Show Notes
You have to always manage risk with the odds in your favor.
Even if you lose, if you’re sticking to your rules, it could be a good trade that just had a bad outcome.
Keep putting on trades with high expected values and over hundreds of trades you’ll come out ahead.
How you recover from a drawdown is more important that the duration or magnitude of the drawdown.
Everyone has drawdowns. Therefore, focus on your rules and play superior defense and allocations such as Peter will respect your process.
Transcript
Michael:
So, I want to talk about losing money and the positive impact of losing money. A lot of the folks who are listening to this show, they’re cutting their teeth. They have a trading grubstake and they come from a mindset where “if I put a trade out and and I make money, therefore it was a good decision. If I put a trade out and I lose money, it’s a bad decision.” Can you shed some light on the decision making process and how it’s possible for someone to make a good decision and lose money?
Peter:
That’s a good point and I think that the biggest mistake that most people tend to make is I guess I would call it a misunderstanding of the Kelly Criteria and for your listeners, you should sort of Google that, but essentially it’s what should be your risk per trade when I start trading. We tend to think of itself … It’s also the gambler’s fallacy where if I start and I lose, I’ll add or I’ll bet bigger because I can’t lose so many times in a row and then that’s, of course, not the case and then you continue to lose and you run out of money and the next trade, it’s particularly smaller. It’s your winner.
Sometimes winning is losing because it forces you to lose your discipline. Trading is not about winning or losing. It’s about probabilities. Every time I initiate something, the risk-reward has to be defined, but I define a good trade as if I have the same set of inputs, the same variables, would I make the same decision regardless of the prior outcome? If the answer to that is ‘yes,’ even if it was a loss, it was a good trade. If I’m a manager and I relate trading very much to baseball and I’ve got a lefty power hitter up and I bring my lefty specialist out of the bullpen and he gives up a hit, is that a bad decision? Would I do it again?
If you say it’s a bad decision, that’s the misplaced fallacy because the next time you’re in that situation, you are less likely to do what you should be doing because you’re adding too much weight to the most recent observation, so if you’ve had a successful trade, sometimes you trade too large and you risk too much because you’re putting too much on that last trade, saying, “I’m smart or things are going and I’m hot.” The flip side is if I’ve lost and I don’t have my initial trading size correctly, I may cut it down too small because I’m leaning on that last observation. You need to be able to trade over a period of time with a significant number of trades and therefore your initial trading size, I go back to that first point on Kelly criteria, should be far smaller than most people think.
Michael:
I agree a hundred percent. I did an episode of this show a while back and it was called the positive impact of losing money because I think our losses teach us more than our winners, right? If I put on a trade and I don’t know what I’m doing and I win money, I might think I’m onto something, when in fact I don’t know my backside from a hole in the ground. When I lose money, I get to think about a few things. I get to think about the frequency of trading. I get to think about what my bet size is, because one thing that you and I know and perhaps a lot of folks listening know is that when you’re a pro trader, losses are part of the business. There’s no escaping them.
With that, I’d like to ask you about how in your mind’s eye would a professional handle this concept of draw down, both in terms of length … You know, frequency at magnitude, right? You have XYZ draw down and it lasts three, four, five months, whatever it might be. What is your professional opinion on draw downs and how traders would deal with them?
Peter:
I’m gonna jump ahead. When we’re looking at traders and analyzing them, we very much look to see how they recover from a draw down. Every trader goes through draw downs. Successful traders can come back from them. You know, when you’re doing well, again, in a hot hand fallacy, oh, I’m trading well. I’ll make money. Of course, you’re running around. Your chest is puffed up. You’re feeling good about yourself. The question is when you’re in that draw down, what are you doing? Are you feeling bad for yourself? Are you doing things differently than you did when you were successful? Are you taking a look at that? Are you blaming others for your failures?
Very common problem. “Well, the government did this. This report came out. It wasn’t supposed to do this. I was distracted. I had a personal issue. I had this position on and I went to pick up my kid from school and I forgot to put in a stop and the thing ran away from me and then it was down so much I decided that I would hang on to see if it bounced and then it didn’t bounce and then I took it home overnight and it gapped down.”
Those are great. Those are fantastic excuses. I’ve created every single one. I’ve used them all in my own life except I don’t care about them. You are what your track record is. It’s all about you. It’s not about the excuses that you make, so this is why we want to see how you behave in and coming out of the draw down, both in terms of what did you do with your risk management? How did you deal with your trading size? Did your analysis in everything, as we said in the prior question, did you address the same probabilities? Were you pressing? If you get up to bat as a trader and you’re thinking about the fact that your last trade was a loss, you’re already in trouble because you’re going to change your behavior.
What this means is if you put on that trade and you start making a little money and then it pulls back a little bit, you’re like, “I can’t have a loss in this trade. I’m gonna get out.” Well, okay, that’s an emotional reaction. I need people that are actors, not reactors, so we want to see how you’re acting in that draw down, how you come out of that draw down. That’s gonna tell us a lot about how you are gonna grow and potentially be a bigger and more profitable portfolio manager.
Michael:
That’s pretty profound. Can I read between the lines, then, and think that as an entity, as an allocator, Quad might be more interested, generally speaking, in a manager who has a multi-strategy approach as opposed to one who’s gonna be like a longterm trend follower and they’ll live and die by whether the markets show them trends or not?
Peter:
So, our input for us is a multi-strategy, multi-manager hedge fun. We try to generate performance without taking single-strategy risk. The compilation of managers themselves can have single strategy risk, but we’re trying to define alpha as those that can trade within a time frame that is differentiating, so in very short term trading, high frequency trading, we can’t compete in that space. I’m not trying to compete with the biggest Quant funds. They’re too smart. They’re too good, and as you just said in long run trading, I’ve yet to find an existing investor recently that wants to pay me two percent to be long Google because anyone can get long Google now, so we define things as one week to three months in earning cycle, and that means that if you are trading there and what your strategy is, it’s difficult if you’re just trading a single market, so if you’re trading S&P futures to distinguish yourself is very tricky because look how many people around the world are trading S&P futures, and of course you have the market as a whole and its beta.
But if you’re trading that in bonds and crude oil or other futures contracts or your trading sector ETFs or you’re doing things that are unique, that’s something we’ll be looking for. We’re also not interested, and I don’t recommend people do this and say, “Well, I’m really a long trader but I want to get rid of some beta by taking a ETF or something and shorting that.” If you’re doing that, to me, you’re not a long / short trader. You’re more of risk adverse. You believe what you’re doing if you like your longs and you’re concerned about volatility, trade them smaller or trade them more actively and if you’re long short, then get something that you think is going down. That’s a lot different than a hedge.
Conclusion
If you bail on your rules, like amateurs do, you relegate yourself back to amateurville. How you behave around drawdowns will show allocators how you will behave when you lose their money.
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