The Trading Environment: The Drunkard’s Walk

January 11, 2019

Introduction

In recent years, investors have turned their attention to the currency markets as a way to achieve their financial freedom. Forex is perceived as an easy place to achieve that goal. Trading currencies don’t know about bear markets. Currency pairs simply fluctuate driven by supply and demand in cycles of speculation-saturation, explained by behavioural economic science and game theory.

It looks straightforward: buy when a currency raises, sell once it falls.

However, this idyllic paradise has its own hell. The novel investor gets into this new territory armed with beliefs that fitted well in his normal life but utterly wrong when trading. Some say the market is rigged to fool most traders, however, the reality is that traders fool themselves. A shift in their core beliefs – and in the way they think- is critical for them to succeed.

The purpose of this paper is to boost awareness concerning the main issues the trader faces.

The true knowledge about the nature of the trading environment
The nature of risk and opportunity
The key success factors when designing a system

The trading environment

Usually, people approach the study of the market environment by focusing mainly on market knowledge: Fundamentals, world news, central banks, meetings, interest rates, economic developments etc. At that point, they interminably analyse currency technicalities: Overbought-oversold, trends, support-resistance, channels, moving averages, Fibonacci and so on.

They think that achievement is identified with that sort of information. According to this, a trade had a positive outcome because they were right about the market, and when not it is because they made a mistake.

Huge amounts of paper and bytes have been spent in books and articles on those topics, yet there’s a hidden reality down there not yet revealed, despite the fact that it’s the primary cause for the failure of the majority of traders(the other one is over-leverage and over-trading).

What would be the account balance on a fair coin flip game, starting $100, after 100 bets if you earn $1 when heads and lose $1 when tails?

Many would say close to zero, and they might be right, but this, below, is just one possible path:

Fig 1: 100 flips of a fair coin flip game

Other paths might appear, for instance, this one that loses more than $20:

Fig 2: 100 different fair coin flips

The second path seems taken from a totally different game, but random processes are surprising, and usually fools us into believing these two graphs are the result of different games (distributions) although they’re not.

If we make a graph with 1,000 different games, we’ll observe this kind of image:

Fig 3: 1,000 paths of a fair coin flip 100 flips long

Below, a flip coin with a small handicap against the gambler:

Fig 4: 1,000 paths of an unfair coin flip

Finally, a coin flip game with a slight advantage for the player:

Fig 5: 1,000 paths of a coin flip with an edge

And that’s the genuine nature of the beast. These figures above correspond to diffusion processes and each path is called a random walk. Diffusion processes-happens in nature, likewise, for instance, as a smoke column sprouting out of a cigarette or the spread of a blob of watercolour in clean water.

Our first observation regarding fig 4is that the mean of the smoke cloud drifts with a negative slope. Hence, after the 100 games, just about 1/3 of them lie above its initial value. Furthermore, we may observe that even on the fair coin case 50% of paths end in negative territory.

The coin flip with an edge game (fig 5) is the only long-term winner, although, short term it may be a loser. In fact, before the first 20 flips, close to 50% of the games are underwater, and at flip Nr. 100 about 35% of all paths keep losing money.

Were this game a trading system, it would be a fairly good one, with a mean profit of 70% after 500 trades, but how many traders would hold it after 50 trades? My guess: only those 30% lucky traders. The rest would reject it, even though its long term performance is good enough.

Below fig 6 shows a diffusion graph of 1500 bets of that game, roughly the estimated trades of a system with a mean of 6 daily bets for one year. We notice that every path ends positive and the mean total profit is about 200%. By the way, the edge in this game is merely a reward-to-risk ratio of 1.3 to one, while keeping a fair coin flip.

Fig 6: 1,000 paths of a coin flip with an edge

Before going into explaining the psychological aspects of what we’ve seen so far, let me present some learned observations, regarding this phenomena:

The nature of the random environment fools the major part of the people.
Having an edge is no guarantee for a trader’s success (short-term). There are unlucky paths.
A casino game (and the market as well) collects money from endless hordes of gamblers with thin pockets and weak hands. This happens for one of two reasons: They have no profitable system or they stop trading his system before it could manifest its long term advantage.
Casino owners, knowing the math of gambling, protect their business against volatility using diversification ( multiple customers) and bet limits (only small gamblers allowed).
Therefore, to lower the overall risk a trader should use several uncorrelated paths (trades) at the same time, as does the casino owner.
Proper position sizing is the way to go to protect the account from a catastrophic trade or a losing streak.
A system without edge is always a loser, long term.
A trader without proper psychological attitude is a loser no matter what.

The Trading Environment: The Drunkard’s Walk

Introduction

The trading environment

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