Newsletter of Danny Merkel - Issue #146
Trading Book Discussion:
On rare occasions, one can come across a book that is so profound that it will alter your thinking for the rest of your life.
I experienced this after reading books such as Fooled by Randomness, The Blind Watchmaker and - as I will discuss now - Thinking Fast and Slow.
Written by Daniel Kahneman, 89, Thinking Fast and Slow distils a lifetime of research in the fields of psychology, decision-making and behavioral economics, for which he won the Nobel Prize.
Let’s begin by delving into the heart of the book by focusing on cognitive biases that have massive implications to investors and traders.
Consider this decision:
The vast majority of the population surveyed - across many countries and cultures - don’t want to accept this gamble.
Why? Because the pain of losing $100 on the coin toss generates more displeasure than the thought of winning $150 brings pleasure.
This simple example leads right to the heart of Prospect Theory: gains feel good, but people hate losses twice as much:
In the above example, winning $150 in the gamble would be nice and could be viewed as gaining 150 units of pleasure. But given that losses feel twice as bad, losing $100 is worth 200 units of pain, so the whole gamble is rejected.
Put another way, the average person requires about $200 to accept this coin flip in order to negate the pain of losing just $100.
While the average person needs $200, the actual amount will, of course, vary from person to person. What’s your number? The closer to $100, the better you likely are at trading.
I would really respect someone who would say “I’d do it for $101, but let me flip that coin as many times as possible”. Now that’s a sign of a great trader in the making.
Now consider these two decisions:
For Decision (i), the overwhelming majority of people choose A: the sure gain of $240.
You started off with nothing, and now you can walk away with some extra cash. If you take a chance, you could end up with nothing, so don’t be greedy and lock-in that gain.
For Decision (ii), the the overwhelming majority pick D: Remember that people hate losses, so the idea of a guaranteed $750 loss is disgusting. Much better to take action and try to get back to break-even.
Okay, so the average person off the street chooses A and D. Interestingly, you can combine these two independent decisions into a single package deal.
This requires some strenuous thinking, but the AD combo distills into:
25% chance to win $240 and a 75% chance to lose $760.
Now contrast this with the BC combo:
25% chance to win $250 and a 75% chance to lose $750
When framed in this way, BC dominates AD, meaning that it is better in every possible way, yet only 3% of the population chooses the BC combo.
The more you resonant with this unusual group - the B & C choices - the better your chances are for trading success.
The popularity of choice A illustrates that people like to “lock-in” gains. This trait has been hardwired into humans through millions of years of evolution.
Imagine that you’re an Australopithecus bipedaling along African savanna millions of years ago and you come across a bunch of berries. The berries are small and if you come back in a few weeks, they’ll be bigger and juicer, but your simian mind also knows that they might not be there for much longer. Maybe they’ll be eaten by a Baboon. So you go ahead and lock-in this gain by eating the berries now.
Evolution hardwired you to seek regular, small rewards such as this.
Fast-forward to today and you come across a stock in your portfolio that has a gain. The gain is small and if you wait a few weeks, it could turn into a big winner; however the market could turn around and the gain could disappear. So you go ahead and lock-in this gain by selling the stock now.
It sure seems like humans love to lock-in gains, but is there any hard proof documenting this in the world of trading?
I recently came across a major study conducted by the Forex broker FXCM. The study, which examined tens of thousands of real trading accounts and over 12 million individual trades, sheds light on the psyche of the average trader.
After aggregating data on 12 million currency trades, the first conclusion that FXCM came to was that, surprisingly, the majority of trades are closed out at a profit:
The graph above shows that, for example, 59% of all EUR/USD trades are closed out at a profit. Traders love to lock-in gains and that’s what they do for most trades.
With millions of traders scoring wins, why isn’t the average Forex trader rich? The reason is that while they have frequent wins, they also have infrequent but large losses.
The chart above shows that for every single currency pair, the average trade that is closed out at a loss is much larger than the average trade that is closed out at a profit.
For instance, the average profitable EUR/USD trade earns 65 pips, but the average EUR/USD loss gives back 127 pips - nearly twice as much. The average trader, therefore, is a loser despite winning most of the time.
Because losses are twice as big as gains, the average retail Forex trader will continue trading, locking in winners, until the point where his account reaches zero. The road to bankruptcy is paved by winning trades!
In order to resist what evolution has hardwired into humans, Trend Following traders develop rules-based, systematic strategies that allow them to cut losses without reservation and to ride winners far beyond what your intuition would ever allow.
Here are a few systematic exit strategies that are worth considering:
1) Set a 2 ATR trailing stop
2) Sell after the price closes below the 20ma
3) Exit after a close below the 50ma
4) Exit once the 20ma crosses the 50ma
5) Sell after price closes below the 200ma
6) Sell if price makes a new 100 day low
7) Liquid a position if it is losing money by Friday’s close
In conclusion:
The average trader wants to be right and most traders are right most of the time
Despite a high win rate, most traders lose money
Most traders lose money because their losses are about twice as large as their winners
This can be explained by Daniel Kahneman, who proves that humans find losses about twice as painful as gains feel good.
Trend following traders fight this instinct by strictly cutting losses and letting winners run, thus providing the opposite result of the average trader - they tend to be profitable over time, yet have a low win-rate