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What to do when your Trading System is not the problem

You think you have great entries and exits, and you have position sizes that you’re comfortable with. Yet when you systematize them, the hypothetical results are not critical to the extent that you can use them to manage risk — or raise any capital to trade.

So you go back into the dashboard of your simulator and you start the tweak the living daylights out of your entries. That doesn’t work. You tweak your exits. That does’t work either. You test smaller positions. That doesn’t work.

You begin to add indicators to your rules. They bring small but positive changes, but the overall hypothetical results still stink. You layer another 47 indicators on top of one another and you finally have something that will make money. But now the problem is that the system makes only 3 trades over the last 10 years. It basically needs to be Leap Year for you to put a trade on.

You’re about to scrap the whole file and start over. You’re feeling enormous buyer’s remorse because although the simulator isn’t necessarily expensive, it feels so when you can’t get it to work. You may become so frustrated that you want to quit.

The problem could be with your data. Yes, it’s important to have clean data in that you don’t want any bad prints to trigger trades in your simulator that will otherwise destroy your ethos when it would otherwise yield results that would look promising on the first pass. I’m talking about the universe of names (tickers) in the data that you’re pumping through the simulator.

You may need to rake the data before you run it through the simulator. Gold does not trade like Sugar does not trade like Apple. Why would you have them in the same data universe? You wouldn’t and that’s an easy one to understand. Suppose your trading rules worked better in one asset class that another? Or suppose they worked well for one capitalization but not another? Maybe you should consider segregating the small caps from the large caps…

Here you are double-clicking your mouse for 10 days trying to get your system to work and the problem is not with the system, but in the data.

You can rake your data before you run it through your system and create your own universe of securities to test. Here are a few examples:

–NYSE listed securities only
–Average Daily Trading Volume (ADTV) > 10MM shares
–prices between $20 and $75
–omit Preferreds

Test everything at the portfolio level to make sure that your rules are robust, and try to keep your rules simple so that you can explain them very easily to a non-pro.

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There are many misconceptions about creating a mechanized trading system. Some feel that mechanized systems are better than discretionary systems as if they give a trader an edge. I think this may be true for those traders just starting out. However, I personally know many discretionary traders that have done just fine without systems. The key is to do what’s best for you. Allocators will give money to traders who can perform. Lastly, discretionary trading is a form of a system unto itself. More on this in another post.

I tend to see those traders who wish to become CTAs going the mechanized system route and those that are endeavoring to become prop traders go the discretionary route. What separates them is either years of experience and normally a focus on one instrument or sector.

Overall, I believe that it’s a great idea for a new trader to get to know and build systems from scratch with a simulator such as Trading Blox, for example, to get a very intimate understanding of all the moving parts that involve a trade: volatility, volume, price action, trends, and large counter-trend moves to name a few.

What’s lost on most most new traders is how their emotional intelligence is a major factor on their mechanized trading rules. Hint: they’re there whether you know it or not.

For example, if you are a risk taker in life, you’ll find that your personality type is manifest in your ultimate trading system. If you tend to be methodical and “slow and steady,” you’ll find that your approach to your mechanized trading rules is the same. If you don’t trust yourself, you won’t trust your system no matter how long you spend putting it together. If you have self-doubt, your rules will likely be the perfect system for generating tons of indecision and self-doubt.

Ultimately, all the decisions you make in creating your trading system are discretionary. That includes how much to risk per trade, positions sizes, entries, exits, and what instruments to trade. To say it in writing, there are no rules in creating your trading rules. That’s where your intelligence, emotional constitution, sense of self-awareness, and emotional intelligence all come together. I think the best traders are strong in all of these areas. Wisdom in these areas does not come easy. After I’d completed a great deal of what some of you are about to endeavor, I STILL needed to get my head handed to me. I documented a great deal of what I needed to live through in my book.

You are using your judgement and are weighing the tradeoffs between parameters and hypothetical outcomes to see which “feel” best. Feel here is emotional not intellectual, ie, “I’m scared and fearful about my long gold position,” not “I’m bullish or bearish on gold.” How you feel will affect your behavior and your behavior determines and predicts where you end up in life.

You can set up a system to be geared for triple-digit returns or for fractions of percentage points per month. You get to make those decisions, and as such, your system like all others has a discretionary element. But know this: if you swing for the fences, you’ll have to live with large drawdowns (realized and unrealized losses). You determine the calibration of these tradeoffs — and that is discretionary. Keep in mind, small hypothetical gains go with smaller drawdowns of shorter duration, and large hypothetical gains go with larger drawdowns of longer duration.

Discretion Two Times: Creating the rules and then following the rules.

Creating the rules is discretionary. Following them can be mechanical. The key is how much of your rules capture how you feel in the NOW-NOW and later-NOW. And that’s hard because there are those of us who believe that the future (the later-NOW) doesn’t exist: all we have is the ever-evolving moment of NOW, the NOW-NOW. Knowing how your feel later-NOW is hard to predict. But you’re likely to have an emotional system that you’ve been running for years, and as such, you might be able to get a sense how you’ll behave in the later-NOW because you’ve been doing it for years. That’s where self-knowledge is absolutely key.

[Your emotional system has the part that you're aware of and the other part that you either don't want to look at, or is subconscious and you're not aware of it. That's where a men's group or a Trading Tribe can do wonders for you. For me, I have always put my money where my Tribe is: I was a member of the IVTT for 2 years (while living in LA) and I also concurrently ran the LA Tribe. That means I had a Tribe meeting every week for 2 years.]

What makes your system completely mechanized comes down to your ability to follow the rules alongside your emotional system. At best, the two have converged or at least are running parallel as your grow both intellectually about using Trading Blox, for example, as well as learning a great deal about yourself.

Discretion can appear after you’ve built out your trading rules, even with the help of a simulator. You can get a signal to enter or offset a trade and not follow it. Over-riding your rules here is discretionary. You may not have a signal from your system, but have a bona-fide hunch about an instrument and you affect a trade outside your systematic rules and put it on. That too is discretionary.

Neither use of discretion at this point are bad, evil, or wrong. You get to determine the rules and how you want to stick to them. They are your rules and they are personal. No one can tell you what’s best for you other than you. Even if you look to Bill Dunn – a fully systematic trader – you can have an element of discretion in your trading.

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by Victor Sperandeo

“Economics is the science of means to be applied for the attainment of ends chosen.”

The above quote is from Ludwig Von Mises, a founder of the Austrian School of Economics, a school of thought which mirrors my beliefs. It implies that “how” you solve problems (what political philosophy is to be used) is an (idealogical) choice, as well as an economic one, and “how you attain a goal,” demonstrates what your political beliefs are.

Politics is a branch of philosophy of “how people in society should live.” This is achieved through:

— Capitalism, or freedom: a social system based on individual rights including property rights which is all privately owned. It assumes free markets without government influence. To say “laissez-faire” Capitalism is redundant. What regulates markets from the free market is the courts and the police when fraud is involved.

— Socialism, or a great amount of Government control of the economy, and ownership of the means of production;

— Facsism, believes in the Nation over the individual, and “control” of the means of production, but not in owning them.

— Marxism (Communism) believes in no individual or property rights, and are led by group decision, e.g., the politburo, but generally led by a strong statist, e.g., Mao Zedong or Joe Stalin;

— Dictatorship: led by one with no liberty or rights to the people, e.g., A Hitler-type.

The fact that Paul Krugman calls himself an economist is a facade because he really is a political hack for a progressive (read Socialist) future for the US. His view of “how” to solve economic problems is by taking away your liberty, by government controlling every aspect of your life, and confiscating your earnings and capital by force. He cares virtually nothing of creating huge debts, and deficits. In the long run Mr. Krugman is promoting, in effect, (hyper)inflation or bankrupting the US. The debt is not an issue to Mr. Krugman, “because we owe it to ourselves” ?!

Logically then, he must believe someone who buys a government bond with his own capital, which the government then spends on an anonymous person (to buy support for power). But then when the government can’t pay it back with the same purchasing power, it’s ok – as inflation does not matter because the government really owns all the money / capital anyway – not the individual – as the tax system has shown. At which point he says “we owe it (the debt) to ourselves ” he means as a “Collective society” not a Capitalist one, concluding the fact people have no property rights.

I call this theft and moral plunder. It concludes in passing the debt to future generations to be dealt with and I my opinion is the highest form of immorality.

An example, and perhaps the dumbest financial idea Mr. Krugman (or anyone in history) has pushed is saying the government should mint a 1 oz platinum coin, and put a fiat value of $1 trillion on it. Today it would be intrinsically worth about $1691.30, not $1,000,000,000,000.00 !! This coin would be deposited by the Treasury into a FED account, and the Treasury would draw on it to spend federal reserve notes (fiat paper) as it desired. His ending comment in a New York Times editorial pushing the idea was. “Mint the darn coin”. (!)

This is truly an amazing fantasy of how to create paper money, using this ridiculous “Madoff like scheme” is the height of how government, with the help of a Noble Prize winner, can destroy a country. When you give government, by way of the Fed, a monopoly over the discretion to control the amount of money and the level (cost) of credit (a Karl Marx recommendation) you end up with ideas like a $1 trillion coin. The Fed passed on this obvious scam of an idea, as they would rather print paper the old fashioned way- using QE’s, which is far more difficult for the public to understand!

Lastly a simple contrast in beliefs is the “lack of demand” that is never mentioned on the differences between Keynes and Von Mises is as follows: A Keynesian would say that currently the lack of “aggregate demand” is due to Bush financial crises, and government must spend to make up for it. An Austrian would say the problem is caused by “Originally Interest” (OI) which is driven by Obama policies which are pushing people to hoard cash, i.e., postpone buying. The definition of OI is the ratio of value assigned present goods versus future goods, or what each person or entity decides to save or spend based of their view of the future.

The Paul Krugman view of deficits (and debt) is we need more of it, and it’s not a concern.

Moreover the direct problem is not the debt, as it will never be paid, but postponed or inflated away. It’s the indirect problem of the interest that has to be paid. Interest rates are 22% of their last 52-year average (approximately 1.4% today). To show how impossible the debt has become to service, if you employed all the temporary workers and unemployed workers and paid them 30% above the median income or $65,000 a year, and all those 23 million people paid $10,000 each in taxes, or $230 billion, the deficit should be reduced?

However, if interest rates rise 1.5% on $16.5 trillion “stated” debt the $230 billion becomes $0 net revenue to the government. If interest rates rise to the average 52-year rate or 6.17%, the budget deficits added by just interest payments rises by $1 trillion without any other spending ! This problem can be understood by a high school senior who is proficient in math, but obviously not a Yale, MIT, nor graduate and a London School of Economics and Princeton Professor who is a Nobel Prize winner.

The fact that Mr. Krugman uses as his proof that the markets are accepting his “debt doesn’t matter” premise for the last several years with low interest rates, and no crises, (which is due to fear of Gov’ts fiscal polices) is not the point — as when one gets cancer you don’t die right away.

The fact is all this printing and borrowing is an unsustainable cancer.

For example if debts don’t matter then why did 1920 Germany develop into hyperinflation? The velocity of money was virtually identical to US today or 1.5 versus 1.6 in the US (M2), today. Germany had created a huge debt in fighting WW I, and after the end of the war on November 11, 1918, with reparations, they could not pay the debt and the interest. They began to lose the ability to borrow and raise taxes. Taxes were so high that even “under penalty of death” did not matter people would not pay. However they also had a printing press (unlike Greece today).

In 1920 Germany began to print Reichmarks to pay the debt and interest. The velocity of the money rose to 12 in 3 years. Stated differently, the German money supply turned over once a month in 1923 instead of 1.5 times a year in 1920. The bell rang and people lost confidence in bonds and the currency. Today the US is like 1920 Germany. Printing (fiat money) via QE’s and debt are icreasing at “increasing rates” while bonds and the dollar are generally declining, and taxes although being increased, while (to date) tax collections have declined as a percent of GDP even though the recovery started in June 2009.

Today the US Fed buys between 70-85% of all the debt floated by the US since QE2. My speculation is that as early as 2014, reality will provide the evidence Mr. Krugman needs to show him 2+2 is always 4. The debt will turn into 100% printed money, i.e., total monatizing of the debt, and thereby hyperinflation will begin to occur in the US. The freedom based of the US “Constitutional Republic” will begin to accelerate to its end as we know it.

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innervoice e1357971514904 Why Most People Fail at Trading

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One cold winter morning a young man flies 1,377 miles on a plane to visit his friend and mentor. He knocks on the Banjomaster’s door. The Banjomaster answers with a long-necked banjo in his hand.

mike 300x225 The Banjomaster

“Yes?”
“I want to learn about the Banjo.”
“Very well then, come in out of the cold.”

edmike 300x225 The Banjomaster

They sit at the kitchen table eating soft-boiled eggs and blueberry sausages. The Banjomaster hands the young man an instrument and begins to talk about the fundamentals of firewood.

After a few minutes, the young man interrupts.

wood 300x225 The Banjomaster

“Excuse me, I am here to learn about the banjo, not the fundamentals of firewood.”

The Banjomaster takes the instrument and tells the man to go to bed and come back downstairs in the morning.

The next morning, the young man returns to the kitchen table. The Banjomaster puts another instrument in the young man’s hand and continues the story.

The young man interrupts. Again the Banjomaster takes back the instrument.

A few hours pass and the young man also learns to speak Hindi, Mandarin, and Russian fluently and code in C++.

realization1 240x300 The Banjomaster

At one point, the young man observes –
“The instrument I hold is not a genuine banjo…it is a chainsaw.”

“Yes, they are both loud, noisy, and obnoxious,” the Banjomaster said. “And in that regard, they are hard to tell apart. However, I need firewood at the ranch for the winter, and for that the banjo is useless.”

chainsaw 225x300 The Banjomaster

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