Average Sizes of Winning and Losing Trades
It doesn’t help to have 60 percent winning trades if the average size of your losers is twice that of your winners. Keeping score of the average sizes of winners and losers will tell you a great deal about your execution of trade ideas—whether you’re entering at points that provide you with favorable returns relative to the heat that you’re taking. The data will also tell you how well you’re sticking to your risk management discipline, particularly stop-losses. If your average win size and loss size are expanding or contracting at the same time, you may simply be dealing with greater or lesser market volatility (or you may be sizing your positions larger or smaller). It is the relative shifts in size of average wins and losses that are most important for managing your business. If your winners are increasing in average size and your losers are decreasing, you’re obviously trading quite well. It will be important to identify what you’re doing right so that you can be consistent with it. Conversely, when losers are increasing in average size and winners are not, you want to figure out where the problem lies. Are you reading markets wrong, executing and managing trades poorly, or both?
Average Win/Loss Per Trade
Suppose you make a particular amount of money in January and the same amount in February. You might be tempted to conclude that you traded equally well in the two months. That would be a mistake, however. If you had placed 50 trades in the first month and 100 in the second month, then you can see that more trading did not produce more profit. Your average profit per trade actually declined. This suggests that at least some of your trading is not providing good returns, and that bears investigation. The situation is similar to that of a business that opens five new stores in a year, but reports the same sales volume year over year. The average sales per store have actually declined, an important factor masked by the increase in overall activity. Average win/loss per trade will vary with your position sizing and with overall market volatility. Be alert for occasions in which market volatility may increase, but your average win per trade goes down: you may not be trading as well in shifting market conditions. Many times, traders make as much or more money if they simply focus on their best ideas and reduce their total number of trades. This selectivity shows up as a soaring average win per trade. It’s a great measure of the efficiency of your trading efforts.
When you trade more often, make sure that the incremental trades are adding economic value.
Variability of Daily Returns
If you take your wins and losses for each day and convert those to absolute values, you’ll then have a distribution of your returns. You’ll see how much your equity curve moves per day on average. You’ll also observe the variation around this average: the range of daily swings that is typical for your trading. The variation in your daily returns will ultimately shape the size of drawdowns you experience in your portfolio. Given that you’re going to experience runs of losing days over your career, you’ll have larger drawdowns when those runs are 2 percent each than if they’re ½ percent. Indeed, if you investigate the losing periods that are historically typical of your trading, you can use these to calibrate the daily variability you want to tolerate in your trading. This is central to risk management. If you want to keep total drawdowns in your portfolio to less than 10 percent, for example, you cannot risk average daily swings of 2 percent. Of course, if you’re keeping drawdowns to less than 10 percent, you also cannot expect to be making 50 percent or more per year: risk and reward will be proportional. By calibrating the average swing in your portfolio per day, you target both overall risk and reward. If you’re trading very well (i.e., very profitably) with a relatively low variation in your portfolio size from day to day, you can probably afford to gradually pick up your risk (increase trade size to generate larger returns). If you’re trading poorly and losing money beyond your norms, you may want to reduce your daily variation and cut your risk.
What all of this means is that, when you’re your own trading coach, you are also your own scorekeeper. The metrics above are, in my estimation, an essential part of the journals of any serious trader. The more you know about how you’re doing, the more prepared you’ll be to expand on your strengths and address your vulnerabilities.
COACHING CUE
See David Adler’s lesson in Chapter 9 for additional perspectives on trader metrics. A particular focus that is helpful is to examine what happens to your trades after your entry and what happens to them following your exit. Knowing the average heat that you take on winning trades helps you gauge your execution skill; knowing the average move in your favor following your exit enables you to track the value of your exit criteria. Sometimes the most important data don’t show up on a P/L summary: how much money you left on the table by not patiently waiting for a good entry price or by exiting a move precipitously.
LESSON 75: ADVANCED SCOREKEEPING FOR YOUR TRADING BUSINESS
After the last lesson, you may be feeling overwhelmed by the data you need to keep to truly track and understand your trading business. I’m sorry to inform you that such items as equity curve, average numbers of winning/losing trades, and average size of winning/losing trades are just a start to serious scorekeeping. Professional traders at many firms obtain much more information than that about their performance. Access to dedicated risk-management resources is one of the great advantages of working in such firms. Although it is unlikely that you could duplicate the output of a dedicated risk manager, it is possible to drill down further into your trading to uncover patterns that will aid your self-coaching.
In this lesson, we’ll focus on one specific advanced application of metrics that can greatly enhance your efforts at performance improvement: tracking results across your markets and/or types of trades. This tracking will tell you, not only how well you’re doing, but also which trading is most contributing to and limiting your results.
Of the different types of trades that you place, which most contribute to your profits? These are the drivers of your trading business success.
We’ve already seen how important it is for your trading to be diversified. Among the forms of diversification commonly found are:• Trading different instruments, such as individual stocks versus index ETFs.
• Trading different markets, such as crude oil futures and stock indexes.
• Trading different setups, such as event trades and breakout trades.
• Trading different times of day and/or different time frames.
To truly understand your trading business, you want to tag each of your trades by the type of trade it represents. You will thus segregate trades based on the criteria above. All your overnight trades, for instance, will go in one bin; all your day trades in another. All our stock index trades will fall into one category; all our fixed income trades in another. If you’re a day trader, you may want to segregate trades by time of day, by sector traded, or even by stock name.
Each of these categories is a product in your trading business. Each category is a potential profit center. When you think of your trading as a diversified business, you want to know how each of your products is contributing to your bottom line. Simply looking at your bottom line will mask important differences in results among your trades.
In practice this means that the metrics discussed in the last section—equity curve; proportion of winning/losing trades; average size of winning /losing trades; win/loss per trade; and variability of returns—should be broken down for each portion of your trading business. My own trading, for example, consists of three kinds of trades: intraday trades with planned holding times of less than an hour; intraday swing trades with planned holding times of greater than an hour; and overnight trades. The short intraday trades are based on short-term patterns of price, volume, and sentiment. The swing trades are trend following and are based on historical research that gauges the odds of taking out price levels derived from the prior day’s pivot points. The overnight trades are also trend following and are based on longe
r-term historical research that shows a directional edge to markets. These trades comprise different kinds of trades, because they are based on different rationales and involve different positioning in the markets. For instance, I can take a short-term intraday trade to the long side, but short the market for an overnight trade that same day.
You can identify the inventory of your trading business by segregating trades based on what you’re trading and how you’re trading it.
For other traders, the division of the trading business will be by asset class (rates trading versus currency trades versus equity trades) or by trading strategy/setup (trades based on news items; trades based on opening gaps; trades based on relative sector strength). Relatively early in my trading career, I broke my trades down by time of day and found very different metrics associated with morning, midday, and afternoon trades. That finding was instrumental in focusing my trading on the morning hours. In other words, the divisions of your trades should reflect anticipated differences in your income streams. If the returns from the trading strategies or approaches are likely to be independent of one another, they will deserve their own bin for analysis by metrics.
One of the breakdowns I’ve found most helpful in my trading is based on tagging the market conditions at the time of entry. To accomplish this, you would tag each trade based on whether it was placed in an upward trending market, a downward trending market, or a nontrending market. You will want to be consistent in how you identify market conditions; my own breakdowns (because I trade short-term) were simply based on how the current market session was trading relative to the previous one. It is common that traders will perform better in some market environments than others. For instance, based on a different breakdown, I learned that I was most profitable in moderate volatility markets, as tagged by the VIX index at the time of entry. When markets were relatively nonvolatile or highly volatile, my returns were significantly reduced. This was useful to me in knowing when and where to take risk.
Your trading business is most likely to succeed if you play to your strengths and work around your weaknesses.
What you’ll find by breaking your trading down in this fashion is areas of relative strength and weakness in your performance. You will have a historical database of the normal trading in each area of your trading business, and you will have a way to see how your current trading compares with those norms. Thus, for example, you might make money overall, but your event-based trades (those based on fast entries after news items and economic reports) perform much better than your trend-following trades. This may say something about the market you’re in and how you want to be trading that market by focusing more on what’s working than what is not. Similarly, you may find that your average numbers of winners versus losers is fine overall, but lagging in one particular market. This could lead you to fine tune what you’re doing in that market.
The goal of keeping score is to identify your own patterns and use those patterns to your advantage.
When you are coaching yourself, I encourage you to think of yourself as a collection of different trading systems. Each system—each market or strategy that you trade—contributes to the overall performance of your portfolio. Your job is to track the results of each system, see when each is performing well, and determine when each is underperforming. Armed with that information, you can thus allocate your capital most effectively to the systems that are working rather than those that are not. Diversification can’t work for you if you are not diversified in how you view and work on your trading performance. Just as a football coach breaks down his team’s performance into segments—running, kicking, defense against the run, defense against the pass, throwing—and works on each, you want to analyze and refine your team of strategies. Many a drawdown can be avoided if you stay on top of each segment of your trading business.
COACHING CUE
When you add to positions or scale out of them, how much value does your management of the trade provide? What is the performance specific to the pieces that you add to positions? How much money do you save or leave on the table by removing pieces from your positions? If you hedge your positions, how much do you gain or save through those strategies? Are you better trading from the long or short side? Do you perform better when trades are entered at certain times of day or held for particular time frames? If you drill down with metrics you can become specific when you work on various facets of your trading performance.
LESSON 76: TRACK THE CORRELATIONS OF YOUR RETURNS
A department store is an example of a diversified business. The store sells a variety of goods, so it attracts a wide range of customers. If consumers aren’t buying seasonal items, they may come in to shop for clothes or housewares. The departments that offer products for children, teens, men, and women ensure that there will be a mix among customers, evening out peaks and valleys in traffic patterns for any of these individual groups.
In your trading business, diversification provides you with multiple profit centers. You can make money from intraday stock index trades and longer-term moves in the bond market, for example. If you divide your capital among different ideas and strategies, you smooth out your equity curve, much as the presence of many departments keeps traffic flowing to the department store. When any one or two strategies fail to produce good returns, others contribute to the bottom line.
Diversification in your trading enables you to stay afloat when any one of your strategies stops working for a while or becomes obsolete.
But how do you know your trading business is truly diversified? Just because you are trading different setups or markets doesn’t mean that you necessarily possess a diversified portfolio. The only way you can ensure true diversification is by tracking the correlations among the returns of your different strategies.
Suppose you are a day trader who trades two basic patterns: moves on earnings news and breakouts from trading ranges. The idea is that your returns would be diversified because you would be long some names (earnings surprises and breakouts to the upside) and short others (earnings surprises and breakouts to the downside). You would also be diversified across market sectors and perhaps even by the time frame of your holdings. If you follow the logic of the previous lesson, you can track performance metrics for your earnings-related trades and your breakout trades. You can also track performance across your long trades and your shorts.
When you track the correlation of your returns, you take the analysis a step further. You calculate the daily P/L for each of your strategies over a period of time. You then evaluate the correlation between the two number series. If the strategies are truly independent, they should not be highly correlated. A slow market, for example, may yield little in the way of breakout trades, but you could still make money on selected stocks with earnings surprises. Similarly, you may get little earnings news on a particular day, but the market may provide a number of breakout moves due to economic reports.
Many traders think they are diversified, when in reality they are trading the same strategy or idea across multiple, related instruments. This means they’re taking much more risk than they realize.
One stock market trader I worked with had a phenomenal track record and then stopped making money all of a sudden. On the surface, he was well diversified, trading many issues and utilizing options effectively for hedging and directional trade. When we reviewed his strategies in detail, however, it was clear that all of them relied on bull market trending to one degree or another. When the market first went into range-bound mode and then into a protracted bear move, he no longer made money. He was trading many things without much in the way of diversification. His trading business was like a car dealership that sells many kinds of trucks, vans, and SUVs. Once large vehicles go out of favor, perhaps due to high fuel costs, the business becomes vulnerable. It’s not as diversified as it looks.
Suppose you track your performance historically and find that your strategies correlate at a level of 0.20. The outcome variance shared by th
e strategies would be the square of the correlation—0.04, or 4 percent. That means that results from one strategy only account for 4 percent of the variation in the other strategy—not a high level. Imagine, however, that during the last month, the correlation soars to 0.70. Now the overlap between strategies is close to 50 percent. They are hardly independent.
What could cause such a jump in correlation? In a strongly trending market, the breakouts might all be in one direction—the same direction as earnings surprises. Alternatively, you might get caught with an overall market opinion and select your trades to fit that opinion. In either case, your diversified business is no longer so diversified, just like the car dealership.
Correlations among your strategies and trades vary over time because of how markets trade and because of your own hidden biases.
That lack of diversification matters, because it means that your capital is concentrated on fewer ideas. Your risk is higher, because instead of dividing your capital among two or more independent strategies, it is now concentrated in what is effectively a single strategy. The same problem occurs when different markets or asset classes begin trading in a more correlated fashion, perhaps due to panicky conditions among investors. During those periods of high risk-aversion, traders will often shun stocks and seek the perceived safety of bonds and gold. The three asset classes (equities, fixed income, and gold) will thus trade in a highly correlated manner. Instead of being diversified across three markets, your capital is effectively concentrated in one.
The Daily Trading Coach Page 33
