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“Last Night, They Got the Elephant"—Fighting a Bias That Kills Profits, By D.R. Barton, Jr.
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: Are Your Tracking Your Mistakes? by Kevin J. Davey
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“Last Night, They Got the Elephant" —Fighting a Bias That Kills Profits
by D.R. Barton, Jr.
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One winter night during one of the many German air raids on Moscow in World War II, a distinguished professor of statistics showed up in his local air-raid shelter.
It caused quite a stir because of all the air raid signals of the past (and there were many) he had never appeared there before. "There are 7 million people in Moscow," he used to say. "Why should I expect them to hit me?"
This time, his friends were astonished to see him and asked what had happened to change his mind. "Look," he explained, "there are 7 million people in Moscow and one elephant. Last night they got the elephant."
This story is from Peter Bernstein's delightful book Against the Gods— The Remarkable Story of Risk. It is easily one of my favorite reads. It is so well written and tells story after story about how our understanding of risk and uncertainty has been formed over the centuries. If you have a trading or investing friend who needs a good present for Christmas or Hanukkah, this is a nice pick.
I love this tale because it encapsulates how human beings deal with uncertainty. We may be able to calculate the chance of something happening using statistics and probabilities. We may even understand what the probabilities mean.
But the numbers "don't matter" to us if they get in the way of one of our beliefs.
I know I sound a lot like Van here, and it’s very much on purpose. Van has taught more people about how to understand and overcome bias and how to work within our belief systems in our own trading and investing than anyone I know. One of Van’s key tenets (in my own words) is this: Our personal beliefs act as a filter for ALL information that we take in.
Take the statistics professor in the anecdote above. He understood his chance of being killed by a bomb. But a random (and highly memorable) event, the death of the local circus elephant, made him rethink and ultimately change his decision making process, minimizing the importance of the true statistics.
You and I are very likely to make similar mistakes in our trading. And that costs us money.
Let's look at why we ignore profitable trading strategies when certain random and highly memorable events happen. It will help us to keep those strategies in mind, regardless of outside events— and that will give us a greater probability to do the most useful thing.
It Wasn't an Elephant— But It Sure Smelled Like Peanuts
You have a strategy in place that tells you what stock to buy or sell short. The strategy tells you how to get out if you're wrong or hang on when you're right. Through testing or real-time use, you know that the strategy works.
And then it happens—you get a big winner because you followed a tip from your neighbor. Or because you saw a news story on CNBC. Or you held a stock that was a loser, let it run through your stop and then it turned around and made some good money.
The reason why it happened isn't that important. What did happen is that you made nice profits in a trade or investment that wasn't part of your trading plan. This is like Moscow's only elephant being killed, it becomes a random but very memorable event for you.
What happens next is you put the strategy that has been working for you on the back burner. Or you abandon it all together. All of your thoughts are consumed by your own private elephant— that big memorable trade. You want to re-create it, even though there's no evidence that you can.
Three Ways to Combat the Single-Elephant Problem
All the while, your good and faithful strategy (now long forgotten) keeps churning out boring but predictable profits. And you find out that there is no magic formula for monster profits. There was just the one elephant after all.
This is a common problem for traders. Like the Moscow statistics professor, our thoughts and actions become clouded by one event. What can we do to combat this problem? Here are three suggestions that every trader and investor can use avoid being sidetracked by unusual events:
- Have a written plan. If you have no plan, how can you follow it? This is one of the most critical steps for successful investors and traders. But very few people have a plan. And if you have a plan but it is not written down, you don't really have a usable plan. If you need resources for a trading plan, Van’s website is great place to start. And you can find great help for developing a trading plan (a business plan for your trading and investing) in Chapter 3 of the book Fin. Free. through Electronic Day Trading”. Don’t let the title throw you off — 70 percent of the book is general information applicable to all types of trading. And the business planning chapter is quite comprehensive and particularly good. (I wrote a large part of that chapter and it includes my trading and business plans from early 2000 as models.)
- Understand in advance that distractions will come. Decide what you will do with "special opportunities" before they arise. If you get a credible stock pick that is outside of your strategy, how will you handle it? Include those steps in your written plan. Be sure to include how you will enter and exit such "special cases" and be especially aware of how much capital you are willing to risk on an unproven pick.
- Work to learn your biases. What catches your attention? Does a stock that makes a big win inside your strategy lead you to overtrade that stock? Are you worried that your friends will kid you if you miss out on their hot tip?
I'd love to hear your thoughts and feedback – just send an email to drbarton “at” vantharp.com. Until next week…
About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured analyst on Fox Business’ Varney & Co. TV show (catch him most Thursdays between 12:30 and 12:45), on Bloomberg Radio Taking Stock and MarketWatch’s Money Life Show. He is also a frequent guest analyst on CNBC’s Closing Bell, WTOP News Radio in Washington, D.C., and has been a guest on China Central Television — America and Canada’s Business News Network. His articles have appeared on SmartMoney.com MarketWatch.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".
Editors Note: Our readers may notice that we never spell out the full title of some of Van's books. That is because two of the words in the title will cause the email to be triggered as spam, so we abbreviate the title to be sure your email is delivered to your inbox.
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Are Your Tracking Your Mistakes?
by Kevin J. Davey
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This is a photo of a gallon of milk. Normally around $3 a gallon, this one cost me a whopping $2350.
Well not exactly, but when I look at milk these days, that is all I see. And it is all due to a trading mistake.
Let me explain.
Right now, I trade around 80 different strategies, in all types of futures markets. Many of my strategies are automated, so I only need to check on their status a few times a day.
A few of the strategies, though, require me to enter positions manually. These are either calendar spread trades, options trades or low volume futures markets (like Milk futures). Markets like these usually require limit orders— market orders will have too much slippage. So, manual order entry is sometimes the best approach. Cue the ominous music…
Of course, manual order entry depends on a human (me!) to place the correct order, at the correct time. And of course, I get distracted, try to multi-task too much, and basically screw up on occasion. We probably all fall victim to mistakes like this.
So, with the milk trade, I misread my signal, and went short when I should have gone long. By the time I realized it, I lost money from being short in an up market, and plus I didn’t participate on the long side when I should have (the dreaded double whammy!). Total cost of this misstep: $2350, and a lot of fist pounding on my desk.
This trade drove home the fact once again that trading mistakes usually cost capital, both emotionally and financially.
Over time, I’ve learned that 100% perfect trading is impossible. But, it is still the goal to aim for. Here is what I do:
I keep a log of every mistake that happens. An example is shown below. I categorize the mistake, and record pertinent details about it, most importantly the amount the mistake cost me. Sometimes, a mistake will make me money, so that gets counted in the results, too.
I define a mistake as a difference between what my strategy platform records, and what my live account says. Mistakes could be from manual operations (bad order entry, missed exits, etc), automated operations (maybe the Internet connection goes down), or anything else that should not have happened. Late on following your signal? That’s a mistake. Overruling your system? That’s a mistake, too.
Every few months, I look at the mistake list, and try to determine corrective actions to eliminate the root cause of the mistake (my old experience as a Quality Assurance leader for an aerospace company kicking in). I ask myself “this type of mistake cost me $xxx in the past 6 months – how can I eliminate it?”
If I can correct a habitual mistake, and save money by doing so, I’ll implement a fix. Note that I have to save money with the fix. Hiring a midnight to 8 AM person to monitor positions and make necessary trade corrections might be one way to eliminate overnight related mistakes, but since it is not cost effective, I probably won’t bother.
When I review, I make sure that fixes actually worked as intended. It is amazing how the “law of unintended consequences” comes into play here: you have to be careful to not create a new mistake possibility by eliminating the old one!
This sounds simplistic, and is really just common sense, but do you do it? Could you tell me how much money mistakes have cost you in the past year? I know I can (right around 5 figures in mistakes – ugh!). My guess is you make mistakes, and they cost you money, too. Eliminating them might boost your ROI by a bunch.
Now, I keep a photo of this $2,350 gallon of milk close by. It reminds me that trading mistakes can be costly. It is certainly a good lesson to remember, over and over. It also sometimes reminds me to go to the store to buy more milk, which I am going to do right now…
About the Author: Kevin J. Davey is a professional trader and a top-performing systems developer. He is the author of “Building Winning Algorithmic Trading Systems – A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading” (Wiley, 2014), recently awarded “Trading Book Of The Year” by TraderPlanet.com. An aerospace engineer and MBA by background, Davey has been an independent trader for over 25 years. He can be reached at his website: www.kjtradingsystems.com
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In the six minute video below, Ken analyzes several trades from the relatively quiet session on Monday, October 12. He opens with a swing trade that started last week on XIV talking about the entry, initial stop, target, and progress of the trade so far. That swing trade offers the opportunity trade XIV intraday with some confidence in the long bias. Ken provides two tradeable intraday scenarios for the XIV move during the Monday session and the position sizing ramifications for each. Ken then discusses a second trade where one of the traders in the chat room went short USO and earned a couple of R for the effort.
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December 9, 2015 #763
Van's Top-Twelve Favorite Trading Books
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