Misconceptions: I Can Quickly Tell What Works

There are two flavors of this misconception:

• Pessimistic: I tried it once, and it didn’t work, so it never works
• Optimistic: I saw it work once, so it always works

Let’s look at them in a little more detail…

Pessimistic Flavor

I see so many traders trying a new idea for a couple days, and then dropping it when they lose money. Losing money makes it hard to remain rational about the situation, but you have to remind yourself: Trading is a probabilistic activity. Even several failures in a row may not be meaningful, if the win rate you were expecting is in the lower end of the profitable range.

If you have a trading idea, and you know why you think it works, don’t let a few losses early on bother you. As long as you still believe in your reasoning, collect enough data to see what impartial statistics say. That means at least 30 to 50 trades to get a preliminary read on the idea. You can do this by backtesting the idea, or paper-trading the idea, if you don’t want to risk your actual money.

Traders suffering from the Pessimistic flavor often fall into a trap where they’ve given up on all of their trading ideas, and start drifting from system to system. They’ll write me emails asking about my strategies, or which indicators I use. Sadly, they sometimes ask me which indicators I think pinoy trader might be using (for the last time, I DON’T KNOW). I tend to think that you don’t need to find a new strategy… the first one you ever heard about probably works. It’s almost always your execution or in-trade management that needs help.

Traders sometimes write me mail or blog comments that start like: “Since breakouts don’t seem to work anymore…” And they say it matter-of-factly, as if the statement doesn’t need explanation or clarification. When I ask about it, usually they admit that the breakouts they were watching have been reversing for the last few days. That’s just a handful of trades, and not even necessarily all the breakouts on those days!

Optimistic Flavor

You can probably imagine how the optimistic flavor of this misconception goes. I think this is far less prevalent than the pessimistic flavor, but I still spot it from time to time.

These are the traders that say “I’ve noticed that whenever X happens, Y happens.” But, if you dig further, you realize that they should have said “I saw Y happen after X once.” This poor soul starts using their new “rule” as part of their trading, and the results are not always pretty.

Another common manifistation of the optimism problem goes like this: “I would have made more money on that trade if I had raised my stop earlier. From now on, I will raise my stop earlier.” Whoa there, cowboy! Trading is a probabilistic pursuit, and you need statistics to tell you what works and what doesn’t. Maybe you’ve just optimized your whole system so that this trade makes more money, but several others make less money.

Summary

When playing with trading ideas, you can’t just extrapolate from a couple examples you happen to spot while trading. Instead, you should always strive to have two things:

1. An idea with reasoning behind it that makes sense to you
2. Some statistics on as large a corpus of examples as you can reasonably scrounge up

Isn’t (2) enough? Actually, no. You need (1) to keep you from being fooled when your samples feeding (2) just happen to fit your hypothesis by accident. Say I hypothesize that the 10:15 candle will be green on Wednesdays, if the 10:15 candles from Monday and Tuesday were both also green. Obviously, this is nonsense! But what if I pull 60 examples, and 74% of them happen to work? See where I’m going with this? You need to understand intuitively why your idea ought to work, before you bother gathering data on it. Real trading ideas you are considering won’t be so obviously nonsensical!