Understanding recurring patterns in financial markets lies at the heart of trading and investing … [+]
There is perhaps no concept so lightly tossed around by investors and traders as the notion of possessing a market “edge”. This is meant to convey a probabilistic advantage associated with particular trading strategies. Almost by definition, every trader and investor believes that there is some edge to their market involvement. In spite of this, success in financial markets is remarkably rare, particularly for active traders. What is a genuine edge in trading and investing and how can it be acquired? In this first article in a two-part series, I will summarize my observations over many years of full-time work with portfolio managers and day traders and share ways in which traders can develop and expand their profitability.
Observation #1: Edges exist, trading and investing talent exist, but they are rare.
At every professional firm where I’ve worked, the rate of success among new talent is below 50% and the majority of profitability is attributable to a modest fraction of traders. While this might be discouraging to those aspiring to trade for a living, it should not be a total surprise. In any performance field, from athletics to musical theater, the proportion of participants that can make a living from their craft is small. Elite performance lies at the intersection of inborn talents, acquired skills, and rigorous, talented mentoring/coaching. The probability of sustained success through self-teaching at home is dismally low in any field, whether it be golf, chess, or trading. Trading success is possible, but it’s much more difficult that the would-be gurus would have us believe.
Observation #2: Durable edges in markets reflect deep and unique understanding.
Whenever I have encountered an investor or trader with years of superior risk-adjusted returns, I have noticed uniqueness to their strategies, reflecting a detailed understanding of the markets they trade. For example, one trader with many years of success in fixed income markets possessed a highly detailed understanding of central bank policies and what was priced into markets by various instruments across major economies. When one instrument traded out of line with expectations and also out of line relative to similar instruments, he sold the expensive asset and bought the cheap one. His portfolio covered hundreds of bets, allowing many small positive expectancies to work in his favor. Similarly, I’ve worked with portfolio managers with detailed knowledge of options who have learned to recognize shifts in patterns of volatility among assets and utilize options structures to profit from these shifts with limited downside. I’ve also worked with very active traders who track unusual order flow activity in stocks and exploit those flows for small “scalp” movements all day long. In a very important sense, these successful traders are playing a different game from their more generic counterparts.
Observation #3: Successful edges in markets reflect sophisticated pattern recognition
The trading strategies of successful investors and traders are diverse. They can be grounded in an understanding of macroeconomic variables, geopolitics, monetary policies, price/time/volume relationships, the relative pricing of similar assets, or some combination of these. In each case, however, successful trading decisions are based upon a configuration of variables that reflects the trader’s understanding. This pattern recognition skill is like the skill of a physician, who understands anatomy, physiology, pathology, and disease entities and thus is able to assemble patterns of information into meaningful diagnostic impressions and treatment plans. As in the case of the physician, the skill of the trader follows from prolonged immersion in these meaningful patterns, allowing for their internalization. This is why a prolonged period of apprenticeship and mentoring typically precedes trading success. The successful market participant requires ongoing opportunities for deliberate practice, so that sound decisions can be made in the heat of the moment. Mike Bellafiore of SMB Capital calls this process “PlayBooking”, akin to the development and drilling of plays by football coaches and players. In football, the plays capture patterns of a team’s strengths and an opponent’s weaknesses. In trading, the PlayBook is a collection of meaningful market patterns that yield an edge and that can be practiced, refined, and perfected for real time performance. This requires a consistency of coaching, mentoring, and “copying the masters” that simply is not available to the self-taught trader.
Observation #4: Edges in discretionary trading can be observed and developed in serious trading communities
A number of online trading communities and mentoring programs have emerged in recent years to facilitate pattern recognition and the acquisition of trading expertise. Some of the communities that I have participated in include the Futures.io group; Edge Trading Group; SMB Futures; BearBull Traders; and My Investing Club. Communities can also coalesce around platforms that keep detailed statistics regarding simulated and actual trading success. At SMB Capital, trading teams utilize TraderVue to track not only profitability, but also risk management and the specific profits and losses associated with different markets and patterns. Groups of traders I’ve encountered have used the Edgewonk platform to not only log trades and profitability, but track variables that can help traders make the most of their trading edges.
Observation #5: Traders can expand their edges in financial markets by marrying discretionary pattern recognition and quantitative research
One of the most exciting developments in trading is the emergence of hybrid trading, where discretionary decision-making by the trader is blended with researched and quantified trading strategies. These quantitative strategies also make use of deep understandings of market variables and keen pattern recognition. The difference is that the strategies are programmed and systematized, so that long periods of training in pattern recognition are not necessary. Among the platforms offering quantitative strategies for discretionary traders are InvestiQuant, Quantifiable Edges, SentimenTrader, Market Tells, Paststat, and Trade Ideas. These services are allow investors and traders without programming or mathematical expertise to generate objectively backtested signals. These can be combined with one’s own pattern recognition in a hybrid fashion to create investment ideas with multiple, independent sources of edge.
The field of trading psychology has traditionally emphasized that our psychological development can assist our performance in markets. By managing stresses, enhancing our mindfulness, and taming our emotions, we can make the best use of our knowledge and skills.What we’re finding in the above overview is that there is more to consistent profitability than maintaining a good mindset. By understanding the ingredients of trading success and optimizing our learning processes, we can greatly improve both our mindset and our performance. In my next post, I will explore hybrid trading in greater detail, illustrating how traders can improve their odds of success through next-generation research tools.