How important is money management for your trading?

In this episode of 2Traders Podcast, Darren and Walter explore the elements in your trading that may make a big difference to your bottom line. What are these? And how does psychology play a role in your trading success? According to Darren, trading is similar to gambling and getting your insurance policy.

Walter explores a different angle: is trading analagous to ensuring your new car? He also talks about the “brick method” and how this can help you improve the results for any trading strategy.

Also, the 2 Traders discuss the importance of your trading strategy and your trading psychology?

Download (Duration: 26:20 / 30.2 MB)

In this episode:
00:48 – a tweak
01:51 – accentuates winners
03:26 – trapped in the loop
05:30 – illusion of control
07:10 – rabbits in the headlights
09:29 – good feeling
11:37 – fixed fraction
13:09 – insurance companies
16:34 – brick method
18:45 – gap
20:25 – lock limits
22:40 – winning bricks
25:16 – pair it up

Tweetables:
Make a list of important things[Click To Tweet].
Look on money management [Click To Tweet].
Psychology is the key[Click To Tweet].

Download The Full Episode 127 Transcript Here

Darren: I don’t think the idea of risking 1% of your current balance is ideal for all strategies and again, it kind of highlights this point, that money management is important as a part of your strategy…

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 and I’ve got Darren on the line.  Hi, Darren.

Darren: Hi, Walter.

Walter: So, Darren, just before we hit the record button here, we were talking about a potential risk management strategy that I’ve been testing — and it’s really nothing new. It’s just a tweak to an old strategy. The way it works for the listener is this. Essentially, if you have a winning trade, on your next trade what you do is you’ll risk that money that you won and you’ll risk your normal percentage risk that you would have.

If you’re a trader that risks say 1% on every trade, a winning trade might return you 1%. It might return you 3%. I mean, who knows? It depends but that’s not important. What you do on your next trade is you risk all of the winnings that you had on your previous win plus your normal 1%.

And then that way, if you get another winner — it’s accentuated quite a bit but, really — you’re only risking your winnings. Some traders do this. In fact, they’ll take their account, they’ll grow their account and they’ll take all of the winnings out of the account. Reset the account to zero and get really aggressive with that little tiny account that they now have of winnings.

And it’s this kind of like doing that, but it’s doing it a different way. What I found in my testing is that, your drawdowns aren’t that bad. But, obviously, you really accentuate your winners because you get 2 or 3 winning trades and you’re really on a roll. So we were just talking about this and I was just getting some of your thoughts about this and how it related to like gambling theory and things like that.

Darren: Yeah. When you think about it rationally, it makes complete sense because if you’ve ever done a lot of testing on systems or you’ve traded a lot of systems, they all seem to have the distribution of wins and losses. It’s not linear so you get clumps of your wins together and clumps of your losses together.

Obviously, that’s because trading strategies work on exploiting particular market conditions and those conditions don’t change everyday so when a market’s in strong movement, it tends to go on longer than you’d expect and the same for consolidation. You get this clumping of wins.

It makes complete sense. We’re obsessed with trying to play with the elements that make small amounts. The difference are hard to control and ignore some elements which really could make a big difference to your profits and money management strategies can.

And I was saying, it’s similar. If you ever look at gambling websites and strategies, their approach, it tends to be more in these areas. I think it’s an area as traders, we tend to overlook or there’s something psychological that goes on that says to us, “No, this isn’t the answer.” We’re kind of trapped in this loop of looking for the magic equation and sometimes missing really obvious things.

The interesting thing is one of my trading strategies has a very high risk reward so it has very low win rates in the 20% area. But even there, there is a clumping of wins. You notice you’ll get 2 or 3 wins together and then a long period of just losing and single wins, but they still clump together.

I think with this particular idea, if you have something — lets say 40% win rate — 2 to 1 risk/reward in those kind of areas, that’s a distinctive clumping of winners in those sort of strategies. It could be a sign that it really works well.

Walter: Yeah. I mean, basically, you’re just growing your winners by… It’s like an exponential growth kick to your winners.

Darren: It’s like the whole hand thing, isn’t it?

Walter: Yeah, exactly.

Darren: Although because you’ve had a winner, there’s no guarantee that the probabilities change for the next. When you look at your data, the wins do clump together.

Walter: Yeah and obviously as your win rate increases, you get longer streaks of winners. And as your win rate decreases, you get longer streaks of losers. But like you say, you’re always going to get some clump together even with a 20% win rate, you’re still going to get clumps of winners.

I was thinking about what you were saying about gamblers. I think that gamblers have kind of come to the conclusion that they’re working inside of a closed system. In other words, the odds are set for certain games and they understand that. That’s why they’re sort of feeling around those areas that they have control over which is essentially their bet size.

The way that they use risk management and position sizing but traders have this illusion of control. We feel like we have control if we tweak the way that we decide to get into a trade.

Gamblers have kind of given up on that, haven’t they? They say, “Look, we understand that were looking within a closed system here, there isn’t really much we can do to change the odds.”

We can monitor them, like for example in blackjack, we can monitor them and say, “Okay, at this point I have a slight edge. With this other point, the house or the dealer has a slight edge or whatever.” They can certainly do that but they have resigned themselves to just focusing on risk management.

I think that’s kind of a key point you’re making. As traders perhaps were just too focused on feeling like we’re in control and doing things to make us feel like we’re in control. When really, we can exert a lot of control.

I mean, what I’ve found with this sort of risk management, it makes a huge difference in your system. I’m talking about systems that aren’t even necessarily very good. You have trading systems that aren’t necessarily that good and they’re making 7 times than what they would normally make over the same sequence of trades. To me, this is really powerful stuff.

Darren: Yeah. It is quite fascinating, isn’t it? I mean, strategies like these  can make a huge difference to the performance of a system but it’s almost like we don’t want to accept it so we’ll scratch around in the areas where you can maybe eke out a few more percent a year.

Like tweaking the entry slightly or tweaking the moving average slightly. We’re like rabbits in the headlights with that. We can’t break away from that when there’s obvious simple ways. You just don’t seem interested in that.

Walter: It’s true. It’s definitely not the sexy stuff. We want the 85% win rate indicator or whatever. That’s the important thing, isn’t it? It’s not in the way that you risk. It’s funny when you think about the companies that have the biggest buildings. The insurance companies, things like that, that’s really all they’re doing.

They’re just like casinos, really. I mean, insurance companies to me, they’re no different from casinos. They take the bets from their clients that pay their premiums then they look at the odds and work out how they’re going to make money out of the deal even though they have to keep paying out.

Casino has to keep paying out. The insurance company has to keep paying out but they have just enough edge that they make money overall. They do so much volume. So many gamblers, so many people paying premiums to the insurance company. They make this huge sums of money and trading is the same way. The way I see it, it’s the same way. We’re just doing it on a much smaller scale. At least most of us are.

Darren: You’ve got to argue that those companies — like insurance companies — clearly understand  the edge of their strategy because if they’ve got it wrong, they’d be losing money. They clearly understand what makes it work.

I think half the problem with trading is our psychology is constantly urging us to get it wrong. Everything that it urges you to do is in the areas that aren’t important and we tend to gloss over in the areas that are important.

Have you actually been sort of live testing this idea? Because, the interesting thing that jumps to my mind is how this sort of a loss aversion, fear would creep in taking that winning trade. All of that good feeling about that winning trade, the next trade sets up then you’ve got to put that all on the line again. You step in back into the trade. How’s that executing?

Walter: No, I’ve only tested it in Forex Tester. I haven’t gone live yet but will go live and I’ll post it in the forum so people can see. I think the interesting thing about this is that I’m not going to focus on the strategy. I’m just going to focus on what I attribute the results to. The strategy is not that important at all,  it’s just the risk management but I think you’re right. I think it’s really difficult, isn’t it? To give back even if it is “the market’s money”.

Darren: Yeah, sure. I mean, this would be similar to say you risk a fractional proportion of your account. So that’s 1% of your balance and obviously if you have a winner, 1% of the new balance. So your next trade would be larger than your previous trade.

Walter: Yeah it would be. You’re right. Lets say, your next trade might be risking 1.1%. If you compare it to the previous balance but this is so much more. This is so much more now. isn’t it?

Darren: Yeah. Bit, if your balance goes down you’d have to still be risking the original 1% to basically get the same effect but not as pronounced.

Walter: Yeah. That’s right.

Darren: I’ve always wondered about that. The fixed percentage of your current balance strategy always just doesn’t feel quite right to me.

Walter: So, what do you risk the fix percentage of the previous balance? Like before the trade?

Darren: I feel much more comfortable saying, “Okay, my account is $20,000. So I’m going to risk 200.”

Walter: 200 or whatever.

Darren: You know, 1%. Yeah, $200 and that’s what I’m going to continue risking. When I reach a next goal post say $30,000 or $25,000 then, I will increase. Do you see what I mean?

Walter: Yeah. So if you look at it from a fixed fractional, your last trades in that sequence are much like 0.7% rather than the full 1%, basically.

Darren: Yeah because if you have a high risk/reward, low win rate strategy, it’s quite likely you’re going to start with 8 losses. Then when your 1 win comes, trading off a much smaller size will actually reduces the effect. I don’t think the idea of risking 1% of your current balance is ideal for all strategies. Again, it kind of highlights this point that money management is important as a part of your strategy.

Walter: Yeah, its funny that it’s one of the last things we look at typically. It’s just not the focus. I think you almost have to go through so many different strategies and go down so many different dead ends before you finally come to the conclusion. It doesn’t really matter why I get into the trade. What matters is what I do after I’m in it.

Darren: Yeah and that part we tend to read someone’s trading strategy where they say, “Risk this much.” We’ll take and say, “Ah okay, that will do.” We don’t really dig into it any deeper and say, “Okay, how about if I play around with this.” It’s interesting that it doesn’t grab our attention.

Walter: Absolutely. Another thing that comes in mind when we’re talking about the insurance company is even insurance companies are always trying to look for a different angle. I notice the typical things that they’ll look at. Let’s say, if you’re insuring your car, they’ll look at which postcode do you live in. How likely is that your car is going to be stolen or something like that given where you live.

There are other things too. Like, I’ve noticed in Sydney, a lot of people who will take the ferry to work because the harbour is everywhere. You’ll see advertisements on the ferry — at least they used to have them — that would say, “If you take the ferry to work, go with us. Insure your car with us because you’ll get a much better rate” because they basically know you’re not driving your car that much.

You’re basically just driving your car on the weekend. Essentially, if you commute into the city into work on the ferry so they should give you a break because you are a lower risk. You know what I mean? They’re always looking for things like that. There are different angles and different ways to approach it. In a sense, it’s just looking at the odds from a different angle.

It’s the same way with trading. You can take the same trading strategy. Insurance is all the same strategy. They take money from people who are worried about something bad happening. Right? And they know that it’s unlikely going to happen but for a small percentage of people, something bad will happen and then will have to pay.

It’s the same with trading, isn’t it? Where you risk a little bit of money hoping that something really good is going to happen. The key to your trading success is basically how good are you at making something really good happen.

When you have a winning trade do you capitalize on it by using some sort of risk management strategy or are you so bad at it that you just don’t capitalize enough? You keep taking these 1R winners when you should be taking 5R winners or whatever, that sort of thing.

Darren: Definitely. I notice this as well in insurance companies. They do listening now, don’t they? Where you can pay a lower premium if you put this app in your phone and you take it in your car and you stay below a certain speed. They monitor the speed you’ve got and for 3 months if you drive a lower average speed, then you get a lower premium.

They’ve clearly looked at accident rates and the speeds. They’ve worked out, “If we give people this much money back, we’ll save this much money there.” They’ve looked at the whole risk/reward thing really carefully. That’s how they make their money. Like you say, trading should be the same. We’re sort of our own insurance company, if you like.

Walter: I’m thinking now that you said that, Darren, maybe I should download that app on my phone and just ride around in my bike for a while. Then I’m guaranteed the best rate, right?

Darren: There’s a really good quote from a comedian. He said that when you’re in a car, everyone going slower than you is an idiot; everyone going faster than you is a maniac.

Walter: Yeah, that’s so true. So what are some of the other strategies? We’ve talked in the past about the fixed ratio. Which is basically, once you make a certain amount in you account, your risk goes up. I think that was the Ryan Jones one where, basically, trying to build a small account rather quickly.

Then we’ve talked about this method that I’m calling the brick method where you add a winning brick to your normal percentage of risk everytime you win. What are the other ones? You’ve talked about the one where you actually risked the same dollar amount until you reach a certain goal and then you move it up which is kind of similar to the fixed ratio.

It’s a bit similar to that but there are other ones too that you can just add to a winner, right? If you have a winning trade and let’s say you’re looking for 4R target. If the market goes 2R on your favor, you could move to breakeven and then just take another position on the way to the target. I mean, things like that.

Darren: Definitely. It’s something I looked at when I’ve been playing around with my system recently with regards to risk/rewards. On the high risk/reward trades, I tend not to re-enter, add another trade, until a certain point has been reached but I find that, you can generate a similar effect by taking profit quickly and re-entering. Essentially, a lower risk/reward trade that has a higher frequency of entries.

Although the returns are different, the drawdowns are different as well. Then you can adjust for that just by changing your position sizing so getting the correct position size for the different risk/reward targets then becomes the key to how much you make.

One might have 40R return over a period and another one might have a 10. Because of the lower drawdowns, you can risk much more on the 10R return. You essentially end up with very similar strategies that are just played out differently psychologically.

Walter: When you’re in a trade like that, like a 10R trade, what do you do if you’re in  a trade on a Friday? Do you close it out and then re-enter the following Sunday evening? Or, what would you do?

Darren: No. I just leave the trade unless my entry is very close to the close price and then there’s a risk from a large gap. When you’re on a high risk/reward trade, a large gap can be a large loss so you have to use a little bit of discretion there.

But, this is a problem with really bad events, catastrophic events we tend to overemphasize how often they can happen. And I think when I’ve done testing over this year, over 2017 on E-J there was one occurence where it would happen with the gap.

I think instead of losing 1R, I would have lost about 5 or 6R. When you look at it on the charts, that one event that looks really catastrophic over the big picture of the year. It didn’t really make much difference.

Walter: Still hurts though when you get gapped. It’s one of the reasons why I like Forex charts actually because they’re not so gappy. They’re quite smooth. I feel sorry for the traders that trade those charts that are really, everyday is a gap. I don’t know how they do it, really.

Darren: Yeah. I suppose you have to have the right system and maybe you trade it with wider stops.

Walter: Yeah. I think they must. I mean, these share traders and things like that. Like the Australian stocks are very gappy and a lot of the crypto-currencies are quite gappy. These markets, I’m sure they’re great for some people but I wouldn’t want anything to do with them.

Then you have like laws and things like stories about people in the futures market  where the market goes lock limits so they can’t get out. They’re actually in a trade and soon as the market open, it goes lock limit and they cant get out. It just sounds crazy. Any other thoughts on this?

Darren: Well, my initial thought was Van Tharp. Is it Van Tharp

Walter: Yeah, Van Tharp.

Darren: He does a lot of work on this side of it, on the money management.

Walter: Yeah, money management and Psychology. He’s done a lot of great stuff. I think his stuff is mostly focused on share traders or future traders but definitely, he’s done lot of really cool stuff here.

Darren: And your current research explorations on this is leading you to think that to risk all of your previous win and just kind of get that compound and stack of trades.

Walter: Yeah. The idea is just disregard that win and use it. For example, you have a 3R so your system is either a 1R loser or a 3R winner. If I have a winner, I’ve now made 3R and I’m going to risk 1R anyway. So on my very next trade, I’m going to risk 4. Essentially, 4R instead of the 1R. Now if that wins, of course now that’s made 12R. Right? I’ve made 12R in 2 trades.  Normally I would have made 6R in 2 trades.

Now, let’s talk about the losing. If I take a trade and I lose, then I lose 1R and then I take another trade, I lose. I lose another R. I’ve lost 2R. But if I take a trade and I win, I’ve made 3R and then I’ll risk that 3R, plus another R — that I’m normally going to risk anyway — so that’s 4R. And if I lose that trade, now I’ve lost 4R. Right? Then I’m back to risking 1R again. You only really add the markets money when you have that winning trade.

The variable I’m testing now is this idea of should I reset after 1 win? So if I have 1 win and I risk that winnings plus the normal risk percentage that I normally would risk. Do I just do that once? Then if I win, “Woohoo! I made 12R.” Then that’s it, or do I do it again? How many of these winning bricks do you add up and where is the point of diminishing returns?

That’s one of what I’m working on right now. Once I figure out what I want to do, I’ll go ahead and live test it. It’s really cool when you think about it. To get to 12R, normally, I’ve had essentially, had to have 4 winning trades in a row. Four winnings in a row would give me 12R but with this strategy, really you just need 2 winning trades in a row to get to 12R. Right? So, it’s kind of cool.

Darren: Yeah. You just need to look over your testing and see how often you get those clumps of 2 consecutive trades, isn’t it?

Walter: Yeah and that will go up depending on the win rate. But like what you say, if you have a 25% of the win rate, you’re still going to get a few clumps of trades. In a normal pyramiding situation, you’re scaling into the position as the market goes in your favor, which a lot of trend traders will do. But this is not really looking at it at the trade perspective, it’s more of a sequence perspective. Like you say, you’re looking at to get a run of winners, which you normally will.

If you have a win rate around 50%, it’s easy to have a string of winners or losers. That’s definitely going to happen. I’ll put the risk calculator in for people — I always like to put that in the show notes. The risk calculator’s kind of cool because you can see what’s the likelihood of having for example having a 50% win rate.

Let’s say that my reward to risk is 2 to 1 so I’m risking 1% of my 2%. If I risk 1% over the next thousand trades, what’s the likelihood that I’m going to have basically 7 losing trades in a row?

I have a 50% win rate, a 2 to 1 reward to risk ratio, I’m risking 1%. The question is can I get 7 losers in a row over the next thousand trades? And yes, the answer is absolutely 98% likely that I’ll get 7 losers in a row over the next thousand trades.

These are the sorts of things that, obviously, if it’s a 50% win rate, it’s likely that I’m going to have 7 winners is a row too. In fact, it’s just as likely the payout will be different because it’s 2 to 1.

These are the sorts of things that traders would probably find more useful over the long haul. You can literally take a strategy. It’s okay that its not that good. But if you pair it up with a good money management and you get your mind right, you know what you’re dealing with here, then I think it’s a pretty powerful thing.

Darren: Yeah, definitely. It’s what we’ve always been talking about here. With psychology being more important and the strategy being important but because of psychology, you’ll tend to be focusing on the wrong things. A really good tip is to list the things that you think are most important and then go and look at the other things because that’s probably where the real chunks of gold are lying.

Walter: Absolutely. Well, thanks for your time, Darren. I look forward to seeing you next time. Thanks a lot for your time.

Darren: Cheers, Walter! Thank you.

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SHOWNOTES

Forex Tester
Risk Calculator

Is it possible to have too many rules for your trading?

In this episode of 2Traders Podcast, Darren and Walter dive into trading systems: how many rules should your trading systems have?

They discuss some of the biggest trading events and what impact these should have on your trading strategy.

Walter talks about how having a little of this one thing can take you further with your trading. According to Darren, finding these little things can slightly adjust your beliefs and make big impact on overcoming your trading challenges.

The two traders also give a juicy hint about a coin-based trading system for the next episode…

Download (Duration: 21:22 / 24.4 MB)

In this episode:
01:03 – too many elements
03:11 – cockpit doors
05:40 – long term memory thing
07:05 – flashing indicators
09:07 – humility and empathy
11:19 – swing the racket
13:07 – simple subliminals
15:07 – hold up or break down
17:37 – multiple regression
19:31 – a bit tighter
20: 14 – flipping coin strategy

Tweetables:
Have a bit more of humility[Click To Tweet].
Leverage your strengths [Click To Tweet].
Psychology is the one[Click To Tweet].

Download The Full Episode 126 Transcript Here

Walter: But this is probably one of the best exercise anyone can do listening to this. You can just flip a coin. Literally flip a coin and take a 5R exit, see what happens. See if that trading strategy works…

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. Walter here. Hello, Darren.

Darren: Hello, Walter.

Walter: Welcome back. We’re going to talk about do too many indicators lead to overconfidence or do indicators in general lead to overconfidence? Building off of that, what about having too many rules in your strategy? What that could mean to your trading? What do you think about this?

Darren: I think overconfidence is a problem. I’m not sure about too many indicators leading to overconfidence.

Walter: What about — sorry I guess, I kind of constructed this. What about if I reconstruct the question as this: If you have too many elements in your strategy, does that lead to overconfidence?

What I’m thinking about here is when you have the strategy and then you have all these contingencies — well, if this then we do this and if that then we do that. What you’re doing is you’ve kind of… You’re making a very complex strategy because what you’re trying to do has account for everything. What about that? That’s what I’m getting at.

Darren: I think that is a major problem and that is kind of looking at the problem. It’s misinterpreting the problem because I don’t think it’s a complex problem. I’ve done a lot of testing on this myself where I used a secondary moving average for, say, the trend and then a fast moving average for the entry.

Completely buying to the fact that this other moving average makes big difference. It may make a difference but it’s a lot less than you think. That’s what I found. Even if in cases, in certain cases, where the additional filters actually make the system much worse.

Walter: Right, that’s awesome. I mean that’s the thing. I feel like the big issue here is that traders are trading their last trades. They’re letting their last trade beat them because the last trade, whatever happened, so now we have to create this rule so that it doesn’t happen again.

This is like a normal thing in life. Big businesses are — or actually governments — are the best example of this where something happens. Like take an example, September 11th in the United States. That was awful.

It was really interesting living there at the time, where, how after it happened people were so different. Everyone basically become really nice to each other which, just setting it aside, I thought it was kind of a really nice thing.

A nice result of that but the interesting thing that occured after September 11 is essentially, these doors now to the cockpit of the planes are basically bullet-proof. There’s no way everyone, anyone, can ever storm into a cockpit of an airplane again.

That’s not going to happen. The next tragedy will be something else. They’ll do something else. It’s the same thing with trading. We come up with these rules to try and bandaid, put a bandaid on something that happened in the past.

Now, what you end up with is all of these extra rules and it’s just going to make you feel better. You’re going to feel more confident, “Well, that won’t happen to me again” or whatever but you’ve totally changed your strategy.

You’re trading something else and you’re adding degrees of freedom which is a terrible thing. I believe like you, Darren, that one of the most powerful ideas in trading is to have a very simple idea that doesn’t have a lot of moving parts. Those are ones that are usually going to be robust and last the longest.

Darren: Yeah. This desire to remove all of the unpleasant elements possible. It’s kind of this deep belief that if there’s a bad feeling associated with your trading strategy then there’s a problem with your trading strategy. Not that you’ve just got a problem dealing with any downsides.

Walter: Yeah, exactly. It’s really you, isn’t it? It’s not the strategy, it’s you and you’re upset that the trading strategy didn’t pull a profit or whatever.

Darren: Yeah. And I think there must be parts of life where we are much better at dealing with those downsides. I suspect it’s where we are more in control of the outcome. Is it particularly trading or is it just things with a lot of uncertainty and risk? Is it the money? Is it the money being involved?

Walter: Yeah. I think people who play trading like it’s a game do better than people who think about, “Oh, wow! I can take that money and go on holiday” or whatever go buy a motorcycle or something. I think people who look at it that way as if they’re playing a video game, they tend to do better.

Darren: We see with traders that have been around a lot longer that have already made consistent money, they seem to get better dealing with the negative effects of a strategy. As an example, I always mention Dunn Capital. He can have losing years but when trying, change his strategy. Whereas a new trader who’s been trading for one year, if he has a losing month or even a week, that might make him change his strategy.

When there’s this kind of a bit of a long term memory thing here and if you can just say, “Okay, my aim for the next three months is just to grind out a losing spell or a drawdown. I’m going to just go wait for the next drawdown and I’m just not going to change anything. I’m not even going to debate change. I’m not going to go look for different entries. I’m just going to see if I can get to the point where I would recover that drawdown and get comfortable with that uncertainty and those bad feelings.” I think it’s a major hurdle. If you can do that then maybe that is one of the keys.

Walter: Yeah, I agree. But, it’s just so much easier to add another indicator to your chart.

Darren: Yeah, definitely.

Walter: It is. It’s like it’s setup. There’s certain things when you have kids around the house, you’ll look at those in a totally different light. You’ll say, “That could be turn into a step and then they could dive into an aquarium” or whatever.

You’ll look at these things and you’ll think that can be used as this. I look at the same thing with these charts and I see these advertisements for… You get all these advertisements for brokers.

They talk about how they’ve got all these indicators of these flashy charts and everything. It’s like the charts is just beckoning you to add as many flashing indicators as possible. It’s just insane, really. It’s crazy to me. It feeds into this. It feeds into this idea of adding complexity to make it better

Darren: Yeah. You could argue, really, that people with certain — I know we’ve talked before about this idea of certain personalities are better suited to trading and I’ve kind of being a bit where I’m not completely sure about that — but maybe people who are just really good at looking at both sides of the argument or accepting that they’re maybe on the wrong or being about to have a debate on something and see both sides of the debate.

These personality traits which are not common in a lot of people, to be honest, are probably best suited to being a trader. I didn’t want to vote for Brexit. I wanted it to remain in the EU but I can see some of the points for people who voted out.

It doesn’t mean I necessarily believe they’re right but there’s elements in both arguments that could possibly be true. It’s really hard to do, isn’t it? Because, it’s just not about you. It’s about your cultural group and groups you’re associated with.

I saw a talk recently about global warming and why with so much evidence that global warming is happening and that humans are pretty likely affecting that. Why so many people are still kind of resist those arguments.

I think all of these things are playing to be becoming a better trader and I think if you can just stop and say something like Brexit that you are really strongly on one side or the other, if you can start to just say, “Okay, let’s reassess this. Let’s have a look at the other side of the argument.” If you can have a bit more of humility, I suppose, or empathy.   

Walter: Yeah, absolutely. Humility I think is a big one for traders. In my opinion, I think that’s why female traders often do better as a whole than men because men hold on to their ideas of wanting to be right and, “I did this. I would want to make back that money so if I lost 5% of my account, I would want to make back that 5% the next day” or whatever.

You kind of getting into this tug or war with the markets. But, your idea of personality I think is interesting because one of the things I always laugh at is that traders think that they can just copy another trader and everything will be fine. That doesn’t necessarily work another thing.

I can watch all of the videos of Tiger Woods swinging his golf club or Rafael Nadal swinging his tennis racket and I could try and make everything the exact, do the exact same thing that these experts are doing. It doesn’t necessarily mean I want to play tennis as well but I can take elements of that and I can leverage of my strength.

For example, your strength might be different than one of the listener. You might have the strength of essentially self-reflection. Being really good at looking at, “Why am I doing this? Is this going to be helpful? Am I following into a trap here?” Just thinking about your trading in that point of view.

It’s something that keeps coming up. Is this going to be helpful or should I be working on this? And, another trader might be exceptionally good at keeping records so that trader might be able to take very good, have a very good journal of why they took a trade and what they’re feeling. Have a screenshot of before, during, and after the trade and have this wonderful records of all of their trades.

They may not be as self-reflective as you but they can leverage their strength with just to be conscientious with their records and they can learn about themselves through the records. You see what I’m saying?

To me, that’s the great thing about trading. It’s that even though we can all sit here and say, “Everyone needs to do this” or “If you do this, you’re going to shortcut your way to success.” It’s not the case that we can all swing the racket like Rafael Nadal and we can’t also reflect like, Darren.

We can leverage our strengths. We can still leverage our strengths and we can still find something there. I think that’s the big story here with trading. Is that there’s so many different ways to make it work. It’s not that you have to follow Darren’s way or my way or whoever. You don’t have to do that but what you do have to do, I believe, is figure what you’re good at.       

Darren: Yeah. All the kind of proven ways of, you say, you need to kind of find things that you need to work on. Parts of your psychology you need to work on and that kind of proven ways and techniques of improving. You’re too impulsive or you’re too impatient or other good ways of getting better at these.

Walter: Yeah. Well, it depends on who you ask. If you ask Freud, he would say “Yes, of course. Lie down on my couch, we’ll talk about your dreams.” Freud actually moved away from dreams, initially thinking that was where you’re going to get the gold. And then, he moved later on to free association where he says a word and whatever pops into your head – the first thing in your mind.

If you’ll ask Skinner, the Behaviorist, he would say, “Yes, of course you can. All you have to do is reward yourself for doing the right thing and setup a reward system.” It depends on the theoretical orientation or whatever.

But to me, the subconscious has been the key, and I know some people are going to laugh. This is crazy but that’s the great thing about life. Everyone can take a different approach but for me, the data and the results that I’ve seen with traders who used simple subliminals has been exceptional.

There are subliminals that you could use. I’ll put them in the show notes for things like over trading so impulse control. If you have this problem where you know you should seek your system but you don’t and you take trades just based on some tip that you saw CNBC or whatever, Fox, or Sky news. That sort of thing.

If you have that issue, if that is your issue — impulse control — there’s a subliminals for that. There’s a subliminals for people who have this idea that money is evil and deep inside they know that they shouldn’t be making money as easily as clicking a button on a laptop.

For trading, you make a decision. You get paid for taking a risk and making a decision, that’s basically what we get paid for. Those sorts of things, those subliminals are quite good and there’s a pretty good body of research that shows that these subliminal tracks actually do affect behavior. For me, that’s the simplest way because you don’t have to do much. You just kinda have these playing in the background when you’re working or sleeping or whatever.   

Darren: Alright. Going back to the indicator thing then what’s the rule of thumb with indicators? How do we know if we are using too many and how do we know if we are using them right or whether we should use them at all or have none?

Walter: Well, one of the fascinating things I’ve learned from the guys that do the automated backtesting where they’re looking to make algos and stuff, one interesting way that they do it is… Let’s say for example, you, Darren, you have a system that uses the 6-period moving average and that is one of the critical component of the system. What happens if you use the 7 moving average or the 9 or the 4?

What these guys will do, they’ll run that through and see does the edge still hold up or does it break down? That’s a logical thing. If you’re purely a discretionary trader, you might think there’s something magic about the 21 moving average or whatever it is so they do that.

They’ll just slightly shift it up and down and then they’ll say, “Okay, is this still going to work?” Let’s say you’re using an exit which is at 3R exit so you’re looking to make 300% of your risk on the trade and you just let it go. See if it’s going to hit your 3R exit or it’s going to stop out at -1R so all of your risk money is gone.

Now, what happens if you test a 2.8R or 3.3R or whatever? Does that really change it? I think that’s a useful way to see. I think that if you have too many indicators on your chart, there is a likelihood that you could lock into something that works really, really well over a short period of time and then outside of that little time window, it completely breaks down but that’s just my belief.

I could be wrong on that. I just believe that in other words you can almost like curve fit where you have everything set up perfectly for the 6-month window. Outside of that, you’re just totally throwing your account into the fireplace.      

Darren: The problem with too much backtesting like curve fit. I think what you’re saying about testing in different indicators and variations on moving average is really important to get that data and then actually use that data as well.

I see often people will pick the data that confirms what they already believe and then just gloss over all in that. What’s really important is to get that comparison and then actually take on board what the data is telling you. That’s something that we seem to really have big problem with.

Walter: Yeah. And if you’re a discretionary trader, you could just pull off indicators. Let’s say you have five indicators, you could backtest 4 out of 5 just keep testing 4 out of 5 and keep pulling off each of the 5, seeing what happens when I do that, what happens if I take off 2 and just test 3 out of the 5. That sort of thing.

You could do that if you’re statistically inclined or using some sort of algorithm. You can also do a regression. Multiple regression is basically where you’re trying to predict a curve based on a bunch of variables.

Now, statistically the program can spit out and tell you how much each of those indicators contributes to that. You could statistically go, “Well, the MACD is only really just giving me 5% of the overall power. It’s really kind of a prediction of the curve so maybe I can just delete that.”

If you’re really mathematically inclined, that’s another way to see it quite obviously and just go, “Yeah, okay.” If you’re a discretionary trader, you can do the same thing like I said with the pulling them off the chart.

You can just also flip a coin. You and I, we’ve talked about this before but this is probably one of the best exercises anyone can do listening to this. You can just flip a coin, literally flip a coin and take a 5R exit, see what happens. See if that trading strategy works.

Darren: Yeah. So many of those random test or a random selection of direction or just super simplifying strategies, think you can kind of need to do this research to make it clear  what’s really going on. What sort of game you’re playing and I think we don’t do it. We go for complex solutions.

Walter: Why do you think that? You and I both know logically that I could flip a coin and I could place a 5 to 1 reward to risk. I’m risking 40 pips to make 200 pips, I could do that and that’s probably going to make money. I’ve tested that and it does make money.

I tell and say to people when they’re worried about a strategy, “Well, just look at the exit. The exit is probably going to help you here if you’ll just make that a little bit tighter. Make it a higher reward to risk ratio.”

Yet, you don’t trade. Do you trade that system? Do you trade a system where you flip a coin, literally flip a coin? Take a trade and just walk away?

Darren: I don’t know but I’ve tried to get as close to it as possible.

Walter: I don’t either. That’s awesome. Let’s talk about this next time. I want to talk about Darren’s almost flipping a coin strategy next time we get together because I really want the listeners to hear this. This is going to be a good stuff. Let’s talk about that next time. Are you keen?

Darren: Yeah, definitely.

Walter: Okay, next week. Next podcast guys, we are going to talk about Darren’s almost flipping a coin strategy. It’s going to be awesome I can’t wait. So, any final thoughts about having too many rules for this episode?

Darren: No. I think we’ve covered everything really, Walter. As always, Psychology is the one.

Walter: Everytime we set sail and run the boat, we think we’re going to this and then the winds come up and we end up back but that’s alright.

Darren: Yeah. It’s difficult to get away from it though. Where are we going to go? Unless we come back next week and we both completely change our beliefs.

Walter: Exactly. Cool! Alright, Darren, we will see you next week. I can’t wait to talk about the almost random flipping a coin entry strategy. Let’s do it.

Darren: Yes, Walter. See you next week.

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SHOWNOTES

SUBLIMINALS
Impulse Control
Money Management
Ultra Prosperity

Did you make a mistake on that last losing trade?… Or was it just bad luck?

In this episode of 2Traders Podcast, Darren and Walter examine causality bias and why humans tend to look for reasons behind everything – including trading results. Walter takes on the idea of fate, horoscopes and star signs and how we cannot control everything that’s happening. He also touches on the complexity of human psychology and the one best solution to overcoming your habits that don’t serve you well.

Darren talks about complexity bias and how humans tend to solve problems through assumptions. He also delves into the two biggest benefits of journaling in this episode.

Download (Duration: 30:02 / 34.4 MB)

In this episode:
01:06 – causality bias
03:04 – digging around
05:30 – need or want
07:27 – complexity bias
09:51 – simple rules of thumb
11:12 – you should fix “you”
13:25 – super complex
15:18 – win by losing
17:47 – ice cream ad
19:15 – we’re all the same
21:47 – beauty and the beast
23:38 – blockers
25:29 – magically drawn
27:18 – psychological strategy
29:10 swear up and down

Tweetables:
Trading is chaotic[Click To Tweet].
Get past what you need [Click To Tweet].
Work on YOU[Click To Tweet].

Download The Full Episode 125 Transcript Here

Darren: Until you accept what we know, what we can prove and what we can’t prove, then you’re going to make cognitive errors all the time…

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. Walter here, hello Darren.

Darren: Hi, Walter.

Walter: How are you going today?

Darren: Really good. Just came back from a few days from the beach.

Walter: Awesome! Excellent stuff. The question we have today is do we “need” to explain what’s happening? In other words, “Why we’re having a losing streak or whatever?” or “Should we have to explain things when we’re trading?” or “Is there a better way?”

Darren: Yeah. This is the causality bias, isn’t it?  That’s what we’re talking about?

Walter: Yup.

Darren: Yeah. It’s one thing in trading that really annoys me. I dislike it but it does seem like something that’s ingrained in us as humans — this need to have a reason for everything and we particularly like doing it with trading.

I think that’s because of the nature of trading itself. There’s a lot of uncertainty there. We know that but we’re never particularly happy with it. We are much happier if we can give a reason for every twist and turn in the market for everytime we lose or even everytime we win.

I’m guessing at some point in the past, when life was there’s sort of things we dealt with were much more simple, that was probably really very beneficial for us to be able to do that because you could learn from that.

But, I think the problem with trading is trading isn’t simple and you can’t even say it’s complex. It’s chaotic. There’s masses of uncertainty. I think trying to use causality, trying to explain why everything is probably detrimental to us.

I really try and avoid it at all costs but it’s a big part of trading. We do like it. We like to tune in to people that’s explaining why the markets going to do this today or why the market did that yesterday. We really like that and we hook on to it very quickly without really questioning it.

If it fits what we want to hear, then we’re unlikely to do it anymore. Sort of digging around to find out if it’s true or not. If you had a line, $1.30 and that’s being explained as the reason and the explanation agrees with that, we’re going to lap it up. I think it’s a kind of dangerous bias to have.

Walter: Yeah, it’s interesting. I wonder what trading would be like for people who just decided, “You know what? I am not going to try to explain why I have a winner or a loser. I’m just going to take these trades. I’m just going to go for say 5 to 1 on all the trades and I’m just going to concentrate on myself, in trying to calm myself down, and keep myself on track with this 5 to 1 strategy.” I wonder how a lot of traders would do if they just did that.

Darren: They’d probably be profitable.

Walter: Exactly. Yeah.

Darren: There’s data to back that up as well. There is data to back that up and you can get your own data to back that up as well. It’s called back testing.

Walter: Of course. But the thing is, Darren, here’s the thing, we know as humans we have horoscopes and star signs. Some people would say, “I didn’t really have control over that. I see now, looking back, that was God’s will. God’s will made that happen. That’s why that happened it was God’s will.” Or, “the reason why I’m doing this is because I’m an Aquarius.” It’s like almost part of being human.

Even one of our heroes, the Taleb book. Nassim Taleb’s book, “The Black Swan”, he talks about how as humans, we need to  explain things. We piece it all together after the fact, sort of hindsight bias.

We have this need, this yearning, to explain things whether or not the explanation is true or not. I’m not arguing that it is or it isn’t God’s will, or it is, or isn’t the fact that you’re an Aquarius and why you do this or that or the other.

All I’m saying is for trading, just looking at trading, is it possible that we’re going to give ourselves a handicap if we rely on this? Are we  better off trying to fight this and trying to work on our own thinking rather than succumbing to this?

Darren: Definitely. And, I think when the key things is to get past in trading, to get past what you need and think more about what you want. If you want to feel comfortable all the time and assured and remove uncertainty, that’s good. That’s naturally how you’re going to feel. But, if you want to make profit then you have to approach it differently and that I think is the battle. That is why trading is so difficult because what we want and what we need don’t match up.

Walter: Yeah, exactly. Two things that come to mind when I’m look at I’m losing trades. I’ll ask traders, “Why is it that we have this streak of losing trades?” We have 7 losing trades in a row, why is it? And traders will come up with all of ideas, anything under the sun and yet I believe that there should only be one reason in this. It’s just bad luck. That should really be the only reason.

There should be no other reasons. It shouldn’t be because my broker’s screwing me or it shouldn’t be because Donald Trump sent another Tweet. It shouldn’t be because the markets have changed and my strategy no longer works. It really should be because of one thing and it’s just bad luck. I mean, that’s true. What say you about that?

Darren: Yeah, a hundred percent. But, luck again is one of these things that people really have an issue with because it is challenging those biases to accept that there’s luck involved. I’m always bringing up this point about how much of an effect good and bad luck has on your trading result and you get responses like, “Well you know, it depends on the strategy. My strategy doesn’t have any luck involved.”

I think one of the other important biases is in all this is this complexity bias. We like to see problems have a lot of uncertainty where you have to use a lot of assumptions. We like to label them as complex so we go searching for complex solutions for these problems.

Whereas, when there’s a lot of uncertainty, you really don’t know or you can’t plan what’s going to happen next. The problem is chaos. It’s a chaotic situation. In those scenarios, it’s much better to go for a simple solution. There’s a really good rule of thumb and that is if you’re making a lot of assumptions then the solution is probably the simplest.

Recently, I’ve been having an argument with people about, “Has entry got an edge?” The problem with that debate is there is no answer because you can’t prove it. I mean you could say, “Well, here’s my proof that entry has an edge” but the problem is you can’t prove that it was the entry that generated the edge.

It might have just been good luck. It might have just been the market condition at that time. It might have actually been how you’ve managed the trades and you can’t really pinpoint where the edge is coming from. All you know is that you used a series of things and it generated an edge so that makes it. Is it a problem of chaos and not complexity because there is no answer? You don’t know.

Walter: Yeah. Well, you can always argue like I’d say, “Darren, I’ve got this great thing. This moving average gives me a great edge.” Then you could argue, “How many trades do you have?” And I say, “I’ve got 700.” And you could say, “Well over the next 14, 000 trades or next 2, 000 trades, that edge will probably erode or get back. Like, it will give back or regress to the mean or whatever.” You could argue that as well.

Darren: Definitely. And, that really is my point. You don’t really know and you’ll never know. Rather than trying to getting an answer to that, you’re much better just say, “Okay, well, you never really know. So, what’s the simplest way to go about this problem?”

You look for a simple solution, some simple rules of thumb. That’s the best way to kind of go about it, I believe. That’s why Psychology, I think, is the most important thing because until you kind of accept what we know, what we can prove and what we can’t prove, then you’re going to make cognitive errors all the time.

Walter: Right. The questions comes out something like this: “I have this strategy but it’s not good enough. It doesn’t have a high enough win rate.”  Or they say, “I really want to have a strategy that has a win rate of X, 70% or whatever it is.”

Sometimes, you can ask yourself this question: “If I had to choose between making money and being right, what would I choose? Which one would I choose?” I think if the answer is you’d really rather make money than just being right, why not choose a strategy where you don’t have to be right 70% of the time. Instead, you can be right 40% of the time or 35% of the time but you’re going to make a lot more money.

The reason why, of course, is people don’t like that. It’s uncomfortable, it’s difficult. It’s very difficult through losing streaks which happen all the time blah, blah, blah. It’s a difficult way to trade. That’s the main reason. But then, we come back to then you need to work on YOU. That’s really the key here. You work on you, not the trading system. You shouldn’t fix the trading system. You should fix you.

Darren: Yeah, definitely. And it’s one of the hardest things to do. I’ve recently been chatting with traders about this idea of where edges lie and do really simple ideas have edges. We’ve run tests. To be fair, I haven’t run the tests.

One of the members of the group has been testing this over years and years. Just running test on really, really simple ideas. As simple as you can make strategies. The interesting thing is that all of these end up with positive expectancies. All of them.

You start having to question, “Well if this is true then how come it’s so hard to make money trading?” You know the big conclusion that we have come to is that people just don’t stick to it because all of these systems have periods where they perform badly.  But, at the same time, over a long sample they all make profit. The simple rule of thumb is like you say, the problem is with the trader because they’re failing to deal with the bad sides of the strategies.

Walter: So basically, the solution is to work on yourself and to be able to teach yourself to execute the strategy, essentially. The other side of that coin is understand probabilities and understand the math behind the way you’re trading it because you might be trading that strategy in a manner that guarantees you’ll have a 37% drawdown and you freak out when you have a 22% drawdown. That’s what I’m hearing. You can have strategy that potentially with compounding and such you can reach all of your life goals within 5 or 6 years but the real problem is how do you teach yourself to keep trading it.

Darren: Definitely. The interesting thing when you mentioned the math is actually really simple maths as well. It’s not really super complex. I think people see hedge firms and big firms using this really complex algos. They’re just trying to squeeze a little bit more blood out of a stone. You don’t need to be that complex. It’s highschool math.

So, again, simple things work with that as well. When you talk about being able to manage yourself in that when it comes to forex education, this is kind of one area where it is worthwhile spending your money on a coach because even expert traders will benefit from having a coach who basically monitors their actions and their behaviors.

Walter: Yeah. And, if you want to do it on the cheap you can get an accountability partner. You can get somebody. Essentially, like a performance coach or someone that you’re going to be accountable to. You can also find a trading buddy that you’re going to Skype every week and you’re going to lay everything out just as he or she will do for you. That’s another way to do it on the cheap.

Looking back, if I had figured out how to backtest in Forex Tester and if I had someone that I was accountable to every week, that would have made the biggest difference. I kind of did for about 6 months or so but the problem was we didn’t really treat it the way we should have.

We should’ve have like these meetings where we talk about what we did this week, whether or not we stuck to our rules and instead, we were just talking about trades and trading war stories and crap like that, which doesn’t really help.

Which is another thing, I believe, sort of along the lines of the Ed Seykota. Ed Seykota said everyone gets what they want out of the markets. People can win by losing — I’m just paraphrasing or something like that. Sometimes, what people want as traders, even if they won’t necessarily admit to this, they may not necessarily even know that this is the case because it’s kind of a subconscious thing but they want to be able to tell the war stories about this great battles they had with their trades and that’s how they win. What they’re getting out of trading is having all these stories so that they can tell other traders about them which is a fascinating thing when you think about it.

Darren: Yeah. It’s amazing how the ability we have of being able to lie to ourselves and completely cover up that fact that is going on. It’s amazing that we don’t just say, “Hang on a minute, that isn’t really what happened.” That comes from a subconscious thing, doesn’t it?

It’s an emotion, I suppose, where we’re afraid to say, “Look, I just didn’t stick to my system.” We naturally get into this defense response of saying, “Ah, well yeah but the ECB release came out and we’re just some bizarre thing where quite simply what we did was we know we broke our rules. We closed our trades early.”

Walter: It’s so true. It’s interesting because as traders, we feel like we’re in control because we’ve read the news or we’re aware of the news or we understand how this indicator works or whatever and yet it’s just a crapshoot. You can literally flip a coin.

Darren: Definitely. And it’s why I strongly argue with this “the entry doesn’t matter.” When I’m making those arguments, it’s not really that the entry doesn’t matter. It’s that because it’s so significant to you. It’s more likely to be a lot less significant. I kind of accepted really that we try and fool ourselves with this very uncertain risky situations so more significant stuff fills. I try and reverse that one instead.

I noticed, I used to do this when I was a kid as well. If someone advertise something on tv, say an ice cream — this is like the new super chocolatey ice cream — I deliberately not buy that ice cream because I felt like they were trying to lure me into buying it.

And the way to win the argument really was just to deliberately not to buy it even if I fancied one of those ice creams. You know when someone’s marketing something to you with an advert, they’re trying to lure you into doing something. I would deliberately fight against that.

Walter: Yeah, definitely.

Darren: I’m definitely not going to buy that ice cream even though I quite fancy one because you’ve laid a plan that’s going to make me buy it so I’m deliberately not going to buy it. I try and do that with my own psychology now.

As soon as I get that urge or it’s not quite reach my TP, I think I’m going to close it now. Then I have that instant response, “Okay, this is what I’m feeling I should be doing so I’m definitely not going to do it.” I use that as my way of dealing with these urges and these biases.

Walter: Yeah and I think a lot of traders are probably like I always sort of fight trends with people who are always wearing a certain thing or whatever. I was just like trying to go against it. It’s just in my nature. I think it’s more fun to try and fight it.

It is crazy when you think about it, how you look at people and we’re all the same. It’s like looking at animals in the zoo. Like, everyone’s doing the same thing. That’s just crazy but I think that’s what makes us as traders too. It’s the fact that were like a contrarian. A lot of traders are sort of contrarian by nature.

I think investors tend to be more herd followers, in my opinion. To me, an investor is just a trader who doesn’t have a stop loss and just kind of only buys things. Like, the bitcoin right now. As we’re recording this, bitcoin is a big one.

So, you have all these “bitcoin traders” but really, what they’re doing is buying bitcoin hoping it goes up and not really having any sort of stop loss or any way of mitigating a risk. I could be wrong but I think most trades tend to be sort of contrarian by nature. Yet, we don’t apply that to the psychology side of things as we should.

It’s basically your point. We need to shift our focus from contrarian in our approach to other things and look at it. That’s why I think it’s helpful when you look at a trade you’re saying, “Who’s the other person at the other side of this? I see a bullish market here, I see an opportunity to buy. Who is the person that’s selling here? Who would that be? What would they be looking at?” I think that’s a really useful exercise.

Darren: Yeah. Well if we go back to the original question, this “need” to explain what is happening, it is actually something really good to do but you should be doing that on your psychology and your decision making. Like you say, the psychology in decision making of the other participants in the market, not the actual what happened on the charts.

That’s what we really need to be explaining and if we made notes on that, what we’re  feeling when we closed that trade and how much of that feeling did we have, were we anxious or scared? Assessing that, that could lead to much better decision making. That’s been tested and proven.

Walter: Yeah, exactly.

Darren: There is a really good book on this, the “Storytelling Beast” or something. I think it’s called the “Storytelling Beast”. It’s about the psychology of using stories and where it comes from and where it’s beneficial to us and when it’s clearly not. I’ll find the link for you.

Walter: It’s not “Beauty and the Beast” storytellers?

Darren: No.

Walter: Okay, we’ll put it in the show notes. Okay, cool. So, Darren, what about journaling? I know you’re a big fan of the journaling. I think that for traders who realized that they had this need to explain things and potentially could be an issue, what is the antidote?

I suspected one useful antidote would be just journaling. There’s two parts to this. One is journaling about your trades; and the other one is actually go back and look, read at what you’ve written in the past because you’ll notice your growth. You’ll see your growth overtime.

Darren: Yeah. Actually, I think there’s two benefits of  journaling. One is the obvious that when you look back over the previous week, you’ll basically add lots of biases to what really  went on. To make you seem really smart. Why you didn’t make any mistakes or your losses were bad luck and all your wins were pure skill.

So for that reason, it’s really good to keep a note of all your trades. But, it’s also a good way of breaking the link between emotions, decision making and actions. For instance, when you’re about to make an important decision in your trading, if you write down at that point what you’re feeling and what your actions going to be — basically write down what you’re planning to do — you’re less likely to make bad decisions.

This is some research that comes from Denise Shull about emotions and decision making. It acts as a blocker from making mistakes, particularly ones that you make repetitively and often.

I always use this as an example. If you’re always closing your trades early when you get that feeling that you’re about to close a trade, if you stop and write down why you’re closing it and what you’re feeling at the time, you can reduce your errors.

Walter: Yeah. To me, the value in that is bringing up to your forebrain to your planning area of your brain. It’s out of the emotions center, that makes perfect sense. This is a really difficult thing for traders who are trading the lower time frames because they’re at the heat of the moment and they feel like they need to make snap decisions and they’re under the gun.

It’s a little bit easier, I believe, if you’re trading time frames that take awhile to unfold so it’s a little bit easier to plan things out and think it over. But, if you keep taking profit early, first of all you’re not alone. It’s probably the most common mistake that we’ve seen. We’ve seen the data, right? The 43 million trades that you’ve posted. That article in the forum which was awesome and that just highlights the big problem. It’s that it’s not being right.

These retail traders are right, but they largely lose because they take profit too early. It’s a very common thing. So, just by writing it down can help. Any other thoughts?

One of the things that comes into mind — I know I keep using this example — but the woman who keeps getting attracted to the wrong types of guys. She keeps falling into these relationships where the guy is abusive or whatever. Yet, every time she gets out of the relationship, she goes and finds another abusive relationship. She just is magically drawn to these.

Some of these mistakes, you’ll notice, are recurring and you keep doing the same things with your trading over and over again. To me, there’s a deeper issue there that you might have to deal with. Working on your subconscious, things like that. I think those things can help as well.

It makes sense to write it down and journaling can definitely help by bringing it up and getting logic involved instead of just pure emotions. But, at the same time, if you keep doing the same thing over and over again, at a certain point you have to decide where is this coming from. Whats going on here? How do I deal with that? To me, that’s a subconscious thing.

Hypnosis can work for many people. Hypnotherapists are really good at figuring out how to change habits. The bread and butter for a hypnotherapist is someone who comes in, they want to quit smoking; and someone who comes in, they want to lose weight. Those are habit-based things. They can work with traders as well. They’re not used to doing it typically but they can certainly help you.

I would also encourage people to look at the subconscious side. If they feel like they keep doing it over and over again and they just feel like they’re out of control, get a trading accountability partner, write it out before you execute and maybe look at some subconscious tools such as hypnotherapy. That would be my sort of list there. What about you? Do you have any other ideas for traders?

Darren: Well I think all of the things we’ve talked about today are the important things. Perhaps, rather than focusing so much on the technical side of your strategy — which is what we like to believe is the most important part — I think really doing some work on a psychological strategy. A strategy that deals with psychology rather than particularly technical.

Like you were saying about one of the issues with trading on a short time frame is disability to have time on your decisions and perhaps break chain of errors that you’re making. That is changing to a strategy that, technically, the shorter time frame is going to offer more opportunities. The potential to make more money is on the shorter time frame but that is basically disregarding psychology completely.

So sometimes, the technical elements of your strategy should be there for psychological reasons. I’d argue actually that that’s probably more important in the long run than whether it’s the best entry on paper. What you should do, there’s rational behavior and is what you actually do. You’re much better to build your strategy on you actually do rather than just the numbers. You have to include the psychology.  

Walter: Yeah. And I think you’ve kind of build it from your beliefs up. The big mistake that traders make is they go out and they say, “Wow, Darren is an amazing trader. You know what, I’m just going to do what he does.” That works or can work if you totally lock in and agree with Darren’s beliefs but if you don’t, I strongly believe that you will always end up trading something else. It is because you get pulled back into your beliefs.

You can find somebody who is an awesome trend trader and you can swear up and down that your going to trade exactly like your awesome trend trader buddy. But you know what, if you’re a counter-trend trader it’s not going to work. It’s just not going to work.

You’re going to have to tweak his strategy and turn it to a counter-trend strategy that will work for you. That’s the other thing to keep in mind. Build on your beliefs and build up from there. Don’t go look for the best trading system that you can find in the internet and go, “Well, I’m going to do that.” That doesn’t work. You need to start with your beliefs and work off from that.

Darren: Totally agree, Walter.

Walter: Alright, thanks for your time, Darren. I really appreciate it and will catch you next time. Thanks.

Darren: Cheers, Walter. Bye

---

SHOWNOTES

The Storytelling Beast

Denise Shull

In this second half of this episode of the 2Traders Podcast, Darren and Walter talk about market patterns and why trading systems are uncomfortable. You will find out the surprising results of a ten-year study. If you’ve ever wondered about the most efficient placements for profit targets, this is for you.

You will also learn about the “hedge fund indicator man”… Also, how do the problems faced by automated traders and discretionary traders differ? Do you know your uncle point (and why this is important for every trader)?

Download (Duration: 21:29 / 24.5 MB)

In this episode:
01:45 – magic things
03:42 – psychological hurdles
05:15 – guardrails
07:11 – impossible to accept
09:39 – hard to make it work
12:05 – scrap the system
15:45 – boom and bust
17:18 – stay on the road

Tweetables:
Workout a better exit[Click To Tweet].
Backwards engineer your system [Click To Tweet].
Reduce your risk[Click To Tweet].

Download The Full Episode 124 Transcript Here

Darren: Most of my rules in my trading systems now are just to stop me from being stupid…

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 here at Part Two. If you didn’t hear Part One, you can go back and listen to Two Traders Episode 123 to get Part One of this Episode. But, in Part Two now, today, you’re going to hear all about the hedge fund indicator man; why trading systems make you uncomfortable and what you should do about this; the really surprising result that was posted in a private forum about ten years of data. Ten  years of testing big profit targets and what he found.

Also, why automated trading and discretionary trading systems are both subject to the same problem and the need for understanding your uncle point. Why is this so critical for your trading. Finally, we’re going to reveal the secret of old traders, what they all have in common.

All these and more in this Episode. Episode 124 of Two Traders.

Walter: Yeah, it’s amazing to me. There’s a guy I know — and I can put it in the show notes for you guys who are interested. He sells information or indicators and stuff in systems. I think they are more like indicators and he’s pretty well known. They’re so expensive they just sell in the funds.

Most private traders wouldn’t even consider buying them. It’s crazy, right? There’s several of these guys actually that do this stuff. They really have these magic things that funds are happy to pay for because that’s the magic thing. It’s crazy but I guess it’s what people want. We’ve talked about this in the last episode.

I’ve said to traders who fight me on the exit thing. I say, “Look, don’t worry about the entry. Keep your entry the same. What you need to do here is you need to workout a better exit.” And they’ll say, “Why? This and that”.

I say, “Here’s what you do. Flip a coin, take 200 trades in Forex tester. Flip a coin heads or tails by yourself and just put a 5 to 1 or 3 to 1 or whatever like a  5 to 1 target. Risk 60 pips to make 300 or whatever it is and come back to me after 200 trades.” Without a doubt, they all come back and they all say, “Wow, this is amazing. It makes money! I can’t believe it. How does this make money? It doesn’t make sense.”

Darren: Yeah. I think the difficult thing then is that’s essentially finding an edge in the market. The difficulty then is executing those systems. I think people see stuff like that and they try trading the system. When it acts as you’d expect it to act, they then sort of drop out because they’re going to feel uncomfortable trading a system.

Any system, at some point, is going to make you feel uncomfortable. That’s I think in those times is when the mind is really searching for new patterns. The mind is saying he’s not liking this, how can we make him feel better, and you search for new patterns. That’s why people struggle. Because the psychological hurdles aren’t just at stage 1, they are all the way through the trading.

When you talk about a magic moving average, I use a moving average in one of my trading strategies that actually makes the strategy perform worse. If I removed it, my test results are much better. But, without that moving average there, I have to make more decisions and there’s these periods where I have to make these really tricky decisions and I make mistakes in those periods although, if I traded it more mechanically, I’d get better figures.

I put this moving average in there to make the whole process easier because I know over 10 years, I would perform better in the system, would perform better because of that. Most of my rules in my trading systems now are just to stop me being stupid. If I can make 3 to 5R every month and I’m not likely to make many mistakes, that is worth more to me than a system that could make 20R in a month or lose 20R if I execute badly.

Walter: Exactly. I’m with you in that one. I think as you grow as a trader a lot of what you’re doing is putting up guard rails to make sure you don’t swerve off the road and stuff like that. It sounds like that’s what you’re doing.

I think one of the big mistakes is that traders think they can just simply hook-in to a strategy, basically an entry, and just ride it for all it’s worth. It’s just not that easy, is it? Even if you don’t believe that a pattern is going to help you find good trades, right?

What you might do is you might decide that, “You know what? I’m just going to trade.” For example, you might trade in a similar fashion in a way that you trade where you just say, “Okay. Every time the market makes a wiggle, I’m just going to assume that it’s going to really go”.

Sometimes it will go and sometimes it won’t everytime it makes a wiggle. But we do know that it’s going to make a wiggle first before it’s going to go. It always makes a wiggle before it goes. It has to. That’s basically your edge in a nutshell, if I understand it right. You’re just trying to milk those big moves for all you can.

If I do that — and I decide that’s what I’m going to do — but what happens in those times when the market does really tiny wiggles. You know, wiggle up, wiggle down, wiggle up, wiggle down. It doesn’t really go anywhere.

You’re getting chopped up, obviously. It’s the weakness of the strategy. You think the next one could be the big one and then eventually you have decide, “Am I going to take a break here or am I going to keep doing it?” I mean, really what you should do is you should keep trading it. But, boy it’s that hard, isn’t ? Isn’t that hard to keep doing it?

Darren: That’s it. And I think the problem is that strategies that have edges have — and I posted on this before — drawdowns are much deeper and much longer than anyone  can accept. We just don’t accept it. Even if we know it, it is almost impossible to accept.

Saw that recently on Reima who did 10 years of testing with different R-targets. Even the 2R target had something like 22 consecutive losses and that’s what happened in his period of testing. You could have 30 consecutive losses but it made really good money.

I think people believe that they can find a system that doesn’t have that element in it. Whereas, I believe if you’ve found a test period that doesn’t have that in there then you probably just got really lucky.

I just don’t think people can take that one on board. When the moment comes then they change because if we think about it, if what we’re saying is true then you should be able to build EA’s that make money. And people’s argument would be, “Well, why aren’t people with EA’s all making money?”

I believe it’s because they all change it. Whenever I follow people with EA threads, as soon as something bad starts happening, they go in there and have some “Aha!” moment and they make changes. That’s what I see always happening but we don’t seem to remember that fact that we gloss over it because it’s uncomfortable to deal with.

Walter: Absolutely. And I’ve had this discussion with Mark Fletcher in the forum. He’s big in the Automated Strategies and I’ve argued that we’re all discretionary traders. Even the EA traders are discretionary traders because they decide when to turn it off.

He used to argue that and I think he has come around. Basically, said “Yeah, I agree with that now.” Because he has ran through that cycle where you end up modifying, turning them of, saying “Oh, it’s not working anymore.”

It’s interesting because Adam Hartley, who’s another trader — I think he’s discretionary now. As a job, he used to build these automated strategies for funds and stuff. Repeatedly, he said that it’s easiest for us to make the trending strategies work.

The automated strategies that capitalize on the trend and just about everything else is really hard to make it work. But these trending strategies seem to be the easiest ones to automate, which I found fascinating as well.

But, I think you’re right. I think it’s so true. That’s the next step in our discussion. You were talking about this stuff — 22 losers in a row, why don’t you just automate it? Well the problem is 22 losers in a row, you’re watching this, you’re not actually physically taking the trades but you watch your robot taking the 22 losing trades in a row. It’s really hard to let it keep going. You’re probably going to flip the kill switch and turn it off.

Darren: Yeah, I know. It’s the drawdown that’s why you’re going to look at you balance. At some point, you’re going to monitor it.

Walter: Absolutely.

Darren: At some point, it’s going to be uncomfortable. Let’s say you tested 20 years and the worst possible scenario you’ve found was 22 losers in a row. When it gets to 23, are you really going to believe that my system doesn’t work anymore? If that’s what’s not going on, are going to be able to do that?

We’ve talked about it ourselves. When do you decide a system is not working anymore? You have to have the mentality that it’s going to work forever but there is a possibility that it does stop working. How do you deal with that?

Do you just keep letting it drawdown until it hits zero? And, really, that’s what you should be doing but you should have some sort of diversification in there so if the strategy that has always worked, does go to zero, you haven’t lost all your money. Really, all of these comes down to risking the right amount on each trade, on each strategy. Doesn’t it?

Walter: Yes, exactly. And that’s exactly it. I think what you’ve highlighted is absolutely true. We all have the “uncle point” — to use the American term. I think it’s an American term which is basically, “That’s it, I’m throwing-in the towel. I’m done.” We all have that.

Even if you say you don’t have one, you have one.  And I’ve run into traders that can completely pull a drawdown of more than 50% and they will keep chugging along. Actually, I didn’t notice but I’ve known a trader for a while and a couple of months ago I met him and we were talking about this and his point is 5%. If he hits a 5% drawdown, he scraps the system and it’s all done.

We all have different uncle points where we’re going to throw-in the towel. The key is exactly what you say — I believe, Darren — which is you’ve got to backwards engineer it. You’ve got to understand, where is my uncle point? And understand that we usually are faster to shut it down than we think we would be.

In other words, if you say your uncle point is 20%, it might actually be like 15%. It’s easy to say that you’ll sit through a 30% drawdown but when you see that Dollar amount, then it’s different. “Ah, man! That’s a car!” or whatever. That’s hard to sit through losing a car with your trading account. You just need to backwards engineer. Figure out what is your max drawdown that you don’t want to hit, and then from there, you can work out your risk.

Also, diversification strategies that are complementary that kind of one usually does better, when the other ones not usually doing so hot. That sort of thing. Both of those things can help. It really comes down to math in that sense.

Like, Darren, you run your strategy through 800 trades in Forex Tester or whatever but you don’t know your max drawdown was 22 losing trades in a row. You don’t know if in the future you might have 40 losing trades in a row and really, the only way to get around is to reduce your risk.

If you reduce your risk to such a point where it doesn’t really matter to you, it’s not going to keep you up at night. You’re okay letting it hit the stop loss or whatever. It’s so much easier to do that.

Alex Upton is really good at this and he talks about this. You know how much he risks? He risks, I think he said a quarter of 1% is what he risks in his trade. But ,guess what? He’s making money. He’s following a strategy. He’s not changing anything because it’s so easy for him to fall asleep at night knowing that he’s risking a quarter of 1% on any given trade.

Darren: He’s probably also accepted that he is going to make slightly more modest returns as well. I think people, they think “Well yeah, I can reduce my risk. I can be smart about risk.” But, can you also accept that you are not going to make a hundred percent a month? Everyone wants to make amazing returns but for no risk and you’ve got to have to marry these two up.

Nick Radge did a thing about his clients and his fund and he says to them, “What is the most you’re prepared to lose? Work out the risk, how much you want to risk based on your testing for that.” And he said then, “Half it because whenever you’re sitting here now thinking you’re prepared to lose, when you’re halfway there is when the pain is going to be hitting you.”

Walter: Yeah, that’s so true.  

Darren: It’s about getting through those drawdowns.

Walter: That’s it. That’s when the Psychology comes in. The longer you trade, the more you realize that the traders are able to withstand the drawdowns are the ones that keep trading. Everybody else is changing their strategy or giving up or whatever.

It’s crazy but some traders, when you look back historically — Jesse Livermore. If you don’t know who he is, I’ll post in the show notes. I’ll post his biography. He was able to withstand drawdowns. He had crazy drawdowns. Actually, you could argue that he didn’t, because he ended up committing suicide so maybe he didn’t.

Actually, he wasn’t actually able to do that, sadly. But, he would have these “boom and bust periods” where he would make tons of money and then he’d lose it all. But, he would go back and do it again, make tons of money and he’d lose it all. He had these wild swings with his trading.

But now, the polar opposite of that is Alex Upton who has this really defined small amount of risk. He understands that he’s not going to have the Jesse-Livermore-highs, but he’s not going to have the Jesse- Livermore-lows either.

He’s going to be pretty steady and he’s probably going to be much better off over the long run. Yes, he’s going to take longer to compound it but who cares? If he’s making money, he’s making money. He’s not going to go through the psychological torment of the boom and bust of the “Boy Plunger”, Jesse Livermore.

I love that name. I love that nickname, the “Boy Plunger”. That’s what they call him. It’s so crazy. Have you read his book? He’s from like the 20’s and stuff. They call him the “Boy Plunger”. I think he really loved to short the stock market so he made a big pile of money during the depression and all that sort of thing.

Anyway, so patterns, I know we’ve kind of wandered around here in this episode but if I’ll sort of wrap it up from my point of view I would say test your patterns and see if they work for you. They could be something very useful.

Like you say, you’re using a moving average that maybe it’s not really going to improve your strategy but it just helps you keep things in a box, helps you stay on the road, so to speak, with your system.

Even if you’re wondering about the patterns, if you test them and they work for you and you realize it helps me keep my strategy in alignment and it helps me stick to my rules. I can use them but, no.

The big deals in trading are working on you, on your psychology, withstanding your emotional highs and lows, and really trying to figure out your risk, and backwards engineering the horrible drawdowns that you may or may not have. And based on that, that’s really where you are going to make your gains.

It’s figuring out, “Okay, how do I avoid the catastrophic drawdown?” I’ll link up in the show notes the calculator so you guys can go and type in your numbers and figure out a lot of that stuff because that comes down to probabilities. That’s my overview of patterns. I think they’re pretty useful. What say you, Darren?

Darren: Yeah. I think if you’re still looking for patterns in Forex charts, I think the important thing is to ask yourself: why you’re still looking for patterns? Because if you can answer that honestly and accurately you’re probably going to find stuff of more use than looking at the charts for patterns.  If that makes sense.

Walter: Well, thanks for your time, Darren. Will see you next time. We’ll talk about the subconscious next time. That sounds interesting.

Darren: Cool, Walter. Nice chatting with you again.

Walter: Thanks.

---

SHOWNOTES

About Tom DeMark
Reminiscences of a Stock Operator
Risk Calculator

Are market patterns totally random?

In this episode of 2Traders Podcast, Darren and Walter dig into the human psychology of seeing patterns in everything… especially your trading charts. And what factors you should focus on when you see it. Walter talks about the “3 Soldiers” and how he learned a thing or two while testing it. He also touches about apophenia and how it can help you understand numbers and patterns better.

According to Darren, it could be just blind luck. He argues that some things cannot be explained by science and just rely on randomness and that winning often comes from luck. All this and more in this first half of a two-part episode of 2Traders Podcast…

Download (Duration: 21:29 / 24.5 MB)

In this episode:
01:00 – watching cockroaches
03:06 – imagining patterns
05:29 – pushed to the background
08:54 – blind luck
10:43 – why it gets interesting?
12:03 – broader concept
14:15 – sparks an idea
15:36 – pop up
17:43 – it’s not everything
19:06 – bookstore

Tweetables:
How do you follow a system?[Click To Tweet].
It’s not the pattern, it’s you. [Click To Tweet].
Be logical[Click To Tweet].

Download The Full Episode 123 Transcript Here

Walter: That’s kind of the fascinating thing about trading. It’s that we can all be looking at “the same pattern.” We’re all trading the same system and yet we’re not really because we see things totally differently. It’s just fascinating to me.

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 Peters here and I’ve got Darren on the line. Hello, Darren.  

Darren: Good morning, Walter.

Walter: We’re talking about this idea and I’d love to get your thoughts because I think we are going to have different approaches on this — which is always interesting but… What do you think of this idea that there are these patterns in the markets that are repeatable, that you see them over and over again versus the idea that there’s just looking at the patterns in the market its like watching cockroaches walk up and down the wall? It’s just totally random. They both have their supporters.

My thought is when someone says to you, “This is a repeatable pattern. I see this happening all the time.” What are your thoughts?

Darren: Well my initial thoughts, that’s what we’re built to see so you’re going to see patterns. I would say if you’re going to trade off patterns like that, I think that’s fine but, you need to understand how much of an impact it’s going to have on your trading results.

The fact that that’s just a part of the bigger equation, if you like, that you need to work on and you’re not going to find a pattern in its own that’s going to make you a successful trader. It’s quite difficult to talk about things like patterns with trading.

First, you have to just do some 5 minutes research on the internet about humans and patterns. There’s a few biases that relate to us and seeing patterns. For instance, there’s the one where you see faces and things where people have seen…

Walter: Apophenia.

Darren: Yeah, apophenia, and we have a few biases like that. When you look at the research into it and why that exists, then it makes sense. It’s logical that we would see patterns. Whenever there’s a deep rooted bias and then you believe you’ve found a pattern in something like a Forex chart, it’s quite difficult to convince yourself that your pattern’s not valid. But you just need to join the dots up here, don’t you?

You need to say, “Well, let’s have a look at the evidence here. Is there evidence that I might just be imagining this pattern or I might be making more out of it than it actually is?”  — and I think there’s a lot of evidence to support that.

You have to be logical and step back a little bit and say, “Okay, this is a pattern I think exists. There is a possibility that that’s just being created by random up and down movements. There’s a possibility that I’m visualizing it because it’s what I want to see.”

If you still decide to trade based on that, then I know at least you’re going into it with an open mind because I think most of these patterns don’t really exist. For me personally, if I’m going to trade a pattern, its a much broader concept of a pattern rather than a very precise, this goes below the 61.8% retracement and then it prints this color bar at this time. When you start getting that deep into it, then I think you’re over rigging it a bit.

Walter: Right. But, what if that’s not — I see what you’re saying — but what if someone has a pattern and they’ve got it really detailed? Like it’s got to be this 33% and whatever and blah, blah, blah. But, that might just also work as a method of restricting them to taking certain trades. It’s just like a rule, basically. It’s a system-rule. It could be helpful in that way, right?

Darren: Yeah, definitely. And, I think there’s some logic behind it. Its saying this is a pattern that occurs. Presumably, they’ve gone on to test that they can use it as a tool for trading and its main purpose is it stops me from over trading, such as a pattern of waiting for a deep retrace after a strong momentum move. That makes sense to me.

I think the problem is that a lot of people say, “I’ve found the pattern that’s always going to win.” I think they see patterns like that, they somehow solve the problem. Then, other elements of the trading tends to be pushed to the background and not given the importance it requires.

Walter: Right. So reading between the lines here, listening between the lines, basically you might say… Okay, you see this pattern. I understand that and it looks like this is something you want to trade but you’re really focusing on the wrong thing. What should be talking about or concentrating on is your reward risk ratio or how you manage your exit. It’s not really about the pattern that gets you into the trade.

Darren: Yeah, andI think like you were suggesting patterns. If we are talking about a particular candlestick patterns and as such on charts, they’re better used for — like you say — giving you some sort of order and guidelines to trade around and not really the elements that are going to make your profitable.

Walter: Yeah, right.

Darren: Some people would disagree with that, though. For me, it’s always whenever something like this comes, I always look at the Psychology first and see if there’s a compelling case that we might be making a judgement mistake on. I always look for that. If there’s really strong evidence that that could be happening then you have to be much more open-minded about what you have discovered.

Walter: Yeah, absolutely. I find patterns very useful for me and I’ll test them. I have tested the patterns that I don’t like. For example, one of the ones I’ve seen or came across — I think it was 2003, 2004 — was this it’s called the “3 Soldiers”.

Anyone who’s familiar with candlestick patterns has probably heard of the 3 Soldiers. I found it to be completely unreliable. In fact, I contemplated a trading system based on fading the 3 Soldiers. It was that unreliable. Whereas other patterns I’ve seen, such as the Big Shadow or Kangaroo Tails or whatever, I found to be quite reliable.

Now, I’m open to the idea that perhaps because I understand apophenia, I understand you give people random numbers and they can find the patterns inside there. I’m open to the idea that maybe there isn’t anything going on there. But, what I don’t understand is how is it that I can go and test the 3 Soldiers pattern over 12 years, let’s say, and take 700 trades and it completely stinks.

And then I’ll use the Kangaroo Tail, test that over 12 years, and it works even if I’m using the same exit strategy on both patterns. To me, there has to be some sort of edge there. There’s got to be something going on. I realize I’m open to the idea that perhaps I’m seeing something that’s not there but, at the same time, why do I see this disparaging statistics.

I mean, one theory would be that the reason why your Kangaroo Tail seems to work, or your Big Shadow seems to work, is just because you happen to live or test in a period where it is working, then later on it will stop working. Is that one thing you would maybe point to?

Darren: It could be just blind luck. It could be just randomness and you have to be open to that. That’s why you have things. That’s why you do backtesting and then you make sure you trade the right size. You make the best of your winners.

You have some sort of exit strategy that’s got a positive expectancy. That is one possibility. It is a possibility like you say that there is a true edge in that. I think if I looked at Big Shadows and find a positive expectancy I’d say, “Well, what is actually going on here?”

Essentially, I’m presuming prices, say, are rising very strongly and then it peaks and reverses very strongly. That is a good indication to sell because there’s clear evidence on the chart. The biases change and momentums increase with that bias change but then you have to say to yourself, “Well that’s not the only pattern, candle pattern that represents that.” You really have to test the Big Shadow against a similar price movement that has a different pattern.

Walter: Yeah, absolutely.

Darren: I mean you could argue that people are looking for that particular pattern. If that was true that the majority of people are watching the instruments you trade, on the time frames that you trade, in the time slots that you trade — and they’re waiting for that — then it would really have a high success rate, wouldn’t it? Because, majority of the people would be trading that signal.

Walter: Yes. But, here’s why I think it gets so interesting — I agree with that premise — but here’s why it really gets interesting. I get emails from traders around the world and they say, “Hey look at the EUR/JPY right now,” then save a screenshot or whatever. I’m sure you’ve seen the same thing and it’s like there’s no way I would take that trade. Like, I can kind of see what they’re talking about but it’s completely different to what I would. When I look at a chart, it has to either hit me straight away and I go, “Yup that’s the trade!” or I just walk away like it’s got to be obvious.

Darren: You’re basically taking in information that isn’t really just a pattern.

Walter: I would have to say probably. But the fascinating thing is that I can give you the Big Shadow pattern. I can give it out to 25 different traders. We can all come back a month later and compare our trades and there’s going to be some overlap. But, it’s fascinating to me to see the difference and how people supposedly trading the same strategy, the same discretionary rules are taking completely different trades. I think that’s what makes the market.

Darren: Yeah. I think there is a broader concept going on, isn’t there? Rather than just the pattern. Maybe that’s what makes the difference between traders.

Walter: Yeah. The first time I really found this — and I’ll put this in the show notes for people interested.  There’s a book by a guy named Daryl Guppy. Daryl Guppy is an Australian trader — and I think I read this in 2003 in one of his books.  I find his books kind of hard to go through and I haven’t read one in years.

I’m sure he has more and I think he’s in Singapore now. But, the interesting thing in the book is he actually demonstrated how here’s a strategy, you give this to some people and then they all take totally different trades even though officially we’re all trading the same strategy but it ends up with totally different results because everyone sees it a little bit different.

That’s the fascinating thing about trading. It’s that we can all be looking at “the same pattern”. We’re all trading the same system and yet, we’re not really because we see things totally differently. It’s just fascinating to me.

Darren: Yeah. And again, it comes back to — I don’t know. Can you put that down to psychology? Because how much are you being affected by what happened this morning before that Big Shadow and what happened when you were trading yesterday before that Big Shadow.

All of these things we don’t think are being used in our decision process. We think we’re being completely rational all the time but science has pretty much disproved that now. With the amount of rationality is probably the smallest percentage, the rest or all of it is coming from the subconscious.

Walter: Absolutely. And that would probably make an episode in itself. Maybe we can talk about that next time. There’s a lot of going in there that we’re not aware of and I think that sparks an idea or a thought in me when you say that, Daren.  This idea of what’s going on in our head. How maybe our experiences perhaps play into that. We see things slightly differently.

A good example of that is — sad example — is somebody who has been abused, physically abused as a child. They will see other people and interpret what’s essentially a neutral expression or a neutral interaction with somebody as the other person’s being aggressive. They see agression everywhere because they’ve been attuned to that.

To me, that’s the same thing with the woman who keeps choosing the husband or the boyfriend who is abusive. You tell her you’ve got to leave this guy, you’ve got to find someone better. And then she leaves him and then she comes back with the exact same guy. It’s a different guy but it’s the same situation over and over again.

To me, that’s kind of the psychology of the markets that is exposed when you’re looking at patterns. If there are patterns that offer an edge, to me, the reason why they’re there is because we humans are the ones that are making them appear over and over again.

The vacillation between fear and greed. We see these things pop up over and over again not because everyone’s trading the same system but maybe because we’re all predictable in a certain kind of way. You kind of know what someone’s going to do in a given situation.

For example, maybe you know someone they’ve been in a trade for 2 days. The trade has been going against him the whole time. What are they thinking? A lot of times they are thinking, “If that trade can just get back to breakeven then, I’ll dump it.” Right? Well guess what, if you took that trade at a support or resistance level, my theory is that’s why the support resistance level is there because everyone’s ready to get out of breakeven or whatever. Everyone’s thinking the same thing and that’s where it pops up.

To me, I find it fascinating that as humans, all these people were taking this trade for all different reasons and yet it seems to me there are some glimpses of what we’re thinking as a group and these are the patterns. I understand it could be wrong. It could be apophenia, it could be something else.

If the lady that keeps going for the wrong husband that’s going to abuse her even though if she knows she shouldn’t do that; and the kid who’s been physically beat up keeps seeing aggression everywhere he goes; then, why isn’t it that also traders keep seeing the same thing in the markets and keep doing the same thing around support resistance or whatever. To me, that’s where it makes sense.

Maybe I’m just trying to construct a case so to help myself believe it. But when you can test it, when you can see it over historical data and you piece it together, why would it be these way? To me, that’s one theory.

One theory would be a lot of people are kind of just like we make the same mistakes in life with our behaviors. We do the same things in the market, I don’t know. It’s a fascinating topic. I guess the other thing that you are highlighting to me is that it’s not everything. When we first get into trading, we think that the pattern or the entry is everything but it really it isn’t, is it? That’s just one little, tiny, small piece of what it takes to pull profit out.

Darren: Yeah. And I’m often kind of beat up on people about obsessing about the entry and probably don’t get my point across clearly. Like you say, there are reasons for these patterns but just relying on finding a pattern to become a successful trader is throwing a lot of really useful tools that we can utilize and are probably easier to be consistent with.

Psychologically, they are easier to use, I think. All I’m trying to do is to highlight to people that there’s perhaps other methods that you can use that are easier to get good at than just perfecting the entry.

Walter: Exactly. It’s like the focus is on the wrong thing. I think that if you look at most trading books or most trading courses, or what most people talk about on the trading websites around any form, anything you pick up. Like, if I go  in the bookstore… There’s a bookstore in Sydney that has a lot of trading books.

If I go in there and I just randomly pull one with my eyes closed off the shelf,  it’s a 9 out of 10 chance that that trading book is going to talk about trading systems. It’s going to be about trading systems. How to trade this way and that way, why this way is the best.

But you know what? The longer you trade —  and maybe I’m wrong here, Daren, you let me know — but the longer you trade it seems like the more emphasis you put on YOU, on understanding you and not really the system. You can understand a system in a weekend, you can figure out its weaknesses and all that. That’s easy.

The difficult part is how do you follow it. How do make sure that you follow it? I mean, there are so many times I’ve run into traders and they just throw their hands up and they quit because it’s a tough market for their strategy or they’re risking too much. They can’t sleep at night or their accounts are  too deep at drawdown or whatever.

To me, it’s like we’ve got it wrong. It’s our own fault that we want to have dessert. We don’t want to have our vegetables, do we? We don’t want to work on the psychology of trading. We just want to eat that really nice chocolate ice cream, creme brulee, or whatever. The pattern, or the magic moving average, or whatever.

It’s amazing to me that people pay for like… Did you know that there are moving averages that people pay for? I’m talking about like private funds. Private funds will pay to use moving averages that have secret formulas that create the moving average. Like, to me that’s crazy. That’s insane but it’s true.

Darren: Yeah. I’m surprised funds are still making those mistakes…

Walter: That’s all the time we have for Part One. In Part Two, you’re going to learn about the hedge fund indicator man. Why trading systems are making you uncomfortable and what you need to do about this. The surprising result of a ten-year study, testing big profit targets. Why automated trading and discretionary trading systems both have the same problem and the need in understanding your uncle point.

As well as the secret of O traders and what they all have in common. All these and more in Part Two. We’ll see you next time.  

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SHOWNOTES

Trend Trading: A Seven Step Approach To Success 1st Edition