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8 Truths About Trading That
No One Tells You
Brought to you by Boris Schlossberg
1. Trading is all about price not value
To badly butcher the great Oscar Wilde, good traders should know the price of everything and the value of
nothing. Many people who start out in the markets confuse trading with investing and often fall back on
fundamental explanations to justify their positions. But trading and investing are radically different. Investing is
essentially the art of buying assets. The simplest and surest way to make money as an investor is to simply
diversify your portfolio and dollar cost average into a broad market index over a very long period of time (30 to
50 years). Investing works because real assets appreciate as economy grows and wealth becomes a simple
function of compounding that economic growth.
Speculation on the other hand has nothing to do with investing. It is the art of trading sentiment and by its very
definition is bidirectional in nature with participants equally prepared to go short or long on a moments notice.
Speculation also tends to revolve around assets that are price bounded such as commodities and currencies.
The simplest way to understand the difference between speculation and investing is to consider the chart of
the Dow Jones Industrial Average versus the chart of the GBP/USD going back to 1980. Since that time the
Dow has appreciated from 1000 to 17,000+ (1700%). Meanwhile sterling has basically range traded from
approximately 1.0000 to 2.0000 providing zero long-term return. Unless we face an end-of-the-world scenario
currencies and commodities will always range trade and will therefore be instruments for trading sentiment
rather than investment vehicles.
2. Traders trade levels not themes
Walk into any dealing room in the world and the first thing you will see is high low prices for the prior days, the
prior week, the prior month and the prior year. That’s because speculators are keenly aware of key price
levels. Leave the macro themes to the strategists. They are usually right only 50% of the time but are
wonderful at explaining the movement in hindsight. Want to know why a certain currency suddenly nose dived
or rose? Very often it has nothing to do with news but with a break of a key level. In other words trading can
often be a self-fulfilling prophecy i.e. the currency tumbled because the currency broke key support.
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3. Indicators are less than useless
Think about what you do when you are using an indicator. You are taking the raw data (price) and then
applying a mathematical operation to it to produce a derivative of that price. In other words you are creating of
abstraction from what is actually happening in the market. A moving average is just a delayed and distorted
representation of price action.
Some people find the use of indicators helpful in analyzing price behavior - but do you really need a sloping
moving average to tell you that prices are in a uptrend? Do you really need a MACD or and RSI to tell you that
momentum has slowed when you can easily see that price is bunching up on a chart?
Trade naked.
Look at the price chart across multiple time frames and watch only the price levels and suddenly pricing
behavior will become quite clear. Remember that investors are putting on positions while speculators are
buying or selling levels and the dynamic between the two creates most of the movement
4. News Matters But Not in the Way You Think
One of the stupidest things that a trader can ever say is, “I don’t pay attention to news.” News is what moves
price most of the time so to state that you don’t pay attention to news is the equivalent of saying that you don’t
pay attention to trading. At very minimum even the most ardent technical day traders are keenly aware of the
news calendar as the volatility from the event could easily blow up the trade irrespective of the merits of the
setup.
News, however, can be maddening to trade on a directional basis. The basic assumption of “good news then
buy” is often proved wrong as prices can quickly reverse after an initial spike. This can happen for a variety of
reasons - too much supply at a given level, another “hidden” piece of data that completely counteracts the
impact of the news but may not become obvious for several days, or simply the antics of dealers who try to
shake out momentum price chasers.
Here are a couple of rules of thumb to keep in mind when it comes to news. The stronger the impact of the
news on interest rate policy the more likely that the directional move will have some continuity. Interest rates
are the only thing in the currency market that have any “value” since they actually pay the currency holders a
rate of return. So anything that changes that dynamic such as a rate hike or cut and any policy threat or
promise to do so will have a big impact on trade as investors make adjustments and speculators pile on for the
ride.
Another key aspect of news is that in an uptrend positive news generally reinforces the price action while
negative news is ignored. The converse works in a downtrend. So another good rule of thumb when it comes
to trading is that if there is a divergence between news and price (news is good but price declines and vice
versa) - always follow price - that’s generally the right bet.
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5. Why 2 to 1 is such a sucker bet
One of the most common myths in trading is that you need to make 2 dollars for every dollar of risk. That
sounds great in theory but actually works horribly in practice. The basic math behind the 2 to 1 risk reward ratio
is that you just need to win 40% of the time to be overall profitable. That’s a very seductive proposition but it is
subject to some real life constraints.
First and foremost markets are just not that generous. Nobody willingly gives you 2 dollars of reward for 1
dollar of risk. In fact the job of the market is to sucker as many people as possible into unsustainable positions.
If your stop is half the size of your take profit the market will take out your stop much more frequently than 60%
of the time. In fact it can often be as high as 75% to 80% of the time rendering the strategy worthless. If 2 to 1
r/r worked then most successful traders would gladly use it. But instead history is littered with examples of
traders experiencing “death by a thousand cuts” as they bleed away their capital through frequent stop outs.
The 2 to 1 r/r ratio has another key disadvantage. It is part of the family of setups known as high reward/low
probability trades. Capital markets allow you only two types of trades - high probability/low reward or high
reward/low probability. There is a direct mathematical relationship between payout and the amount of risk you
assume. The more payout you want and the less risk you assume the less likely it will be that you will achieve
your goal. Everyone who trades wants to find ideas that are both high reward and high probability but they
don’t exist because if they did, the person who employed them would eventually own the whole market.
Once you accept the relationship between probability and reward you begin to understand the challenges of
high reward/low probability trades. The single biggest drawback is that the high reward trades are rare and in
an actual trading environment you frequently miss that one out five trades that will be the winner to erase all
your losers. So under real life conditions the 2 to 1 r/r strategy often fails miserably because it generates many
consecutive losses and then compounds that problem as traders fail to execute the one or two profitable trades
that generate the bulk of the profits.
6. Commission Costs Are a Sign of Success
When it comes to commissions traders are often given the worst possible advice. “Minimize your transaction
costs!” is the standard mantra of every trading guru out there and it is possibly the stupidest advice you will
ever get. On the face of it, the logic behind the statement makes perfect sense. Who wants to incur costs? Isn’t
the object of the game to maximize profits and aren’t cost controls the key to that objective? Actually no. They
key to any growing business is maximizing revenue. Cost are important to be sure, but they are a very distant
second.
Imagine you ran a restaurant and your food costs were $10,000 a month. Let’s say you worked very hard to
reduce them to $7,000 a month. What have you earned for your troubles? A measly $3,000 per month gain.
Now imagine if you used all that energy to actually increase your revenues from $50,000 per month to
$100,000 a month. Even if you saved nothing on your food costs your gross margins would go from $40,000
per month to $80,000 per month. Sure your food costs would increase, but so what? Your revenues would
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increase as well and overall you would be much wealthier. Costs are finite while revenues are infinite and in
any start up business it is much more important to focus on revenues rather than costs.
Commissions for a trader are just like food costs for a restaurateur. They will inevitably go up as you do more
volume. At the end of the month where would rather be - make 200 pips and pay 200 pips in commission or
make 50 pips but only pay 25 pips in commission? Its a classic case of being penny wise and pound foolish.
Low transaction costs are great advice for an investor where wealth is generated by compounding of time, but
terrible advice for a trader where income is generated through turnover of inventory. In a decent high
probability trading strategy it may take as many as 100 trades to generate 100 pips of profit because real life
trading is just like real life - it takes work. Does it take just one cold call to make a million dollar sale? Of
course not. In real life it takes a thousand cold calls to create a viable income stream. So why would you think
that trading is any different? The idea of making a financial killing from trading with a few well chosen ideas is
about as realistic as believing that your lifestyle can be funded with a few well chosen lottery tickets. It is one of
the most insidious lies about this business.
7. The Single Greatest Way To Control Risk is Not
Discipline
Let’s face it if we had to rely on iron clad discipline to achieve anything in our life, none of us would succeed.
From eating that utterly unnecessary chocolate truffle, to blowing off our work routine we are all lazy, impulsive
and often highly undisciplined. So it is no wonder that most traders fail when they are told that they must stick
to their trading plan with the intensity and rigor of a professional athlete.
Here is a real life fact. There is NO WAY to completely eliminate impulsive trades when you are actively
engaged in the market. As human beings we will always want to “touch the flame.” And that is actually a very
good thing. Impulsive trades allow us to explore ideas, to fine tune our timing and analysis and learn more
about market action. Unfortunately, they are also the single biggest reason we all blow up our accounts.
Impulsive trades that start out innocently frequently spiral out of control and as we try to manage them we lose
most of our capital.
There is only one solution this problem. The size of one. Whenever you decide to put on a trade that is outside
of your strategy, the only requirement is that it cannot be larger than the smallest possible unit in the retail
market - the micro lot. A micro lot pip is worth only 10 cents, so that even if the trade moves against you by
1000 pips the worst loss from such a decision is a mere $100.
When you trade the size of one several things happen. You satisfy the urge to explore and keep yourself
engaged in the market, but you do it at such safe level that any adverse price action will almost never put you
out of business. Furthermore, if the trade looks hopeless and has racked up big losses, it is far easier to close
it out for a 50 dollar loss rather than be forced to realize a 5000 dollar loss if you had used your typical position
size.
Trading is as much about understanding our personal weaknesses as it is about discovering the next great set
up and the power of one helps you to indulge your worst impulses without any dangerous consequences.
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8. Size is the Dirty Little Secret of Trading
One of the biggest mistakes that many traders make is to assume a static probability distribution for their
trades. It is the principle reason that all backtests are worthless. Price patterns do not follow standard
probability distributions and just because the last 1000 trades showed a 75% wins, does not mean -in fact will
almost certainly not mean - that the next 1000 trades will be 75% accurate. Human behavior is just too
unpredictable to fit the classic statistical models, which is why quant traders almost always blow up. But price
action is not random either. Trading behavior does not occur in a vacuum. It is highly context sensitive. Traders
are keenly aware of the recent past and it will greatly inform their upcoming future actions.
That’s why one of the most important aspects of any trading system is to understand not only the basic
historical probability distribution of its trades, but the conditional probability as price action evolves. Even in a
purely random distribution the answers to conditional probability questions can be very different that you think.
Take the standard coin flip example. Traders have been conditioned with near Pavlovian certainty to believe
that any given time the probability of heads or tails is 50%. But what if you flipped 5 heads in a row. What
would be the probability that the sixth flip is heads - 50%? No. The probability that the next flip is heads is only
(1/2*1/2*1/2*1/2*1/2=1/32) or just 3%. Can you still flip heads? Absolutely but chances a progressively smaller.
That’s conditional probability and it is key to understanding how trading works. Indeed the dirty little secret of
trading is that the best, most profitable traders aren’t the ones with the most accurate setups, but ones that can
vary their size in response to conditional probabilities. As George Soros once said, “it’s not whether you’re right
or wrong that’s important, but how much money you make when you’re right and how much you lose when
you’re wrong.”
Proper sizing of positions is truly a mix of math and art. But let me be very clear. Position sizing has nothing to
do with martingaling, which is simply the strategy of constantly adding to your position in hopes that the
average price will eventually become profitable. Martingaling is probably the single biggest reason retail traders
lose money. When you are martingaling you are in effect carrying “bad inventory” in your position and the
further the price moves away from you the more “spoiled” that inventory becomes. Eventually, martingaling
always results in total loss. ALWAYS. That’s why all the greatest traders in the world never martingale. As Paul
Tudor Jones said “Only losers average losers.”
Position sizing is the true secret of successful trading but to explore it fully you need to really engage with the
market on a daily basis so come
join us at BK
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and start your journey.