With the recent sell-off in pretty much everything, it’s a good time to talk about managing your expectations of trading.
The essential thing is to understand and embrace the mayhem of the markets.
And to understand what you can control and can’t control so that you don’t send yourself crazy worrying about things that there is no point worrying about.
Random stuff happens in the markets all the time.
That means that the trades that you have on, which will be exploiting some marginal, noisy, “on-average” effects, are constantly battered by this flow of random, unpredictable stuff.
Remember, there’s absolutely no sense of precision with the sort of trading you’ll do as a retail trader.
You’re just getting yourself in the right place at the right time on average, systematically swinging the bat, letting all of that randomness wash out on average.
That is the goal.
It’s counter-productive to second guess and try to finesse every situation – that’s unrealistic.
We donk our edges with blunt instruments and let the noise play out over a long period of time.
Your job – and this is easier for some people than others – is to look past all of the short-term noise and see the bigger picture.
Like an expert poker player who just lost a pot because some random dude got lucky, you must understand that noise dominates in the short term, but skill dominates in the long term.
Beginners often think that every situation is a special one requiring special action. Usually, it isn’t.
Systematic trading is about sticking to a plan. And nowhere in the plan does it tell you to interpret the current situation and override the system.
Your job is to mechanically trade the edges that you have.
If something has changed in the market generally or structurally, then you need to make a strategic decision about what you should be trading.
But not every situation is indicative of something significant changing. You want to err on the side of relaxing and letting the edges play out over time.
Your time is much better spent doing research and looking for new things to trade than worrying about the minutiae of the markets and whether something fundamental has changed.
Certain things make it easier to achieve this zen-like state of relaxation in the face of a drawdown.
First of all, having the right expectations is crucial.
This is something we talk about a lot in Trade Like a Quant Bootcamp.
We want you to not only understand the variance of market returns intellectually but feel it in your bones.
We want you to internalise the idea that risk and returns are wired together – you can’t have one without the other.
The trader actually wants to target some level of risk – usually proxied by volatility – rather than avoid risk altogether.
No risk, no return.
Secondly, understanding what you can and can’t control is critical in being able to relax and let the market gods do their thing.
The biggest thing within your control is the positions you have on.
First and foremost, you want to be sure that you actually have the correct positions on.
If you don’t, fix them immediately.
Don’t wait for them to recover if they’re underwater. You don’t have an edge if you don’t have the correct positions on.
Secondly, you have some control over the amount of risk you take on.
Your biggest lever is your position size. You might have some ability to increase diversification as well, but that’s typically going to be harder to control than your volatility.
Since you’re an insightful trader, you’re targeting a certain level of volatility at the portfolio level. But given the events of this week, your portfolio volatility has almost certainly shot up.
So you’ll want to reduce your position sizes to bring your portfolio volatility back down to a level that lets you sleep at night (side note – a fantastic barometer of whether you’re trading too big is how well you sleep at night; if your portfolio is keeping you up, you’re sized too big).
Finally, if you have solid evidence that the strategies you’re trading are a good bet, you’ll have more confidence in weathering the storm than you would if you were trading your mate’s breakout strategy that he read about on Elite Trader (trust me, I’ve been there).
You get this evidence from:
- Having a good hypothesis for why the trade exists and why you get to participate. It should generally be based on some behavioural effect (such as risk premia) or some structural thing that you observe in the market.
- Analysis of the past data – which is simpler than most people tend to think.
So if you find yourself sweating bullets over the carnage this week, consider the following:
- Am I in the right positions? If not, fix them.
- Am I sized too big? If so, size down.
- Am I confident that what I’m trading is a good bet? If not, ask yourself why the edge exists and why you get to trade it, and go look at how persistent it was in the past data.
