Thoughts - A Better Framework for Trading
Interested in trading? Here are three factors that you absolutely need to be successful.
Last year, I published an article titled How to Get Rich Trading (without getting lucky). The article’s title and content were inspired by Naval Ravikant’s famous How To Get Rich (without getting lucky) Twitter thread.
Oh, the unfounded hubris that compelled me to write and publish the article! I felt like I gave surface-level, inactionable advice for a subject that deserves so much more nuance.
With today’s newsletter issue, I hope to correct the record by just a little bit.
I’ve been thinking a lot about what it takes to be a successful trader over the past few months. Until now, I was hesitant to put thoughts on paper. The catalyst for this newsletter issue is the book Trading in the Zone by Michael Douglas. It helped to focus my contemplation such that I could boil a mass of messy ideas into succinct principles. The distillates of this process felt like something I was finally comfortable with sharing.
Here are my thoughts on what it takes to be a successful trader.
There are three main factors that are required to be a successful trader. You can’t consistently win unless you ace all three. They are: (1) mentality, (2) creativity, and (3) execution. The most important of the three is mentality. You can’t turn yourself into a successful trader if you don’t have an innate drive to keep pushing on, no matter how rocky the path inevitably becomes. As such, I think anyone looking for long term success in trading should start by working on their mentality.
Trading is tough on the mind. No matter how creative a trader is at coming up with ideas, or precise they are at executing trades, there will always be days, weeks, or months of underperformance. This can weigh heavily on a person’s mood and mindset.
As Michael Douglas puts it, trading is a long term process where a bet with a slight edge repeated over and over again will yield significant rewards. This is exactly how casinos make money.
However, a trading mentality that yearns for peaks but is ill prepared for troughs could easily eschew trading discipline or even disengage from the process altogether. Both result in a significantly diminished chance of becoming consistently profitable.
A strong mentality is very hard to build.
One needs to have extraordinary emotional understanding and control to endure the market. In Trading in the Zone, Douglas devotes several chapters to dealing with irrational fear and biases that the market can impart on you over time.
Legendary investor Stanley Drunkenmiller, in interviews, often shows significant understanding of his own emotional weaknesses and biases. In addition, in a recent interview at the Sohn Conference, he mentioned that a large part of trading for him is understanding whether he’s “hot” or “cold”. If he’s “hot”, he needs to trade often with larger size to capitalize on this state and when he’s “cold”, he needs to significantly pull back his exposure.
Maybe even go on an extended vacation.
It’s clear that Drunkenmiller has extraordinary emotional discipline.
Finally, if you’ve watched the TV show Billions, you’ll notice the titular characters are often seen meditating. In researching for the show, the writers performed deep studies of several billionaires, especially those that made their fortune trading in the markets. Meditation is a well known technique to train the mind and it’s very likely that most hedge fund billionaires practice meditation to not only survive but thrive in environments with constant and exceptional stress.
As a quick supporting point on building a strong mentality for trading, Trading in the Zone recommends traders to reorient their perspective of the world from one with binary outcomes, which is the default for human nature, to a world with probabilistic outcomes. Like building emotional discipline, this is not an easy shift in mentality and requires constant practice. Once you can naturally assume this probabilistic perspective of the world, trading will be much easier as (1) you’ll expect losses rather than be scared of them, (2) you’ll not be afraid of being wrong, (3) you’ll pivot out of a bad idea quickly once you realize you’re wrong, and (4) you won’t waste energy overanalyzing markets in a futile attempt to maximize an edge.
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Creativity is about one's ability to find an edge. Typically, this is about obtaining micro and macro market knowledge. The former involves getting a feel of how the market moves in short-term time frames, relying heavily on personal intuition and technical analysis. It also helps to have knowledge about more nuanced aspects of the market such as fund rebalancing periods and options fund flows. Macro market knowledge involves having a deep understanding of the global economy, such as geopolitics and domestic/international monetary policy, to make large and long term bets.
One might be surprised to hear this but I consider creativity to be the least important factor of the three for successful trading.
Let me explain.
Many of us have heard the saying “ideas are a dime a dozen”. This is usually said in the context of starting companies but it also applies to trading. It's relatively easy to come up with trading ideas but it’s much harder to have the discipline and mental fortitude to execute on them to discover if they’re viable.
Even if you do have an excellent idea where profits can roll in despite sloppy execution, the edge probably won't last a meaningfully long time in today's hyper competitive markets. Once the idea overstays its welcome, you'd need to come up with another excellent idea to maintain profits. This is incredibly hard to do and not reliable.
On the flip side, it's a lot easier to come up with ideas with subtle edges (e.g. 55% win rate). The subtleness of the edge gives these ideas more longevity as well. The hard part is that they require both an excellent mentality and excellent execution to generate profits from. Don’t be discouraged! Both can be consistently achieved through hard work.
Again, I want to share a learning from Trading in the Zone related to creativity in trading. There’s a common fallacy that in trading, you want to obtain as much market knowledge as possible such that you can spot edges with extremely high rates of success. In other words, market knowledge is being used in a vain attempt to conjure certainty from a system that’s fundamentally chaotic. It only takes one random decision from a trader managing a massive position on the other side of the world to cause a trade to fail, no matter how much market knowledge was used to come up with the trade. As such, it’s important to realize that market analysis should be used to find probabilistic edges and not to find certainty from chaos. This is an important component of probabilistic thinking.
The last, but not least, factor that is required for successful trading is execution. Execution takes the prior two factors and turns them into profits. Execution is where financial freedom is realized.
In my opinion, there are five stages to executing a trade idea:
Coming up with the idea.
Determining the parameters of the trade system by defining when to enter a trade, when to call a loss, and when to take profits.
Taking trades and exiting them whenever the predefined criteria are met.
Consistently repeating Steps 1 to 3 to generate a large enough sample size such that a statistical edge can be detected.
Reviewing results. In this stage, you’re trying to find problems in the system so that you can adjust parameters to try to fix said problems. Once adjusted, repeat Steps 1 to 4 to see if the system has improved. If so, you can keep improving the system or just run with it and make $$$. If the results continue to be poor, it might be time for a new idea (Step 1).
Trading in the Zone emphasizes that a successful trader is one who consistently and mechanically executes trade ideas without divergence from the plan. A strong trading mentality is vital for sticking with this process.
Drunkenmiller recently shared an interesting piece of insight on trade execution. For him, a trade idea’s win rate is less important than your ability to cap losses when you’re wrong and capitalize on wins when you’re right. Framing this through the execution process I just shared, it’d mean placing relatively more emphasis on Step 2 to develop a trade system where losing trades are swiftly cut while winning trades are given room to run. This is obviously easier said than done and will require many many iterations of the entire process to perfect.
For those who really want to succeed in trading, my best advice is to vet as many ideas as quickly as possible by concurrently running them through the process I outlined above. Make sure to keep your risk low when testing by using a small amount of capital or even paper trading accounts.
Successful trading is not just one or two winning ideas, but a process that needs to be consistently followed with mental fortitude. Sticking to this process is hard, which is why most traders fail. A 2020 study following 1,600 Brazilian equity futures traders found that 97% of them lost money!
Even though it’s hard, the rewards are well worth it. In addition, one of the biggest hurdles to successful trading is having the interest, ambition, and initiative to make money from the markets in the first place. If you’re reading this, congratulations! You’ve already surmounted this significant hurdle.
Finally, let’s end this newsletter issue with Michael Douglas’s 7 Principles of Consistency for trading:
I objectively identify my edges.
I predefine the risk of every trade.
I completely accept the risk or I am willing to let go of the trade.
I act on my edges without reservation or hesitation.
I pay myself as the market makes money available to me.
I continually monitor my susceptibility for making errors.
I understand the absolute necessity of these principles of consistent success and, therefore, I never violate them.
I hope you’ll find the trading framework I’ve shared today helpful. If you plan to start trading, or are already trading on a regular basis, I wish you safe, consistent, and bountiful profits.