Hi everybody,
I’ve just had what I believe is a significant "Aha! moment" that I’d like to share with you all. It came as a result of my reading the posts here and here.
These guys are (apparently) trading profitably by turning conventional "wisdom" on its head. FXTitan is advocating that we "cut profits short and let losses run indefinitely" and StevieT is using an RR profile of 1:20, i.e. he is setting profit targets of 50 pips and stoplosses of 1,000 pips. I asked myself "How can these guys break the established rules, and still be profitable?", and attempted to probe deeply enough into their rationale to learn why.
My conclusions follow below. Be warned: to fully grasp all of this, you must think beyond all of the "textbook" maxims surrounding entry, exit, RR and MM, and apply lateral thinking, just as I did. If so, I can guarantee (well, almost) that what follows will revolutionize the way in which you think about trading methods. I hope I can express myself simply and clearly enough to make this post a worthwhile read. OK, here goes:
1. The types of order that we use (buys; sells; market or limit orders; profit targets; stoplosses; hedging by taking long and short positions in the same currency pair) are effectively irrelevant. All order types simply add to, or reduce, our net overall position (long or short).
2. To profit, we must be net long while price is rising, and/or net short while price is falling, frequently enough to overcome costs (spread + swap). This applies to all methods, "conventional" or otherwise, without exception, at all times. As long as we are achieving this, our account equity (which is the sum of realized P/L from previously closed positions, plus unrealized P/L from currently open positions) will rise; otherwise it will fall.
3. For as long as our account equity continues to rise overall, we may justifiably assume that we have an "edge". To achieve this, we need to somehow time our orders (i.e. adjust our net position) accurately enough around market reversals, on balance, to be net long while price is rising, and net short while it’s falling. This is the bottom line regardless of whether we’re (in conventional terms) entering, exiting, scaling in, scaling out, realizing a profit, realizing a loss.
4. The result of any one trade is insignificant (if we are "hedging", or scaling in/out, with positions offsetting each other, the idea of an "individual" trade is effectively meaningless, anyway). It is the overall effect on account equity, i.e. net P/L, that is the bottom line.
5. RR (in the conventional sense) is effectively irrelevant. Firstly, TPs and SLs are effectively "offsetting orders" that bring our net long/short position back to neutral. Secondly, everything else being equal, the further away we place our TP from entry than our SL, the less likely the TP will be reached before the SL. All this ultimately amounts to is a compromise between win size (RR), and win rate ("batting average"), i.e. everything else being equal, win size and win rate always operate in exact inverse proportion to each other.
[Note: Since markets are driven by intangibles (mathematically) like greed and fear, the probability that a trade will succeed can’t be calculated in advance. Mathematical edge (or expectancy, or profit factor, call it what you will) can only be measured in hindsight, as the product of win rate and win size.]
I’ll try to explain my point about RR with an example. Let’s say we believe price, currently rising, will likely reverse at heavy overhead resistance. So, following conventional maxims, we set a tight stoploss ("cut losses quickly") just above the resistance point, and then let profits run, as price falls, using a trailing stoploss. However, expectancy is the product of win size and win rate, and the latter is determined by how frequently our assumption of a reversal is correct. That relates to the efficacy of our analysis and forecasting. It's the extent to which the forecasting goes beyond the inverse balance of RR and win rate that provides the edge.
Since exit is effectively nothing more than an offsetting order, entries and exits are ultimately mirror images of each other (just like Merlin said here). Hence, to improve overall expectancy, exits must be likewise somehow be timed accurately around "probable" market reversals, i.e. as described in point 3. (The only difference being that, if we use "conventional" RR/MM techniques, stoploss combined with position size is used to allocate a pre-determined maximum risk with each trade).
So what about "let profits run, cut losses quickly"? Again (if we revert to thinking in "conventional" terms) "let profits run, cut losses quickly" is going to operate profitably to the extent that prices trend. In a trending market, it is a profitable strategy; in a ranging market, the exact reverse applies (more on all of this here). The key is to somehow apply the correct paradigm, as explained in points 2 and 3. (To simply apply the conventional maxim in all situations – assuming that it in itself provides an edge – is to presuppose that forex "trends" more frequently than it "ranges").
If I may digress further..... if I understand correctly, the "let profits run, cut losses quickly" maxim originally applied to equities, and has been "transplanted" into forex. More on this here. My observations are that while stock trading is purely speculative, allowing prolonged trends while positive sentiment escalates (e.g. the dot-com boom), forex tends (on balance) to revert to a mean, (1) in the long term, due to national economic boom/bust cycles, and government/bank intervention,when economic indicators reach "undesirable" extremes, and (2) in the shorter term, there is mean reversion unless/until news announcements generate the sentiment necessary to move price up/down to another level. (However, I realize that "trends" do occur in forex, on every trimeframe, and that the reality is much more complex than this generalization).
Finally, I'd like to recommend two posts that (IMHO) are both excellent, and relevant to this discussion:
(by Plutonite)
"……It is a MIRACLE that we are making ANY correct statements about a market that was at one point thought to be inherently chaotic and foolish to participate in. Remember that it took several academic papers in the Journal of Finance to prove that the market is not a random walk model.
In fact, the market (and any similar exchange) is inherently chaotic, due to the large number of unrelated participants whose actions both commercial and speculative cannot be previously determined, and whose collective effect, weighed by volume, is even harder to predict. It's a crazy game we are playing if you think about it. Just because you have charts that seem to tell a picture in hindsight does not mean that anything makes sense at all. This is an unknown function with a built in random factor, and we're trying to ride it. F*cking crazy.
At the same time, there seem to be recurring patterns in the market activity that repeat themselves, and which do form both a statistical and an intuitive basis to make time series propositions (aka trades), but that is a topic for another discussion. ......"
(by ItalianSharp)
"I believe most traders - regardless of them being forex traders, futures traders, commodity traders, or stock traders - fail because they don't have a real edge.
Most of the reasons I read from forums, books, articles only focus on discipline, money management, adequate capital, experience, etc...
However, if you only have discipline, money management and enough capital to trade and you still are missing a real edge, it'll only be a slower death.
I also believe it's a lot easier to be disciplined when you have a real edge than when you don't have any edge.
If you seem to be on the wrong side of the market most of the times, the temptation to tweak your system around is always around the corner. How can you be a disciplined soldier if you have no reward from what you are doing? Unless you are a masochist, I can't really see how someone can stay disciplined using a losing strategy.
What about experience? Well, experience can just help so much. If you still have no edge, your experience will be brutal and will only tarnish your confidence permanently.
In conclusion, a trader fails because his strategy doesn't provide him with an edge good enough to make money.
Many losing traders think that money management can fix this handicap and try their luck with "averaging down" until they blow up their account and go broke.
If you don't have an edge, don't trade. Forget about ratios, money management, discipline, experience...it's all useless if you don't have a real edge."
What provides that edge? Refer back to points 2 & 3 above.
Hope all of this makes sense.
David
I’ve just had what I believe is a significant "Aha! moment" that I’d like to share with you all. It came as a result of my reading the posts here and here.
These guys are (apparently) trading profitably by turning conventional "wisdom" on its head. FXTitan is advocating that we "cut profits short and let losses run indefinitely" and StevieT is using an RR profile of 1:20, i.e. he is setting profit targets of 50 pips and stoplosses of 1,000 pips. I asked myself "How can these guys break the established rules, and still be profitable?", and attempted to probe deeply enough into their rationale to learn why.
My conclusions follow below. Be warned: to fully grasp all of this, you must think beyond all of the "textbook" maxims surrounding entry, exit, RR and MM, and apply lateral thinking, just as I did. If so, I can guarantee (well, almost) that what follows will revolutionize the way in which you think about trading methods. I hope I can express myself simply and clearly enough to make this post a worthwhile read. OK, here goes:
1. The types of order that we use (buys; sells; market or limit orders; profit targets; stoplosses; hedging by taking long and short positions in the same currency pair) are effectively irrelevant. All order types simply add to, or reduce, our net overall position (long or short).
2. To profit, we must be net long while price is rising, and/or net short while price is falling, frequently enough to overcome costs (spread + swap). This applies to all methods, "conventional" or otherwise, without exception, at all times. As long as we are achieving this, our account equity (which is the sum of realized P/L from previously closed positions, plus unrealized P/L from currently open positions) will rise; otherwise it will fall.
3. For as long as our account equity continues to rise overall, we may justifiably assume that we have an "edge". To achieve this, we need to somehow time our orders (i.e. adjust our net position) accurately enough around market reversals, on balance, to be net long while price is rising, and net short while it’s falling. This is the bottom line regardless of whether we’re (in conventional terms) entering, exiting, scaling in, scaling out, realizing a profit, realizing a loss.
4. The result of any one trade is insignificant (if we are "hedging", or scaling in/out, with positions offsetting each other, the idea of an "individual" trade is effectively meaningless, anyway). It is the overall effect on account equity, i.e. net P/L, that is the bottom line.
5. RR (in the conventional sense) is effectively irrelevant. Firstly, TPs and SLs are effectively "offsetting orders" that bring our net long/short position back to neutral. Secondly, everything else being equal, the further away we place our TP from entry than our SL, the less likely the TP will be reached before the SL. All this ultimately amounts to is a compromise between win size (RR), and win rate ("batting average"), i.e. everything else being equal, win size and win rate always operate in exact inverse proportion to each other.
[Note: Since markets are driven by intangibles (mathematically) like greed and fear, the probability that a trade will succeed can’t be calculated in advance. Mathematical edge (or expectancy, or profit factor, call it what you will) can only be measured in hindsight, as the product of win rate and win size.]
I’ll try to explain my point about RR with an example. Let’s say we believe price, currently rising, will likely reverse at heavy overhead resistance. So, following conventional maxims, we set a tight stoploss ("cut losses quickly") just above the resistance point, and then let profits run, as price falls, using a trailing stoploss. However, expectancy is the product of win size and win rate, and the latter is determined by how frequently our assumption of a reversal is correct. That relates to the efficacy of our analysis and forecasting. It's the extent to which the forecasting goes beyond the inverse balance of RR and win rate that provides the edge.
Since exit is effectively nothing more than an offsetting order, entries and exits are ultimately mirror images of each other (just like Merlin said here). Hence, to improve overall expectancy, exits must be likewise somehow be timed accurately around "probable" market reversals, i.e. as described in point 3. (The only difference being that, if we use "conventional" RR/MM techniques, stoploss combined with position size is used to allocate a pre-determined maximum risk with each trade).
So what about "let profits run, cut losses quickly"? Again (if we revert to thinking in "conventional" terms) "let profits run, cut losses quickly" is going to operate profitably to the extent that prices trend. In a trending market, it is a profitable strategy; in a ranging market, the exact reverse applies (more on all of this here). The key is to somehow apply the correct paradigm, as explained in points 2 and 3. (To simply apply the conventional maxim in all situations – assuming that it in itself provides an edge – is to presuppose that forex "trends" more frequently than it "ranges").
If I may digress further..... if I understand correctly, the "let profits run, cut losses quickly" maxim originally applied to equities, and has been "transplanted" into forex. More on this here. My observations are that while stock trading is purely speculative, allowing prolonged trends while positive sentiment escalates (e.g. the dot-com boom), forex tends (on balance) to revert to a mean, (1) in the long term, due to national economic boom/bust cycles, and government/bank intervention,when economic indicators reach "undesirable" extremes, and (2) in the shorter term, there is mean reversion unless/until news announcements generate the sentiment necessary to move price up/down to another level. (However, I realize that "trends" do occur in forex, on every trimeframe, and that the reality is much more complex than this generalization).
Finally, I'd like to recommend two posts that (IMHO) are both excellent, and relevant to this discussion:
(by Plutonite)
"……It is a MIRACLE that we are making ANY correct statements about a market that was at one point thought to be inherently chaotic and foolish to participate in. Remember that it took several academic papers in the Journal of Finance to prove that the market is not a random walk model.
In fact, the market (and any similar exchange) is inherently chaotic, due to the large number of unrelated participants whose actions both commercial and speculative cannot be previously determined, and whose collective effect, weighed by volume, is even harder to predict. It's a crazy game we are playing if you think about it. Just because you have charts that seem to tell a picture in hindsight does not mean that anything makes sense at all. This is an unknown function with a built in random factor, and we're trying to ride it. F*cking crazy.
At the same time, there seem to be recurring patterns in the market activity that repeat themselves, and which do form both a statistical and an intuitive basis to make time series propositions (aka trades), but that is a topic for another discussion. ......"
(by ItalianSharp)
"I believe most traders - regardless of them being forex traders, futures traders, commodity traders, or stock traders - fail because they don't have a real edge.
Most of the reasons I read from forums, books, articles only focus on discipline, money management, adequate capital, experience, etc...
However, if you only have discipline, money management and enough capital to trade and you still are missing a real edge, it'll only be a slower death.
I also believe it's a lot easier to be disciplined when you have a real edge than when you don't have any edge.
If you seem to be on the wrong side of the market most of the times, the temptation to tweak your system around is always around the corner. How can you be a disciplined soldier if you have no reward from what you are doing? Unless you are a masochist, I can't really see how someone can stay disciplined using a losing strategy.
What about experience? Well, experience can just help so much. If you still have no edge, your experience will be brutal and will only tarnish your confidence permanently.
In conclusion, a trader fails because his strategy doesn't provide him with an edge good enough to make money.
Many losing traders think that money management can fix this handicap and try their luck with "averaging down" until they blow up their account and go broke.
If you don't have an edge, don't trade. Forget about ratios, money management, discipline, experience...it's all useless if you don't have a real edge."
What provides that edge? Refer back to points 2 & 3 above.
Hope all of this makes sense.
David
. I've just got in from another hard day's slog at the office lol.