Tuesday, December 04, 2012

Don’t Always Believe What You Think

Don’t Always Believe What You Think

I saw this expression on a bumper sticker one day and I've loved it ever since. Like so many concepts that are seemingly unrelated to trading, when you dig deeper this one has lessons for all traders.


I believe it was Dr. Van Tharp who said something to the effect of “Traders don’t trade the markets, they trade their beliefs about the markets.” This is one of the catch-22s for new traders. You can only develop beliefs about the markets with experience and new traders don’t have the experience to develop their beliefs.  So how do you get started? It’s a difficult question.

Trading gurus will of course suggest that you follow their teachings and picks. This is an ok first step for some folks. The problem with this approach is that what you’re doing is trading someone else’s beliefs about the markets. You’re shoehorning someone else’s style to hopefully fit your own. Without a plan this is doomed for failure.

The answer is to develop your own beliefs. The best way to do that is through testing your own theories about how the markets work. A good place to start is by testing some commonly believed “truths” about the markets. Take a popular one like when a stock reaches a new high, go long. This seems intuitive at first glance. Look at AAPL over time and look at all the new highs. Of course this is a winning strategy, right?

Take that idea and put it to the test by backtesting it. You’ll probably be surprised at how non-universal this “universal” truth really is. I’m not saying that it can’t be traded profitably (it certainly can) but it’s way more nuanced than buying new highs. How old was the previous new high? How’s the market been acting recently? Is the volume higher or lower than normal? There are a million data points that may or may not make a difference in the profitability of this strategy.

Backtesting can help you quickly find out how these data relate to each other. Slowly but surely your beliefs become more and more robust and tailored to your psyche. In the long run this approach of developing your own beliefs is really the only one that works.

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