Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner

Keep Out of Those Switches! by Martin Lindkvist with the Assistance of Victor Niederhoffer

With excuses to Bacon.

"Some amateur traders carry inconsistency to such a degree that they demand consistency from the market, while at the same time being utterly inconsistent in their methods of trading. It's not the markets that beat these traders - it's the switches!

Trading is simple. Everything about the game is logical and common sense and elementary. You don't need a whole staff of PhDs. All the figuring and the mathematics and the mechanics of trading can be understood by a child in junior-high school. But the game is decked out in an endless number of minor contradictions and open switches and deadfall traps, in order to lure the average trader into doing everything wrong.

If the average trader kept out of all these switches and traps, then the powers-that-be would have to make the markets far more complicated in order to insure the fact that the majority of traders continue to lose and thus continue to furnish money to keep up the market.

The amateurs who trade so carelessly and who fall into all the wrong switches, do not stop to consider the percentages of their rightful losses. When an amateur goes to the market and loses nine days or months in a row and loses all his capital, he has lost many times what the percentage calls for. He has no right to lose so much. It's almost as if he did it on purpose!

Look at the percentages. For example, suppose the stock market goes up an average of 5% per year. If so, a blind play on January 1st, or February 6th, or any mechanically designated day and holding for a year, will give 5% per year, over a period of time.

The amateur trader makes every possible wrong move and gets caught in every wrong switch. Thus the careless trader loses from 33% to 100% of total trading capital over a period of time, instead of earning from 5% and more per year on the money put in the market.

The amateur goes long only to have the stock turn south. He goes short and the stock stands still. He goes short a straddle only to have the stock start swinging violently and then sink down. Then when he switches back to short the stock runs up ten percent.

This situation gives a rough idea of why some system promoters claim - and rightly - that for the average trader, any system is better than no system at all! At least the system, no matter how bad it is, keeps him out of the switches.

But, of course, we are not studying here to play any senseless systems or methods. We want to play the smartest angles and plans of the "insiders" and the professionals. And it should be clear to straight thinking readers that what the professionals win is the difference between the amateurs actual losses of from 33% to 100% of betting capital and what the markets move up over time, minus commissions.

The professionals, including the hedge fund managers who make good from putting a stake available to other peoples trading, can win no more than this margin. The market gives its 5% first (for example) and then the balance of what the amateurs lose is cut up among the professionals. Once a student of trading learns to view the whole picture of trading operations as a picture of percentages, all these facts of life become clear.

As noted, it's the switches and not the markets that beat the amateur trader. A whole volume of books could not record all the possible switches that the amateurs can get themselves into. But here are a few that the professionals take good care to avoid:

First there is the switch of position: The professional trades long, only, because there is the least unfavourable percentage against a long position due to long term positive market drift. He never goes short; that keeps him out of the amateur's position switches.

Besides sticking to long positions only, the professional always makes trades of even amounts. He isn't like the amateur who lets greed or fear change the size of his trades. The beginner plunges on a trend that suddenly turns, then puts on a light trade on a contrarian situation that does turn around. He keeps switching amounts and positions so that he never has a worthwhile trade on when the market goes his way. He is always one day behind the direction of a stock and several days behind the rhythm of the market.

The professional trader gauges his capital so that he has a planned series of trades of even amounts. If he is a big winner at the end of one month and feels that the next month will be good, he plans for a series of slightly larger trades for the entire next month. If he is not too pleased about the outlook for the next month, he plans on using a smaller scale of even trades for the whole month.

The amateur never does anything right when it comes to the handling of trading capital. He trades heavily when he has just gotten his bonus or the fund he's managing gets new inflow, which if it is in spring is the poorest time of the year for the amateur's corny method of picking the trending favourites. Then in the summer he trades heavily again on the type of contrarian setups that he should have traded in the spring, but summer is usually more serially correlated, so he loses.

In late summer the trader feels the pinch in the bankroll department. He trades lightly. By early fall he has used up most of his trading capital, so he can only make one trade. It is a stab on pyramiding a three week move that loses when the Fed chief blocks the move and the market crashes in the end of the third week when the first two weeks were up. Then when winter comes he has no money with which to trade, even if a terrific setup for a trade presents itself.

One of the worst (and most common) switches of all is to change methods of trade selection without giving the first method a fair chance to win. That is one of the switches that the professionals avoid by doing a statistical workout of their methods before actual trading, so that they know just what to expect. Amateurs switch from one method, one news story, one hunch, one angle, one stock, or one type of market to another, without reason.

The first wrong switch breeds a fear of wrong switches, which automatically puts the trader into an endless chain of unfortunate decisions. For example, the amateur starts trading bearishly based on some reports of terrorists threats or the negative outlook for the dollar. But he changes to long positions based on the good earnings reports, just before the market tumbles in a fine losing streak. He is afraid, at first, of getting caught in another switch, so he dares not jump right back to shorts based on that Roach is coming out with a gloomy view. He sticks to the fact that consumer sentiment continues to rise. But the markets continue to go down while all his news stories are bullish. Finally he can't stand it any more, so he goes back to short because the President is losing trust among the voters or because some species somewhere caught a virus. Yes, he goes back, just in time to run into the long overdue streak of up days.

But there is now use kidding: The professionals keep out of switches by waiting for the sound trades with a positive expectancy. They don't take bad trades at any end of the trading week. They don't take bad trades - period!

Everybody knows that there is no better sport or entertainment than taking family or listmembers to the market for a day's fun. Everybody eats and drinks from the meals for a lifetime and laughs and hollers. Everybody in the party makes crazy statements as basis for trades, such as "It's like 87 again", "May is down a lot just like in 2000, better sell it all" or "It's inverted, the market always goes down when it's inverted", or "Everybody's long, is there a psychological disjoint", and then shrieks "I was right all along" as the market breaks down the last 15 day stretch. That's some fun! But it's fun only. It's not professional play.

The Professionals always remember that it's not the markets that beats the trader - it's the switches.