

I just want to make sure that, that is really clear. Anything that you want to sort of conclude with, Darren? 

Darren: No. I think we’ve covered a lot of stuff there. Definitely have a look at this trader because he’s a really interesting guy to listened to. I love how kind of relaxed he is about it all, this very, “Yeah, you know we’ve done alright.” 

Like I said, at the start of the interview, if you have this strong belief about how things are with trading, do not ignore or blank out stuff that disagrees with your approach because that is being, looking outside of your circle of competence, is where you are really going to learn the good stuff.

Walter: Right. Thanks so much, Darren, for your time. See you again next time.

Darren: Thanks, Walter. I will see you next week.

Walter: Thanks.

SHOWNOTES:
Nick Radge’s book “Everyday Traders”

EP145: The Mathematics of Trading (Part 1 of 2)

In this episode of 2Traders Podcast, Walter and Darren dive into the mathematics of trading and discuss a numberphile who incorporates his talent into his financial decisions.

Darren talks about the importance of doing this ONE THING with your trading to mitigate risk. He also shares a unique perspective on one of Andreas Clenow’s ideas and how you can use this in your own trading to deal with unlucky streaks.

Walter examines statistics, probability and the human need for wanting to “crack the code” of the markets. Also: why do we NEED to feel like we’re in control? You will learn about the 80/20 rule (and how to apply it to trading) and the importance of beliefs in your trading decisions.

All this and more in this first part of a two-part episode of 2Traders Podcast.

Download (Duration: 26:43 / 64.1 MB)

In this episode:

00:49 – fascinating chat
02:32 – unlock the key
04:24 – balance your view
06:05 – slightly different flavor
08:00 – crack the code
10:16 – the smartest trader
12:12 – used the alphabet
14:44 – depends on when you buy
16:39 – importance of trading strategy
18:03 – what you are in control of?
20:50 – weigh it up
22:30 – the right formula
24:19 – belief on intuition

Tweetables:
Seek out contradictory data [Click To Tweet].
Everybody wants to be in control [Click To Tweet].
It’s about cracking the code[Click To Tweet].

Download The Full Episode 145 Transcript Here

Walter: Your genes aren’t your destiny. This whole thing in Sciences, swinging back the other way with epigenetics. It’s not true that your genes determine who you are and what you’re going to do…

Announcer: Two Traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.

Walter: Welcome to Two Traders. It’s Walter here. Hi, Darren. 

Darren: Hi, Walter.

Walter: Today, I thought we would talk about – and I know you know a bit about this guy. I’m just kind of learning about him. His name is James Harris Simons. I’ll give everyone in the shownotes a link to a video where you can see this interview of this guy. Fascinating chat because he is apparently really good at Maths and has done a lot of work in sort of what you would call a basic science in terms of Math.

When  he was asked in his interview, the other guy who’s apparently also pretty good Mathematician or at least interested in Math, he asked James. He said, “Hey, there are lots of people out there  who are good at Math and there are a lot of people out there who are interested in achieving a lot of money,” — or financial success as how he words it — “and why is it that we don’t see more people like you?” 

Apparently, this James Harris Simons dude is a billionaire and he has his big fund and all this. I found it interesting the way that the conversation was going because I thought that that’s kind of how… The way that this guy interviewed him, the guy who’s interviewing him is more interested on the Math-side of things and I think that’s actually why James agreed to do the interview. 

He probably gets a lot of interview requests and probably knocks back for a few. In this case, he was interested in talking to this guy because he’s more about the Math side of things. 

What are your thoughts about this guy because I know you have a bit of a background and learning about him. 

Darren: Yeah. I mean I was drawn to because you know, my belief about the market is that the Math can get you so far but as traders, what we want to do is we want to remove the uncertainty. We want to unlock the key and say, “I’ve worked the numbers out and this system is infallible. I’ve sorted and I can’t go wrong now.” That’s kind of what we are looking for.

When I first heard about this guy, I was drawn to watching it because it goes against what I believe and I think it’s really important to look at those things. Secondly, this is what we want to believe that you can just sweep the numbers with Math with intelligence, basically. We can unlock the key and he certainly backs that arguments up.

As you’ve pointed out, there’s very, very few that are doing it that way and when you hear their process and how they trade, they’ve got a lot of really smart, highly paid Math guys, Science guys. They’re crunching insane amounts of data to find these trading opportunities and they’ve been really successful doing that.

When you see things like that, you’ll think that that’s the answer. “That has got to be where I’m going wrong. I need to get more precise and then I’ll probably be okay.” If that is what you want to believe, I think deep down that is what we’d like to be with trading. That you can unlock the key and then don’t really have anything to worry about.

When you use evidence, you have to use all of the available evidence. Like you say, there’s very, very few people doing this. There’s a lot of very successful people who are doing almost the opposite of this.

I think you have to balance your view and for me it was good because it always reminds me that however much I believe in my approach and whatever evidence I’ve got to back that up and other traders who’ve been successful doing this similar approach, you should always keep in mind that the opposite approach or approaches that are contrary to what you do can still work. For me, that’s what I get from his videos. Just because I have something that I believe works and I’ve got evidence it works, don’t blank out everything else because you can learn stuff from stuff that disagrees with it.

Walter: Yeah and there’s a danger there. If we just let our bias filter out the information we pay attention to, we all kind of do that and use the confirmation bias. But, I think you’re right. It’s useful to seek out contradictory data and theories.

I find it useful to do it at the trade level. Like, when I take a trade I say, “If I’m doing this, who’s the other person on the other side that’s taking the other side of it? What are they looking at? What are they seeing? How are they viewing this differently?” To me, I think that’s useful as well.

Darren: Also, if you believe that diversification is important and you have a very singular view of how to make  money in the market and very difficult to get diversified then because, essentially, everything is going to be doing slightly different flavors of the same thing.

For me, the edge that I try to exploit is when my winners are so much bigger than my losers. If I want to diversify from that, I should really be looking at ways of using the same core ideas. Perhaps, having winners not quite as big but perhaps a higher win rate where I can risk a little bit more. You have to have, like you say, have to have that open view on what works. 

Walter: Yeah. I thought it was interesting how he basically admitted in the interview that when they first started the fund, they were sort of doing what every other fund was doing at the time. Which was, basically, looking at the fundamental information, fundamental news and analyzing the markets that way and taking positions that way.

It was only after a couple of years getting into this that they started using a data-driven approach. The interviewer was asking him, “What sort of Math or Science are you using?” He says, “It’s all statistics with a little bit of probability in there”, which is exactly how I see trading. 

I’m glad that I have at least one thing in common with this billionaire. He’s been described as the World’s Smartest Billionaire. I think a lot of trading just comes down to probabilities and stats. I mean, that’s how most of our data. When we look at trading systems, they’re all statistical. Everything. 

It’s the same statistics they’ve used in medical research. It’s the same thing that traders used when they’re assessing trading systems. One of the things you’re talking about was how a lot of us, we like to see it this way. We like to see trading this way which is if you can just crack the code, if you can just figure out the right formula, you can make a big pile of money. It’s a very common theme in trading. It’s all about cracking the code.

But I often wonder, contrasting this to the simple very few moving parts style of trading, I often wonder if you get much value as you add more variables like as you add more data, as you add more variables and more layers of complexity.

The old 80/20 rule comes into play where you can get 80% of your results from 20% of what you’ve basically leveraging. I think that last bit that you get, the additional bit that you get — and you’ll see this in statistics where they’ll throw a whole  bunch of variables and they’ll say, “Let’s try and predict how tall you are going to be. What’s your heights going to be when you stop growing.”

Inevitably, there‘s a few variables that are the ones that basically are the best predictors. And while there’s other variables that are going to help and make that prediction a little bit better, you can pretty much get away with just a handful of things which is basically like how tall was your father and how tall are you at age 5 or something like that. There’s like two things. If you know those two things, it’s pretty easy to figure out how tall someone is going to be.

I think the same thing goes for trading. Like you’re saying, I’m a big fan of simple trading systems. I think that you can get really complex with this but I wonder if the 80/20 rule comes into play here where you’re not really getting that much more bang for your bucks so to speak, when you start adding these layers of complexity.

I actually think that you also run the risk of curve-fitting or becoming too good at describing a certain set of data and then that makes it more likely that your system will fall out of favor later in the future. But, I think we’ve talked about that in the past.

Darren: I thought it was interesting that he was labelled as the smartest trader because it’s purely maths so he’s going to be smart. You could really say that the value-investors who really don’t do a lot that they’re buying good companies and they just sit and wait for them to rise over time.

You do very little and you could argue that there’s much more simpler approach. It’s smart because of its simplicity as well. I find it interesting that because his approach is really complex and it’s Math-based that that makes him smarter because when you look at the people who’ve made a lot of money, the largest percentage of them tend to be doing something very simple. 

Walter: There was an old book called “One Up On Wall Street” by Peter Lynch and he talks about that kind of like a simple idea. “Which stock should I buy? We’ll just drive by the stores and see which one has the parking lot full of cars.” I remember that.

You can make the argument that you can use very simple ideas that just cut through everything and give you a pretty good idea of what’s going on. I’m sure there are plenty of traders out there who think that they can read the balance sheet of the company then they can understand whether or not they should be investing in that sort of thing.

Peter Lynch I think at the time, the “One Up On Wall Street” book was running the world’s largest hedge fund for a while there. I don’t know. I’m not sure what happened to him . 

Darren: I’ve seen so many such simple ideas that work if you can actually buy into the idea. There’s a guy called Andreas Clenow written a really good book about momentum and he did a thing where he just used the alphabet. 

He said, “Over the last 30 years, if you pick all stocks with just the symbol starting with the letter A and then he went through the whole alphabet. Only two letters in the alphabet actually made a loss. Every other letter in the alphabet from the starting symbol of stocks made massive returns.”

He was trying to show that picking stocks or picking trade entries is not really the answer. His argument was that in a rising market, if you pick all the stocks that begin with the letter A, you actually end up with a quite diversified portfolio. You’ll end up with stocks in different sectors and it is actually quite hard to lose money if you’ll hold onto them.

I see this all the time and he did another example where you’ll just literally look at the previous year. If the previous year was up then you bought back that stock and if the previous year was down you sold that stock and then you just rotate your portfolio every month. Again, it made really good returns.

I like this approach to trading. I like this approach of losing position and looking at the big picture. Where is the money made most of the time over a long period of time? Then it’s really just a case of making sure of your risk control. 

If it just so happens that you start trading in a period where the markets stops performing in its usual manner, that you’re not going to blow up. You apply some patience to that and do it over a long time then you can make money without having to get really complex or really precise. I think that is the best approach. There’s a lot of evidence to back that up.

Walter: Who was the guy that was doing the “just buy the A stocks” or whatever? Who was that?

Darren: Andreas Clenow his name is.

Walter: I’ve heard one interview with him. To me, that is interesting but it seems like that would depend on when you buy them right? Like, if you bought a whole pile of stocks in 1999 or 2000 or something like that, some of those companies do not exist anymore like Netscape. Do you know what I mean? 

I hear those stories and I understand them, I know that that’s what people say. I feel like it still depends on when you buy them. If you bought all the stocks that were in a dow, you wouldn’t have any stocks. They’re all gone. There’s one stock left in the dow from 50 years ago. It’s General Electric.

Darren: Yeah but that would be the same for the people who did a lot of analysis on picking their stocks as well because they wouldn’t most likely pick Netscape.

Walter: Yes.

Darren: His argument is that you can do all of the analysis you want but that is not the answer. His argument really is that if you’re diversified, well that is as important as being a good stock picker.

There’s another. There’s a society where every year, they get all the top fund managers together to pick their top ten stocks for the next two years and they do like a monkey throwing darts.  

Walter: Yeah, they do that too. I think they do that in a paper.

Darren: And the monkey-throwing-darts, they generally outperformed these fund managers managing millions of Pounds. 

Walter: They used to have one that had… Like in Australia, there’s this monkey, the astrologer, and then a bunch of fund managers.

Darren: I think that was a little bit of fun but it does really highlight some important things that you have to consider. Taking it back to forex day trading which most of our listeners are interested in, this obsession with getting really precise, accurate entries is a similar thing as stock picking.

My argument is always that you should really put that as being about 20% of the importance of your trading strategy. But, it seems that is the popular approach.

Walter: Absolutely. We want to feel like we’re in control. Don’t we want to feel like we’re in control? Isn’t that the key? If you don’t feel like you’re in control then you can’t. Like allowing yourself to take a trade based on a dart or a monkey or whatever, it feels like you’re not really… It’s like picking your own lotto numbers. If you pick your lucky numbers, you have a better chance of winning the lotto.

Darren: My business partner wanted to buy the Euro Millions Lottery about two weeks ago. It was some ridiculous amount a 180 Million Euros or something. He wanted to go buy some lines and he asked me for my numbers. I said, “Obviously: 1, 2, 3, 4, 5, 6, 7.” That combination has as much chance as any other combination of 7 numbers coming up. People will never pick that. 

Psychologically, it is great to want to feel in control but the worst thing is to think you’re in control when really you are not because that’s when you’re going to lose all of your money. You have to be about what you are in control of and the only way to do that is to back it up with evidence. Where are these traders that are making huge returns over long periods of time? Being really precise with their entry and being really accurate with their entry. Now, you could argue that the guy we’re talking about today is one of those guys but you’ll find many more that aren’t doing that.

Odds and probabilities, what you’re going to base your money. Are you going to base your money on being the next smartest guy on the planet or are you going to go with this group of guys doing simple things and making lots of money over 20, 30, 40 years?  

Walter: Yes, I get your point. But, if I go to the forex forums, I don’t see simple stuff. I see like 4, 5 indicators. I see if-then rules and I don’t really see much simplicity. Maybe in years but that was I saw.

I used to see like regressions plus the zigzag and Stochastics and the moving average and all these stuff and then all will go ahead and add Martingale to it. That’s how I would see it. There wasn’t much there but I guess your argument with those guys aren’t really making money either. 

Darren: I could be cynical and say, “Well, it’s all a bluff and now I need to be making money for a year,” but that would be the wrong thing to say. There are some retail traders that are being fairly precise and using complex entries and making money. 

We can give that some sort of wait if you’re like in a strategy pool of failure. That can be important but are you going to take that as being more important from guys who’ve been around 40 years and make an average 20% a year and have never blown up and are managing Millions of money and there’s a huge group of them. Which one do you want to believe?

Which group of people do you want to believe? These guys, these institutional traders are people trading other people’s money. They have to be transparent with their performance.

Walter: Obviously, yeah. They also are restricted in the markets and the amounts because when you get to a certain size, it becomes about finding more markets more than anything.

Darren: You have to take all of the evidence and weigh it up and then get a broad idea by it. “Okay. This is the weight of evidence and I am going to base my trading on that”. The danger is if you write down all of your beliefs about how you are going to trade and how you are going to money and the weight of that evidence backing that up is slim, then you are in danger of feeling like you’re in control but really you are not being in control.

Let’s not disregard the data from brokers. Brokers have to be fairly transparent in their results as well. It’s very difficult to find a broker that says the majority of their retail traders are making money without failing. Nearly all of them are saying that the majority are losing money.

Walter: Yeah.

Darren: You have to weigh that evidence as well. It is easy to find people on retail forums that are winning. Actually, if you weigh it up, they are all bloody winning all of the time if you will listen to what they are saying. That is why you have to be a bit more open-minded and say, “C’mon, mates. Let’s weigh the evidence up here” and base your trading on that.

Walter: To me, I feel like when I first started trading, if it wasn’t complex I just didn’t believe it. I just feel like a lot of traders, they want to take the path that James Harris Simons is taking which is you feel like you need to have the right formulas or the right custom indicators and the right data and all these stuff.

It’s almost like it is the normal path. It feels like if you don’t really think about it, you’re just kind of go with what is obvious and intuitive. You would do that. You would just go for that. That would be the way.

You would want to win more often than you lose and you would want to use a high-powered computer to spit out. What should I do? What should I buy or sell here? I did that. I created a neural network based on all these data from all these different markets around the world and try to put it the USD/JPY. Like, that was where I thought I should go. 

You know how you’re saying about using different systems and specification of systems is true diversification. If you’re trading a bunch of trend-following systems, you are going to be highly correlated and you’re going to basically accentuate your equity peaks and accentuate your drawdowns. You are going to make your drawdowns deeper and your peaks higher. That’s true but you also have to believe in it.

You have to believe in this type of system, it’s going to work. If you believe that a trend-following system is going to work, are you also going to be able to believe that an end of the trend system is going to work too? Or, do you have to do something slightly different like a breakout or something? I think that is important too. You are not going to trade it if you don’t believe in it. Not long term, anyway.

Darren: I think so, to an extent. A lot depends on where you are getting your beliefs from. It is the evidence that other types of trading systems work as well as trend trading and build your belief on that. 

If you build your belief on intuition like you’re saying, you know what Psychologists say about intuition. It is really good in closed-circuits wherever there’s not much uncertainty but intuition when there’s a lot of uncertainty involved, it’s pretty much a waste of time.

A systematic model generally works better in those environments. It’s not just about your beliefs, it’s what you’re building your beliefs on. I think your beliefs can change, you have to understand them. You are right. When we come to trading our intuition tends to consider it as being something that has a very little uncertainty in it. When you learn there’s a lot of uncertainty in it, you realize that you need to start questioning your intuition and perhaps base it more on evidence.

SHOWNOTES:

James Simons’ Numberphile Full Length Interview


EP144: Broken Systems (Part 2 of 2)

In this second half of a two-part episode of 2Traders Podcast, Darren and Walter look into the “optimal risk amount” for a growing account and very few traders seem to use this risk algorithm. You’ll also hear about the trader who lost 45% of his account and is considered as one of the best traders in history.

Darren shares his hack for outperforming other traders. Hint: it doesn’t involve watching the news or reading the Wall Street Journal. Walter talks about how to adapt profitable trading habits that crush the confidence of most traders but could work wonders for you. And did you know there’s actually this one thing that you should write down before you trade any system?

The two traders also talk about a critical skill for successful traders and why this helps some traders achieve great things and others simply quit. This could be pure gold for your trading! All this and more in this episode, Episode 144 of the Two Traders.

Download (Duration: 25:04 / 57.4 MB)

In this episode:

00:53 – rule of thumb
01:16 – Darren’s hack
03:31 – setting boundaries wrong
05:12 – more profits, less risk
07:48 – informational edge
09:49 – repeating the same thing
11:05 – comfort zones
13:50 – uncomfortable areas
15:27 – different perspective
17:53 – not significant
19:41 – number one skill
21:52 – broken or not
23:10 – manufacture risk

Tweetables:
The higher the risk, the bigger the return [Click To Tweet].
Go with the simplest? [Click To Tweet].
Is it still profitable?[Click To Tweet].

Download The Full Episode 144 Transcript Here

Darren: If you’re quitting a system that you’ve tested over 10 years, after 6 months of live trading then based on that 6 months, you’re more likely to be wrong than right…

Announcer: Two Traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.

Walter: Welcome back. You’re in the right place at the right time. It’s the Two Traders Podcast and in this Episode, this is Part Two. This is Episode 144. If you haven’t listened to Episode 143, go back and listen to Episode 143. The first half of this conversation.

In Part Two, Darren and I talked about the rule of thumb for determining the optimal risk amount for growing an account and why no one trades this way. You’ll also hear about the trader who lost 45% of his account and is considered as one of the best traders in history.

You’ll also see why the optimum trading system settings are avoided by most traders. How to keep trading even when it seems like everything is working against you; Darren’s hack for outperforming other traders and it does not involve watching Sky news or CNBC or reading the Wall Street Journal or the business pages of the newspaper.

Also, we get into is this why most traders use the same profit target and what does it say about consistently profitable trading. We talked about how to adapt profitable trading habits that crush the confidence of some traders, actually most traders but could work wonders for you and what you should probably write down before you trade any trading system and keep this handy.

Finally, Darren and I talked about the number one skill for successful traders and why this helps some traders achieve great things and others simply quit. This is a key and I hope this helps your trading. All these and more in this episode, Episode 144 of the Two Traders.       

Darren: Yes. I mean, in other words, just because you’ve got a backtest over a very long period of time, it still doesn’t mean that there’s no uncertainty anymore.

Walter: Yeah, because what you could be looking at is an edge that has an expectancy of 0.1 or 0.01 or something. So for every dollar you feed to the system, you make 1 cent. That’s the kind of power you’ll get if you’ve got 6,000 trades under your belt but if you’ve got 30 trades under your belt, you won’t find that. 

You’re very unlikely to say, “Yeah, this works” if you’ve got 30 or 40 trades but if you have a lot of trades because the power goes up, you could see the really small effects. That’s the only thing I’m trying to get across because I know people understand quite easily this idea that you need more data and that’s true but the other side of it, of course, is you’ll get a great result.

Darren: What do you think of this idea of setting boundaries on your system? I like the concept that the thing that springs to my mind is that people will set these boundaries wrong.

Walter: Why don’t you allow yourself to do like, it could just be based on what you can stomach?

Darren: Yeah but I just think, a natural reaction to that is to lean too much towards comfort rather than leaning towards the optimum.

Walter: I think you’re absolutely right. That’s why most traders don’t trade anything near Optimal F. The Optimal F of course which is the best way to grow, it’s the geometric growth rate of your account. Optimal F is the way to go.

Most people can find that. The easiest way to find that is to just divide your win rate. So if your win rate is 60%, divide it by 2. Divide it in half, so if you have a 60% win rate then you should be betting 30% of our account. Which is crazy.

I think you’re right and that’s why, Darren, like you say, you’d talked about these trend followers around this 25-year records and all that and then they’ll have down years. They’ll have 2 down years and then they’ll have an amazing year next year. But if you ask them they’ll tell you that most of their withdrawdownsals come right before the big 135% year.

Darren: Yeah.

Walter: Because people are uncomfortable with the 2 years of drawdown.

Darren: It’s kind of like this idea of you can only really profit big by taking on more risk and what we really want is more profit with less risk. So what that leads us to do is actually make less profit in the end because we’re not prepared to take on enough risk.

It is difficult because risk is bad, isn’t it? Risking too much is bad. We’re always told that risk is bad. It’s tied to the profit so you can’t have your cake and eat it.

Walter: Yeah, absolutely. The classic example of that is Larry Williams who won the trading competition. He was basically trading Optimal F and he asked Ralph Vince. Here’s the point. Everyone says, “Oh, Larry Williams is so great.” He took $10,000 to 1.1 Million or whatever it was. It was something like that right back in the 80’s but what people forget is this, Larry Williams was like in a $900,000 drawdown when he won that contest.

So, he literally had peaked out at 2 Million and he won the contest at 1.1 or whatever, it was something like that. Over 12 months, he took the $10,000 account to 1.1 Million but he was like in a, it was essentially like a 45% drawdown but he kept trading. He kept going. He kept pushing on and that was the whole point.

You’re absolutely right. The reason why risk is bad, I think is because most people forget that yes, you make more money when you risk more but then the other side of that is your drawdowns are that much more painful. That’s what kicks us out of the game, it’s the drawdown. It’s always the drawdowns.

Drawdown is the thing. I believe that if you’ve kind of set yourself up to survive the drawdown, if everything you do psychologically, mathematically, everything that you do in terms of the risk side of things and the psychological side of trading, if you can set yourself up to cushion yourself and that means basically being a very resilient person, if you can do that then you can make it. You can keep playing the game but soon as drawdown breaks you, then boom! You’re out of the game.

Darren: Yeah, definitely. I think that is why this question of when is the system broken is really important. It’s what trading is all about. Can you just stomach a little bit more pain than everyone else. 

I think really that is the easiest way to have an edge over everybody else. I mean, everybody else is looking for the informational edge, aren’t they? They’re looking for their little tweak on reading price action that’s going to make them better than everyone else. Let’s be realistic, everyone has got the same information that you’ve got. The information is all out there. 

It’s a little bit arrogant really to say, “You know what? I’m just a little bit better than everyone else. I can see it when nobody else can. ” That’s a little bit, I don’t know if arrogant is the right word but it’s a little bit hurtful should we say.

Walter: Overconfident.

Darren: Overconfident, yeah. At the same time, if you’ll look at it from the pain side of things, if I can just hold on to my trades a little bit longer, I’ll know. If I’m feeling this pain then everyone else is feeling it and it doesn’t really take much. I can actually just write a very simple set of rules to follow that would push me to the other side of the pain.

If I could just do that and I can do it repetitively day in, day out actually that could be a really easy way to have an edge over everybody. That is how I try and look at it. I just want to be more uncomfortable than everyone and not do anything about it.

Walter: So, when you say more uncomfortable, you mean sitting through more difficult time as a trader? 

Darren: I mean, looking at where does everyone getting uncomfortable. I’m going to set my boundary on the other side of that. If you can go troll the retail trader forums, you’ll see that if you’ll look at the profit targets of every system and then find the average then you’ll find it’s pretty much everybody is repeating the same thing. They’re either 3:1, 2:1 or 1:1. The majority are in that zone.

You could take it two ways: That’s the right answer or that’s where most people feel comfortable. To me, that’s where everyone feels comfortable. Where do you see the threat where they’ll say, “Set your profit targets at 5:1 or 10:1 or 20:1?” You don’t see them.

I’m not saying that, that’s the right answer but the fact that there’s so little interest there suggests that it’s an uncomfortable place to be. So how about going and testing those notions of trading the uncomfortable places to be and see what the results are. You’ll find that if we’ll go back to that group of traders who have been successful over the long period of time, they haven’t even got a target.

They’re just saying, I mean, I’m generalizing, not all of them but, you’ll find that a lot of them are saying, “As long as it keeps going, I’ll stay in and when it turns around then it’ll take me out”. They have not even decided where their comfort zones is. They’re letting the markets decide for them.

It’s an idea, isn’t it? I mean, maybe you can find the easy way to get an informational edge over everyone. Maybe, you have a special skill or a higher level of intelligence than the majority. I think the majority of us are average, that’s how the numbers work, isn’t it?

Walter: Yeah, at least 68% of us. It’s true, technically. 68% of us are all clamped together and what’s the next level, 86% or something percent is pretty close to the 68% largely.

Darren: It would be interesting to find out how many consecutive losers people can take before they’ll feel uncomfortable.

Walter: It’s really interesting to say that, Darren because I’ve met with a trader, talked to a trader, a group of traders in London and one of them, he trades 20:1. His winners make 20R and his loser lose 1. What he was saying was, he’s talking obviously a lot about, he automated it. He basically trades and abandons the charts, kind of like you do.

He was saying that it’s amazing. It’s so tough when you’re up 16R to not, either you’ll go in there. He’ll go and check the EA, have a look. He’s like, it’s so hard for him to let it go because it’s up 16R so I’ll just close this one out or you know, sometimes it’ll go up 10R and it’ll go back down to the entry price and then it’ll go back up to 20R. But the good news is, it doesn’t have to happen all that often. 

He doesn’t really have to have a really high win rate and the fact that it’s all automated, it means, he doesn’t actually in theory, all he really has to do is just babysit the EA and make sure that it is running on the server and everything is fine there. He doesn’t have to actually feel like he’s the one making these decisions when 92% of the trades are losing trades. 

I thought it’s fascinating because if you’ll work out the numbers on that, if you’re making 8% winners and your winners are making 20R and so, 92% of the time you’re losing 1R. It’s a pretty good system. A really good system.

Darren: Yeah, and the thing is that when you step into those uncomfortable areas, they don’t stay uncomfortable for long, that’s the surprising thing. If you can just kind of force yourself to do it then before you know it, you’ll start finding it easier and easier and less and less uncomfortable. 

The illusion is as well, is that if you stay in the comfort zone then you’re going to avoid ever feeling uncomfortable but that’s wrong because it’s always going to come, there’s always going to be a payoff for that.

If you’ll sit on that high win rate, you’re taking your profits quickly zone then it’s going to feel comfortable for a long time but sooner or later you’re going to have a bad period and you’re going to have a bad week that wipes out 3 months of feeling comfortable. There will always be a payoff for that.

Walter: I think here you’re describing, it kind of reminds me of the people who sell all of their possessions and move off in the mountains, move off to Tibet or whatever, you’re just kind of you want to go all-in now. Actually, I had a girlfriend who did that. Before I met her, she basically left everything and move into a monastery with the monks and stuff. 

It seems like it’s such a big step to do that and leave your everyday life and do that but after a while, it’s not that bad. It’s actually quite nice to have that different perspective and I think it’s the same thing that you’re talking about trading.

It’s going to be tough in the beginning. If you’re going 2:1 on your trade to move to 20:1, that’s a big jump. All of those losers that you have to deal with and dealing with the risk management side of things knowing that you’re going to lose 92% at the time or whatever it is, it’s a tough thing to handle.

But I think it’s like everything, you’ve built up those calluses and then after awhile, it’s a little bit easier. It’s almost like building up a tolerance to a drug or something. It takes a little bit more for it to affect you.

Darren: Yeah because you’re learning a new scale. It’s like say, you’re trying to learn languages. Say you find learning languages difficult. When you first start out, it just feels like, you’re never going to get it but if you keep trying then it does sink in. 

It becomes like a behavior that you’ll learn. Maybe that is the secret, whether you actually ever push yourself into those uncomfortable areas and I think if you never do, then the chances of becoming successful in trading are probably diminished. In the last 6 months, I had a 43R drawdown.

Walter: 43R, wow!

Darren: 43R which sounds unbelievable but in the last 6 months, I made 80R back and that’s the only reason I sat through the 43R drawdown. Obviously, if you get your position size wrong then you bug it.

Walter: Yeah, you won’t survive that 43R, that’s right. It’s so funny.

Darren: The upside is that taking setups that fit my model, that meet my rules are easier now because that individual trade is not going to make a difference. It’s not going to get me to my goal, it’s not going to blow me up, it’s not significant anymore. It’s the last 200, 300 trades that are significant which means you have to be patient and that is the case however you trade.

You’ve got to have that stickability, that resilience. I listened to a really good podcast the other day about a fund that set up rather than having interviews in trying to find traders to teach to trade their strategy, they were looking for traders and test their resilience.

For the interview, they’ve got them to come in for the day and trade and they’ve just set up all of these scenarios where they could test their resilience. They were messing with their data feed and they’d sit a trader opposite them that was constantly badgering them because they were looking for how much of this quality does this trader already got. If they have got this quality then we can build on that and they can become really good traders.

Walter: I agree. There was this Psychologist who came up from the States to Sydney recently and went to where he’ll speak and he’s kind of what they call the Father of Positive Psychology. 

Part of the deal is you’ll go in the afternoon, listen to him talk and then you can go and ask him a question, have your book signed or whatever. He’s always got books and stuff. Anyway, I asked him. I said, “What is the number one skill? What’s the one thing?” and he says, it’s resiliency. It’s resilience.

I asked it kind of like from the point of view of a parent. What should you teach your kids? “Have no limits. You can do whatever you want. You can do anything you put your mind to.” I agree. I think he’s right. He says it’s resiliency.

If somebody has resiliency, they can pull out of anything. I think it’s so important to trading. Resiliency is the key. He said, they had this study, these guys contacted them from the Pentagon and they said, “We’ve got all these soldiers coming back from Iraq and they’re all messed up. What can we do about it? Basically, fix our soldiers. You talked about resiliency and how people are so able to rebound on this and that but we’ve got all these soldiers. We can’t reintegrate them into society and blah, blah, blah.”   

You know what he said? He told the General or whatever, he said, “Look, if you’ll look at the soldiers coming back from war, most soldiers within about 3 to 6 months are able to reintegrate into society.

It’s only like, 9% really have difficulties after about 6 months. 3 to 6 month into it, most people are so resilient that they’re able to get it back together. It’s only the much smaller percentage that aren’t able. So basically, the Pentagon hired his team to help these people and give them skills as they come back into society from war.

I thought it was really interesting that it’s easy to take the pessimistic point of view and say that this doesn’t work or this is so horrible or whatever, his point was, “Well, actually most people were able to do it. It’s the few that you’re concentrating on” I thought that was interesting.

Darren: What’s the broad drawdown about deciding whether your system is broken or not? 

Walter: To me, I think you’ve got to go into it with expectations set. If you’re listening to this, if you’re like me, I enter into trading thinking all I want to do is get a good system and I’m set. I didn’t consider drawdowns, I didn’t consider risk of ruin, I didn’t consider any of that stuff. I didn’t understand that.

What you need to do is based on your testing, before you go into trading live, you have to decide going in. “Look, these are the ground rules. If it happens like this, I’ll keep going. If it happens like that, something is a bit weird then I’ve got to reassess. Figure out if I still want to do this.” That point can be when you’re accounts are out of money. 

Maybe you have that ability to keep trading your account until you literally don’t have enough money for another trade. Maybe that’s what it is but it might be a different level. For a lot of traders, it’s probably a different level.
I think if you’ll go, “Look, if I hit 25% drawdown I’m going to be in trouble. I’m going to freak out” You have to manufacture your risk and set it up in a way so that you’ll think that’s very, very unlikely that you’ll hit that number. To me, that’s the smart way to do it.

Like you say, Darren, as you collect more data, you put that data into your, basically add that data to your file and say, “Okay, where we at here? Where we at in terms of, is everything about a horse or it’s totally off?” That’s how I would do it.

I think collecting your data as you go through it and setting the uncle point for you to get into trading that system, to me that’s the smart way to do it. So you’ve got your rules going into it because it’s so hard to figure out what to do when you’re under the stress of a drawdown. To me, that’s not the time to make those important decisions.

Darren: Yeah, I agree. I think it would be a good idea when you start out with a system. Write down why you’re trading the system. Why have you decided to start trading the system? What information have you got and what expectations has that led you to? 

As long as when you decide your system is broken, it’s referring back to those notes you’ve made then you’re more likely to be making the right decision. In other words, don’t jump to conclusions so quickly. I think that’s what people do.

Walter: Thanks so much for your time, Darren. I look forward to seeing you next time.

Darren: Yes. It’s good to be back, Walter. I’ll see you next week.