Wednesday, February 27, 2008

Trading, GPS navigation and mates

I have a mate, a really good friend.

I rely on GPS navigation systems when I drive around the city. I figure that, even though there may be a quicker way, on average, I am better off with a good navigator. My mate (call him Peter) detests sat nav systems – he knows the city exceptionally well and the nav system is pretty well nearly always "wrong".

Peter decides that he wants to trade, wants to make some easy money. The managed funds he holds are doing ok but he is sure that he can do better. So he comes to me. I know that it is not as easy to show someone how to trade so I give him a list of things that he has to do – set up a brokerage account, get a data feed, buy software, work out how much money he wants to use. I want him to think about how much effort is involved. This takes him around 18 months to set up since he is very nervous about jumping into the market and also has very limited computer skills (his wife is much more comfortable with computers).

I give Peter a system, as well as a list of simulated trades that the system would have made over the last 5 - 10 years. I suggest that he studies these past trades to see how the system performed, what it’s weaknesses and strengths are, to get a feel for the system. I am very conscious that this is unlikely to happen. Paper trading is very hard. The pull of the markets, the excitement making that first trade is far too strong to waste time understanding what could happen and how the system behaves.

As usual, after waiting for some years before he can gather the courage to face the markets , the market struggles and Peter loses a little bit of money. But soon he falls into a rhythm and seems to be following the system quite well. He even wings a couple of trades because he believes that he is getting a feel for the markets.

Then the market has a bit of a downturn and Peter, who has been trading quite well for around 18 months thinks that he can improve the system by ignoring the sell signals, much like he ignores a satnav system. For a few trades he waits a few weeks and then gets out a little better then acting immediately on the signal.

But then he ignores the sell on CHC. This is not the only sell signal ignored, there are a couple of others, but this one illustrates the point nicely – none of them have recovered yet. Instead of getting out at around $2.50 back in December 2007 he holds it.



It’s early February and Peter isn’t looking too happy. I ask him how the trading is going.
“I don’t want to look” he tells me.
Over a couple of days I find out about CHC and another trade that have gone seriously wrong.
“What should I do? What would you do?”
“I would have sold CHC back when the signal was given.” I tell him. “If I did somehow ‘forget’ to act on a signal then I would get out as soon as I realised my mistake. I would sell immediately and move on.”

I am in a risky position. It is just as likely that as soon as the stock is sold it rebounds back above a $2 and Peter is cursing acting on my system based advice and believing that his judgement is better than any system. So I make sure that he understands it’s his decision, he is outside the system and I really have no special knowledge of what might happen to this stock over the next few months. He is navigating blind in a city where roads are built, moved and destroyed every day. In this sort of city a well thought out strategy is required if you want to get to your destination.

This is a true story and I take the following from it;
1. If you are going to trade a system then trade the system, don’t try to beat or “improve” the system on the fly.
2. Believing that you have some special, innate ability, some “gut feel” for the markets is a seriously delusional state of mind. Sure you can be lucky some of the time, but luck tends to run out the more it is relied on.
3. Taking a loss is hard for many people. We are not brought up to take losses. Trading is not a natural activity for humans to undertake.
4. Some people seem to be able to follow a system as easily as they breathe. They don’t question, they don’t try to beat it, and they just follow the signals and move on. For others it is not that easy!
5. Don’t look back – always move forward. What could have been is irrelevant. Peter would always say things like “if I had held it longer it would have recovered.”
6. We tend to see what we want to see. It is easy to find examples that validate our beliefs about the market and ignore the trades that don’t.
7. Some people are not suited to trading a system, or trading in general. They should go for managed funds or use a blue chip buy and hold approach.
8. It is much better to learn from another’s experience than to be the guinea pig yourself. Experience is the cruellest teacher when it comes to trading.

Do we really believe that we are, without any training, strategy or insider knowledge, natural born traders? Or do we just try to sway the probabilities in our favour and hang on for the ride?

stevo