What Makes Trading So Difficult by Stephen Duneier
In this edition of Seeds, I will discuss why it is that one of the most common approaches to trading is dead wrong. I’ll also explain what makes it so appealing and why it will continue to be difficult to resist, even after I prove to you that it is irrational. Let’s begin with the basics of investing. You form a view and with it comes expectations. See Chart 1 for an example. In this case, the investor is bullish.
Of course, we aren’t so naive as to believe that anything will move in such a straight line, so we have a range within which we expect it to trade (see Chart 2).
As time goes by, the spot price ebbs and flows. Sometimes moving higher, thereby confirming your view, while other times it moves lower, calling your view into question (see Chart 3). When we look back on an asset’s price action, it actually appears to be this clear cut, and the job, with the benefit of hindsight, seems like it really is that simple. The reality, however, is quite different.
Let’s examine what happens when the price moves down toward the lower end of your expectations (see Chart 4). So long as all of the reasons behind your establishment of the view remain in place, the only thing that has changed is the risk/reward. The closer spot gets to the lower end of your expectations, the more attractive the trade becomes from a risk/reward perspective. As a result, it is the point at which the position should be at its maximize size. Think about that for just a moment. I am suggesting that you should max out your position size at the exact moment when your confidence is likely to be at its lowest. Why would it be low? Well, something must have happened to drive the price lower and that something is likely to be what everyone is talking about at that moment. It is also evidence against a bullish view. Why else would it have pushed the price lower?
So, in that moment you are likely to be bombarded with all the reasons you should not be bullish. The guy sitting next to you, the talking heads on tv, analysts and salespeople are all essentially telling you why your view and accompanying expectations are wrong.
Assuming your investment process is valid and you have identified up front what the important factors are that affect your view (the signals), then everything else is essentially noise as it relates to this position. Therefore, it shouldn’t matter what the guy next to you or anyone else has to say. You should feel as confident in your view and expectations as you did on day 1. As a result, you should take full advantage of the move down and max out your position size.
Why is it that this moment creates so many problems for investors? Well, most don’t invite cognitive strain up front, during the planning phase of the trade. Most don’t put in the effort to identify what represents a signal when they first establish the view and set their expectations. Therefore, when the noise is released, everyone is talking about it and it pushes the price lower, it becomes difficult to determine whether it is, in fact, signal or noise. You begin to question your view. Your confidence wanes. So, instead of sizing up like you should, you sit and wait for confirmation, or even worse, you cut it.
Now let’s examine what happens as you approach the upper end of your expectations (see Chart 5). Your confidence is at it peak. Everything, especially price action, is supportive of your view. Everyone who told you your view was wrong is now explaining to you not only why it has gone up, but why it will make new highs and break out to the upside. Momentum traders have received confirmation and are beginning to really load up. You are giddy with excitement, knowing that you were right all along. The guy sitting next to you is now singing your praises, patting you on the back for being so amazing. He too has loaded up and is feeding you a constant diet of evidence confirming your view, including information that you hadn’t identified as signal when you first established the position. (Yes, even confirming evidence can be noise.) With everyone talking about it and so many profiting, you begin to worry that others, particularly those who were arguing that it would breakout to the downside just days earlier, will profit more from your idea than you will. That is what makes it so difficult to begin unwinding the position, but that is exactly what you should be doing as the risk/reward has flipped to the opposite extreme. Being so close to the upper end of your expectations and so far from the lower end, means your risk is now much greater than your potential reward. As a result, your position size should be at or near zero. Take a second to contemplate what I am saying. At the moment your confidence is at its highest, your position size should be at its lowest. It sounds and feels counterintuitive, which is why it is so difficult to make the rational decision.
What do most traders do instead of unwinding the position? They move their stop-loss up, thereby effectively rebalancing the risk/reward. While it may appear rational, it is not. The reason is that the upper and lower expectation bands represent discrete moments. What that means is, the probability of spot trading just above the upper band is disproportionately lower than the probability of it trading just below it (see Chart 6). So, if you want a high probability that your take-profit will be hit, you should set it below the upper band.
On the other hand, the probability of spot trading just below the lower end of your expectations is disproportionately lower than the probability of it trading just above the lower end. Therefore, if you don’t want to be stopped out while your view is still in effect, you should set your stop-loss just below the lower end of your expectations. If you were to raise your stop-loss with the objective of rebalancing the risk/reward, you are shifting the probability of triggering that stop-loss from very low to very high (see Chart 7). So, while you are reducing the magnitude of your potential downside, you are significantly increasing the likelihood of actually realizing that loss.
What I am saying is that the rational decision would have you reduce your position when momentum traders are loading up, and loading up when they are stopping out. If you are an investor who expresses a view based on fundamentals, momentum trading is incompatible with your approach. In fact, it is downright corrosive. Do it often enough and you’ll find yourself saying, “I got my view right, I just didn’t make any money on it.”
"With his probing nature, Duneier gets you to think deeper."
Real Money Manager London, England $1.5 Billion AuM
For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
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Lead Portfolio Manager $9 Billion Hedge Fund New York, NY