So you want to be a stock trader? Finding a trading system & dealing with emotion (Part two of many)

This article will address the emotional requirements, discipline, and risk controls necessary to be successful at trading. I will then address how to find a trading strategy that works. This is the second article in a series. I suggest reading the first article (on the extreme difficulty of trading profitably).

Types of Trading

There are a few different types of trading (as opposed to investing) that distinguish traders. My definitions are not going to be the same as others’ definitions, and I will make some broad generalizations that are not always true–keep that in mind. There is daytrading (rapid trading intra-day, usually not holding positions overnight), swing trading (buying stocks based on longer-term charts and news), and fundamental speculation. Day-trading can be subdivided into scalping (going for small 10 cent stock moves), trend following, and dip buying (counter-trend trading). Day traders typically do not trade on news (although they may adjust stop losses or profit targets if there is particularly good / bad news). Day traders do not care about fundamentals; all they care about is a stock’s price movement. I do a decent amount of day-trading. Swing trading, on the other hand, is a longer-term trading style. The classic example is Bill O’Neil’s CANSLIM system. Most swing traders I know like to hold stocks for a few weeks or months at the longest. They often use a combination of fundamental and technical analysis. I have never swing-traded. The last kind of trading I will address is fundamental speculation. This involves taking a directional bet on some security for some fundamental reason. My profitable short sale of Silver State Bancorp from $2.00 to $0.09 (in bankruptcy) was a fundamental speculation.

There are other types of trading but they are not particularly relevant or they fall within one of the above classifications. Most fake arbitrage (merger arbitrage, pairs trading, statistical arbitrage, and anything else called arbitrage that involves risk) is simply a type of fundamental speculation.

Disclipline is the Key

No matter what kind of trading you are trying to do, you need to be disciplined. Ego, greed, fear, and any other emotions only get in the way. When a trader is undisciplined or trades based on emotion, he will make costly errors and lose money. In the book of Chuang-tzu there is a story about a discussion the philosopher had with a student. Master Chuang stated that a man who could not swim would make a poor fisherman, a man who could swim would make a decent fisherman, and a man who is as much at home in the water as on land would be an excellent fisherman.  That last man would be free to concentrate on fishing because he would have neither fear nor excitement at the prospect of being out on the lake.  So it is with trading: the best traders are emotionally detached from trading and the prospect of winning or losing large sums of money.  This emotional detachment allows them to focus solely on carrying out their trading plan. It may sound odd, but I have gotten very excited about a small $100 gain (because I had made a perfect trade albeit using little capital) and I have become despondent after a $6000 gain (because I had failed to implement my trading strategy correctly, missing out on far larger profits on what was a perfect trade setup).

Anything that will prevent a trader from being detached, calm, and focused will lead almost certainly to losses.  Stress in other aspects of a trader’s life will distract a trader and likely cause losses.  Outside stressors that cause a trader to focus on money are the worst.  Whether it is a need to make money to impress a girlfriend, sustain a lavish lifestyle, or provide for the family, the need for money will cause the trader to lose focus and will almost certainly lead to losses.

Discipline Requires A Plan defines discipline in the following ways:

1.     training to act in accordance with rules; drill: military discipline.
2.     activity, exercise, or a regimen that develops or improves a skill; training: A daily stint at the typewriter is excellent discipline for a writer.

The first definition perfectly captures what discipline should mean for a neophyte.  Discipline means sticking to rules.  That is why chess students study famous games and strategies and first learn to implement classic strategies whole cloth before trying to mix and match bits of different strategies.  Likewise young doctors learn to follow a clear diagnostic protocol when diagnosing a disease.  Only with much practice will a doctor, chess player, or trader reach a level of knowledge and skill that they do not have to consciously implement a set of rules.

How Not to Trade

In my previous article I discussed several trading strategies that I believe to be very poor.  Simply put, any trading strategy that relies upon the trader implementing that strategy being smarter, better, or faster than other traders is a poor strategy.  When analyzing potential trading strategies, the key is to identify niches that besides offering opportunity for profit, exist for some reason, will likely continue to exist for some time, and do not suffer from a lot of competition from other (potentially better) traders.

A great example of a trading strategy that does not meet any of the above criteria is trying to swing-trade the stock market.  There is little evidence that any one can predict where the stock market will go in the next week, month, or year. The CXO Advisory Group has a good analysis of various stock market commentators, none of whom show any evidence of being able to reliably predict the direction of the market. The best among them was accurate only 63% of the time, while the group average was 48%. Mark Hulbert, who tracks many stock-investing newsletters, agrees that market-timing does not work (this is compounded by market timing becoming more popular during market lows and less popular at market highs). If predicting the market were possible, there would be a lot more smart traders (such as hedge funds) that time the market. Instead, the traders who try hardest to time the market are small retail traders (suckers). (I should add that I believe that sometimes it is possible to beat the market by making fundamental calls, such as betting that housing was going to cause a recession, but past experience shows that the people who bet correctly on the current market downturn have no more ability than you or I to predict where the stock market will be in a year. John Paulson, for example, has been sitting on his bearish bets on mortgages for a couple years.)

Now, for an example of a trading strategy that works and that meets all the above criteria.  This is my strategy for arbitraging the differences in value between Berkshire Hathaway share classes.  While this has made me money, it is niche trading strategy; the strategy produces bond-like returns, requires that I pay close attention at all times, requires a minimum of $200,000 to trade, and cannot be scaled up past maybe a few million dollars because the shares are relatively illiquid.  The problems with this strategy preclude all of the following types of traders from competing with me in this niche: hedge funds, part time traders, traders with little capital, and traders who have enough capital and time but use their capital all of the time for other trades.  In essence, the very problems with this strategy are its strengths for me–its problems keep other traders away, meaning that I will likely be able to continue profitably trading this strategy far into the future. (Disclosure: I am currently short BRK-A and long BRK-B.)

The Characteristics of a Good Trading System

Most people believe that the only thing that matters about the trading system is how profitable it is.  This is incorrect.  There are many different aspects of trading systems to which a trader must pay attention.  Profitability per se is actually not one of them.  Instead, profitability is best thought of subdivided into its component parts: percentage of winning trades vs. losing trades and the average profit per winning trade / loss per losing trade.  Many good trading systems will produce about the same number of winning and losing trades, but they produce much greater profits on winning trades than losses on losing trades.  It is a rare trading system indeed that produces both a large percentage of winning trades and significantly larger profits on winning trades than losses on losing trades.

Besides these measures of profitability, there are many other important aspects of trading systems.  The frequency of trading opportunities is one of the more important; the trading system that produces three trade opportunities per week will be three times as profitable as the system that produces only one trade opportunity per week.  Conversely, anything that makes the trading system more profitable can be tweaked to make it that much less risky instead.  So if a trading system produces many trades, the trader can devote less capital to each trade, reducing the probability of losing large sums of money on any one trade.  Another benefit to a trading system that produces many trades is that allows for quicker evaluation of a system and higher statistical certainty that a trading system actually works (given equivalent profitability profiles, we can be more statistically sure that the trading strategy with thousands of trades is not due to chance than we can of the trading strategy with just 50 trades).

Another important facet of a trading system is its scalability.  It is a lot easier to devise a trading strategy that generates 100% annual profits with $100,000 in capital than it is to generate such profits with $10,000,000 in trading capital.  If you’re reading this article, you are likely not a hedge fund manager with over $50,000,000 or $10,000,000,000 in capital.  You should use your size to your advantage by pursuing non-scalable strategies.  Pursuing non-scalable strategies also guarantees that you will not be competing against the best and brightest traders.  A good example of this is my recent arbitrage trade in KV Therapeutics stock.  Over the last week, my trading was over 2% of the trading volume in KV B shares (KV-B); on the days I actually traded the stock, my trades accounted for up to 10% of the volume!  A hedge fund with even $50,000,000 (tiny for a hedge fund) that does the same type of arbitrage trading I do would not be able to build up a meaningful position in such an illiquid stock, forcing it to trade other pairs of securities that offer much less profit potential.

How to Find or Design a Trading System

There are many different ways to trade stocks profitably.  These do not generally include common trading systems that you find advertised everywhere.  There are multiple problems with these systems.  The main problem is that there is no way to know if these trading systems work.  I have not heard of one trading guru whose returns are not only audited but also can display the great audited returns of a random sample of their followers.  The only trading guru of whom I am aware that has great audited returns is Timothy Sykes (who has plenty of educational materials to sell you).  He has the website tap into his brokerage account automatically to verify all his trades.  So at the very least you know that the trades he has been reporting are trades that he has actually made. If you run into any trading guru selling some system, ask them why they don’t use Covestor (it is free) or have a well-known auditor audit their trades. The evasive answers will likely be amusing.

So with anyone selling a trading system (or with just random trading bloggers) it is impossible to know if they are telling the truth or not.  There was actually a recent case where a trader I am acquainted with exposed a  generally respected trader/blogger who had blatantly lied about a trade he said that he made.  While that blogger was not selling anything, I am sure people have lost money following his free advice. If there is not a reputable source that has verified the trades of a trading guru or system, I would recommend following trades in real time (for a long period, such as a few months) to see if a system actually works before committing money to trading the system or paying the guru.

Other than fraud, the main problem with using someone else’s trading system is that it is easy to mess it up.  In any probabilistic endeavor, whether shooting a basketball or trading stocks, there will be long streaks of hits and misses.  If a person is shooting a basketball and knows that on average he hits 60% of his shots, he will not give up in disgust and quit basketball when he misses seven shots in row (which should happen by chance alone 0.16% of the time, although much more frequently in games due to variation in a defender’s skills).  (I should also point out that there is no statistical evidence that such a thing as a hot hand exists in basketball; people simply misinterpret the chance occurrence of a long string of good shots; the same is probably true for stock traders).  If a person is confident in a trading system that she has developed (or that she has rigorously tested and understands) and is confident that the trading system will continue to work, she will not abandon it.  A trader who uses another person’s trading system without fully understanding it and testing it will be prone to abandoning it when by chance alone the system produces a string of losses.

Another important caveat for those who would consider purchasing a trading system from some guru is that the best trading systems will never be sold.  Take me, for example: I use four main trading systems; my most profitable trading system I will never disclose to anyone (unless they wish to pay me $500,000 right now) because I can make far more money trading that system than by selling it.  On the other hand, I’m perfectly willing to discuss my other trading systems because they are far more limited (as I have done above with my share class arbitrage trading strategy).

Designing Your Own Trading System

By now it should be obvious that I believe it is much better for a new stock trader to design her own trading system, or at least plan on adapting an existing trading system to her own personality and style.  If you are interested in designing swing-trading systems based partly on technicals and fundamentals, I would recommend  I successfully used Portfolio123 to design trading systems that have helped my IRA outperform the stock market by 20 percentage points over the last 18 months (when I stopped using Portfolio123 last July and switched my IRA to other stocks I was outperforming by 40 percentage points!).  If you are interested in purely technical trading, I recommend I use Stockfetcher to
scan for my day-trading stocks.  As far as books go, I think most trading books are utter crap; I recommend James Altucher’s “Trade Like a Hedge Fund“. It encourages the right kind of critical thinking in designing a trading system.

One last note: as far as technical analysis goes, 99% of it is crap. I only use the simplest kinds, all of which I can justify by understanding the psychology of traders. No happy prime Fibonacci retracement levels for me!

Note: I have not yet published a followup to this article, although I will eventually.

Disclosure: Short BRK-A and long BRK-B. This article was originally posted on my investing blog on 2/7/2009. I have paid Tim Sykes money, have successfully used his system, and am an affiliate of his. See my disclosure policy for details.

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