Did you take the right trade? Will you pull a profit from this trade?
In this episode of 2Traders Podcast, Darren and Walter take a trip down the memory lane. Both recall how they validated their trading systems and market beliefs.
Because traders have a need to know that we are right, it can muddy your trading decisions — and is this need counter-productive for your trading? So, how do you know your system will pull profits from the constantly changing markets?
Walter offers methods to test your beliefs, and even the ubiquitous Martingale system makes an appearance in this episode.
Darren offers advice on finding your edge in the markets and how to make a difference with your trading results.
Download (Duration: 26:32 / 30.3 MB)
In this episode:
01:18 – try and validate
03:57 – extract money
05:39 – what else can people do?
06:47 – strategy tester
08:44 – robotic automated system
10:25 – outside perspective
11:47 – average trade
13:26 – outlier-type trades
16:31 – falling off the cliff
20:59 – the need to win
22:19 – verification
24:22 – flip your trades
25:41 – a bit smart
Naturally, we all have this strong need to win. [Click To Tweet].
Verify your system by trading it in a simulator. [Click To Tweet].
Where is everyone going to lose their money next? [Click To Tweet].
Darren: To reach that point then, you have to use some unique thinking and I think that is what we all need to do at some point even if you are trading something that is a tried and tested approach. You need to have that little edge to how you are applying it and that will make all the difference, I think …
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 the Two Traders Podcast. In this episode, Darren, we were thinking about doing something a little bit different. We are going to take this idea and talk about how that applies to your trading. So, how are you today, Darren?
Darren: I am good. I’m actually just pulling out the definition of the word so just I know that I am talking about the same thing you are.
Walter: Good. The good news is it probably does not matter. You can talk about how, what it means to you. The idea is that we are going to talk about verification. How does verification affect your trading?
One thing I could think of when I thought of this is, well, one thing that we do as traders is we try and validate or verify that our ideas are correct. One way that you do that is you would go onto the internet and look up whatever your idea is.
Your idea might be that when the market hits a moving average, it’s going to bounce off that. It is like this dynamics support and resistance level. That could be something that you think you observed and you want to verify that by checking that in the markets.
When it comes to trading, this idea of verification can come into play because we look to other traders, to other authority figures to say “Yeah, that is the right idea”. So, my question is, how well is it that verification affects our trading?
I think it does. I think it is one of those things because, let’s face it, I mean there are rare exceptions where this has happened but you don’t go into a university or some sort of a class where they teach you how to trade.
Most people, the way they learned how to trade is by bouncing ideas of other people on forums or by reading trading books from other traders or talking to other traders. This is how they figured out trading systems and find trading systems.
You don’t actually go and sit down to do a four-year degree in Technical Trading or whatever although, I suppose, you could argue that there are some certifications or stuff along those lines.
How do we verify that what we believe is going to work in the market is going to work? That is one thing I think about when I think about trading and verification.
Darren: I think a lot of traders do this on forums, don’t they? They start of a trend on the forum explaining their situation, their strategy and they’ll look for people to say “Yeah, that works” or, “No, it doesn’t work”.
We are looking for everyone that comes along to say “Yeah, great trading system. That works”. I am not a hundred percent sure that that is a good thing, though. It’s difficult and whenever I’ve had an idea that everyone got a straight away, it didn’t really work for me in the end.
In fact, what’s worked for me most successfully has been the one that most people say “No, that is not going to work. You are going to lose your money”. I think how you verify it is important rather than any verification.
Walter: So, let’s talk about what do you do. I think it’s an important thing. We, as traders, wants to know our belief that what we believe is going to extract money out of the market is going to do that.
What I would say is, and I always say this — some people might be sick of me saying this — but what I say is “Look, if you want to build up the confidence in your system, it’s probably a good idea to get a lot of trainings in that system”.
One of the easiest way to do this is, and you can debate on whether it’s real or useful or whatever — I think it’s extremely useful — but, one of the ways you can do this is you get something like forex tester and some sort of trading simulator and you go through and trade your system historically so you’d know what would have happened, how you’ve been trading at the last twelve years or whatever.
That is one thing that I say. That is how you verify and what that will do? Couple of things: one is, you’ll see how it performs in many different markets.
Assuming, of course, that the markets have changed over the last ten years where you did your testing. It doesn’t work if you’ve only tested it during a strong, out of control bullish trend. That would be a mistake.
The other thing is you actually get those trades under your belts. You’ve actually executed the trades. You have those trades as experience and then finally, you get some confidence if you do in fact make money by doing that.
That confidence could even be in your subconscious. It is not only in the spreadsheet that you could extract from forex tester and look at your data and pat yourself in the back and say “What a great trader am I”.
Also, it’s in your subconscious and you know in there, deeper into that “Yeah, I can do this”. That is one way that I always say “Look, you want to verify it? That is what you do”. That is how you get good at in this game is you do that.
What else would you say? What else can people do? If it’s not to ask other people and look for affirmation on the forum, what do you do?
Darren: I think for one thing I would have to agree on you on the backtesting, although it’s not really the route I took but, I have seen a lot of traders do exactly what you say and it’s worked.
What’s going on there is they’re verifying it for themselves. I think that’s probably the key thing and if you give traders a system that is already being verified to work, then it doesn’t necessarily work for the traders.
Also, if you put a system out there and wait for everyone to agree, to wait for the public to verify that your system is valid, then that doesn’t work either. There’s something in that element, like you say, are basically going and verifying it for yourself on your own.
I think that is probably what it makes it work.
Walter: The other thing is some people are listening to this and they are maybe thinking “Well, I could just do that by running it through strategy tester and metatrader or something like that, like coding it and doing that”.
I don’t think that is going to work for you unless you are going to allow the computer to take your trades. If you are going to trade in the EA, then that EA, that robot, if you are not able to verify that through the data that you have it spit out and say “What would’ve taken 592 trades over the last two years? And would’ve done this and made this amount of money”.
Even that, I think, there is some value in actually going through and manually taking the trades, you’ve got to understand the logic of what’s going on there. The other thing is a lot of traders do not do that.
A lot of traders, if you talk to them even if they are ardent robot traders, EA traders, they’re coders, they believe in this. A lot of times, if you really dig into it and you ask them, they will tell you that there were times when they turn off their robots.
My question has always been if you do not turn off your robot when you are doing the strategy testing and you are having the robot take all the trades over the last twelve years, why is it that you are turning it off because the Brexit votes are coming up, because the CPI is going to be released, or the non-farm payroll or the interest rate announced?
Why are you turning off your robot, if that is the case, because you did not do that when you did your testing when you’ve got all your numbers so, that is one thing that I would say.
It can be extremely useful to use something like forex tester when you are a discretionary trader, and even when you are not a discretionary trader, I think it can be useful so you’ll at least understand what is going on with your system.
I think that all traders are discretionary traders even if they trade EA’s and it’s up to their discretion whether the EA is turned on or off. That’s always been my belief. There’s a lot that goes on in terms of verifying your systems even if it is like a robotic, automated system.
Darren: There is definitely something in there about physically taking the trades yourself rather than running them on an EA. It is quite funny when you say… Actually, I was listening to a guy this week who did exactly what you said.
He, basically, has been trading this manual system and he had a very bad loss this week. He was talking about his loss and he was saying that he has dealt with it and now he’s programmed an EA to trade his system.
He showed us all his backtest result and they were… Obviously, it was just a beautiful, smooth equity curve going. Up in the dotted line, it was the perfect system. Then he said that he was going to switch it off and on.
I pose the question to him “Why are you switching it off and on?”. He said “Well, because certain events in the market will be coming up”. I thought “Well, how can you consider that data is valid but then, at the same time, say that you’re not going to go with it?”
I found out all the time that there is that conflict in what traders might be saying and they do not see it. To me, it was — as an outside party — to me, it’s really obvious that if you’re going to mess with the EA then there’s obviously something on your mind that says “There is a problem with these results”. Otherwise, you just switch it on and let it run, wouldn’t you?
Walter: Exactly. Yeah, that’s exactly it. I mean, didn’t take sometime to just take an outside perspective and sometimes you can get that from somebody who is not a trader. You could just have someone who is not a trader, you can explain everything you are going to do. Show him all your data and everything.
Sometimes, you get these questions and you don’t consider the fact that you’ve built this beautiful equity curve and then you are going to mess with it in the future because, of course, you know better. It’s crazy but I suppose it happens.
Darren: When you are trading something manually, it is like a bull part figure of how long or how many trades you should take before you can consider your system verified. It’s like a number or time that we could agree on where you can say “I’ve given this system enough time to know fairly confidently that the results are going to replicate going forward.” Or, does it vary completely for every system?
Walter: Yeah. I mean, people will throw out things like thirty trades or a hundred trades and their formulas that are based on all that. At least a hundred trades pop up your numbers in these formula and all that.
What I found is, I think it’s depending on the systems. I’ll give you an example: if I’ve got some sort of reversion to the mean type of system, I can probably have a pretty good idea over a hundred trades what my average trade is going to look like.
What I mean by average trade is how much money does your average trade make based on all the winners, all the losers. You add it all up and you’ll find what your average trade is. Also, what’s your average loser will look like and all that.
The other piece of this is, what if you trade a system? The reason why I used the reversion to the mean system is because those are pretty consistent and that you are either going to try and catch a trade when a market is taking off in a trend which means you are going to be stopped out. Or, you are going to catch the market reverting to the mean and then you are going to make money or break even or something. Not quite as bad as getting stopped out.
Here is the thing, if you are trading a system where you really need to have those “fat tails” as they were called, or those outliers just related to… If you have a trailing exit or some sort of really aggressive target like twenty to one or something like that, you are probably going to need to have more trades in your samples to have a good idea of what is going to happen.
You can see this in the equity curve. If your equity curve is, generally speaking, it looks like it’ll shoot straight up,and then it’ll flat toe, it’ll go down for a little bit then shoot straight up so it makes those really strong jogs up and it goes down, drift around, flags down for a bit then shoot up again, then you probably are trading one of those systems where you need those really big outlier type trades to make it work.
If you don’t take enough trades in your backtest, you won’t catch enough of those to really understand what is likely. For example, let’s say on your equity curve, you see the market shoot up and then it just sags down and flags down and then it never shoots up again, would that probably means that you only have a handful, maybe even one of those really big fat winners that you are counting on?
Then the rest of your trades are basically losers and so you end up and go “Well, this isn’t very good. This system is not really good at all. It didn’t make much money at all.” Well, if you’ve gone through and take another 500 trades, you’ll probably see another five or six of those really strong winners that makes it all worth it.
To me it depends on the system, that is my point of view. I think that some systems depend on outlier trades more than others. If you’ve seen that in your equity curve where you see this really drastic steps up, then that means you are relying heavily on those outliers types of trades.
That is what I would say but, I suppose, everyone’s got their own perspectives there.
Darren: I am definitely going to agree with you here. When risk/reward is, and win rate is skewed massively, you need a much bigger sample. The one that I see much more often is, basically, the opposite of what you were just saying there.
Where, this person has a very very high win rate and all the very small wins, and you’ll look at his equity curve for six months and it’s just steadily, steadily going up and then he has one loss which takes away half of his profit over the six months in that one loss.
I see loads of those as often with EA’s and the danger with them if you use too small data to work out seems like you’ve got the perfect system, you risk too much and then at one loss, completely wipes you out.
I see those kind of curves all of the time. It seems like that that is a trap that many people fall into that style of trading. It might be where they’re trading without a stop loss, as well, and the trades always comes back until the one that doesn’t.
That one that doesn’t completely wipes you out. If you are trading those extremes of risk/reward, you need much bigger data to work out on.
Walter: I think the classic example of what you were talking about is the Martingale and most traders come up on this idea when they get into trading which is you have a loser, you lose $20, the next trade you’ll go for $40.
You lose $40, you’ll go for $80, 160 and 320 and so forth until you get your money back, eventually. People are talking about this with gambling and everything. I think that is where it came from, from the gambling world.
The point is if you do that, you’ll see an equity curve exactly like what Darren just described which is you’ll see a steady, up, up, up and then it’ll fall off the cliff. Here is one way to see whether or not your system is going to be running into this issue.
What you’ll do is, for whatever data you have, your live trades, your backtested trades, get all of the sum. Sum up all of your winners, flag all your winners in a spreadsheet or whatever, add them up then divide those winners — that pile of winners — by your largest loser.
It’s a really simple formula. What you will find is if your system is crap, sorry to tell, sorry to break the news. If your system is crap, what will happen is you will have a number less than six.
Now, six is, to me, the bottom of the line just barely scrapes the bias. As a verified system will call, we were talking about verification. Ideally, you’ll have ten or something or greater than that, thirty or something like that.
If your number is three, in other words, what that’s saying is that your largest loser is taking out 33% of all of your winners. We are not even talking about the other losers, we are just talking about the largest losers.
Then you have some sort of Martingale type system that’s going on to you. Your reward/risk is just a way off. I know this is a simplified way of doing it but, for a lot of people, it is going to be a very useful thing to do.
What you want to do again is get that number over six. If it is anywhere below that, you are in big trouble. You are going to have an equity curve like what Darren was talking about. You are going to have this Martingale style of drop off. It’s just horrifying when you experience it live.
Definitely, try and keep an eye on that number. That would be my advice to people listening to this.
Darren: It is amazing how popular those styles of trading are. I’d never really noticed it before but I use my FX books sometimes to look at other traders and strategy performance.
You see so many of these, I can understand why it is popular. We do not want to go through those that constantly giving money back, win some, lose some. That is really part of parcel of trading successfully.
We all want to avoid that, loss aversion is strong in all of us. I never realized how popular it is and how people got hooked into it so quickly. You can have a trader put together a really amazing six, eight, nine months of trading that looks like the perfect system for.
Unless you know how to dig deep into the numbers, it’s very convincing. I’m sure that a lot of people lose their money going down this way.
Walter: Yeah. And I remember when I first found trading forums, it was not even really a forex forum but there were enough forex traders that there were little subdivisions in these stocks trading forums.
There was a guy who really divided the crowd. You would have these people in there who would talk to this guy. He’s like an internet rockstar. He would get occasionally banned from the forum then come back under a different name.
It was so funny but his whole thing was, basically, based on the Martingale and he was saying like “Look, if you have such a large account that you can keep taking these really small trades, you are going to survive”.
He was like he had this big story about how he learned it from some rich guy in China or whatever. All these stuff, it’s hilarious but the point is don’t take my advice, go ahead and test the site yourself.
If you look at these equity curves, what you’ll find is some of them will get really lucky and they’ll go on for thousands of trades. The Martingale system fails because, eventually, you’ll just get a losing streak that you cannot recover from.
The beauty of it is it’s so simple, isn’t it? Such a simple idea, why not just do this and it feeds right into our biases. Like you say, Darren, it feeds right into this need to win. We have this strong need to win.
It is the reason why these really valuable, profitable trading systems that do not win that often are so difficult for so many people to trade over the long term because of the need to win. You need to be right, you need to say “Yeah, I did good”.
That is one of the things I think traders need to be aware of. It’s that you can feel like you are verifying your system because you are winning but in actuality a lot of these systems have a really, really high win rate or terrible at growing your account and will just send you another pour out, so something to be wary of.
Darren: I think it’s where that saying of “cutting your losers short”. I look at a lot of them and if you just took a few more losses, if you were just able to limit those losses by half as much, then you’ve got a good system here. But, that kind of really high win rate takes over as being as the most important thing and it eventually becomes their downfall.
I do know some traders that go down this route of having this skewed risk/reward and having small winners and relatively large losers. What they are really good at is having that threshold for the losses and when it gets to that threshold, they cut them short.
The people that come on start, they think that it is always going to come back and that never happens.
Walter: Yeah, exactly. We are talking about verification, there’s a couple of things I suppose that I am thinking of. Verify your system by trading it in a simulator like forex tester. Verify your system by making sure that your winners are not dwarfing your losers, like using that formula that I gave you.
If you are like Darren and you are a contrarian — I am quite a contrarian too, I like to see what other people are talking about in the business papers and on the business channels and things like that. The reason why is I want to know where all the losers are gathering.
You know what I mean? I want to know where is everyone going to lose their money next so I pay attention to what the currencies are doing. These are the things that you can use, if they fit with your personality.
Verify with the number of trades that you take, make sure that the number of trades you take in your simulator fits the style of trading you do. If you are a trader who depends on those really big winners then you have to take more of those.
I know I told this story before.For those people who haven’t heard it, I think it is worth repeating because it fits with what you just said, Darren, which is this idea of if you were just able to cut your losers a little bit, cut those in half, you would have such a different system and how all these traders are so interested in Martingale Style of trading.
I have a friend who started a fund and he brought these traders in and he told them that if they could do well. They’ll trade live money but in the meantime they have to do it in his demo account. I know there’s all kinds of moral dilemmas with this situation but this is reality of what he did.
He took these traders in and they had this platform where they couldn’t really change the position in size so they didn’t know how much they are trading. It was a demo account anyway, they thought, but it is actually a live account.
What the system would dois it would custom program platform that they’ve created for this and they would flip their trades. So, if they went long the EUR, they would actually be shorting the EUR and it was connected to the funds money so it is actually a live account.
What was happening is he’s bringing all these traders in and, occasionally, he get a trade that he would win and occasionally will have to move them up to a “live” account. Most of the time, they would make a whole lot of money from the losing traders because they were, of course, cutting their winners short and letting their losers run.
It sounds silly but it’s exactly what most traders do. His big deal was trying to make sure that these guys take motivated because they were getting down on themselves feeling like “I will never going to qualify for the fund” and they were like “No, you can do it. Keep going”.
They were trying to keep these guys in the game because, of course, these guys are making the money for them. I know it is crazy but it’s true and it just shows you how so many of us are not born to do this.
It is such a difficult thing to learn because we want to cut our winner short and let our losers run but it’s true.
Darren: It also proves the point that your edge in the market is not going to be something that is already out there. It’s going to be for you, thinking outside the box and being a bit smart. Now, it sounds obvious but if all new traders tend to lose then you need to set in their EA up that reverses their position.
Sounds obvious but to reach that point, then you have to use some unique thinking and I think that is what we all need to do at some point. Even if you are trading something that is tried and tested approach, you need to have that little edge to how you are applying it and that will make all of the difference, I think.
Walter: That’s great, Darren. Thank you so much for your time and we’ll see in the next episode.
Darren: Okay. Cheers, Walter!