My notes on the previous chapters of the book here, here and here.

The ninth chapter discusses about the building blocks of trading such as breakouts, moving averages, volatility channels, time based exits and simple look backs in detail. The next chapter follows with a detailed discussion on various systems such as the ATR channel breakout, Bollinger breakout and Donchian trend etc. This chapter also gives the performance data for all these systems based on the historical data. For ex: donchian trend has a 10 year return of 30% p.a with a max drawdown of 38.7%.

The important point in this chapter is the author’s emphasis on backtesting. Backtesting means that every system should be evaluated with respect historical data for returns and maximum drawdown. Backtesting may not help predict the future or ensure that the system will always work, but it would help to determine which system could be profitable in the future and what conditions are needed for the success of the system.

My comment: The same approach should be applied by investors too. For ex: value investing has almost a 50 year history of performance over varying periods and business conditions. So this approach to investing has proven its ‘fitness’ over a long period of time and in varying conditions. I would say that any other approach such as momentum investing should also be evaluated in a similar manner.

The next chapter discusses in detail the pitfalls of backtesting. The key reasons why the historical test results differ from actual trading are as follows
– trader effects : As more traders use the system, the effectiveness of the system is lost
– Random effects
– Overoptimization paradox:
– Curve fitting: Fitting the system to data

The chapter then discusses how these distortions can be resolved and backtesting results improved.

The next chapter discusses how one can get better results from backtesting. One approach is by using better measures such as RAR (regressed annual return), R-cubed and a robust sharpe ratio. In addition a representative sample and appropriate sample size can help to get better results. The author also discusses about monte-carlo simulations to analyse the various systems based on historical data.

The sixth chapter discussed various trading concepts such as support and resistance. These concepts are discussed in detail in this chapter with examples.

The seventh chapter is crucial to help answer the question: How can you know if a system or a manager is a good one. I would suggest reading this chapter in detail and understanding it and applying it when selecting or evaluating a trading system. A lot of trading systems refer only to the returns and choose to ignore risk. The chapter refers to four types of risk.

Drawdown – String of losses than can reduce capital in the trading account. It is the maximum loss the trader / manager or trading strategy incurred at any point of time.

Low returns – period of small gain where the trader cannot make enough money to make a living

Price shock – sudden price change which can wipe out a trader

System death – Change in market dynamics that causes a previously profitable system to start losing money.

The chapter discusses each type of risk in detail with examples for various trading systems. I was amazed with level of volatility which a lot the trading systems show. For example the author refers to trading systems which can generate returns of almost 35%+, but incur drawdowns of 40-45%. So there would be times when your capital would drop by 40%.

How many of us have the nerve to withstand this kind of losses?. So the next time around if some one recommends a trading strategy with high returns,ask about the drawdown. If the other guy cannot tell you the drawdown of his strategy, run (he does not know about trading or is trying to fool you). If he does give you a number, try to figure if you can tolerate that level of risk. The book also indicates that the higher the level of return, higher is the volatility and higher the drawdown. So if one is a beginner, try for a system which has a lower return and lower drawdown.

The next chapter revisits risk and money management again. The author again cautions the reader from underestimating risk and blindly accepting the claims of vendors or money managers. Curtis’s advise is to go for returns at which the risk is manageable and let compounding do its magic. No point in trying for 100% to 200% returns and then blowing up (losing all the money).

The author makes a very important point in this chapter. He says that trading is simple, but not easy. He gives the example of people like dentist or doctors who are smart and under the assumption that if they are smart and successful in their profession then they should be good at trading too. The reality is that these folks are not good traders.

I find this comment interesting. I have seen this all around me. A lot of people I meet are smart and very good at their jobs. They automatically assume that they will be good at investing. Intelligence may be a necessary but not a sufficient ingredient for success at investing. It is surprising that most professionals think that they can put 1-2 hours a week into investing and be a great investor. By that analogy, all of us should be good doctors and architects too. Anyone can be a good or great investor, but like most other pursuits in life, one has to work at it.

Coming back, the author also says that most new traders underestimate the pain of a drawdown. They believe that they can live through a 50-60% drawdown, but when it hits them, they may stop trading completely or change methods at the worst possible time. I have faced a drop of almost 25% early in my life as an investor and even that was painful. When you are starting off and face this kind of drop, it is easy to question the process.

Posts on previous chapters here and here

I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

– Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
– Manage risk: Control risk via money management discussed earlier
– Be consistent: execute plan consistently to achieve the positive expectation of the system.
– Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

– portfolio selection : alogrithms which markets are valid for trading on any specific day
– Entry signals : alogrithms that determine when to buy or sell to enter a trade
– Exit signal : alogrithms that determine when to buy or sell to exit a trade

I referred in my previous post about a book on trading – Way of the turtle which I have been reading for the past few days. Now why should a guy who displays a mental block against trading, read a book on the topic? The short answer is to challenge my own biases against trading.

I can definitely say that this is a good book and anyone wanting to learn about trading or wanting to evaluate a trading system (in a book or being sold by someone) should read this book. What follows over this and the next few posts is my own summary (not review) of the book with my own thoughts and comments (which I cannot resist putting 🙂 )

The book is written by curtis faith who was one of the turtles (traders) recruited by richard dennis and william eckhardt as a part of an experiment that trading can be taught. The author was one of the original recruits (and probably one of the most successful) who made more than 30 million for Richard.

The book describes the difference between an investor and a trader. An investor buys stocks, but is really buying an underlying business. A trader in contrast is concerned only about price and is essentially buying and selling risk. The second chapter of the books talks of the turtle mind, which I think is equally relevant for an investor.

As we all know that markets are populated by individuals who are driven by fear, greed and all other cognitive biases, which create opportunities for a trader. The book refers to various biases such as loss aversion – higher preference to avoid losses over gains, sunk cost effects – tendency to treat money that has already been committed as more valuable than money to be spent in the future, disposition effect – tendency to lock in gains and ride losses, outcome bias – tendency to judge a decision by the outcome than by the quality of the decision at the time it was made and several other biases such as recency biases, anchoring etc.

The second chapter describes each of these biases in detail and how it affects a trader. The chapter continues with various trading styles such as trend following, counter-trend trading, swing trading and day trading.

One the key points I realised from the initial chapter was that each of these trading styles are valid for specific types of market. Curtis refers to various markets such as stable and quiet, stable and volatile, trending and quiet and trending and volatile. For example, trend followers love markets that are trending and quiet where they can make more money than a volatile market which is more punishing to trend followers. In contrast counter-trend traders love markets that are stable and volatile.

Another key learning for me in the chapter – successful traders never try to predict the market direction. Instead they look for indications that a market is in a particular state and trade accordingly.

I will be posting the rest of my notes over the next few posts. You can find the author’s blog here.