On Designing a Trading System-II, we will deal with some basic facts to raise awareness about the realities of the trading business. That information is necessary to avoid the typical psychological flaws most (unsuccessful) trader have.
Key Facts
Economic information translates gradually to price changes. Future events aren’t instantly discounted on price. That is the reason for the existence of trends.
Leverage produces instability in the markets because participants don’t have infinite resources to hold to a losing position. That’s one reason of the cyclic nature of all markets and their fat tail probabilistic density distribution of returns.
There is a segmentation of participants by their risk-taking potential, objectives, and, therefore, by time-frames, because less risk means a shorter time-frame and shorter targets.
The market reacts to new strategies. A new strategy has diminishing returns as it spreads between market participants.
The Market forgets at a long timescale. The success rate of market participants is less than 10%. Therefore, there is a high turnover rate. A new generation of traders rarely learn the lessons of the previous one.
There is no short-term link between price and value. Therefore, the short-term price is the result of the market noise.
The market as a noisy structure
All these facts make the markets chaotic, with a fractal-like structure of price paths. That is, a place with millions of traders trading their beliefs, but everyone with a different timeframe and expectations.
That is ok, as no trade is possible if all market participants have the same viewpoint. But the result of hundreds of thousands of beliefs and perspectives is that the market is as noisy as the random path of a coin flip game. Fig. 1 shows the paths of three 200-coin-flip-bets. They closely resemble the paths of currency or futures markets.
Too much freedom is dangerous
The marketplace is an open environment where a trader can freely choose entry time, direction, the size of her trade and, finally when to exit. No barrier nor rule forces any constraint on a trader. Such freedom to act is the difference between trading and gambling, but it’s a burden to discretionary traders, especially new to this profession because they tend to fall victims of their biases.
The main biases that a novel trader suffers are the need to be right and the belief in the law of small numbers. These two biases combined are the main culprits for the trader’s bias to take profits short and let losses run. The need to be right is also the culprit for the trader’s inclination to prefer high-frequency of winners instead of high-expectancy systems.
To counteract this unwanted behaviour, the trader needs to restrict his freedom by forcing strict entry and exit rules that guarantee a proper discipline and ensure the expected reward to risk, and, at the same time, avoiding emotionally driven trades.
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